Economic Tools• 1. Graphs: review basics

– A. Plotting points.– B. Computing slope.

• 2. Micro approach– A. Choices– B. Constraints– C. Maximization (best choice)– D. Comparative statics

• 3. Functions– A. Utility function– B. Household production fn

• 4. Totals and marginals• 5. Supply & demand• 6. Empirical methods

– A. Regression analysis– B. Natural experiments

Micro Approach

• Choices: – have a goal (maximize something); – chooser has info and is rational; – choice has limits (budget constraint);– constrained maximization.

• Variables: – Endogenous (dependent); – Exogenous (independent).

• Theory: Posits relationship between dependent variable and independent variable(s).

• Functional form: X* = F(Z).• Marginal decision-making.• Best choice (solution): x*

Comparative Statics

• From earlier: X* = F(Z).• Theory: X*/Z 0.• If Z , this causes X*.• Relate to Law of Demand:

– Simple: D = F(P); – Full version:

• D = F(price of X, other P, Preferences)

• Microeconomics:– Economic actors choose endogenous

variables to maximize something.– Best choice: satisfies above total condition and

a marginal condition.– Theory predicts how best choice changes

when exog variables change.– Predictions: comparative static results; use to

assess theory.

Functions• Functions: convenient way to show what

depends on what.– Demand function.– Could write as: D(P).

• Utility function:– U = U(X,Y).– X & Y are two goods; – Ordinal utility;– utility theory a theory of choice;– rational choice model.

• Household production function:– G = G(T,Z).– G: amount of HH goods produced.– T: first input: time.– Z: amount of all other inputs.– Like firm prod fn: Q = Q(K.L).

How Make Best Choice

• Ex.: With 2 goods X & Y.

• 1. Maximize total utility.

• 2. Equate utility on the margin– Marginal decision-making.– On the margin: as X and Y,

utility from that last extra X is equal to utility from that last given up Y;

– So: U/X = U/Y.

• 3. See graphically.

Supply and Demand

• Law of Demand– Qd = F(P; other P; Y; Pref)– Negative slope.

• Law of Supply– Qs = F(P; input prices; techn.)– Positive slope.

• Equilibrium– Occurs naturally.– Excess supply– Excess demand

• Change in ceteris paribus factor– Shift demand curve.– Shift supply curve.

Empirical Methods:Regression

• Methods: – Testing predictions of a specific theory. – Ex: Law of D:P of X D for X;

• qualitative prediction; • quantitative prediction.

• Regression Analysis: statistical technique for estimating relationship between two or more variables. – One dependent variable and one or more

independent variables.– Example: prediction from Law of D.– Write as regression equation:– Qd = + P +

Qd/P = ; (1/ is slope of D curve) is value of Qd when P = 0; (intercept). is random error term: • See picture.

More on Regression

• Multiple regression: adds in more independent variables (usually these are ceteris paribus factors).

• Book calls these more Xs.• Want to add in as many relevant Xs

as we can (so now have 1, 2, etc.)• Qd = + 1P + 2Y + 3Pref +

– Where Y is income.

• If leave out an important X, then the estimated values of and are “bad.”

More on Regression

• Types of variables:– Continuous

– Dummy: yes/no.

– Natural logs: ln(wage) so on education is a percentage returns to education.

• Sampling error: to what group do the results relate?

• R-squared: what percent of variation across individuals in dependent variable is explained by the regression?

Experiments

• Scientific experiment: testing effectiveness of a new drug.– uses double-blind random assignment.

(individuals assigned to get real drug or a placebo and doctor/individual do not know which it is).

– Current real experiment in labor economics: temp work for welfare-to-work population.

• Natural experiment: – Useful because economists usually cannot

conduct real experiments.– when something like real experiment

occurs in real world.– Mariel boatlift of 1980: impact of

immigration on local labor markets.