Econometrics, economic theory and reduced forms

The following post is a slightly altered version of a column I’ve written for our student newspaper (see page 8 of the November 2011 issue of Nekst). In Tilburg, we have a separate department of econometrics, which I am a member of.

Wikipedia says econometrics is the discipline that “aim[s] to give content to economic relations”, citing the New Palgrave dictionary in economics. A sub-discipline of it is theoretical econometrics, which is concerned with statistical properties of econometric procedures, among other things. When people say econometrics in the Netherlands, this is what they mean. But actually, econometrics is much broader.

The most prestigious journal of our field is Econometrica, and when you visit the website looking for the “aims and scope” of it, then you will find that it “promotes studies that aim at the unification of the theoretical-quantitative and the empirical-quantitative approach to economic problems and that are penetrated by constructive and rigorous thinking” (emphasis added; you find a similar statement for the Journal of Econometrics). Interestingly, the ultimate goal is given here, namely to study economic problems. Studying statistical properties of estimators is part of it, but ultimately we want to answer questions that are interesting in the eyes of economists.

This brings me to the general approach in economics. Most economists study economic problems by means of models. An economic model is an abstraction of the world, which is made to focus on just a few aspects of human behavior and interaction. It is phrased in terms of assumptions, and one can think of it as a tale. We tell a story, and thereby hopefully learn about the big picture. Econometrics is of course concerned with the empirical side to this.

When you read an applied article in the Quarterly Journal of Economics, then you will often see that people exploit, in one way or another, exogenous variation to learn something about the average causal effect this variation has on some outcome. They then call this a reduced form approach, because they don’t estimate what the mechanism is through which something has an effect on something else. But they then move on and interpret their findings, having particular mechanisms or a class of models in mind. For example, when interpreting findings on unemployment duration, they will interpret their findings against the background of job search theory. Traditionally, there is a heated debate between followers of this approach, and followers of the so-called structural approach to econometrics. The structural approach is to spell out an economic model, and to estimate parameters of that model. Having the estimated parameters in hand, one can simulate how people would react to a policy change such as a tax reform that has not taken place. In a recent issue of the Journal of Econometrics, Michael Keane propagates the latter, in a somewhat provocative article.

What may seem confusing in this context is that every structural model has  so-called “reduced forms”, which one gets by solving the model and expressing some of the variables as functions of the other variables. Under the right assumptions, this yields an equation that is linear in parameters, and that can also be estimated. Then, one estimates structural parameters from a reduced form equation. But these are often not the same reduced forms people have in mind when they read the Quarterly Journal of Economics. So, one way to confuse them is to ask what the equation they are looking at is a reduced form of (but many of the authors will actually have a good answer to this question). In any case, Tilburg does not take sides in this debate. There are people who pursue the reduced-form approach, and people who pursue the structural approach, also within our department. The latter have recently formed a group, and you can check their website in case you are curious. In our seminar series, you can see the whole variety of things econometrics has to offer, and you are of course welcome to attend.

About kleintob

Tobias Klein is an Associate Professor at Tilburg University. He is an economist by training and obtained his Ph.D. from the University of Mannheim, Germany. Before that he visited the University of California at Berkeley Ph.D. program and the Ph.D. program at University College London, respectively for a year. He is passionate about economics, politics, food, and travelling. See for his professional website.

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