Lecture 2 Principles of Economics and Economic Methods 2019

9/6/2019
Lecture 2:
Principles of Economics and
Economic Methods
David Laibson
Ec 10a – Principles of Economics (Microeconomics)

September 9, 2019
Harvard College | Cambridge, MA 02138
Overall plan for the lecture
• Harvard Honor Code

– Kevin Stephen
• Unit Review Program
– Stacey Gelsheimer
• Three Principles of Economics
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The Harvard College Honor Code

“Members of the Harvard College community commit
themselves to producing academic work of integrity – that
is, work that adheres to the scholarly and intellectual
standards of accurate attribution of sources, appropriate
collection and use of data, and transparent
acknowledgement of the contribution of others to their
ideas, discoveries, interpretations, and conclusions.
Cheating on exams or problem sets, plagiarizing or
misrepresenting the ideas or language of someone else as
one’s own, falsifying data, or any other instance of
academic dishonesty violates the standards of our
community, as well as the standards of the wider world of
learning and affairs.”
Source: https://honor.fas.harvard.edu/honor-code
Unit Review
Program
Stacey Gelsheimer
Unit Review Coordinator
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This Photo by Unknown Author is licensed under CC BY
Each Unit is Worth 1% Extra Credit
8 Nights
Per Cycle,
Watch Out
for Deadline
Nights!!
This Photo by Unknown Author is licensed under CC BY‐NC
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9/6/2019
A Few Important Abante-ChotzenFreund

Details… Brown
Cornell-Gilmore
• “Deadline Nights” look Goldemberg-Meeker
something like this
Klein
Pan-Tadros ***Based on your

• Why Not Mark your deadline nights in your
SECTION LEADER’S
calendar now? ( with a 4 day reminder? =)
last name,
Vargas-Yoon NOT YOURS!
• NO “makeups”!
The Process...
• Grab a Unit Review test from the

supervisor at the front of the room.
• Take your Unit Review test to a desk

– Sit at least one desk away from any
other student
• ***No phones, no computers, no notes!

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Turn in your test to the supervisor…
This Photo by Unknown Author is licensed under CC BY‐SA‐NC
Return to your desk…
This Photo by Unknown Author is licensed under CC BY‐SA‐NC
5
9/6/2019
Wait for your name to be called…
Wait for your name to be called…
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Learn Your Results
Try Again!
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A Few Important
Details…
• Unit Review
Tests MUST be
turned in no
later than 9pm
• Come at 6:30!
This Photo by Unknown Author is licensed under CC BY‐NC‐ND
Use the Unit Review

Program for Extra
Tutoring!
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Remaining Outline
In last week’s lecture we defined economics: the study of choice

(i.e., allocating scarce resources).
We distinguished positive from normative economics.
We distinguished microeconomics from macroeconomics.
Today: More material from Chapters 1 and 2

1. The first principle of economics: optimization
2. The second principle of economics: equilibrium
3. The third principle of economics: empiricism
Three key ideas:

Principles of economics
i. People try to optimize: choose the best feasible option given
the available information.
ii. Economic systems tend toward equilibrium: a state in which

no agent perceives that they would benefit by changing their
own behavior. The economic system is in equilibrium when
each agent feels that they cannot do any better by picking
another course of action.
iii. Economists test their ideas with empirical analysis – in other

words, economists use data to test their theories.
Economists are particularly interested in understanding
causation: what is causing things to happen in the world.
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Outline
1. The First Principle of Economics: Optimization
2. The Second Principle of Economics: Equilibrium
3. The Third Principle of Economics: Empiricism
Outline
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1. Optimization
• Economics is the study of choices (From Lecture 1:

Economics is the study of how agents allocate
scarce resources and how those choices affect
society.)
• Optimization is a theory about how choices are made.
• Economists believe that people and other economic

agents try to optimize
• Definition: Choosing the best feasible option, given

the available information, is optimization.
Optimization: choosing the best feasible option.
Source: Jin (2015).
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Optimization toolbox
• 4 related tools discussed in Chapter 1

