ECN 104 Fall 2024 The Economic Approach (Chapters 1 & 2) PDF

The Economic Approach (Chapters 1 and 2) * ECN 104 - Fall 2024 September 6, 2024 1 / 71 Outline The Economic Approach First principle of economics: Optimization Second principle of economics: Equilibrium Third principle of economics: Empiricism...

The Economic Approach (Chapters 1 and 2) * ECN 104 - Fall 2024 September 6, 2024 1 / 71 Outline The Economic Approach First principle of economics: Optimization Second principle of economics: Equilibrium Third principle of economics: Empiricism Economic questions and economic methods Example: The Return on Investment of University Education Randomization 2 / 71 What is the economic approach? - A couple of definitions: - “Economics is the study of how societies use scarce resources to produce valuable commodities and distribute them among different people” (Samuelson and Nordhaus, 1995) 3 / 71 - A couple of definitions: - “Economics is the study of how societies use scarce resources to produce valuable commodities and distribute them among different people” (Samuelson and Nordhaus, 1995) - “Economics is the study of how agents choose to allocate scarce resources and how those choices affect society” (Acemoglu et al., 2022) 4 / 71 - Economists study human behaviour - Choice - not money - is the unifying feature of all the things that economists study - Economic agent = any group or individual that makes choices, such as consumers, firms, parents, politicians, etc. 5 / 71 Figure: Examples of economic agents 6 / 71 - Going back to our definition: “Economics is the study of how agents choose to allocate scarce resources and how those choices affect society” (Acemoglu et al., 2022) - What does it mean to be “scarce”? 7 / 71 - Scarce resources are things that people want, where the quantity that people want often exceeds the quantity that is available. - Scarcity is the situation of having unlimited wants in a world of limited resources. - Imagine a bowl of chocolates... 8 / 71 Positive Economics Describes what people actually do (some people take more than one and not everyone got a piece) Normative Economics Recommends what people, including society, ought to do (Each student should just take one so that everyone gets a piece) 9 / 71 Normative analysis and public policy Normative analysis also generates advice to society in general Figure: Examples of economic agents 10 / 71 Microeconomics The study of how individuals, firms, and governments make choices Macroeconomics The study of the whole economy 11 / 71 How would you classify the following: - The inflation rate - The market for coal-fired electricity generation - Environment - Understanding how sleep affects students’ grades - The growth rate of a country’s total economic output 12 / 71 - These definitions are silent about what the “economic approach” is. - What kind of behaviour drives the usage of the scarce resources? The production of these valuable commodities? Who gets to consume what? 13 / 71  - What is the economic approach? - The Economic Approach: ”The combined assumptions of maximizing behaviour, market equilibrium, and stable preferences, used relentlessly and unflinchingly, from the heart of the economic approach as I see it.” (Becker 1976, p.5) - The economic approach consists of four components: 1. Stable preferences 2. Optimization 3. (Market) equilibrium 4. Empiricism 14 / 71 Breadth of the economic approach - The economic approach is not limited to the market sector (market for goods/services, stock market, unemployment, among others) - Also useful in the analysis of the non-market sector (discrimination, human capital, marriage, fertility, crime, among others) - The economic approach applies uniformly to ALL areas of human behaviour 15 / 71 A powerful tool - Well known/obvious results of this approach: - Downward sloping demand curve - Upward sloping supply curve - Why? - As prices (i.e., incentives) change, buyers/sellers re-optimize 16 / 71 - Not-so obvious results of this approach: - Not only prices, but shadow prices - When the “cost” of committing a crime increases (i.e., shadow prices of crime decreases) supply of crime goes down - When the “cruise time” for cab drivers goes down, supply of cab-rides increases (Becker, 1976) - When the shadow prices of children increases, demand for children decreases 17 / 71 Source: World Bank 18 / 71 Why is this approach such a powerful tool? The economic approach: 1. Stable preferences 2. Optimization 3. (Market) equilibrium 4. Empiricism 19 / 71 Three principles of economics: 1. Optimization = making the best choice possible with given information 2. (Market) equilibrium = when everyone is optimizing; no one