# 6 Economic theory, modeling, and connecting this to empirical work

Lecturers/Professors generally love when students carefully use economic theory and models in their work, even when these are only very simple ‘toy’ models (see discussion below)…

• explaining existing formal (mathematical) models, theories and ‘solution concepts’, and applying them more broadly outside of the original discussion

• building (simple) models inspired by prior work (see textbooks, academic papers, etc)

• discussing the different assumptions and predictions, and their plausibility.

However students often err on the side of quantity over quality here. It is much more valuable if you can carefully explain and show a deep understanding of a single model or theory … rather than glossing over a range of technical concepts without demonstrating your understanding of each of these.

Present these models fully and carefully. Yes, be succinct, as always, but show your understanding, and explain it to the reader who may not be well-versed in this particular model.

• Define the variables and assumptions carefully, and their justifications

• Explain the frameworks the models uses to derive predictions (e.g., some type of equilibrium, comparative statics, dynamic optimization). Present the key insights and the logic of how these are attained or proven.

## 6.1 (From theory to) empirical work

Theory can inform applied questions and empirical work in several ways:

Empirical:

1. ‘Motivating’ which questions to ask (e.g., test efficient market hypotheses, test optimal consumption smoothing…) and why?

2. Suggesting particular functional forms and ways of measuring outcomes/variables (e.g., measures of risk aversion)

3. Economic theory imposes restrictions on systems of equations (e.g., demand systems must be homogenous of degree and obey adding-up restrictions), informing statistical analysis (and possibly making it more efficient)

4. Suggesting plausible ‘causal identification’ strategies (e.g., cost as an ‘instrumental variable’ for shifts in supply curves)

5. Providing structures for iterpreting results, including through ‘structural modeling’

## 6.2 Doing economic modelling and theory

Economic models usually involve one or more of:

• Individual (or firm or other actor) optimization… maximization of a utility, profit or welfare function (over time, perhaps involving uncertainty) subject to one or more constraints

• Aggregation of the above and consideration of an ‘equilibrium’ outcome, usually involving an equilibrium price

• Game theoretic (or principle-agent/mechanism design) treatment of a strategic interaction between multiple ‘actors’, considering the equilibrium (or other reasonable predicted outcome) and the ‘comparative statics; of this as key factors (’parameters’) are varied

### 6.2.1 Doing economic theory

You may have heard that ‘you should not do a theory dissertation as an undergraduate.’ It is indeed difficult to make a substantial contribution to pure economic theory. This work is highly mathematical. The models stemming from our basic framework and beyond have been explored in great depth and sophistication. The frontiers have been pushed very far in terms of ‘what are the implications of our standard assumptions and in what ways can they be relaxed’.

However, this does not mean that you shouldn’t do theory and modeling in your undergraduate dissertation. You should try to incorporate and adapt existing models (remember Economic theory=models=maths… approximately). You can also make this the main focus of your dissertation.

Remember, you are not writing this dissertation to advance the frontiers of Economics. In large part, you are trying to show your understanding and ability to apply techniques to specific questions.

If you can explain and adapt a rigorous theoretical model to apply to particular case, yielding intuition, you have done well. (For example… )

Even if you’re not doing a “theory paper”, specifying a model will benefit your paper in several ways:

1. Fixing your ideas and arguments precisely and demonstrating internal consistency

E.g., why might we expect an impact of education on income? Why might the private returns exceed the social returns? What are the channels by which education could yield personal and social gains (or losses)?

1. Providing structure and ‘restrictions’ for your empirical analysis

2. Connecting to the Economic literature and incorporating the general insights of the field

3. Helping you consider and estimation ‘policy implications’ of your results

### 6.2.3 Posing your hypothesis as an empirical test

Key points:

• What would be observable in the real world (data) if your hypothesis were true that would not be true if your hypothesis were false?
• Are you ‘sure’ the same patterns would not hold if your hypothesis were false? Would there not be ‘alternative explanations’ (alternative hypotheses) for such a result?
• If so, can you pose additional measures and tests: things that would not hold in the data if an alternative explanation were explaining the first result?

If your hypothesis has no ’implications for the real world… then your hypothesis may not be relevant or meaningful.*

If the potential outcomes of your test “Black” or “White” are the same whether or not your hypothesis is true (or if the probability of ‘observing’ Black is the same whether or not your hypothesis is true), then your test is not informative.

For an event to be evidence about a target of inquiry, it has to happen differently in a way that’s entangled with the different possible states of the target.

*If instead you are measuring a parameter (e.g., risk-aversion, the money-multuiplier, number of black balls in an urn… ) rather than testing a ‘true/false’ hypothesis, the outcomes/probabilities should vary with the true parameter value.

• What is the outcome (or outcomes) you are measuring, and how can you observe these?

Writing an empirical/econometric model

Explain the limitations of your analysis to the reader, and what the next step would be. Perhaps you are aware there is an advanced estimation technique, or a larger data set, that could better answer your thesis question. However, this might be “too difficult” considering your abilities and resources. If you can explain this, do so.

If you’re doing a theory paper (also useful in an empirical paper) try to explicitly state and clearly explain a formal economic model, using mathematical notation.

If you’re doing an empirical paper clearly explain and describe your data, techniques, and results. Explain the econometrics behind your techniques as clearly as you can.

## 6.4 Empirical work: techniques and econometrics

Techniques. Understand what techniques others have used to answer your question, what technique you are using and why, and the arguments for each technique. Understand the limitations of each technique, previous papers, and of your own work.

Show you understand economic theory and the connection between theory and econometrics and empirical work. Understand the difference between these, and what each can do.

Use of techniques: use the tools you can handle, understand, and explain. Try to use the right techniques, but also try to limit yourself to techniques you can explain, at least in general terms.

Justify the techniques you use; don’t merely hide behind the rationalisation that “other authors did it”. If other authors jumped off the Brooklyn bridge, would you jump?

This is something parents in New York used to tell their children when the kids wanted to do something that was forbidden to them (like go to a party, or buy a leather jacket or something.

Teenager: But everyone is doing it

Parent: If all the other kids jumped off the Brooklyn bridge, would you do it too?

Know your limits. Set reasonable goals for your dissertation, and do not claim to have achieved more than you have done.