Nobel Economists: They Opened Their Eyes

(From nobelprize.org)

Economics has been nicknamed the "dismal science", but this year's Nobel Prize winners have not only published insightful studies with real-world policy implications but also have injected creativity into a profession which seemed to have been destined to a future of endless number-crunching. [bold added]

The Nobel Memorial Prize in Economic Sciences was awarded Monday to David Card of the University of California, Berkeley, Joshua Angrist of the Massachusetts Institute of Technology and Guido Imbens of Stanford University.

The prize committee cited Mr. Card’s “empirical contributions to labor economics” and praised Messrs. Angrist and Imbens for “their methodological contributions to the analysis of causal relationships.” Messrs. Card and Angrist have contributed by running “natural experiments” in economics, and Messrs. Angrist and Imbens have contributed to the theoretical basis for these experiments.

Natural experiments have led economists to conclude that an additional year of education substantially raises one’s lifetime income, that small increases in the minimum wage don’t have much effect on employment, and that Medicaid has little effect on people’s physical health.

Why do natural experiments matter? One of the toughest problems in economic research is figuring out whether a relationship between two variables is causal or coincidental. So, for example, economists find that the lifetime earnings of people who go to school for 12 years are higher than those of people who go to school for 11 years. But what if those who stay in school longer are more motivated or smarter than those who are in for only 11 years? Then the earnings of the more-schooled would be higher even if schooling per se doesn’t add much to earnings. What one would ideally like is to compare the earnings of people whose motivations and intelligence don’t differ.

Enter compulsory schooling. In 1991, Mr. Angrist and the late Alan Krueger noted that under compulsory-schooling laws, students born in the first quarter of the calendar year would be able to leave school earlier than students born in the fourth quarter. Sure enough, they found, those born in the fourth quarter had an average of 0.15 year more in school. And the earnings of those in the fourth quarter were 1.4% higher than the earnings of those born in the first quarter. Extrapolate that to a full-year difference in schooling, and you can conclude that one extra year of schooling raises earnings by about 9%.

Messrs. Card and Krueger conducted a famous natural experiment by studying employment at fast-food restaurants in New Jersey and Pennsylvania before and after New Jersey raised the minimum wage while Pennsylvania didn’t. Contrary to what one might expect, employment in New Jersey’s fast-food restaurants rose slightly relative to employment in Pennsylvania’s.

Economist Alex Tabarrok discusses why the approach used to answer the minimum-wage question was so brilliant:

The obvious way to estimate the effect of the minimum wage is to look at the difference in employment in fast food restaurants before and after the law went into effect. But other things are changing through time so circa 1992 the standard approach was to “control for” other variables by also including in the statistical analysis factors such as the state of the economy. Include enough control variables, so the reasoning went, and you would uncover the true effect of the minimum wage. Card and Krueger did something different, they turned to a control group.

Pennsylvania didn’t pass a minimum wage law in 1992 but it’s close to New Jersey so Card and Kruger reasoned that whatever other factors were affecting New Jersey fast food restaurants would very likely also influence Pennsylvania fast food restaurants. The state of the economy, for example, would likely have a similar effect on demand for fast food in NJ as in PA as would say the weather. In fact, the argument extends to just about any other factor that one might imagine including demographics, changes in tastes and changes in supply costs. The standard approach circa 1992 of “controlling for” other variables requires, at the very least, that we know what other variables are important. But by using a control group, we don’t need to know what the other variables are only that whatever they are they are likely to influence NJ and PA fast food restaurants similarly. Put differently NJ and PA are similar so what happened in PA is a good estimate of what would have happened in NJ had NJ not passed the minimum wage.

Thus Card and Kruger estimated the effect of the minimum wage in New Jersey by calculating the difference in employment in NJ before and after the law and then subtracting the difference in employment in PA before and after the law. Hence the term difference in differences. By subtracting the PA difference (i.e. what would have happened in NJ if the law had not been passed) from the NJ difference (what actually happened) we are left with the effect of the minimum wage. Brilliant!

Indentifying control variables is tricky, as Prof. Tabarrok points out, and the more control variables one has the more statistical noise is created, and the less powerful the results. With a control group, researchers need not be concerned with control variables.

The Nobel winners aren't superhuman, however. The minimum-wage study likely wasn't error-free:

Unfortunately, Messrs. Card and Krueger’s data weren’t so great—they gathered it by phoning restaurants.

Nevertheless, once the idea was originated, the data could be obtained and analyzed.

At the dawn of the age of artificial intelligence, Professors Card, Angrist, and Imbens, and the late Alan Krueger, have given us hope that human ingenuity is not dead:

Card and Krueger revealed to economists that there were natural experiments with plausible treatment and control groups all around us, if only we had the creativity to see them. The last thirty years of empirical economics has been the result of economists opening their eyes to the natural experiments all around them.