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HowtoBuildanEconomicModelinYourSpareTimebyHalR.VarianUCBerkeleyDecember1994Currentversion:June11,1997Abstract.ThisisanessayforPassionandCraft:EconomistsatWork,editedbyMichaelSzenberg,UniversityofMichiganPress,1997.Keywords.Address.HalR.Varian,Dean,SchoolofInformationMangementandSystems,UCBerkeley.Webpage~halHowtoBuildanEconomicModelinYourSpareTimeHalR.VarianMostofmyworkineconomicsinvolvesconstructingtheoreticalmodels.Overtheyears,Ihavedevelopedsomewaysofdoingthisthatmaybeworthdescribingtothosewhoaspiretopracticethisart.Inrealitytheprocessismuchmorehaphazardthanmydescriptionwouldsuggest---themodelofresearchthatIdescribeisanidealizationofreality,muchliketheeconomicmodelsthatIcreate.Butthereisprobablyenoughconnectionwithrealitytomakethedescriptionuseful---whichIhopeisalsotrueformyeconomicmodels.1.GettingideasThefirststepistogetanidea.Thisisnotallthathardtodo.Thetrickypartistogetagoodidea.Thewayyoudothisistocomeupwithlotsandlotsofideasandthrowoutalltheonesthataren’tgood.Butwheretogetideas,that’sthequestion.Mostgraduatestudentsareconvincedthatthewayyougetideasistoreadjournalarticles.Butinmyexperiencejournalsreallyaren’taverygoodsourceoforiginalideas.Youcangetlotsofthingsfromjournalarticles---technique,insight,eventruth.Butmostofthetimeyouwillonlygetsomeoneelse’sideas.True,theymayleaveafewlooseendslyingaroundthatyoucanpickupon,butthereasontheyarelooseisprobablythattheauthorthoughtaboutthemawhileandcouldn’tfigureoutwhattodowiththemordecidedtheyweretootedioustobotherwith---whichmeansthatitislikelythatyouwillfindyourselfinthesamesituation.Mysuggestionisratherdifferent:Ithinkthatyoushouldlookforyourideasoutsidetheacademicjournals---innewspapers,inmagazines,inconversations,andinTVandradioprograms.Whenyoureadthenewspaper,lookforthearticlesabouteconomics:::andthenlookattheonesthataren’tabouteconomics,becauselotsofthetimetheyendupbeingabouteconomicstoo.Magazinesareusuallybetterthannewspapersbecausetheygointoissuesinmoredepth.Ontheotherhand,ashalloweranalysismaybemore1stimulating:there’snothinglikeafallaciousargumenttostimulateresearch.1Conversations,especiallywithpeopleinbusiness,areoftenveryfruitful.Commerceisconductedinmanyways,andmostofthemhaveneverbeensubjectedtoaseriouseconomicanalysis.Ofcourseyouhavetobecarefulnottobelieveeverythingyouhear---peopleinbusinessusuallyknowasetofrulesthatworkwellforrunningtheirownbusiness,buttheyoftenhavenoideaofwheretheserulescomefromorwhytheywork,andthisisreallywhateconomiststendtofindinteresting.Inmanycasesyourideascancomefromyourownlifeandexperiences.OneofmyfavoritepiecesofmyownworkisthepaperIwroteon‘‘AModelofSales’’.IhaddecidedtogetanewTVsoIfollowedtheadsinthenewspapertogetanideaofhowmuchitwouldcost.Inoticedthatthepricesfluctuatedquiteabitfromweektoweek.Itoccurredtomethatthechallengetoeconomicswasnotwhythepricesweresometimeslow(i.e.,duringsales)butwhytheywereeverhigh.Whowouldbesofoolishastobuywhenthepricewashighsinceeveryoneknewthattheitemwouldbeonsaleinafewweeks?Buttheremustbesuchpeople,otherwisethestoreswouldneverfinditprofitabletochargeahighprice.Armedwiththisinsight,Iwasabletogenerateamodelofsales.Inmymodelthereweretwokindsofconsumers:informedconsumerswhoreadtheadsanduninformedconsumerswhodidn’treadtheads.Thestoreshadsalesinordertopricediscriminatebetweentheinformedanduninformedconsumers.OnceIdevelopedthemodelIhadaresearchassistantgothroughacoupleofyears’worthoftheAnnArborNewssearchingforthepricesofcolorTVs.Muchtomydelightthegeneralpatternofpricingwassimilartothatpredictedbythemodel.And,yes,IdidmanagetogetaprettygooddealontheTVIeventuallybought.2.Isyourideaworthpursuing?Solet’sassume(afavoritewordofeconomists)thatyouhaveanidea.Howdoyouknowifitisanygood?Thefirsttestistotrytophraseyourideainawaythatanon-economistcanunderstand.Ifyoucan’tdothisit’sprobablynotaverygoodidea.Ifyoucanphrase1Butwhichsourcestoread?IreadtheNewYorkTimes,theWallStreetJournalandtheEconomist;theseareprobablygoodplacestostart.2itinawaythatanoneconomistcanunderstand,itstillmaybealousyidea,butatleastthere’shope.Beforeyoustarttryingtodecidewhetheryourideaiscorrect,youshouldstoptoaskwhetheritisinteresting.Ifitisn’tinteresting,noonewillcarewhetheritiscorrectornot.Sotryitoutonafewpeople---seeiftheythinkthatitisworthpursuing.Whatwouldfollowfromthisideaifitiscorrect?Wouldithavelotsofimplicationsorwoulditjustbeadeadend?Alwaysrememberthatworkingonthisparticularideahasanopportunitycost---youcouldbespendingyourtimeworkingonadifferentidea.Makesurethattheexpectedbenefitscoverthatopportunitycost.Oneoftheprimarypurposesofeconomictheoryistogenerateinsight.Thegreatestcomplimentis‘‘Ah!Sothatexplainsit!’’That’swhatyoushouldbelookingfor---forgetaboutthe‘‘nicesolidwork’’andtrytobecomeaWizardofAhs.3.Don’tlookattheliteraturetoosoonThefirstthingthatmostgraduatestudentsdoistheyrushtotheliteraturetoseeifsomeoneelsehadthisideaalready.However,myadviceistowaitabitbeforeyoulookattheliterature.Eventuallyyoushoulddoathoroughliteraturereview,ofcourse,butIthinkthatyouwilldomuchbetterifyouworkonyourideaforafewweeksbef