1. Tradeoffs
2. Budget constraints (see chapter 1)
3. Opportunity cost (see chapter 1)
4. Cost benefit analysis (see chapter 1)
• Much more to come later in the course
Tradeoffs
Definition: An economic agent faces a tradeoff when the agent
needs to give up one thing to get something else.
For David:
sleep vs. “economics research”
“time with Max” vs. “time with Lowellians”
“another beer” vs. “retirement savings”
exercise vs. “time surfing the web”
Write down some examples of tradeoffs that you face:
Do you feel that you are making these tradeoffs optimally?
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Trading off life vs. convenience
• The U.S. president asks you what the federally mandated

speed limit should be.
• About 40,000 people die each year in traffic accidents in

the U.S. (1.25 million die worldwide per year).
• Would you attempt to reduce the number of deaths on the

road?
• If you desired, you could essentially eliminate traffic

fatalities.
• But setting the speed limit to 15 mph would have high

costs.
Outline
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2. Equilibrium
Definition: Equilibrium is a situation in which

nobody perceives they would benefit by
changing their own behavior.
Intuition: in equilibrium, all economic agents are

simultaneously trying to optimize.
Which check-out line should you join?
In equilibrium, it should not matter. Why?

Source (photo): https://boingboing.net/2015/06/02/the‐most‐efficient‐checkout‐li.html
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A 10-person game implemented on Qualtrics:

https://harvard.az1.qualtrics.com/jfe/form/SV_9ZC8Y3dNahtFQj3
• If you play "Up", you will receive a base payment of $15.

• If you play "Down", you will receive a base payment of $10.
• No matter what you play, your base payment will be reduced
by the number of players (among the 10 players) who play
"Up".
• What does private optimization imply I should do if I care

only about my own material payoffs in this game?
• What is the equilibrium of this game if everyone cares only
about their own material payoffs?
• What fraction of Ec10 students play “Up”?
Ec10 class data from this experiment
• What is the socially efficient outcome?

• How might that have been achieved?
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Elinor Ostrom:
Escaping the free rider problem
without government intervention or privatization
• Nobel Prize (2009) “for her analysis of economic

governance, especially the commons.”
• Contribution: “Challenged the conventional
wisdom by demonstrating how local property can
be successfully managed by local commons
without any regulation by central authorities or
privatization.”
Source (photograph): Evonomics, https://evonomics.com/the‐only‐woman‐to‐win‐the‐nobel‐prize‐economics‐debunked/
Free rider problem: making choices that benefit

the individual at the expense of the group
Source (photo): Mos.ru
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Free rider problem: making choices that benefit the

individual at the expense of the group
• Climate
change
• Generate
some of
your own
examples
33
Outline
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3. Empiricism
• Economists test their ideas with empirical

analysis – in other words, economists use data
to test their (positive) theories. Economists are
particularly interested in understanding what is
causing things to happen in the world.
• Definition: Empiricism is analysis that uses data

from the world. Such data is used to test
scientific models, including models developed by
economists.
Red-Ad Blues
• A marketing expert believes that campaigns using
the color red catch people’s attention. To test this
hypothesis, they study past ad campaigns.
• Finds that sales are much higher during campaigns

with lots of red images. Sales are only slightly
higher during campaigns with lots of blue images.
• Tells the CEO (Chief Executive Officer).
• Marketing expert is fired.
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What did the marketing expert miss?
The red colors in advertising don’t cause an increase

in revenue. The holiday season (e.g., Christmas)
causes an increase in our revenue. The holiday
season also causes an increase in the frequency of
red ads.
In this example, Christmas is an omitted variable.
Effect
Cause
Effect
“Omitted variable” High levels of sales
Source: Getty Images; Walmart
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9/6/2019
Causality and Correlation
Definition: Causation occurs when one variable

directly affects another through a cause and
effect relationship.
Definition: Positive correlation implies that the

two variables tend to move in the same direction.
Negative correlation implies that the two
variables tend to move in opposite directions.
When the variables have movements that are
not related, we say that the variables have zero
correlation.
Another example
• Ice cream sales (by month)

