Make a PowerPoint about the attached file. (Theory, General Equilibrium, and Political Economy in Development Economics by Daron Acemoglu) no more than 7 min presentation.Please read the paper before doing the work.

theory__general_equilibrium__and_political_economy_in_development_economics.pdf

Unformatted Attachment Preview

Don't use plagiarized sources. Get Your Custom Essay on

Theory, General Equilibrium, and Political Economy in Development Economics by Daron Acemoglu

Just from $13/Page

Journal of Economic PerspectivesVolume 24, Number 3Summer 2010Pages 1732

Theory, General Equilibrium, and

Political Economy in Development

Economics

Daron Acemoglu

D

evelopment economics investigates the causes of poverty and low incomes

around the world and seeks to make progress in designing policies that

could help individuals, regions, and countries to achieve greater economic

prosperity. Economic theory plays a crucial role in this endeavor, not only because

it helps us focus on the most important economic mechanisms, but also because it

provides guidance on the external validity of econometric estimates, meaning that

it clarifies how we can learn from specific empirical exercises about the effects of

similar shocks and policies in different circumstances and when implemented on

different scales.

General equilibrium and political economy issues often create challenges for this

type of external validity. General equilibrium refers to factors that become important when we consider counterfactuals in which large changes are contemplated.

The difficulty lies in the fact that such counterfactuals will induce changes in factor

prices and technology, which we hold fixed in partial equilibrium analysis, and create

different composition effects than in partial equilibrium. Political economy refers to

the fact that the feasible set of interventions is often determined by political factors

and that large counterfactuals will induce political responses from various actors

and interest groups. General equilibrium and political economy considerations are

important because partial equilibrium estimates that ignore responses from both

sources will not give the appropriate answer to counterfactual exercises.

In this essay, I first explain why it is important to think of external validity

in policy analysis, particularly in development economics, and I describe the role

of economic theory in this exercise. I then illustrate the importance of general

¦ Daron Acemoglu is Charles P. Kindleberger Professor of Applied Economics, Massachusetts

Institute of Technology, Cambridge, Massachusetts. His e-mail address is

doi=10.1257/jep.24.3.17

18

Journal of Economic Perspectives

equilibrium reasoning in several major problems in development economics.

Finally, I argue that political economy considerations have to be central to any

investigation of development problems and that inferences that ignore political

economy can go wrong.

Why Development Economics Needs Theory

There is no general agreement on how much we should rely on economic

theory in motivating empirical work and whether we should try to formulate and

estimate structural parameters. I argue that the answer is largely yes because

otherwise econometric estimates would lack external validity, in which case they

can neither inform us about whether a particular model or theory is a useful

approximation to reality, nor would they be useful in providing us guidance on

what the effects of similar shocks and policies would be in different circumstances

or if implemented in different scales. I therefore define structural parameters as

those that provide external validity and would thus be useful in testing theories or

in policy analysis beyond the specific environment and sample from which they are

derived.1 External validity becomes a particularly challenging task in the presence

of general equilibrium and political economy considerations, and a major role

of economic theory is in helping us overcome these problems or at the very least

alerting us to their importance.

To illustrate these points, consider the relationship between the cost of

schooling and schooling decisions. We can describe this relationship purely as a

descriptive one, focusing on a sample and looking at the correlation or the ordinary least squares relationship between these two variables. For example, we could

specify the following reduced-form relationship:

log (si ) = X ‘i ß a log (ci ) + ei ,

where i denotes an individual in the sample, si is years of schooling, ci denotes

the cost of schooling to the individual resulting, for example, from foregone earnings and actual costs of attending schools, Xi is a vector of characteristics of this

individual for which we may wish to control, and ß is a vector of parameters. The

parameter of interest is a. We can then use ordinary least squares to estimate ß

and a.

1

See Shadish, Cook, and Campbell (2002) on internal and external validity. The notion of external

validity, in particular the emphasis on counterfactual exercises, as the defi ning characteristic of a

structural parameter is closely related to Marschaks (1953) defi nition, which distinguishes between

structural parameters that provide useful knowledge for understanding the effects of policy within

a given sample and/or in new environments. It also clearly presupposes that the empirical strategy

has been successful in estimating causal effects (for example, as defi ned in Angrist, Imbens, and

Rubin, 1996).