would be better off with a different choice 3. Empiricism = using data to figure out answers to interesting questions 20 / 71 First principle of economics: Optimization - Economists believe that people optimize - In other words, based on benefits (from preferences/priorities) and costs (constraints) people make the best feasible choice - People don’t always succeed in optimizing - we are not calculating machines - but people generally try to optimize 21 / 71 Discussion: Optimizing your time As a student, you have to determine how to allocate your time to studying, socializing, and sleeping in a 24 hour day. How much time to you dedicate to each activity? You must allocate at least 4 hours to sleeping. Discuss in groups! - NOTE: Think about trade-offs, your preferences, and constraints (i.e., you are constrained with the number of hours in the day, and having a minimum of 4 hours of sleep). - What are the benefits and costs of studying, socializing, and sleeping? 22 / 71 First principle of economics: Optimization - Benefits - Benefits depend on preferences or priorities - So benefits can include your preference for fairness, equity (not just money) - But economists have no say about your preferences or priorities - We are not here to tell you what to like or dislike - But based on what you like, and the resources you have, economists can tell what your optimal choice should be 23 / 71 First principle of economics: Optimization - Costs - Economists think differently about costs - Consider Facebook - by early 2023, 2.9 billion users spent over 1.5 billion hours per day on Facebook - Clearly people love Facebook, but why? 24 / 71 - If you asked Facebook users why they use it, they might say... - It’s fun - Easy way to stay connected to family and friends - It’s accessible and convenient - It’s free - BUT, is Facebook really free? 25 / 71 Opportunity costs Even if you don’t pay Facebook to use it, what is the value of the time of its users? - Let’s consider wages: - $9 minimum wage in high-income countries - $1 minimum wage in low-income countries - Half of Facebook’s users are in low-income countries: weighted average = 0.5($9) + 0.5($1) = $5 - We assume a $5/hour opportunity cost of using Facebook 26 / 71 Opportunity cost - All choices have opportunity cost (an alternative option) - Sometimes, people find it hard to consider the opportunity costs of a choice (particularly if it is non-monetary) - Get used to assessing monetary value to opportunity cost 27 / 71 - So Facebook has its costs - Are you spending the optimal amount of time on Facebook? - That’s your decision! - You probably know the benefits of using Facebook (try hard to put some monetary value to it) - But using Facebook because it’s free should NOT be the reason - Make sure you consider the opportunity cost 28 / 71 Optimization, trade-offs, and budget constraints What is the optimal level of crime? - Pollution? Poverty? - Spending more money on crime reduction means less money on education, social programs, etc. - Also, reducing the last bit of crime is very costly - Trade off! Again, benefits vs. costs! 29 / 71 Optimization: benefits vs. costs - Optimization is about balancing out benefits and costs - Cost-benefit analysis - All optimization problems involve trade-offs - Trade-offs arise when some benefits must be given up in order to gain others 30 / 71 - A budget constraint is the set of things that a person can choose to do (or buy) without breaking her budget - Economists use budget constraints to describe trade-offs - Evaluating trade-offs can be difficult, because so many options are under consideration - Again, opportunity cost is the best alternative use of a resource - Economists sometimes try to put a monetary value on oportunity cost (e.g., our FB example) 31 / 71 Something to ponder... - Are Google services free? - Google (i.e., Alphabet) provides a number of services for free (up to a certain extent) - Q1: Are they really free? - These services are costly to provide for Google - Q2: So, is Google being irrational? 