Two Cheers for (Good) Theory

Everyone is having a grand-ole time cheering about the "new" empirical wave of economics. Write-ups about the recent Nobel winner, Angus Deaton, have talked all about his influence on data analysis:

His method of careful analysis of data from household surveys has transformed four large swaths of the dismal science: microeconomics, econometrics, macroeconomics and development economics.

He has brought microeconomics — traditionally a field populated by theorists — into closer connection with the data. Partly because of his influence, modern microeconomists are more likely to spend their days knee-deep in large-scale data sets describing the real-world decisions made by millions of people, and less likely to be mired in Greek-letter abstractions.

Much of the empirical revolution in economics has been enabled by the tools that Mr. Deaton developed. These tools reimagine the role of economic theory, using it to organize and interpret the tidal wave of data coming from the hundreds of household surveys conducted around the world each year.

Bloggers have gone nuts over it, but it's not only them. The John Bates Clark award has been heavy on the empirical micro lately;

(E)ssentially changing this prize from “Best Economist Under 40” to “Best Applied Microeconomist Under 40”. Of the past seven winners, the only one who isn’t obviously an applied microeconomist is Levin, and yet even he describes himself as “an applied economist with interests in industrial organization, market design and the economics of technology.”

I get it. Increased data and computational power have allowed us to do things we couldn't do 10 years ago. It has exploded.  Plus, for the blogosphere, the data turns into pretty pictures that we can all uuuhhh and aaawww at. FiveThirtyEight and others have made a whole industry out of this.

It's great. I love it.

But theory is ultimately the force that drives our understanding of the world. As Hayek wrote, the abstract is primary. That's why I love seeing Rakesh Vohra come to the defense of theory. I know; shocking that a theorist would defend theory... It's short, snarky, and spot on, as blog posts should be. (And hard to excerpt it so read it.)

If you'll indulge me and let another theorist try to defend the first theorist, using theory... I'll use a theory to try to think through the marginal benefits of theory and empirical work. I think Supply and Demand is a pretty useful theory for thinking through things... But I might be biased.

Let me try my best at making pretty pictures. (If FiveThirtyEight wants me to start designing charts for them, I'm available. Call me.)

Suppose because of a technology "shock" the marginal cost of empirical work declines. This causes a shift to the right of the supply curve of empirical work, lowering the marginal value of empirical work.

supplyshift (1)

This LOWERS the marginal value of empirical work. The next regression gives less value than before the technology shock.

If you believe, like I do, that empirical work and theoretical work are complements, then this should cause a shift of the marginal benefit of theoretical work. I don't think that markets adjust instantaneously, so there might be lag for the theory market to adjust to the change in the empirical market.

demandshiftIf this model gives us any insight into the markets for research, I'd say it says the exact opposite of the standard conclusion.

The marginal value of theory is now HIGHER, because of the "data" revolution. If today is between the shock and the final adjustment of theoretical work, the marginal value of the theory will continue to grow.

So I'll get back to my theory work...

Mas-Colell Chapter 5: Production

For readers who accept and enjoy Mas-Colell's treatment of consumer theory (the first pillar of his teaching method), producer theory (the second pillar) is smooth sailing. The concepts are parallel to consumer theory, but with less concern mess along the way with budgets and turning ordinal preferences into cardinal utility functions.

Production

For Mas-Colell, production is a black box. Some inputs enter the firm and some outputs leave the firm. Put another way, firms buy some goods and sell others. The netput of this process is the production vector 1. Most economists do not care how rubber turns into a tire or seed into corn. All of that occurs within the black box, the firm.

Of course, at anytime, firms need specific inputs to produce specific outputs. Any plans that are possible make up the production set. Just like the consumption bundle in consumer theory, production sets have some specific assumptions. The two key assumptions, which are not always obvious but key, are "No Free Lunch" and "Free Disposal"1.

While these have specific mathematical explanations, they have intuitive interpretations. No free lunch means that it requires inputs to get outputs. Nothing is free. This is obvious, but sometimes forgot. Free disposal means that firms can get rid of inputs at no cost. While this is more controversial, it basically allows us to rule out "too much stuff." We can always get rid of the stuff we do not use.

Firms look to choose the best possible production vector out of all the possibilities. This is just like consumer theory, except the firm's constraint is technology and not its budget.

The easiest example involves multiple inputs and one output, resembling Rothbard's first explanation of production as a combining of at least two goods into another good. Using this framework, economists discuss a marginal rate of technical substitution (MRTS). This is the analog of the consumer's marginal rate of substitution. The MRTS is the rate that the firm can trade between two goods and keep output constant. A farmer could produce the same amount of corner with less acreage and more fertilizer.

The right combination of inputs will dictate the best production vector or schedule given the technology. Again, this mirrors consumer theory, where a consumer tries to pick the best combination of goods to maximize his utility within his budget.

Profit Maximization

The natural next question is "what is the right production schedule?" Words like right or best are hard to work with. Instead, economists try to be slightly more specific. Continue reading

Supply and Demand to the Rescue

I thank God for the coordination possible through supply and demand under prices.

Economics is most exciting when it is counter-intuitive. It teaches us that artificially supporting exports to "get more money" for a country leads to less goods or that price ceilings of rent actually lower the availability of "affordable" housing.

Don Boudreaux posted another counter-intuitive insight on why "necessary" occupations make little money. Prof. Boudreaux uses marginal product theory to explain wages. It is just supply and demand, which everyone should remember from econ 101, but most people forget. He wrote Continue reading