Daron Acemoglu

19

Alternatively, we could start with an economic model. In fact, some simple

theories will lead to exactly this equation. Suppose, for example, that the human

capital of an individual is a function of the level of schooling for that individual. In

particular, suppose that the human capital of individual i is given by hi = s 1i s for

some parameter s between 0 and 1 and si denotes the persons level of schooling.

The individual can then earn income equal to yi = whi , where w is the market wage

per unit of human capital. In addition, individual i has a cost of schooling given by

?i ci si , where ?i is an unobserved nonmonetary cost component (for example due

to differential discounting or borrowing constraints), and ci is the monetary cost

of schooling for this individual. Suppose that individuals maximize net income,

so that individual i will choose schooling to maximize income net of the cost of

schoolingthat is ws 1i s ?i ci si . After working through the maximization problem,

this model implies a relationship identical to the reduced-form equation with

which we started, but now the parameter a corresponds to 1/s

1/s. 2 Once this equation is derived, estimation is also straightforward and can be performed again by

ordinary least squares.

Next comes the harder part. We have seen that the same equation can be

posited as a reduced-form relationship, or it can be derived from an economic

model. But at the end, it is the same equation, and it can be estimated in the same

manner. So in what sense can we think of it as a structural relationship? The

answer is related to the notion of external validity introduced above. Suppose we

now ask the question: what would be the effects of subsidies to reduce the cost of

schooling, ci , for a set of individuals? This counterfactual experiment could be

motivated by a potential policy that is being contemplated or it may be used for

understanding and testing the implications of our theory. The question might be

for the same sample on which the initial estimation was performed or it could be for

an entirely different sample or population. In either case, one answer to the above

question readily follows from using the estimates of a to compute the increase in

the years of schooling for individuals whose cost of schooling has declined. But can

we trust this answer?

If a is indeed a structural parameter, then we should trust this answer (obviously, subject to standard errors), but not otherwise.3 To illustrate what might

go wrong when a does not correspond to a structural parameter, imagine, for

example, that years of schooling are constrained by school enrollments, which are

in turn constrained by the sizes of schools. In this setting, let us further assume

that individuals with low cost of schooling get proportionately more of the available

2

Specifically, the optimal choice of individual i is si = K(?i ci )1/s, where in this case K = ((1 s)w)1/s.

After taking logs and defining ei = log ?i /s and a = 1/s, this gives the reduced-form equation above.

3

Many empirical equations that do not correspond to structural relationships may nonetheless contain

useful information; they just cannot be used for counterfactual policy analysis. We might simply be

interested in uncovering correlations, which may help us distinguish between theories, since many

relevant theories will have implications about what these correlations should look like. This suggests

that it is often useful to estimate reduced-form relationships that do not have structural interpretations, but when doing so, we should be explicit about how they should be (and not be) interpreted.

20

Journal of Economic Perspectives

school resources (for instance, due to some type of efficient rationing).4 In this

example, we can still estimate the relationship between s and c,, and we will obtain a

meaningful-looking estimate of a. However, the estimate will lack external validity.

Consider a policy of expanding the subsidy for schooling to individuals that does

not change the constraint that total years of schooling are determined by the sizes

of schools. Then the estimate of a from the pre-subsidy regime will not necessarily

inform us about the post-subsidy relationship between cost of schooling and years

of schooling and will not give us accurate predictions about the effect of the policy.

The problem described here is of course a version of the Lucas (1976) critique

that reduced-form relationships will not be stable in the face of policy interventions.

However, the discussion also highlights that this problem is not simply circumvented by deriving the relationship of interest from an economic model, unless this

model incorporates the relevant constraints and margins of choice. In the above

example, no model that fails to incorporate the constraint on total enrollments

will be informative about counterfactuals involving large-scale interventions. Thus,

our confidence in the implied answers to policy experiments crucially depends on

our confidence in having captured the appropriate structural relationship with the

model we are estimating.

