C3

Economics Methodology: Counterfactuals, Fundamental Principles, and the Demand Curve

Methodology: Counterfactuals and Causality

• Definition and Importance of Counterfactuals

  • Finding counterfactuals is absolutely necessary in any science, including economics, to distinguish between simple correlation and a true causal relation.

  • A counterfactual addresses the question: "What would have happened if the event being studied had not happened?"

  • Identifying counterfactuals is particularly difficult and hard in the social sciences compared to hard sciences like physics or chemistry, where conditions are easier to control.

Methods for Finding Counterfactuals

• Controlled Experiments

  • This technique follows the same approach used in medicine to test the efficiency of a treatment.

  • Researchers create two identical groups:

    • Control Group: This group is not treated.

    • Treated Group: This group receives the treatment.

  • The groups must be identical in every dimension and characteristic; the only difference is the treatment itself.

  • Example: The Canadian Work Bonus

    • The Canadian government introduced a "Return to Work" bonus allocated completely randomly.

    • Because there was no self-selection, it served as a perfect controlled experiment.

    • Result: There was a positive short-term effect on the probability to return to work, with a increase of $12\%$ in the treated group.

    • Long-term outcome: The effect diluted over time, eventually showing no lasting impact on work habits.

  • Example: University Performance and Recordings

    • An experiment tested the impact of live streaming/recordings on student exam performance.

    • The student population was split into two identical groups.

    • The treated group received access to recordings/live streaming, while the control group (the counterfactual) did not.

  • Limitations of Controlled Experiments

    • They are complicated to implement.

    • Biases often occur in the selection of groups, which can skew results.

    • In social sciences, there are frequent ethical issues or physical limitations that prevent the creation of controlled experiments.

• Natural Experiments

  • A natural experiment occurs when circumstances "by chance" provide the opportunity to study a event as if it were a controlled experiment, without the economist building it intentionally.

  • Example: Minimum Wage Theories (New Jersey vs. Pennsylvania)

    • Two competing theories exist regarding the impact of increasing the minimum wage on employment:

      1. Competitive Market Theory: Predicts that introducing or increasing a minimum wage will have a negative effect, decreasing employment.

      2. Non-Competitive Market Theory: Predicts that increasing the minimum wage will have a positive effect or leave employment constant.

    • The Experiment: The governor of New Jersey increased the minimum wage in the fast-food sector. Simultaneously, neighboring Pennsylvania (which has a similar economic structure and population) kept its minimum wage constant.

    • Control Group: Pennsylvania fast-food sector.

    • Treated Group: New Jersey fast-food sector.

    • Findings (Card and Krueger - spelled "Carter and Kruger" in transcript): The increase in minimum wage had a positive effect on employment in the short term and remained constant in the medium-long term. This supported the non-competitive market theory for that specific case.

• Statistical and Econometric Techniques

  • Economists use various advanced methods to test hypotheses and find counterfactuals, including:

    • Instrumental variables.

    • Stratification.

    • Difference in differences analysis.

    • Monte Carlo experiments.

    • Relations analysis.

Fundamental Principles of Economics

• Optimization and Rationality

  • Individuals are considered rational actors who pick the best available alternative given their specific circumstances and constraints.

  • We make choices because resources are limited. For example, time is a limited resource ($24\,\text{hours/day}$), requiring constant arbitrage and trade-offs between different activities.

• Opportunity Cost

  • Definition: The opportunity cost is the cost of the best alternative that is given up when making a choice.

  • It is distinct from the Accounting Cost (the actual out-of-pocket expenditure).

  • Economic Cost: The sum of Accounting Cost and Opportunity Cost ($\text{Economic Cost} = \text{Accounting Cost} + \text{Opportunity Cost}$).

  • Entrepreneurship Example:

    1. Business setting up costs: $\text{CHF}\,125,000$.

    2. Expected income: $\text{CHF}\,240,000$.

    3. Net accounting income: $\text{CHF}\,115,000$.

    4. Decision: If the alternative income is $\text{CHF}\,0$, setting up the business is profitable. However, if the alternative (the opportunity cost) is a salary of $\text{CHF}\,160,000$, setting up the business is not economically worthwhile because the alternative is better.

