Friday, July 19, 2013

Neo-Classical Economics

As of late I have been getting into many debates with adherents of Austrian Economics about how economists should do economics.  One thing I have found to be in common with all these debates is that Austrians don't fully understand how neo-classicals actually do economics.  They tend to think the neo-classical sits at a computer with data and tries to empirically find economic principles from this data.  This could not be further from the truth.  I have written a few economics papers and there is a standard way to go about writing them.

Step one of writing a paper is deciding what you are interested in.  I personally am interested in education, environmental economics, game theory, agriculture and others.  Step two is to come up with a theory involving your area of interest.  This is no easy step.  The theoretical portion of the paper is THE most important part of the paper.  If the theory is wrong then the rest of the paper means nothing.  Up to here, neo-classicals and Austrians agree.  Theory is the most important part of economics.  That being said, I can understand the Austrians grief with mathematical economics.  A lot of mathematics is replacing theory.  This is not good for economics.  This does not mean that mathematics does not belong in economics, or have uses in economics, however.

After the theoretical part is done, step three is to do literature review.  Often times in this part of your paper you will be able to find whether your theory is on target or needs to be adjusted.  Furthermore, during the literature review you see how other economists have addressed this problem.  This part of writing a paper is important as well because here is where you decide whether past economists have made mistakes in their theory or their model and can find areas to improve upon.

Next is to gather data.  This is where neo-classicals and Austrians disagree.  Austrians think that gathering and testing data is fruitless.  They have various arguments why they think it is fruitless, but these arguments are lacking.  I will address why I think they are lacking in a different post.  Gathering data can make or break your paper.  If you cannot find proper data then your paper is meaningless.  The data obviously has to be relevant, have many observations, be recent, and it must be "clean".

After you have found and cleaned your data, it is time to make your empirical model.  Many times this is a regression.  If you have ever written a proper econometrics paper you will understand a lot of effort goes into this.  This part of your paper takes around 20-30 pages of tests to make sure your estimates are not over or under estimated.  After creating your model you can now run the tests and see whether your theory has merit or not.  Then finally, the last step of writing your paper is to point out the flaws in your own paper and model.  No model is ever perfect and can always be improved upon.  This is one of the most important parts that will lead further researchers in the right direction.

Here is an example from a paper I wrote as an undergraduate.  In the movie Food Inc. (which I highly recommend) they talk about how the price of beef goes up with the price of corn and fuel.  This is bad because cows are supposed to be grass fed and it is healthier to eat local where the cows are not grown as fast and as unhealthily as possible.  I decided to test this.  What I found is that the price of corn and fuel, while it did slightly effect the price of beef it was not statistically significant.  I.E., the price of corn and fuel do not significantly affect price changes in beef.

In conclusion, I hope this sheds some light on how neo-classicals do economics.  It is not this radical data worship that Austrians can make it out to be.  Neo-classicals believe theory always comes first.  I personally think running a regression to see if your theory holds is not very radical.  As Rothbard points out, Austrians play mind games holding things constant in their head to try and extract economic principles is the same thing as a regression except regression can test how significant the economic principles are after you have played this mind game.

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