are strongly correlated with
drownings (by month).
• Does eating ice cream cause

drownings?
• What is the omitted variable?
Source: Boston Magazine, Amorino
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Summary
• Christmas causes sales to rise.
• Christmas causes ads to be red.
• Red ads are correlated with sales increases.
• Red ads do not necessarily cause sales

increases.
Another example: Average yearly earnings of 30-

year-old Americans by education
Average Yearly Earnings of 30-Year-Old Americans
by Education, 2017
2017 Dollars
70,000
$62,767
60,000
50,000
40,000
30,000 $26,035
20,000
10,000
0
High school graduates College graduates
Source: U.S. Census Bureau, Current Population Survey, Annual Social and Economic Supplement, 2018, CPS Table Creator.
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Causality vs. Correlation
• Does education cause people to earn higher

wages?
• Or…do people who would earn more anyway

(e.g., children from wealthy families with good
connections for getting jobs) also get college
educations?
Another example: Average yearly earnings of 30-

year-old Americans by education
Average Yearly Earnings of 30-Year-Old Americans
by Education, 2017
2017 Dollars
70,000
$62,767
Is this difference caused by,
60,000
or just correlated with,
50,000 years of education?
40,000
30,000 $26,035
20,000
10,000
0
High school graduates College graduates
Source: U.S. Census Bureau, Current Population Survey, Annual Social and Economic Supplement, 2018, CPS Table Creator.
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How would you separate causality from

correlation?
• Randomized Controlled Trial (RCT): assign
subjects to a control group and a treatment
group randomly
• Natural experiment: some natural process

assigns subjects to a control and a treatment
group in a random or nearly random way
Natural experiment on years of schooling

• Philip Oreopoulos has studied a natural experiment
created by a change in UK compulsory schooling laws.
• In 1947, the UK increased the minimum school leaving

age from 14 to 15. As a result, the fraction of children
dropping out of school by age 14 fell by 50 percentage
points between 1946 and 1948.
• Those kids reaching age 14 in 1946 are a control group for

those reaching age 14 in 1948.
• The typical student who turned 14 in 1948 (and was forced

to stay in school one extra year) earned 10% more on
average than the otherwise identical student who turned
14 in 1946 and dropped out.
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How are these three variables related?

Better Medical Care
Wealth
Health
Source: flickr: Pictures of Money; The Denise Roberts Breast Cancer Foundation; Runtastic
Wealth causes health?

Better Medical Care
Wealth
Health
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Reverse causality (too)

Better Medical Care
Wealth
Health
Review and glossary

• Correlation: two variables tend to move together (like
beach visits and temperature)
• Causality: cause and effect (Christmas causes red ads)

– Causality implies correlation
– Correlation does not imply causality
• Omitted variable: a missing causal variable that explains

why two variables are correlated (Christmas is the missing
variable that explains why red ads and revenue increases
are correlated)
• Reverse causality: when a causal relationship works the

opposite way people think it does (many people think
wealth causes health, but the evidence suggests it is
mostly the case that health causes wealth)
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Glossary continued
• Natural experiment: situation in which some sort of natural

quasi-random assignment creates a control group and a
treatment group
• Randomized controlled trial (RCT): situation in which

randomized assignment creates a control group and a
treatment group.
Characteristics of a well-designed RCT or

natural experiment
Four key ingredients:
1. Treatment groups (get interventions)
2. Control group (treated exactly the same as the

treatment group in every possible way, other than the
intervention)
3. Randomization (assignment rule that randomly or

quasi-randomly puts people in one of the treatment
groups or the control group)
4. Follow-up measurement strategy that avoids

differential attrition
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Final Example of Empiricism
Researchers randomly assigned each Intro Econ

class at West Point to one of three treatment groups:
1. No laptops or tablets.
2. Tablets only (and they must lie flat on the desk).
3. Laptops and tablets permitted.
All classes otherwise effectively the same.
Source: Carter, Greenberg and Walker (2016).
Moving from
the 50th to the
39th percentile
Source: Carter, Greenberg and Walker (2016).
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9/6/2019
Our electronic devices policy