How do we convince others and ourselves that our estimates have external

validity and can be used for policy analysis or for testing theories? This is where

economic theory becomes particularly useful. As a first step, we have to defend

using economic theory, common sense, and evidencethat key factors potentially

affecting the response to the relevant counterfactual are accounted for and that the

model and the functional form we chose indeed capture the salient aspects of the

reality and are a good approximation to that reality. This in turn involves arguing

that the functional form is stable over time and across relevant samples, that variation across individuals not captured by the covariates and the cost of schooling can

be incorporated into the error term ei , and that this error term can be modeled as

additive and orthogonal to (that is, uncorrelated with) the other variables included

in the equation. Using economic theory is often the best way of clarifying whether

key factors have been omitted and whether the underlying assumptions can be

defended and whether they provide a good approximation to reality.

However, the previous discussion also highlights that specifying a model that

justifies a specific estimating equation is typically not difficult, and may not solve

the underlying problem. For example, we saw how we could derive exactly the same

estimating equation from a model of individual schooling choice; but if in reality

4

More specifically,_the constraint _on school enrollments might imply that total years of schooling

should be equal to S that is, ?i si = S . Suppose that the economic relationship si = K(?i ci ) 1/s still holds

at the individual level (i.e., individuals with low cost of schooling get proportionately more of the available school resources). But it must do so with

_ a different value of K than in footnote 2. In particular, the

constraint on total schooling implies K = S (?i ?? (??i ci )1/s)1. When the cost of schooling is subsidized,

the underlying economic relationship with the new definition of K given here remains unchanged, but

the reduced-form relationship captured by our estimating equation above changes (exactly as shown

by the above formula for K).

Theory, General Equilibrium, and Political Economy in Development Economics

21

years of schooling are constrained by the sizes of schools, the estimates of a will

still not be useful for understanding the implications of a large-scale subsidy for

schooling. The problem of course is that for studying the implications of this type of

policy, the constraints resulting from the sizes of schools are central, and any model

that does not recognize these constraints will not be helpful in such a study. This

emphasizes that the proper use of economic theory does not mean writing down a

specific model; instead, it requires that we incorporate the appropriate constraints

and margins of adjustments, that we develop the case that economic theory robustly

leads to the estimating equation in question, and that we clarify which important

economic mechanisms and effects are being excluded from the model.5

Another advantage of structural reasoning based on theory is that once we go

through the process of explicitly justifying the equation we are estimating, either

using economic theory or other theoretical or empirical arguments, we may realize

that such an equation cannot easily be defended. In such cases, it has to be interpreted with greater caution, or perhaps it has to be modified or abandoned. This

advantage becomes particularly important in contexts where general equilibrium

and political economy effects are present. Finally, economic theory provides the

best way of interpreting what the estimates from an equation, such as the one we

started with, mean. For example, when this equation is derived from the economic

model above, we understand that a = 1/

1/s

s is a function of the elasticity of the

human capital production function.

The structural approach also faces major challenges, however. First, as already

emphasized, writing down a model like the one described above is clearly not

sufficient for achieving external validity. That model itself made several assumptions which are restrictive and may not provide a good approximation to the

economic phenomena in which we are interested. This is again illustrated by the

above example, which showed that one might end up deriving the same estimating

equation from a theoretical model, and thus reach the same conclusions about

the implications of a counterfactual policy change, as one might have done by just

specifying a reduced-form equation.

Second, we may in fact question whether there is any ground for assuming a

constant elasticity a between years of schooling and costs of schooling. After all,

we know that all theories are abstractions and approximations, so there is little

reason to believe that a parameter such as aor the intertemporal elasticity of

5

The online appendix available with this paper at ?http://www.e-jep.org? discusses some issues that

arise in thinking about how we could develop such robust predictions and how we could try to map

them to data. This discussion also highlights that in certain cases one could achieve counterfactual

validity without much theory. For example, we need only the most basic theory in interpreting a

controlled experiment designed to evaluate the effectiveness of a drug. In this case, we can say that

common sense and a very limited amount of medical theory are sufficient to interpret the results of the

controlled experiment and decide whether they are informative about the effectiveness of the drug in

question beyond the experimental setting. It should also be noted that the evaluation of the effectiveness of a drug in this example has a clear parallel to modeling individual behavior in economics. As

further discussed below, the role of economic theory becomes even more central when our focus shifts

to modeling equilibrium behavior.