  • University Enrollment Trends: University enrollment often increases during economic crises because the opportunity cost (the wage one could earn in the job market) is low. Conversely, during economic booms, enrollment declines because the opportunity cost is higher.

• Marginal Reasoning

  • Individuals and firms take decisions based on the value or cost of the last unit consumed or produced.

  • Contextual Value: The value of one additional (marginal) glass of water is very high in a desert but very low in Geneva.

  • Labor Example: A firm does not look at the total cost of all labor but compares the cost of the last unit of labor hired to the benefit withdrawn from that specific unit.

• Reactions to Incentives

  • Individuals change their behavior when the context or situation changes.

  • Examples:

    • Safety Belts: Studies suggest that when drivers wear safety belts, they may become less careful, potentially increasing the number of serious accidents.

    • COVID-19 Vaccines: Upon the introduction of vaccines, people became less careful about social distancing and masks, leading to an increase in cases.

    • Bike Helmets: Personal anecdote where wearing a helmet leads to a feeling of isolation and less attention to surroundings compared to riding without one.

    • Road Construction: Building new roads to decrease traffic jams often incentivizes more people to drive, eventually leading back to the same levels of congestion.

    • The Kindergarten Fine (Israel): A school introduced a fine for parents picking up children late. Instead of decreasing lateness, the fine increased it, as parents viewed the fine as a "price" to pay for the service of being late, which was a rational trade-off for them.

• Equilibrium

  • Definition: A situation where no individual wants to change their choice given the choices and behaviors of all other individuals.

  • Market Equilibrium: Specifically refers to a price and quantity where the amount buyers want to buy equals the amount sellers want to sell ($\text{Demand} = \text{Supply}$).

  • In a perfectly competitive market, decentralized decisions lead to an optimal result without state intervention.

Market Failures and Government Intervention

• Market Failures: Situations where decentralized markets do not produce an optimal outcome, necessitating government intervention or collective action.

  • Externalities: Effects of actions/decisions that are not internalized by the actors (can be positive or negative).

  • Dominant Market Positions: When an agent has market power (e.g., a monopoly) and can influence the price of a good.

  • Asymmetric Information: When one party in a transaction has more information than the other.

  • Public Goods: Services or goods that private suppliers will not provide in optimal quantities.

Demand Side Analysis

• The Market Concept

  • The market is a decentralized institution where buyers and sellers meet.

  • Demand: Determined by the behavior of buyers.

  • Supply: Determined by the behavior of sellers.

• The Housing Market Shock Example

  • Evolution of housing prices from $2018$ to $2023$ showed rising prices for most locations except city centers after the $2020$ COVID shock.

  • The Cause: COVID-19 changed buyer preferences. Commuting time became less important due to work-from-home, while the value of space, gardens, and extra rooms increased. This exogenous shock on the demand side shifted the equilibrium value of city-center apartments downward relative to suburban or countryside homes.

• Perfectly Competitive Market Hypotheses

  1. Homogeneous Goods: All sellers sell the same, identical good.

  2. Atomistic Agents: Sellers and buyers are numerous and small relative to the market; they are price-takers and cannot influence market prices individually.

• The Demand Curve

  • Definition: A relationship between the market price and the quantity demanded by buyers.

  • First Law of Demand: There is a negative relationship between price and quantity demanded (as price falls, quantity demanded increases).

  • Willingness to Pay (WTP): The demand curve captures the maximum price a consumer is willing to pay for each unit.

  • Vickrey Auction Experiment (The Candy Bag):

    • A candy bag is auctioned where the high bidder wins but pays the second-highest bid.

    • This helps identify the true willingness to pay of students.

    • The results are ranked and plotted on a graph (often using a log scale for the vertical axis due to the wide range of bids, e.g., from $0$ to millions).

    • Market Demand: If individual demand curves are aggregated (summed across todos individuals), we obtain the Market Demand Curve.

Questions & Discussion

• Q: (Regarding the Kindergarten fine experiment) Why is increased lateness considered rational?

  • A: If the fine (e.g., $\text{CHF}\,3$) is lower than the value of the time gained to do other things (like going to the grocery store or the garage), then Paying the fine to be late is a rational decision. The fine acted as a price for a service rather than a deterrent.