Chapter 1: Overview. Fall The aim of studying applied economic problems (micro & macro):

Transcription

1 Chapter 1: Overview Fall Applied Economic Analysis The aim of studying applied economic problems (micro & macro): Understanding and Predicting input! xxx! output E.g. Class size! xxx! Cognitive Achievement Import tari! xxx! Consumer welfare Quantitative easing! xxx! In ation rate (in the textbook, policy experiments ) Pencils & Papers only, or Data or Both? Economics as an empirical science! Whether you as an economist use data or not, the queen (or king) is empirical studies. (in my opinion) What is xxx? Two philosophies of empirical studies (J. of Economic Perspectives (2010, Spring)) 1. Leave it as a black box (Angrist & Pischke) Reduced form estimation Make use of experiments! 2. Seriously specify it (Keane; Sims; Nevo & Whinston) Structural estimation (Also see J. of Econometrics (2010, May)) Why can t we all just get along? (Rodney King, quoted by Rust (2010)) 1

2 2 Structural Approach 2.1 How to Formulate an Economic Problem: Optimization Formalize an economic problem as if - an individual agent (consumer, worker, family, rm, government, etc.) - chooses variables (consumption, occupation, marital partner, number of kids and when, how much to sell, trade policy, etc.) - to maximize her/his objective function (utility, pro ts, national interest, etc.) - subject to constraints (resources, time, budget, dishonesty-proof, etc.)! Well suited to the Optimization paradigm. (Economics has borrowed the theoretical tools developed in Applied Engineering in 1950s and 60s.) 2.2 How to Formulate an Economic Problem: Equilibrium Economists also care about aggregate consequences of many people s behavior. e.g. Subsidies for college education may make the future college educated worse o because their relative scarcity will drop down...?! Concept of Equilibrium - Supply and Demand in Market Economy (Market Equilibrium (Price Theory)) - Balance of guessing in strategic situations (Nash Equilibrium (Game Theory)) 2.3 What Do (Structural) Economists Want to Do After All? (Structural) Economists want to understand (and/or predict) how people behave by formalizing the problem and solving it. - Solution (one s choice of variables) is considered as a function of exogenous variables. Economists want to know how the solution varies as exogenous variables move (getting characteristics of the solution). - If they have observational or experimental data, they want to replicate agent s behavior that is close enough to the one in the actual data. 2

3 2.4 How to Solve an Economic Problem 1. Analytically: Get an explicit functional form of solution by simplifying the setting of the original optimization problem and/or employing simpler functional forms. 2. Numerically: Little interest in getting an explicit functional form per se. Rather, why not just write a Matlab or Fortran or C program to let a computer solve the problem. In the last one or two decades, Method 2 has been increasingly popular in economics (thanks to the IT revolution). e.g Nobel Prize: Finn Kydland and Edward Prescott (See Kydland s Noble Lecture (2006, AER, pp ).)! We can talk not only about in which direction but about how much in evaluating the e ects of policies (quantitative evaluation). 3 Dynamic Analysis Method 2 has been applied mainly to dynamic problems, because researchers often have to give up getting an explicit solution once they want to consider models that are close enough to the reality. They are the problems that do not make sense or at least are less meaningful if time elements are not considered. - Firm s investment, Individual s saving behavior... - Issues in one s life-cycle: Educational choice, Occupational choice, Family formation (marriage, raising kids, divorce), Wealth Accumulation, Life after retirement Recursive Formulation of a Dynamic Problem The characteristic feature that makes dynamics interesting/di cult: My behavior and (accidental) events today are a ected by a series of (my and other people s) behavior and (accidental) events up to today ( history ), and a ect (my and other people s) behavior (and accidental events) tomorrow. 3

4 Notice the Recursiveness of the above statement.! Richard Bellman s Dynamic Programming Example: One consumer/worker s decision problem over time: V t (s t ) = max c t;l t u(c t ; l t ) + E t [V t+1 (s t+1 )js t ] subject to c t + a t+1 = w t (l t ; h t ) + (1 + r t )a t h t+1 = g(h t ; l t ) - V t (): value (or value function) in period t a 1 and h 1 are given some values - s t = (h t ; a t ): state variables (that express her/his situation in period t) - (c t ; l t ): control variables (that he/she controls in period t) - If we want to explicitly consider w t () and r t as prices determined in the markets, we need to consider aggregation of state variables...(krusell and Smith (1998), Lee and Wolpin (2006)) 3.2 Computational Burden Comes to Bite When the decision-maker evaluates the consequences of her/his behavior in period t (V t ()), he/she is ready to evaluate, for each s t, E t [V t+1 (s t+1 )js t ] for each (c t ; l t ). To simulate the decision-maker s behavior over time f(c t ; l t )g t, economists want to calculate value V t (s t ) for all s t! Then, economists can replicate f(c t ; l t )g t - With Finite Horizon, can solve backward. - With In nite Horizon, solve for stationary rule c t = c(s t ) and l t = l(s t ). The problem is that the number of all s t s is humongous in many cases. But, for each s t, the procedure to calculate V t (s t ) is the same. 4 About the Textbook Emphasis on dynamic aspects of economic decisions Part I: Theory of dynamic optimization IO, Labor, International, Public, Macro... (your own eld!) Ch.2: Conceptual presentation Ch.3: How to solve it (numerically)! Matlab Ch.4: Econometrics: how to estimate a model (simulated data!!observed data (including data from experiments)) 4

5 Part II: Applications 5