Elkhart County, Indiana Rides the Surge in Spending on Consumer Durables

More than 80 percent of the recreational vehicles (RV) sold in the United States are manufactured in Elkhart County, Indiana. As we discuss in the opener to Chapter 22 in Economics (Chapter 12 in Macroeconomics), being dependent on sales of expensive durable goods like RVs means that the county is particularly vulnerable to the business cycle, with local firms experiencing rising sales during economic expansions and sharply falling sales during economic recessions. Accordingly, the unemployment rate in the county fluctuates much more during the business cycle than is typical—as shown in the above graph.

For example, during the Great Recession of 2007-2009, the unemployment rate in the country rose from a low of 3.9 percent in May 2007 to a high of 20 percent in March 2009, before declining during the following economic recovery.  Just before the start of the Covid-19 recession of 2020, the unemployment rate in Elkhart was 2.8 percent. It then soared to 30.8 percent in April. 

But, as we discuss in the chapter, the recovery from the 2020 recession was unusually rapid, although uneven. Many services industries, such as restaurants, gyms, and movie theaters continued to struggle well into 2021 as firms had difficulty attracting workers and as some consumers remained reluctant to spend time inside in close contact with other people. In contrast, consumer spending on durable goods was far above its pre-pandemic level, as well as being above the rate at which it had been growing during the years before the pandemic. The two graphs below show real consumer spending on durables and on services up through August 2021.

During 2021, sales of RVs through August were 50 percent higher than in the same period in 2020 and were on a pace to reach record annual sales. The success of the RV industry has led to rising incomes in Elkhart County, which, in turn, has allowed the area to attract other industries, including a logistics center that when completed will be the largest industrial building in Indiana and an Amazon warehouse that when completed will provide 1,000 new jobs. Rising incomes have also supported other businesses, such as community theaters, art galleries, and a recently reopened 1920s-era hotel.

In October 2021, the Wall Street Journal ranked Elkhart County first in its rating of metropolitan areas as measured by the index it compiles with realtor.com. The index “identifies the top metro areas for home buyers seeking an appreciating housing market and appealing lifestyle amenities.” If consumers continue to buy more goods and fewer services, it could be bad news for restaurants and other service industries, but good news for places like Elkhart that depend on goods-producing industries. 

Sources: Nicole Friedman, “RV Capital of America Tops WSJ/Realtor.com Housing Index in Third Quarter,” wsj.com, October 19, 2021; Business Wire, “Amazon Announces New Robotics Fulfillment Center and Delivery Station in Elkhart County, Creating More Than 1,000 New, Full-Time Jobs,” businesswire.com, October 7, 2021; Construction Review Online, “Hotel Elkhart Grand Opening Celebrated in Elkhart, Indiana,” constructionreviewonline.com, October 4, 2021; Construction Review Online, “Elkhart County Logistics Facility to Bring about 1,000 jobs in Indiana,” constructionreviewonline.com, August 16, 2021; Federal Reserve Bank of St. Louis; and RV Industry Association.

WeWork Gets SPAC’d

In 2021, SPACs were the hottest trend on the stock market and had become the leading way for companies to go public. A public company is one with shares that trade on the stock market. Private firms make up more than 95 percent of all firms in the United States. Most will never become public firms because they will never grow large enough for investors to have sufficient information on the firms’ financial health to be willing to buy the firms’ stocks and bonds.

But some firms, particularly technology firms, grow rapidly enough that they are able to become public firms. Apple, Microsoft, Google, Uber, Facebook, Snap, and other firms have followed this path. When these firms went public, they did so using an initial public offering (IPO). (We briefly discuss IPOs in Economics and Microeconomics, Chapter 8, Section 8.2 and in Macroeconomics, Chapter 6, Section 6.2.) With an IPO, a firm uses one or more investment banks to underwrite the firm’s sales of new stocks or bonds to the public. In underwriting,investment banks typically guarantee a price for stocks or bonds to the issuing firm, sell the stocks or bonds in financial markets or directly to investors at a higher price, and keep the difference, known as the spread.

