Wednesday, 29 January 2014

Assumptions in Empirical Economics

When a theorist in economics first presents a model to others, the first thing he usually presents or the first question usually asked by those who are attending his presentation concerns the assumptions made when formulating the model. The rationale behind that is straightforward: the assumptions one makes are the building blocks of the model. If they are solid and make sense, then we can trust the outcome more than if they are based on something cooked up in the researcher's mind.  

A simple example showing the importance of assumptions is the following:
Suppose that I want to show that in an economy where only beef and cheese are produced, the production of cheese is economically disastrous. Then, assuming a utility function (a measure of how happy I am by consuming) of U=(Consumption of Beef - Consumption of Cheese)^(1/γ) I could use some derivations to show that cheese will not be good. Why? Because, as the reader may observe in the utility function, cheese consumption lowers my potential happiness. Thus, the only way for me to be "happier" is not to consume any cheese at all. By imposing an unrealistic assumption (even if this might hold for a very small percentage of the population) I can prove practically anything.

Obviously, economists are smarter than this and thus try to avoid such issues. Even more commonly, they just try to mask the lack of a coherent relation between the world and what they assume by imposing more elaborate assumptions, such as the ones Paul Pfleiderer shows in his deconstruction of some peer-reviewed papers. A notable example is one where "the intermediary can threaten not to contribute his specific collection skills and thereby capture a rent from investors". This might sound a bit appealing: if I can threaten to stop being the middle man and they cannot do it on their own, then I can get people to pay me for doing it.

Read the rest on Pieria

No comments:

Post a Comment