32 / 71 - It is not entirely free because we give up our privacy - Google is in the business of selling ads - So Google is clearly optimizing - Optimization tells us that we should weigh both the benefits and costs when making a decision 33 / 71 Three principles of economics: 1. Optimization 2. (Market) equilibrium 3. Empiricism 34 / 71 Second principle of economics: Equilibrium Equilibrium: A situation where no one benefits by changing his/her behaviour 35 / 71 Second principle of economics: Equilibrium Equilibrium: A situation where no one benefits by changing his/her behaviour 36 / 71 Why do we care about equilibrium? - Imagine an environment (or situation, market) where lots of optimizing individuals interact - What will happen in that environment? - It will move towards an equilibrium - The economic model will have predictive power about this equilibrium - Potentially allow “changes” in the environment 37 / 71 Is equilibrium always great? - But equilibrium is not always “nice” - E.g., free-riding 38 / 71 The economic approach in practice - Given the situation/environment you want to analyze: - Who are the decision makers, and what are their preferences? What incentives do they face? - Convince yourselves that these decision makers will pursue optimizing behaviour! - If everybody pursues optimizing behaviour, what is the likely equilibrium? - Do you want to change this environment so that the new equilibrium is a “better one” for you? 39 / 71 Three principles of economics: 1. Optimization 2. (Market) equilibrium 3. Empiricism 40 / 71 Third principle of economics: Empiricism - We are not just armchair economists! - We don’t just ponder theoretically and hypotheticallly about the questions that interest us 41 / 71 - We follow the scientific method - We develop theoretical models of the question - These models will have predictions - We test them with data: we evaluate the match between the models and the data - And we are rigorous, and careful with the data 42 / 71 Economic questions and economic methods Economic questions - Usually people are surprised by the broad range of issues that the economic approach can address - People generally associate “economics” with finance, stock market, the macro economy, money, etc. - Economists are interested in human behaviour, human decisions in general - And we can always apply the economic approach 43 / 71 - Think about the decision made by students to attend university. Why do they go to university? - Like any optimization problem you have to consider benefits and costs - Clearly there are costs: tuition + opportunity cost of time - You could be spending the money and time elsewhere - This is clearly an important decision - We can build economic models to explain your behaviour - Development of human capital? - Asymmetry in information: signalling? 44 / 71 Types of questions: - Health: - Will PR campaigns around the benefits of having a large family increase fertility? - Organizations: - Charitable organizations want to know cost effective ways of fundraising. IF we match donations $1 per $1, how much more can we fundraise? How about $2 per $1? $0.5 per $1? 45 / 71 - Human capital: - Should we spend more money on early childhood education or on high school students to increase high school graduation rate? - Can vouchers for private schools (i.e., use of public money for private schools) increase student achievement while reducing costs? - These are questions involving CAUSE AND EFFECT 46 / 71 A question and decision you have thought about and made already: - Is university worth it? Should you go to university? - It is a big investment - About $6,800 at universities for domestic students (2022/2023) - Costs of college, or vocational school - Plus, opportunity cost of time - So this is a very important decision made by high school students, and as economists we are really interested in understanding such behaviour/decisions Q: Does going to university lead to higher earnings? 47 / 71 Discuss: How would you go about answering the question does going to university lead to higher earnings? 48 / 71 Economic methods - How do we go about answering this question? - Use anecdotes? - My older cousins who have gone to college are doing really well financially! - Use causal observations? - Look at the most successful and rich entrepreneurs in Tech. Bill Gates, Steve Jobs, Mark Zuckerberg. - They are all college drop outs. Surely going to college doesn’t pay off. - Use intuition? - You have to be smart to go to university. You also must learn something useful there. Surely your annual earnings will increase after graduation! 49 / 71 - We are not armchair economists - We don’t just ponder theoretically and hypothetically about the questions that interest us - We follow the scientific method - We develop models of the questions - These models will have predictions - We test them with data: we evaluate the match between the models and the data - Example: Environmental exposure - Does increased exposure to large, unanticipated natural disasters affect how people vote for environmental legislation? - We can think about models for this and test it - E.g., increased exposure by 2 disasters may affect voting more than 1 disaster 50 / 71 Is university worth it? - Do university graduates have higher salaries? - Q: How would you answer this using data? - The natural approach for an empirically minded person is to gather mounds and mounds of data - This person might compare the salaries of those who have graduated from university to those who have not graduated from university 51 / 71 For example, something like this: It looks like university really pays off! Four years of an investment leading to higher earning throughout your working years! 