Beginning in 2020 and continuing through 2021, an increasing number of firms have used a different means of going public—merging with a SPAC. SPAC stands for special-purpose acquisition company and is a firm that holds only cash—it doesn’t sell a good or service—and only has the purpose of merging with another firm that wants to go public. Once a merger takes place, the acquired firm takes the place of the SPAC in the stock market. For instance, a SPAC named Diamond Eagle Acquisition merged with online sports betting site DraftKings in April 2020. Once the merger had been completed, DraftKings took Diamond Eagle’s place on the stock market, trading under the stock symbol DKNG. By 2021, the value of SPAC mergers had risen to being three times as much as the value of IPOs.

Some firms intending to go public prefer SPACs to traditional IPOs because they can bargain directly with the managers of the SPAC in determining the value of the firm. In addition, IPOs are closely regulated by the federal government’s Securities and Exchange Commission (SEC). In particular, the SEC monitors whether an investment bank is accurately stating the financial prospects of a firm whose IPO the bank is underwriting. The claims that SPACs make when attracting investors are less closely monitored. SPAC mergers can also be finalized more quickly than can traditional IPOs.

The experience of WeWork illustrates how some firms that have struggled to go public through an IPO have been able to do so by merging with a SPAC. Adam Neumann and Miguel McLevey founded WeWork in 2010 as a firm that would rent office space in cities, renovate the space, and then sub-lease it to other firms. In 2019, the firm prepared for an IPO that would have given the firm a total value of more than $40 billion. But doubts about the firm’s business model led to an indefinite postponement of the IPO and Neumann was forced out as CEO.

WeWork was reorganized under new CEO Sandeep Mathrani and went public in October 2021 by merging with BowX Acquisition Corporation, a SPAC. Although WeWork’s stock began trading (under stock symbol WE) at a price that put the firm’s value at about $9 billion—far below the value it expected at the time of its postponed IPO two years before—investors seemed optimistic about the firm’s future because its stock price rose sharply during the first two days it traded on the stock market. 

Some policymakers are concerned that individual investors may not have sufficient information on firms that go public through a merger with a SPAC. Under one proposal being considered by Congress, financial advisers would only be allowed to recommend investing in SPACs to wealthy investors. The SEC is also considering whether new regulations governing SPACS were needed. Testifying before Congress, SEC Chair Gary Gensler sated: “There’s real questions about who’s benefiting [from firms going public using SPACs] and [about] investor protection.” 

It remains to be seen whether SPACs will retain their current position as being the leading way for firms to go public.

Sources: Dave Sebastian, “WeWork Shares Rise on First Day of Trading, Two Years After Failed IPO,” wsj.com, October 21, 2021; Peter Santilli and Amrith Ramkumar, “SPACs Are the Stock Market’s Hottest Trend. Here’s How They Work,” wsj.com, March 29, 2021; Benjamin Bain, “SPAC Marketing Heavily Curtailed in House Democrats’ Draft Bill,” bloomberg.com, October 4, 2021; and Dave Michaels, “SEC Weighs New Investor Protections for SPACs,” wsj.com, May 26, 2021.

Economies of Scale in Ocean Shipping and U.S. Retailers’ Response to Pandemic Supply Chain Problems

Beginning in the 1950s, several companies pioneered in developing modern shipping containers that once arrived at docks can be lifted by cranes and directly attached to trucks or loaded on to trains for overland shipping. As economist Marc Levinson was the first to discuss in detail in his 2004 book, The Box, container shipping, by greatly reducing transportation costs, helped to make the modern global economy possible. (We discuss globalization in Economics, Chapter 9, Section 9.1 and Chapter 21, Section 21.4, and in Macroeconomics, Chapter 7, Section 7.1 and Chapter 11, Section 11.4.) 

Lower transportation costs meant that small manufacturing firms and other small businesses that depended on selling in local markets faced much greater competition, including from firms located thousands of miles away. The number of dockworkers declined dramatically as the loading and unloading of cargo ships became automated. Ports such as New York City, San Francisco, and Liverpool that were not well suited for handling containers because they lacked sufficient space for the automated equipment and the warehouses, lost most of their shipping business to other ports, such as Los Angeles, Seattle, and London. Consumers in all countries benefited because lower transportation costs meant they were able to buy cheaper imported goods and had a much greater variety of goods to choose from.

