Economics Nobel for Natural Experiments

The 2021 Nobel Prize in Economic Sciences was awarded to three US-based economists.

Do you know?

The Nobel Prize is officially called as Sveriges Riksbank Prize!

Nobel Committee awarded half the Prize to David Card for his “empirical contributions to labour economics”
Other half to Guido Imbens and Joshua Angrist “for their methodological contributions to the analysis of causal relationships”

This is the first time the economic prize has been divided in this fashion with one half going to one awardee and other half divided across two awardees.
In the past, prize money was divided equally between the awardees even if the prize was for different topics as is the case this time around.
It may appear that the Nobel Prize has been given for two different contributions, but there is a common theme: “natural experiments.”

Economists are often interested in causal questions such as the impact of education on incomes, impact of COVID-19 on poverty and so on.
They are also interested is understanding the direction of causality.
Economists have used two kinds of experiments to study these causality and direction of causality questions: random experiments and natural experiments.

(I) Random experiments

Under randomized experiments, the researchers allocate say medicines to a treatment group and compare the effect of the medicine with the control group which is not given the medicine.
In 2019, the Nobel Committee gave awards to three scholars for their contribution to the field of randomized experiments.
However, one cannot randomize experiments to study issues such as why certain people and regions are more unequal or have fewer educational opportunities and so on.

(II) Natural experiments

In natural experiments, economists study a policy change or a historical event and try to determine the cause and effect relationship to explain these developments.
The trio used such natural experiments to make some landmark contributions to economic development.
Natural experiments are more difficult for two reasons. The first is to identify what will serve as a natural experiment.
Second, in a random experiment, the researcher knows and controls the treatment and control groups which allows them to study the cause and effect of medicine.
But in natural experiments, such clear differentiation is not possible because people choose their groups on their own and even move between the two groups.
Despite the limitations, the researchers could use the natural setting to answer some big policy questions.

One question of interest for policymakers is to understand the impact of higher minimum wages on employment.
Earlier studies showed that increasing minimum wages leads to lower unemployment.
Economists were also not sure of the direction of causation between minimum wages and employment.
Say a slowdown in the economy leads to higher unemployment amid lower income groups.
This could lead to lower income groups demanding higher minimum wages. In such a case, it is higher unemployment which leads higher minimum wages.

Angrist and Imbens showed how natural experiments can be used to identify cause and effect precisely.
We have discussed above how natural experiments make it difficult to separate control and treatment groups. This makes it difficult to establish causal relations.
In the 1990s, the duo developed a methodology – Local Average Treatment Effect (or LATE) – which uses a two-step process to help grapple with these problems of natural experiments.
Say, one is interested in finding the impact of an additional year of schooling on the incomes of people.
By using the LATE approach, they showed that effect on income of an additional year of education is around 9%.
While it may not be possible to determine individuals in the group, one can estimate the size of the impact.

Earlier it was difficult to identify natural experiments and even if one identified them, it was difficult to generate data from these experiments.
With increased digitalization and dissemination of archival records, it has not just become easier to identify natural experiments but also get data.
Economists have been using natural experiments to help us understand the impact of past policies.
As the 2020 pandemic struck, economists used the natural experiments approach extensively to analyse how previous pandemics impacted different regions and tried to draw policy lessons.

The methodology date back to the early and mid-90s and they have already had a tremendous influence on the research undertaken in several developing countries such as India.
For instance, in India, too, it is commonly held that higher minimum wages will be counterproductive for workers.
It is noteworthy that last year, in the wake of the Covid-induced lockdowns, several states, including UP, had summarily suspended several labour laws.
This included the ones regulating minimum wages, arguing that such a move will boost employment.
The main learning is that minimum wages can be increased in India without worrying about reducing employment.

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