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    01 Econ 326 Fundamentals

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    Models are fundamental tools in economics that provide simplified descriptions of the real world to focus on specific forces and questions. There are two main types of models: theoretical models from economic theory and empirical models designed to test theory. Empirical models can be predictive, aiming to accurately forecast outcomes, or inferential, seeking to understand relationships between variables. Structural models directly connect to economic theory while reduced form models indirectly test theory. Causal models are needed to answer questions about cause and effect relationships.

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    01 Econ 326 Fundamentals

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    Models are fundamental tools in economics that provide simplified descriptions of the real world to focus on specific forces and questions. There are two main types of models: theoretical models from economic theory and empirical models designed to test theory. Empirical models can be predictive, aiming to accurately forecast outcomes, or inferential, seeking to understand relationships between variables. Structural models directly connect to economic theory while reduced form models indirectly test theory. Causal models are needed to answer questions about cause and effect relationships.

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    Models are fundamental tools in economics that provide simplified descriptions of the real world to focus on specific forces and questions. There are two main types of models: theoretical models from economic theory and empirical models designed to test theory. Empirical models can be predictive, aiming to accurately forecast outcomes, or inferential, seeking to understand relationships between variables. Structural models directly connect to economic theory while reduced form models indirectly test theory. Causal models are needed to answer questions about cause and effect relationships.

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    Download as pdf or txt
    15 views14 pages

    01 Econ 326 Fundamentals

    Uploaded by

    reet
    Models are fundamental tools in economics that provide simplified descriptions of the real world to focus on specific forces and questions. There are two main types of models: theoretical models from economic theory and empirical models designed to test theory. Empirical models can be predictive, aiming to accurately forecast outcomes, or inferential, seeking to understand relationships between variables. Structural models directly connect to economic theory while reduced form models indirectly test theory. Causal models are needed to answer questions about cause and effect relationships.

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    of 14

    01 - Fundamentals

    Jonathan Graves

    12/15/22

    Models in Economics

    What do we mean when we talk about “models” in economics? To get us started with this
    question, let’s think about what we already know.

    • Can you give me an example of an economic model?


    • Is your model theoretical or empirical?
    • Why do we use this particular model?

    Models are Fundamental

    Models are fundamental in economics

    • They provide a formal but simplified description of the real world


    • This allows us to focus on the forces and questions which we are interested in → ab-
    straction
    • However, they are also limited by their very nature

    A model is only as good as we build it - so how do we build models? And understand them?

    1
    Figure 1: Title

    Figure 2: Understanding Models

    2
    Figure 3: Outline

    Figure 4: Data

    3
    Figure 5: Marbles

    4
    Figure 6: Research Questions

    Figure 7: Models

    5
    Figure 8: Examples

    Figure 9: Correlation

    6
    Figure 10: Classification

    7
    Predictive versus Inferential Models

    A key concept in econometrics concerns the purpose to which a model is applied: predictive
    or inferential. Imagine we have a very general model:
    Figure 11: Prediction

    Figure 12: Clustering

    8
    𝑦 = 𝑓(𝑥|𝛽)

    • 𝑦 is some outcome variable we care about (e.g. earnings)


    • 𝑥 is a (set of) variable(s) we think influence 𝑦 (e.g. education)
    • 𝑓 is the relationship between 𝑥 and 𝑦
    • 𝛽 is a (set of) parameters which describe the function 𝑓

    When we estimate a model, we try to figure out what 𝑓 is relying on data about 𝑥 and 𝑦 -
    usually by evaluated different choices for 𝛽.

    Estimation Outcomes and Models

    • When we estimate the model, we will come up with some optimal value of 𝛽 - let’s call
    it 𝛽.̂
    • This also allow us to calculate fitted values of 𝑦 using this value: 𝑦 ̂ = 𝑓(𝑥|𝛽)̂
    – We can also figure out the error of the model: 𝑦 − 𝑦 ̂

    The key issue we have here is which of these outcomes to do we care about?

    • Do we care about the fitted values 𝑦?̂


    • Or do we care about the estimated parameters 𝛽?̂

    Predictive Models

    When we use a model to try and figure out 𝑦 ̂ we refer to this as a predictive model.

    • In general, most data science applications (e.g. machine learning, AI) are predictive in
    nature.
    • We are interested in creating a really flexible, accurate model - and don’t care about how
    it does that prediction.