In the decades since the 1950s, shipping firms have continued to exploit economies of scale in container ships. (We discuss the concept of economies of scale in Econimics and Microeconomics, Chapter 11, Section 11.6.) Today, shipping containers have been standardized at either 20 feet or 40 feet long and the largest ships can haul thousands of containers. Levinson explains why economies of scale are important in this industry:

“A vessel to carry 3,000 containers did not require twice as much steel or twice as large an engine as a vessel to carry 1,500. [Because of automation, a] larger ship did not require a larger crew, so crew wages per container were much lower. Fuel consumption did not increase proportionally with the vessel’s size.”

To take advantage of these economies of scale, the ships needed to sail fully loaded. The largest ships can sail fully loaded only on routes where shipping volumes are highest, such as between Asia and the United States or between the United States and Europe. As a result, as Levinson notes, the largest ships are “uneconomic to run on most of the world’s shipping lanes” because on most routes the costs per container are higher for the largest ships for smaller ships. (Note that even these “smaller ships” are still very large in absolute size, being able to haul 1,000 containers.) 

Large U.S. retail firms, such as Walmart, Home Depot, and Target rely on imported goods from Asian countries, including China, Japan, and Vietnam. Ordinarily, they are importing goods in sufficient quantities that the goods are shipped on the largest vessels, which today have the capacity to haul 20,000 containers. But during the pandemic, a surge in demand for imported goods combined with disruptions caused by Covid outbreaks in some Asian ports and a shortage of truck drivers and some other workers in the United States, resulted in a backlog of ships waiting to disembark their cargoes at U.S. ports. The ports of Los Angeles and Long Beach in southern California were particularly affected. By October 2021, it was taking an average of 80 days for goods to be shipped across the Pacific, compared with an average of 40 days before the pandemic.

Some large U.S. firms responded to the shipping problems by chartering smaller ships that ordinarily would only make shorter voyages. According to an article in the Wall Street Journal, “the charters provide the big retailers with a way to work around bottlenecks at ports such as Los Angeles, by rerouting cargo to less congested docks such as Portland, Ore., Oakland, Calif., or the East Coast.”  Unfortunately, because the smaller ships lacked the economies of scale of the larger ships, the cost the U.S. firms were paying per container were nearly twice as high. (Note that this result is similar to the cost difference between a large and a small automobile factory, which we illustrated in Economics and Microeconomics, Figure 11.6.)

Unfortunately for U.S. consumers, the higher costs U.S. retailers paid for transporting goods across the Pacific Ocean resulted in higher prices on store shelves. Shopping for presents during the 2021 holiday season turned out to be more expensive than in previous years. 

Sources: Marc Levinson, The Box: How the Shipping Container Made the World Smaller and the World Economy Bigger, Second edition, Princeton, NJ: Princeton University Press, 2016; Sarah Nassauer and Costas Paris, “Biggest U.S. Retailers Charter Private Cargo Ships to Sail Around Port Delays,” wsj.com, October 10, 2021; and Melissa Repko, “How Bad Are Global Shipping Snafus? Home Depot Contracted Its Own Container Ship as a Safeguard,” cnbc.com, June 13, 2021. 

The Many Uses of Elasticity: An Example from Law Enforcement Policy

In this chapter, we have studied several types of elasticities, starting with the price elasticity of demand. Elasticity is a general concept that economists use to measure the effect of a change in one variable on another variable. An example of a more general use of elasticity, beyond the uses we discussed in this chapter, appears in a new academic paper written by Anne Sofie Tegner Anker of the University of Copenhagen, Jennifer L. Doleac of Texas A&M University, and Rasmus LandersØ of Aarshus University. 

The authors are interested in studying the effects of crime deterrence. They note that rational offenders will be deterred by government policies that increase the probability that an offender will be arrested. Even offenders who don’t respond rationally to an increase in the probability of being arrested will still commit fewer crimes because they are more likely to be arrested. Governments have different policies available to reduce crime. Given that government resources are scarce, efficient allocation of resources requires policymakers to choose policies that provide the most deterrence per dollar of cost.