52 / 71 Is university worth it? In this exercise, we are indeed looking at the correlation between annual earnings and college attendance. 53 / 71 For example, with a richer data set at the individual level we might observe something like this: Here, we see a positive correlation 54 / 71 - But does correlation imply causation? - Not necessarily! - Do ice creams cause drowning? 55 / 71 - Do ice creams cause drowning? - Of course not! What’s going on? - There is something that we have not considered here (e.g., hot weather, high temperature) that’s causing both! - Omitted variable - So we need to be careful when looking at just correlation - Correlation does not imply causation! 56 / 71 - Let’s say, we are confident about the causation - So lets think carefully about what’s behind these two numbers: these are average earnings 57 / 71 - Q: If you compared the high school graduates (i=1,2,...,10) to college graduate (i=11, 12,...,20), what differences would you find? - Of course, we already know about the difference in college degree - But what about other observable variables? - Let’s dig in deeper 58 / 71 - We might find out something that looks like... - For high school graduates (i=1,2,...,10): - Lower GPA, parents with lower income, lower teacher quality, etc. - Of course, on average - For college graduates (i=11,12,...,20): - Higher GPA, parents with higher income, higher teacher quality, etc. - Again, on average 59 / 71 First, the graph looks like the following: 60 / 71 But in reality... 61 / 71 - Let’s think about what this selection bias does to how we interpret the data - Some of the increased earning might not be because of college, but... - Better skills acquired before college - So we are likely overestimating the return to college! 62 / 71 - Then what can we do? - College data on GPA, income of parents, quality of teachers, etc. - Isolate the effect of college by looking at students who have similar GPA, parent income, teacher quality, etc. 63 / 71 - In other words, we are “controlling” for those observable variables! - Then, are we done? - What about other potential observable variables? Quality of schools; peer effects from friends; others? - What about unobservable variables that are really hard to measure: student motivation? And others that we are not even aware of. 64 / 71 - Economists (and other scientists) have developed statistical tools to overcome these problems - Highlights the power of experiments 65 / 71 Summary - But collecting data is not always easy - And much worse when we cannot observe the variables; the unobserved confounders - In this context, we want to introduce experiments - How can experiments help us solve the problems we just summarized? 66 / 71 Randomization-Random assignment - Say I shuffle 1,000 decks of playing cards into one pile (i.e., 52,000 cards) - I will successively draw cards from the pile - Each time I draw a card, I toss a fair coin. If it is heads, I placed the card in pile A. If it is tails, I placed it in pile B. - I do this until I have no cards left in the pile. 67 / 71 What does randomization give us? - Q: How many red cards in pile A? - Q: How many even cards in pile A? - How would your answers change if I substitute “A” or “B”? - They won’t change! - No matter which ’variable’ we look at, they are likely to be balanced across the two piles - Balanced on expectation 68 / 71 - Take the entire population of high school students in Toronto - For each one of them, we toss a coin: if heads, the student is placed in group A. If tails, in group B. - When I look at average GPA, parents income, teacher quality across the two groups, what will I find? - They will be balanced! 69 / 71 - As a thought experiment only...think about an experiment in Toronto schools - What if I send the students in group A to college and the students in group B end their education at grade 12? - And then, after 12-13 years, I compared the average annual earnings of both groups? - The selection bias is gone! - I don’t have to worry about the unobserved confounders because whichever they are they are balanced across the two groups! - No selection bias - Randomization into control and treatment gives us the appropriate counterfactual (group for comparison) 70 / 71 Next class: Optimization 71 / 71