    Inferential Models

    When we use a model to try and figure out 𝛽 ̂ we refer to this as an inferential model.

    • In general, many econometric applications are inferential in nature


    • We care about the relationships, summarized by 𝛽, but don’t necessarily care about the
    overall estimation’s accuracy

    This is not by any means a general truth!

    9
    Example

    Réka Juhász (2018): Temporary Protection and Technology Adoption: Evidence


    from the Napoleonic Blockade

    • Wanted to study the impact of temporary trade protection on technology adoption


    • Is not trying to study or predict all technology adoption, only the affect of trade protec-
    tion on it

    Structure and Reduced Form

    In econometrics, we actually take this idea one step further. Generally, economists are inter-
    ested in testing theoretical models: i.e. formal descriptions, from economic theory, of how
    an economic situation operates.

    • The extent to which an empirical model connects to the underlying economic theory is
    called structure
    • Models which have very close connection to a model from economic theory are called
    structural models
    • Models which test an economic theory indirectly are called reduced form models

    This is where the terminology “theoretical” versus “empirical” model comes from. Theoretical
    models are economic models while an empirical model is an econometric model designed to
    test the theory.

    Example

    Why do we care about structure?

    Generally, structural models are much more complex and difficult to estimate. So why do we
    use them?

    • The key advantage lies in the connection to a theory


    • If the structure models lets us estimate the properties of an economic model, we can
    then use that economic model to perform prediction
    • But not just any prediction: counterfactual prediction. That is, prediction which is
    not based on pre-existing patterns in the pre-existing data

    This is critically important in economics, because “the past can be a misleading guide to
    current affairs”

    10
    Lucas Critique

    In economic, this forms the basis of a famous argument called the Lucas critique - articulated
    by Robert Lucas (1976).

    “Given that the structure of an econometric model consists of optimal decision


    rules of economic agents, and that optimal decision rules vary systematically with
    changes in the structure of [variables] relevant to the decision maker, it follows that
    any change in policy will systematically alter the structure of econometric models.”
    (p. 41)

    Basically, many (all?) economic models involve agents who make decisions, and those decisions
    are based on both past outcomes, and their expectations of future outcomes.

    • This means that when we observe a relationship in economic data, it is implicitly a


    description of both what happened in the past, and what economic agents believe will
    happen in the future.
    • Thus, if we wish to evaluate changes (such as government or macroeconomic policy), using
    models trained on historical relationships will be misleading, because those relationships
    include expectations about the policy, which has changes

    Structural models avoid this problem by identifying invariant properties and estimating them,
    allowing for this kind of counterfactual estimation.

    Example

    Suppose we are trying to forecast how much revenue a tax on gasoline will earn the govern-
    ment.

    • What would be the short-run implications?


    • What about the long-run implications?

    Better Example

    Cause and Effect in Models?

    One final element of models concerns what kinds of questions we want to answer with them.

    • One important category of questions are causal questions: that is, questions about cause
    and effect

    11
    Figure 13: Machine Uprising - (c) Zach Weinersmith SMBC 2022

    12
    Ď Tip

    These can normally be phased as “does A cause B?” or “to what extent does A cause
    B?”

    • Many important economic questions are causal in nature, but not all. Other types of
    questions are associative (or correlational) in nature.

    It’s important to remember that both kinds of questions are valuable, but we need to use
    models that are appropriate for them.

    Causal Models

    We refer to econometric models that are design to study cause-and-effect questions as causal
    models.

    • These are nested within a framework which allows us to relate specific parts of the model
    (e.g. parameters) with cause-and-effect relationships
    • In general, causal models require data with specific properties in order to be used
    • One classic example is an experiment: this is a causal model, but it relies on experi-
    mental data in order to work.
    – This experimental data also needs special properties (e.g. randomization)

    We will revisit this topic at the end of the course.

    Example

    Learning Objectives

    The key things you should be able to do after this unit are:

    • Explain why economists use models, and the difference between a theoretical and empir-
    ical model
    • Describe some stylized types of models (e.g. correlation, prediction) and their uses
    • Explain the difference between inferential and predictive models, and determine which
    model is appropriate in different situations
    • Explain structure in a model, and what reduced form versus structural models mean
    • Understand the Lucas crituqe, and give examples of how it applies, and why structural
    models are important in economics
    • Explain what a causal model is, and how they are different from other models
    • Identify whether a question is causal or associative in nature

    13
    Figure 14: Body Image Article

    14

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