The authors note “we currently know very little about precisely how much deterrence we achieve for any given increase in the likelihood that an offender is apprehended.” They attempt to increase knowledge on this point by analyzing the effects of a policy change in Denmark in 2005 that made it much more likely that an offender would have his or her DNA entered into a DNA database: “The goal of DNA registration is to deter offenders and increase the likelihood of detection of future crimes by enabling matches of known offenders with DNA from crime scene evidence.”

The authors find that the expansion of Denmark’s DNA database had a substantial effect on recidivism—an offender committing additional crimes—and on the probability that an offender who did commit additional crimes would be caught. They estimate that “a 1 percent higher detection probability reduces crime by more than 2 percent.” In other words, the elasticity of crime with respect to the detection probability is −2.

Just as the price elasticity of demand gives a business manager a useful way to summarize the responsiveness of the quantity demanded of the firm’s product to a change in its price, the elasticity the authors estimated gives a policymaker a useful way to summarize the responsiveness of crime to a policy that increases the probability of catching offenders.  

Source: Anne Sofie Tegner Anker, Jennifer L. Doleac, and Rasmus LandersØ, “The Effects of DNA Databases on the Deterrence and Detection of Offenders,” American Economic Journal: Applied Economics, Vol. 13, No. 4, October 2021, pp. 194-225. 

Is Bitcoin the New Gold?

As we discuss in the chapter, initially, bitcoin was thought of as a way to buy and sell goods and services. Some stores accepted bitcoin and allowed customers to make payment by scanning a bar code with a phone. Some websites offered merchants a way to process purchases made with bitcoins in a manner similar to the way merchants process credit card payments.

In practice, though, swings in the value of bitcoin have been much too large to make it a good substitute for cash, checks, or credit cards in everyday transactions. For instance, at the beginning of 2015, one bitcoin was worth about $300. Over the following five years, the price of bitcoin rose as high at $17,000 before falling to about $8,000 at the beginning of 2020. During 2021, the volatility of bitcoin prices increased, rising as high as $62,000 in April and falling as low as $30,000 in July before rising back above $60,000 in October. (The following chart shows movements in the price of bitcoin from early July to mid-October 2021; the vertical axis shows the price as dollars per bitcoin.)

Some economists have suggested that rather being a medium of exchange, like dollar bills, bitcoin has become a speculative asset, like gold. Bitcoin shares with gold the characteristic that ultimately its total supplied is limited. The supply of Bitcoin can’t increase beyond 21 million, a limit that is expected to be reached in 2030. The gold stock slowly increases as mines produce more gold, although the output of mines is small compared with the existing stock of gold. Some investors and speculators are reassured that, in contrast to the assets in M1 and M2 that can increase as much as the Fed chooses, gold and bitcoin have limits on how much they can increase.

Will Bitcoin Be a Good Hedge Against Inflation? Can It Be Useful in Diversifying a Portfolio?

Some investors and speculators believe that the limited quantities of gold and bitcoin available make them good hedges against inflation—that is, they believe that the prices of gold and bitcoin will reliably increase during periods of inflation.  In fact, though, gold has proven to be a poor hedge against inflation because in the long run the price of gold has not reliably increased faster than the inflation rate. There is no good economic reason to expect that over the long run bitcoin would be a good inflation hedge either.

From a broader perspective than as just an inflation hedge, some economists argue that gold has a role to play in an investor’s portfolio—which is the collection of assets, such as stocks and bonds, that an investor owns. Investors can reduce the financial risk they face through diversification, or spreading their wealth among different assets. For instance, an investor who only holds Apple stock in her portfolio is subject to more risk than an investor with the same dollar amount invested in a portfolio that holds the stocks of multiple firms as well as non-stock investments. An investor obtains the benefits of diversification best by adding assets to her portfolio that are not well correlated with the assets she already owns—that is the prices of the assets she adds to her portfolio don’t typically move in the same direction as the prices of the assets she already owns.