• Electronic devices may not be used in class unless you opt into a
“laptop” seating section of the classroom (in which laptops and
iPads may be used for course-relevant purposes).
• Cell phones and smart watches are not allowed to be used in

class (except during polls).
• If you wish to sit in the laptop section, please send Paul Kelso an
email by 11:59 p.m. on September 13 (with subject line LAPTOP)
explaining why it is pedagogically valuable for you to use a
laptop in class.
• In our experience, for most students, laptops undermine

learning. Laptops are also a distraction when the people around
you are using them.
Outline
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9/6/2019
Three key ideas:

Principles of economics
i. People try to optimize: choosing the best feasible option
given the available information.
ii. Economic systems tend toward equilibrium: a state in which

no agent perceives that they would benefit by changing their
own behavior. The economic system is in equilibrium when
each agent feels that they cannot do any better by picking
another course of action.
iii. Economists test their ideas with empirical analysis – in other

words, economists use data to test their theories.
Economists are particularly interested in understanding
causation: what is causing things to happen in the world.
Lecture 2:
Principles of Economics and
Economic Methods
David Laibson
Ec 10a – Principles of Economics (Microeconomics)

September 9, 2019
Harvard College | Cambridge, MA 02138
29

Lecture 2 Principles of Economics and Economic Methods 2019

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9/6/2019

Ec 10a – Principles of Economics (Microeconomics)

Overall plan for the lecture

• Harvard Honor Code

The Harvard College Honor Code

This Photo by Unknown Author is licensed under CC BY

Each Unit is Worth 1% Extra Credit

A Few Important Abante-ChotzenFreund

Pan-Tadros ***Based on your

• Grab a Unit Review test from the

• Take your Unit Review test to a desk

• ***No phones, no computers, no notes!

Turn in your test to the supervisor…

This Photo by Unknown Author is licensed under CC BY‐SA‐NC

Return to your desk…

This Photo by Unknown Author is licensed under CC BY‐SA‐NC

Wait for your name to be called…

Wait for your name to be called…

Learn Your Results

This Photo by Unknown Author is licensed under CC BY‐NC‐ND

Use the Unit Review

In last week’s lecture we defined economics: the study of choice

We distinguished positive from normative economics.

We distinguished microeconomics from macroeconomics.

Today: More material from Chapters 1 and 2

Three key ideas:

ii. Economic systems tend toward equilibrium: a state in which

iii. Economists test their ideas with empirical analysis – in other

1. The First Principle of Economics: Optimization

2. The Second Principle of Economics: Equilibrium

3. The Third Principle of Economics: Empiricism

1. The First Principle of Economics: Optimization

2. The Second Principle of Economics: Equilibrium

3. The Third Principle of Economics: Empiricism

1. The First Principle of Economics: Optimization

• Economics is the study of choices (From Lecture 1:

• Optimization is a theory about how choices are made.

• Economists believe that people and other economic

• Definition: Choosing the best feasible option, given

1. The First Principle of Economics: Optimization

Optimization: choosing the best feasible option.

Source: Jin (2015).

1. The First Principle of Economics: Optimization

• 4 related tools discussed in Chapter 1

• Much more to come later in the course

1. The First Principle of Economics: Optimization

Write down some examples of tradeoffs that you face:

Do you feel that you are making these tradeoffs optimally?

1. The First Principle of Economics: Optimization

Trading off life vs. convenience

• The U.S. president asks you what the federally mandated

• About 40,000 people die each year in traffic accidents in

• Would you attempt to reduce the number of deaths on the

• If you desired, you could essentially eliminate traffic

• But setting the speed limit to 15 mph would have high

1. The First Principle of Economics: Optimization

2. The Second Principle of Economics: Equilibrium

3. The Third Principle of Economics: Empiricism

2. The Second Principle of Economics: Equilibrium

Definition: Equilibrium is a situation in which

Intuition: in equilibrium, all economic agents are

2. The Second Principle of Economics: Equilibrium

Which check-out line should you join?