Applying Models to Policy

Applying Models to Policy

By the 1980s the theoretical work had largely been completed, and concern moved to the applicability of microeconomics to policy as economists started to apply the models to policy issues. As long as these models, generally partial equilibrium models were insightful and empirically supportable, they did not have to be consistent with general equilibrium theory, which except for a few studies of computable general equilibrium models, moved to the background. An example of such a policy application is the lemons model designed by Berkeley economist George Akerlof. This model explains why markets might fail in particular instances.

The essence of the lemons model is the following: Say you want to buy a used car, and someone comes to you and offers you one at a very low price. Should you buy it? Not necessarily, because you do not have full information about the car. The fact that someone is selling it at such a low price suggests that something is wrong with it. The point of the model is that prices may carry with them information about the quality of the good, and if they do, the market will not necessarily lead to the right price. It may fail. Creating models in which markets may fail because of such information problems is typical of the theoretical work done by modern microeconomics. This model has many potential applications. Modern economists apply variations of it and similar models to a variety of situations to "explain" why what we observe happens.
Most modern microeconomists don't create models such as the lemons model; they apply them to particular problems. Hal Varian, a top modern microecono-mist, gives the following advice on how to build a model. He suggests that you look into the newspaper for a problem and then see if you can think of an economic explanation for it. For example: Why do stores run sales? Having chosen your problem, you should try to model it. He writes:

Luckily for you, all economics models look pretty much the same. There are some economic agents. They make choices in order to advance their objectives. The choices have to satisfy various constraints so there's something that adjusts to make all these choices consistent. This basic structure suggests a plan of attack . . . and can help you identify the pieces of a model.9
He continues by saying that you should then build your model, following the KISS criterion (keep it simple, stupid). After you have a simple model, you generalize the model.

Here is where your education can be helpful. At last you can use all those techniques you learned in graduate school. Most of the time you were a student you probably studied various canonical models: things like consumer choice, and producer choice, general equilibrium, game theory, and so on. . . . Most likely your model is a special case of one of these general models. If so, you can immediately apply many of the results concerning the general model to your special case, and all that technique you learned can help you analyze your model.

Since most of the models economists use are partial, not general, equilibrium models, as this applied modeling approach became the norm, the connection between modern applied work and general equilibrium theory has become tenuous.