For instance, during a typical recession sales of consumer staples, like baby diapers and laundry detergent, hold up well, while sales of consumers durables, like automobiles, usually decline significantly. So adding shares of stock in Proctor & Gamble to a portfolio that already has many shares of General Motors achieves diversification and reduces financial risk because movements in the price of shares of Proctor & Gamble are likely not to be highly correlated with movements in the price of shares of General Motors.

Studies have shown that during some periods movements in gold prices are not correlated with movements in prices of stocks or bonds. In other words, gold prices may rise during a period when stock prices are declining. As a result, an investor may want to add gold to her portfolio to diversify it. To this point, bitcoin hasn’t been around long enough to draw firm conclusions about whether adding bitcoin to a portfolio provides significant diversification, although some investors believes that it does. 

Finance professionals are divided in their opinions on whether bitcoin is a good substitute for gold in a financial portfolio. In an interview, billionaire investor Ray Dalio, founder of Bridgewater Associates, the world’s hedge fund, noted that while he believes that bitcoin may serve as a hedge against inflation, but if he could only hold gold or bitcoin, “I would choose gold.” His preference for gold is due in part to his belief that the federal government may increase regulation of bitcoin and that regulators might eventually even decide to ban it. A businessinsider.com survey of 10 financial experts found them divided with five preferring gold as an investment and five preferring bitcoin.

Sources: Jade Scipioni, “Bitcoin vs. Gold: Here’s What Billionaire Ray Dalio Thinks,” cnbc.com, August 4, 2021; and Isabelle Lee and Will Daniel, “Bitcoin vs. Gold: 10 Experts Told Us Which Asset They’d Rather Hold for the Next 10 Years, and Why,” businessinsider.com, February 20, 2021.

New 10/17/21 Podcast – Authors Glenn Hubbard & Tony O’Brien discuss economic impact of infrastructure spending & the supply-chain challenges.

Authors Glenn Hubbard and Tony O’Brien discuss the economic impact of the recent infrastructure bill and what role fiscal policy plays in determining shovel-ready projects. Also, they explore the vast impact of the economy-wide supply-chain issues and the challenges companies face. Until the pandemic, we had a very efficient supply chain but now we’re seeing companies employ the “just-in-case” inventory method vs. “just-in-time”!

Some links referenced in the podcast:

Here’s Alan Cole’s blog: https://fullstackeconomics.com/how-i-reluctantly-became-an-inflation-crank/

Neil Irwin wrote a column referencing Cole here:  https://www.nytimes.com/2021/10/10/upshot/shadow-inflation-analysis.html

Here’s a Times article on the inefficiency of subway construction in NYC:  https://www.nytimes.com/2017/12/28/nyregion/new-york-subway-construction-costs.html

A recent article on the state of CA’s bullet train:  https://www.kcra.com/article/california-bullet-trains-latest-woe-high-speed/37954851

A WSJ column on goods v. services: https://www.wsj.com/articles/at-times-like-these-inflation-isnt-all-bad-11634290202

The Pandemic and Hidden Inflation

If the price of your meal is the same, but the service is slow and the menu is limited you have experienced hidden inflation.

Each month, hundreds of employees of the Bureau of Labor Statistics gather data on prices of goods and services from stores in 87 cities and from websites. The BLS constructs the consumer price index (CPI) by giving each price a weight equal to the fraction of a typical family’s budget spent on that good or service. (We discuss the construction of the CPI in Chapter 9, Section 9.4 of Macroeconomics and Chapter 19, Section 19.4 of Economics.) Ideally, the BLS tracks prices of the same product over time. But sometimes a particular brand and style of shirt, for example, is discontinued. In that case, the BLS will use instead the price of a shirt that is a very close substitute.

