Thinking Like a
Modern Economist
CHAPTER
6
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Thinking Like a Modern Economist
McGraw-Hill/Irwin
Economics is what economists do.
— Jacob Viner
Teach a parrot the words ‘supply’ and
‘demand’ and you have an economist
Thomas Carlyle
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.

Thinking Like a
Modern Economist
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Thinking Like a Modern Economist
• Present a problem to an economist and he/she will try to fit it to a specific model or build a new one
• A model is a simplified representation of the problem or question that captures the essential issues
The Great Depression
Stagflation

Thinking Like a
Modern Economist
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Economic Models
• Mathematical e = mc 2
• or heuristic expressed informally in words
Characteristics
• more often use more of an inductive, as opposed to deductive, approach

Thinking Like a
Modern Economist
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Behavioral vs Traditional Economics
• Traditional – more reliance on relatively simple algebraic or graphical models such as the supply and demand model
-provide simple and clear results, which can highlight issues that behavioral models cannot

Thinking Like a
Modern Economist
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Behavioral vs Traditional Economics
• Behavioral use a broader set of building blocks than rationality and self-interest
• Seem to use real-life situations to explain and illustrate economic concepts
• People behave purposefully reflecting reasoned but not necessarily rational judgment
• Act with enlightened self-interest people care about other people as well as themselves

Thinking Like a
Modern Economist
The Limits of Heuristic Models
• Most are simply a stepping stone to a more formal model
• They must be extended to quantify and empirically test the arguments for a true understanding
• To have meaning, data have to be interpreted using theory, models, and building blocks to be meaningful
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Thinking Like a
Modern Economist
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Examples
• story of Martin and Joan.
• extends personal level to all of society.
• uses empirical data/estimates for support.

Thinking Like a
Modern Economist
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• Compares rates in Philadelphia and Ithaca, NY.
• a path-dependent model.
• people in Philadelphia did not buy insurance so rates went up.
• people in Ithaca did, so rates went down.
• this can be applied to the current health care debate.

Thinking Like a
Modern Economist
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Examples
Which would you prefer?
Getting paid $30,000, then $27,000, then
$24, 000 over 3 years or
$24,000, then $27,000, then $30,000 over 3 years

Thinking Like a
Modern Economist
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Examples
or
Return a lampshade (or maybe a shirt) that didn’t get rung up?

Thinking Like a
Modern Economist
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Examples

Thinking Like a
Modern Economist
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Empirical Work in Modern Economics
• Modern economics is highly empirical
• Both traditional and modern behavioral economic building blocks rely on experiments and statistical analysis of real world observations
• An empirical model is a model that statistically discovers a pattern in the data
• Econometrics is the statistical analysis of economic data

Thinking Like a
Modern Economist
Regression Models
• an empirical model in which one statistically relates one set of variables to another
• A regression finds a line that best fits a combination of points
• The coefficient of determination is a measure of the proportion of the variability in the data that is accounted for by statistical data
• The larger the coefficient of determination, the better the fit of the regression
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Thinking Like a
Modern Economist
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Regression Models
Can show the relationship between Class Size and Average Grades
Average
Grade
4
3
2
1
50 100 150 200 250
Class
Size
• The development of computers and empirical models has changed how modern economics is done

Thinking Like a
Modern Economist
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Examples
Gather data about rainfall, weather and other factors
Wine quality = 12.145 + 0.001 (winter rainfall) +
0.26 (average growing season temperature) –
0.004 (harvest rainfall)

Thinking Like a
Modern Economist
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Other Formal Models
• Set theory models are based only on formal logical relationships
• 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
• The agent-based computational (ACE) model is a culture dish approach to the study of economic phenomena in which agents are allowed to interact in a computationally constructed environment and the researcher observes the results of the interaction

Thinking Like a
Modern Economist
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Modern Traditional and Behavioral Economists
Earlier
Economics
Modern Economics
Modern Behavioral
Economists
Modern Traditional
Economists
Assumptions
Approach
Types of
Models
Rationality
Self-Interest
Purposeful behavior
Enlightened self-interest
Rationality
Self-Interest
Deduction
Simple S/D models
Induction and deduction: emphasis on experimental economics and on empirical models
Induction and deduction: emphasis empirical models
All types including complex mathematical models and ACE models
All types including complex mathematical models and ACE models