22

Journal of Economic Perspectives

substitution, or the Frisch elasticity of labor supply, or the elasticity of substitution

between two factors, or any other Marschakian preference or technology parametershould be really constant. But without such constancy, there are severe limits

to external validity.

Finally, one may even question the existence or usefulness of structural

parameters altogether. What we take as a structural parameter for one theory

will naturally become an endogenous object in another. So a particular model can

serve us well as an abstraction for a series of counterfactual experiments, but there

will exist other experiments for which it will be much less informative. For example,

an elasticity of substitution or certain technology parameters may be constant with

respect to certain variations, but would change in response to others. This is almost

by necessity: a precondition for external validity is that key factors relevant for the

outcome of the counterfactual should be included in the model, and models as

abstractions have to exclude several relevant factors, so no single model can include

all of the relevant factors for all possible counterfactual exercises.

These challenges notwithstanding, it is clear that economists often have to

take a position about the parameters being estimated corresponding to structural

parameters (at least for a well-defined though perhaps limited set of variations in

environment and policy). Otherwise, we will have no way of performing counterfactual exercises and making predictions about policy changes (Imbens, 2009).

But this necessitates a claim to external validity (even if it is only implicit), and

economic theory is our best guide for formulating the appropriate models and

justifying such claims to external validity. These issues become only more central

in the presence of general equilibrium effects and political economy factors, to

which I turn next.

The Centrality of General Equilibrium

The bulk of empirical work using microdata, particularly in development

economics, engages in partial equilibrium comparisons. Depending on magnitudes of various effects, general equilibrium interactions can offset or even reverse

sensible partial equilibrium conclusions. However, most empirical strategies do not

directly estimate general equilibrium effects.6

Economic theory nonetheless provides some guidance in assessing the importance of general equilibrium effects. Three types of general equilibrium effects,

which are usually not estimated in partial equilibrium comparisons, are potentially

important. First, in response to large policy interventions or shocks, imperfect

substitution between factors and diminishing returns imply that factor productivities

6

See also Townsend (forthcoming) for a complementary discussion of the role of general equilibrium

analysis in development economics, with special emphasis on credit market issues; Heckman, Lochner,

and Taber (1998) for a discussion of general equilibrium issues in the analysis of the effects of technology on wage inequality; and Duflo (2004a) for a discussion of other difficulties in scaling up

policy interventions evaluated using microdata.

Daron Acemoglu

23

and prices will change. Second, the same policy interventions or shocks can lead to

endogenous technology responses. Third, there may be composition effects resulting

from equilibrium substitution of some factors or products for others (whereby the

composition of micro units changes differently in response to different types of interventions). Theory generally implies that the first and the third eff …

Purchase answer to see full

attachment

Basic features

- Free title page and bibliography
- Unlimited revisions
- Plagiarism-free guarantee
- Money-back guarantee
- 24/7 support

On-demand options

- Writer’s samples
- Part-by-part delivery
- Overnight delivery
- Copies of used sources
- Expert Proofreading

Paper format

- 275 words per page
- 12 pt Arial/Times New Roman
- Double line spacing
- Any citation style (APA, MLA, Chicago/Turabian, Harvard)

Delivering a high-quality product at a reasonable price is not enough anymore.

That’s why we have developed 5 beneficial guarantees that will make your experience with our service enjoyable, easy, and safe.

You have to be 100% sure of the quality of your product to give a money-back guarantee. This describes us perfectly. Make sure that this guarantee is totally transparent.

Read moreEach paper is composed from scratch, according to your instructions. It is then checked by our plagiarism-detection software. There is no gap where plagiarism could squeeze in.

Read moreThanks to our free revisions, there is no way for you to be unsatisfied. We will work on your paper until you are completely happy with the result.

Read moreYour email is safe, as we store it according to international data protection rules. Your bank details are secure, as we use only reliable payment systems.

Read moreBy sending us your money, you buy the service we provide. Check out our terms and conditions if you prefer business talks to be laid out in official language.

Read more
The price is based on these factors:

Academic level

Number of pages

Urgency