A more difficult problem arises when the price of a good increases at the same time that the quality of the good improves. For instance, a new model iPhone may have both a higher price and a better battery than the model it replaces, so the higher price partly reflects the improvement in the quality of the phone.  The BLS has long been aware of this problem and has developed statistical techniques that attempt to identify that part of price increases that are due to increases in quality. Economists differ in their views on how successfully the BLS has dealt with this quality bias to the measured inflation rate. Because of this bias in constructing the CPI, it’s possible that the published values of inflation may overstate the actual annual rate of inflation by 0.5 percentage point. So, for instance, the BLS might report an inflation rate of 3.5 percent when the actual inflation rate—if the BLS could determine it—was 4.0 percent.

During 2021, a number of observers pointed to a hidden type of inflation occurring, particularly in some service industries. For example, because many restaurants were having difficulty hiring servers, it was often taking longer for customers to have their orders taken and to have their food brought to the table.  Because restaurants were also having difficulty hiring enough cooks, they also limited the items available on their menus. In other words, the service these restaurants were offering was not as good as it had been prior to the pandemic. So even if the restaurants kept their prices unchanged, their customers were paying the same price but receiving less. 

Alan Cole, who was formerly a senior economist with the Congressional Joint Economic Committee, noted on his blog that “goods and services are getting worse faster than the official statistics acknowledge, suggesting that our inflation problem has actually been bigger than the official statistics suggest.” As examples, he noted that “hotels clean rooms less frequently on multi-night stays,” “shipping delays are longer, and phone hold times at airlines are worse.” In a column in the New York Times, economics writer Neil Irwin made similar points: “Complaints have been frequent about the cleanliness of [restaurant] tables, floors and bathrooms.”  And: “People trying to buy appliances and other retail goods are waiting longer.”

A column in the Wall Street Journal on business travel by Scott McCartney was headlined “The Incredible Disappearing Hotel Breakfast.” McCartney noted that many hotels continue to advertise free hot breakfasts on their websites and apps but have stopped providing them. He also noted that hotels “have suffered from labor shortages that have made it difficult to supply services such as daily housekeeping or loyalty-group lounges,” in addition to hot breakfasts.

The BLS makes no attempt to adjust the CPI for these types of deterioration in the quality of services because doing so would be very difficult. As Irwin notes: “Customer service preferences—particularly how much good service is worth—varies highly among individuals and is hard to quantify. How much extra would you pay for a fast-food hamburger from a restaurant that cleans its restroom more frequently than the place across the street?”

As we noted earlier, most economists believe that the failure of the BLS to fully account for improvements in the quality of goods results in changes in the CPI overstating the true inflation rate.  This bias may have been more than offset since the beginning of the pandemic by deterioration in the quality of services resulting in the CPI understating the true inflation rate. As the dislocations caused by the pandemic gradually resolve themselves, it seems likely that the deterioration in services will be reversed. But it’s possible that the deterioration in the provision of some services may persist. Fortunately, unless the deterioration increases over time, it would not continue to distort the measurement of the inflation rate because the same lower level of service would be included in every period’s prices.

Sources: Alan Cole, “How I Reluctantly Became an Inflation Crank,” fullstackeconomics.com, September 8, 2021; Scott McCartney, “The Incredible Disappearing Hotel Breakfast—and Other Amenities Travelers Miss,” wsj.com, October 20, 2021; and Neil Irwin, “There Is Shadow Inflation Taking Place All Around Us,” nytimes.com, October 14, 2021.

The College Majors of U.S. Billionaires

Jim McKelvey, cofounder of Square and undergraduate economics major

Each year, Forbes magazine compiles a list of the 400 richest people in the United States. A recent article in Forbes reports on the college majors of these billionaires. Forbes was able to find that information for 357 of the 400. Perhaps unsurprisingly, 65 chose business, making it the most popular undergraduate major.  

Economics was the second most popular major, with 58 having chosen it, followed closely by engineering with 55. There is a substantial drop to the next most popular major—politics and government—with 22 of the 400 billionaires having chosen it. Given that we often associate billion dollar fortunes with the founders of tech companies, it may be surprising that only 17 of the 400 majored in computer science. Included among them, though, is Jeff Bezos, who majored in computer science and engineering at Princeton and who holds first place on the Forbes list of the wealthiest Americans. 

