Lecture Economics (9/e): Chapter 21 - David C. Colander

Chapter 21 - Thinking like a modern economist. After reading this chapter, you should be able to: Differentiate traditional economic building blocks from behavioral economic building blocks, explain what heuristic models are and how traditional and behavioral heuristic economic models differ, distinguish an empirical model from a formal model and list some formal models used by modern economists.

Economics is what economists do.

―Jacob Viner

Thinking Like a Modern Economist

Ø Differentiate traditional economic building blocks from

behavioral economic building blocks

Ø Distinguish an empirical model from a formal model and list some formal models used by modern economists

Ø Explain what heuristic models are and how traditional and

behavioral heuristic economic models differ

Ø Discuss how modern economics and traditional economics

differ in their policy prescriptions

Ø Economists are differentiated from other scientists because

they use different:

graphical, or algebraic)

Ø Models can be mathematical or heuristic which are

models that are expressed informally in words

Ø Modern economists are economists who are willing to

use a wider range of models than did earlier economists

Ø Modern economists use more of an inductive,

as opposed to deductive, approach to modeling

Ø Models can be made from physical components or as

computer simulations

Ø Applied-policy or engineering models are designed

to provide insight into policy issues

Ø Other models fall somewhere in between, there is no

firm line distinguishing science from engineering

Ø Scientific models are models primarily designed to

provide understanding of what is happening for the

sake of understanding

Ø Traditional economists are economists who study the

logical implications of rationality and self-interest in

relatively simple algebraic or graphical models such as the supply and demand model

Ø Behavioral economics is a microeconomic analysis that

uses a broader set of building blocks than rationality and

self-interest

Difficult to Test

Ø Behavioral economics depends on the specific context

of the choices involved so it has many models

Ø Many more patterns can be discerned in the data but it

is hard to know what pattern to focus on

Ø Experimental economics (laboratory and field

experiments) can test alternative building blocks

Ø Endowment effects, people value something more just

because they have it, can be included

Ø Most of the time when people learn about the results of an

economist’s analysis, it is a heuristic or verbal

discussion that conveys the essence of the model

Ø Generally, deeper in the discussion is the model and

behavioral or traditional building blocks can then be

Ø Economists have many types of models, such as verbal,

empirical, or formal, and modern economists use all of

them

• Most economists see heuristic models as simply a

stepping stone to a more formal model

• Heuristic models are not sufficiently precise, making their

validity impossible to test

• In a scientific sense we really don’t know anything more

about the world after using heuristic models than we did

before, therefore science is not based on heuristic models

• Heuristic models must be extended to quantify and

empirically test the arguments for a true understanding

Ø Modern economics is highly empirical

Ø Both traditional and modern behavioral economic building blocks rely on experiments and statistical analysis of real

world observations

Ø Econometrics is the statistical analysis of economic data

An empirical model is a model that statistically discovers

Ø The relationship in the heuristic model is empirically

studied

Ø The primary tool of an empirical economist is a

regression model which is an empirical model in

which one statistically relates one set of variables to

another

Ø A regression finds a line that best fits a combination of

points

Ø The coefficient of determination is a measure of the

proportion of the variability in the data that is accounted

for by the statistical model

Ø The larger the coefficient of determination, the better the

Ø Data, by themselves, have no meaning; they have to be

interpreted using theory, models, and building blocks

to be meaningful

Ø Economists use natural experiments which are events

created by nature that can serve as an experiment

Ø Modern economists use simple models, but they also

use models that allow for much more complex

relationships among variables

Ø In complex models, the aggregate economy can suddenly change depending on what people believe

Ø You can have a self-confirming equilibrium (an

equilibrium in a model in which people’s beliefs become

self-fulfilling) or a butterfly effect model (models in

which a small change causes a large effect)

Ø Although the S/D model is not complete, it is simple

There are many other types of formal models:

Ø Set theory models are based only on formal logical

relationships

Ø Game theory models are models in which one analyzes the strategic interaction of individuals when they take

into account the likely response of other people into their actions

Ø The agent-based computational (ACE) model is a

culture dish approach to the study of economic

Ø Three examples where a modern economist’s precepts

might differ from a traditional economist’s precepts:

1. How much emphasis should be given to benefits of

economic growth?

2. Should the government have done something

about the rise in housing prices in the early 2000s?

3. Are people saving enough?

Ø Traditional and modern economists offer different policy

recommendations based on their own building blocks

Ø Models are the glue that holds economics together but

economists differ in what models they use

Ø Modern economists use more of an inductive, as

opposed to deductive, approach to modeling

Ø Behavioral economists assume purposeful behavior and enlightened self-interested behavior

Ø Models based on modern building blocks fit observed

behavior better, but they are less general

Ø Models must be tested against the data

Ø An empirical model is a model that statistically discovers

a pattern in the data

Ø Two types of models used by modern economists are

game theory models and agent-based computational

models

Ø Modern economists use multiple frames, integrating

judgments about history, institutions, and the limitations

of the models