Transcript Income effect

CHAPTER 2
Tools of Positive
Analysis
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
The Role of Theory

Economic models:

Theory plays a crucial role for empirical researchers by helping
them to isolate a set of variables that may influence a particular
kind of economic behavior.
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Empirical work then tests whether the theory is consistent with
real-world phenomena.

The most widespread method of empirical research in economics is
econometric analysis, because economists tend to be most
comfortable with results based on data from real-world
environments.
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However, honest econometrician can come to very different
conclusions, because the data and statistical techniques are
imperfect.
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The Role of Theory

The economic theory is set by both the
politicians and the economists.

There is one fact which is that there is lack of
definitive answers in economy because the
economists are generally unable to perform
carefully controlled experiments.

Therefore, we never know for certain the
consequences of various policy changes.
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The Role of Theory

Because economists generally cannot perform
controlled experiments with the economy, the
effects of economic policy are difficult to
determine.

Economic theory helps specify the factors that
might affect a given kind of behavior.
However, theory alone cannot say how
important any particular factor is.
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The Role of Theory

Empirical analysis: When doing an
empirical analysis we have to consider the
following:
1.
virtue of simplicity
2.
judging a model
3.
limitations of models
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Empirical research

Empirical research attempts to measure both
the direction and size of the effect of
government policy changes on behavior.

Common types of empirical studies are:
1.
Interview studies
2.
Social and laboratory experiments
3.
Econometric analysis
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1. Interview Studies

Interview studies consists of directly asking
people how various policies affect their
behavior.

Pitfalls:
1.
Interpreting interview surveys results
requires quotation.
2.
People may not actually react to policies in
the way they say they do.
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2. Experimental studies

Experimental studies are based on random
assignment to control and treatment groups.

Experimental studies are divided into:
1.
Social experiments.
2.
Laboratory experiments.
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2. Social Experimental studies

There is a problem to do empirical work in
economics because of the inability to do
controlled experiments with the economy.

Social experiments subject one group of
people to some policy and compare their
behavior with that of a control group.

Example: Public versus private schools.
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Pitfalls of Social Experimental Studies
1.
2.
3.
4.
5.
6.
Ethical issues: People are People.
Technical problems: Sample has to be
representative of the population.
Response bias: People are aware they are under
experiment.
Impact of limited duration of experiment: Life and
personal circumstances always change.
Generalization of results to other populations,
settings, and related treatments.
High costs.
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2. Laboratory Experimental studies

Laboratory experimental studies are used to
some types of economic decisions.

Pitfalls of laboratory experiments include:
1.
They occur in the artificial atmosphere where
persons may not replicate real-world
behavior.
2.
Undergraduate students are unlikely to be
representatives of the population.
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3. Econometrics Studies

Observational study – empirical study relying on observed data not
obtained from experimental study.

Sources of observational data


Surveys

Administrative records

Governmental data
Econometrics: It is the statistical analysis of economic data. In
econometrics, the effects of various policies are inferred from observed
behavior.

Regression analysis: It is used to pick the “best” parameters for an
economic model. Knowing the parameters allows one to predict the
effects of policy changes.
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Effects of Public Finance Policies

Substitution effect: With these high taxes,
it’s really not worthwhile for me to work as
much as I used to.

Income effect: With these high taxes, I have
to work more to maintain my standard of
living.

Both of the two effects can reflect perfectly
rational behavior.
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Types of Data

Cross-sectional data
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Time-series data

Panel data
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Causation vs. Correlation

Statistical analysis

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Correlation
Control group
Treatment group
Conditions required for government action X to
cause societal effect Y


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X must precede Y
X and Y must be correlated
Other explanations for any observed correlation must be
eliminated
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Conducting an Observational Study

L = α0 + α1wn + α2X1 + … + αnXn + ε
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Dependent variable
Independent variables
L
Parameters
Stochastic error term
A: dividends and interest rate, X1: age, X2: number of children, etc…
Regression analysis


Regression line
Standard error
Intercept
is α0
Slope
is α1
α0
wn
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Pitfalls of Econometric Studies

Misleading results occur if:
1.
Data from greatly dissimilar groups are combined.
E.g. unmarried and married women, old and young.
2.
Wrong mathematical form is adopted. Parameters
changes over time.
3.
Variables are incorrectly measured.
4.
Um-measurable variables are used including
perceptions and attitudes.
5.
There is simultaneous causation between variables.
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Quasi-Experimental Studies

Quasi-experimental study (= natural
experiment) – observational study relying on
circumstances outside researcher’s control to
mimic random assignment
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Pitfalls of Quasi-Experimental Studies

Assignment to control and treatment groups
may not be random

Not applicable to all research questions

Generalization of results to other settings and
treatments
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