The article quotes Jim McKelvey, cofounder of credit card processor Square, as observing about economics: “There are a few basic concepts in economics that help in business. Micro and especially game theory are helpful to predict customer behavior. And macro has been super helpful ever since I joined the board of the Federal Reserve.” McKelvey currently serves as deputy chair of the board of directors of the Federal Reserve Bank of St. Louis.

Source: Matt Durot, “Want to Be a Billionaire? These Are the Most Popular Majors of the Richest Americans,” forbes.com, October 8, 2021. LINK

Card, Angrist, and Imbens Win Nobel Prize in Economics

David Card
Joshua Angrist
Guido Imbens

   David Card of the University of California, Berkeley; Joshua Angrist of the Massachusetts Institute of Technology; and Guido Imbens of Stanford University shared the 2021 Nobel Prize in Economics (formally, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel). Card received half of the prize of 10 million Swedish kronor (about 1.14 million U.S. dollars) “for his empirical contributions to labor economics,” and Angrist and Imbens shared the other half “for their methodological contributions to the analysis of causal relationships.” (In the work for which they received the prize, all three had collaborated with the late Alan Krueger of Princeton University. Card was quoted in the Wall Street Journal as stating that: “I’m sure that if Alan was still with us that he would be sharing this prize with me.”)

The work of the three economists is related in that all have used natural experiments to address questions of economic causality. With a natural experiment, economists identify some variable of interest—say, an increase in the minimum wage—that has changed for one group of people—say, fast-food workers in one state—while remaining unchanged for another similar group of people—say, fast-food workers in a neighboring state. Researchers can draw an inference about the effects of the change by looking at the difference between the outcomes for the two groups. In this example, the difference between changes in employment at fast-food restaurants in the two states can be used to measure the effect of an increase in the minimum wage.

Using natural experiments is an alternative to the traditional approach that had dominated empirical economics from the 1940s when the increased availability of modern digital computers made it possible to apply econometric techniques to real-world data. With the traditional approach to empirical work, economists would estimate structural models to answer questions about causality. So, for instance, a labor economist might estimate a model of the demand and supply of labor to predict the effect of an increase in the minimum wage on employment.

Over the years, many economists became dissatisfied with using structural models to address questions of economic causality. They concluded that the information requirements to reliably estimate structural models were too great. For instance, structural models require assumptions about the functional form of relationships, such as the demand for labor, that are not inferable directly from economic theory. Theory also did not always identify all variables that should be included in the model. Gathering data on the relevant variables was sometimes difficult. As a result, answers to empirical questions, such as the employment effects of the minimum wage, differed substantially across studies. In such cases, policymakers began to see empirical economics as an unreliable guide to economic policy.

In a famous study of the effect of the minimum wage on employment published in 1994 in the American Economic Review, Card and Krueger pioneered the use of natural experiments.  In that study, Card and Krueger analyzed the effect of the minimum wage on employment in fast-food restaurants by comparing what happened to employment in New Jersey when it raised the state minimum wage from $4.25 to $5.05 per hour with employment in eastern Pennsylvania where the minimum wage remained unchanged.  They found that, contrary to the usual analysis that increases in the minimum wage lead to decreases in the employment of unskilled workers, employment of fast-food workers in New Jersey actually increased relative to employment of fast-food workers in Pennsylvania. 

The following graphic from Nobel Prize website summarizes the study. (Note that not all economists have accepted the results of Card and Krueger’s study. We briefly summarize the debate over the effects of the minimum wage in Chapter 4, Section 4.3 of our textbook.)

Drawing inferences from natural experiments is not as straightforward as it might seem from our brief description. Angrist and Imbens helped develop the techniques that many economists rely on when analyzing data from natural experiments.

Taken together, the work of these three economists represent a revolution in empirical economics. They have provided economists with an approach and with analytical techniques that have been applied to a wide range of empirical questions. 

For the annoucement from the Nobel website click HERE.

For the article in the Wall Street Journal on the prize click HERE (note that a subscription may be required).

For the orignal Card and Krueger paper on the minimum wage click HERE.

For David Card’s website click HERE.

For Joshua Angrist’s website click HERE.

For Guido Imbens’s website click HERE.