David Card, Joshua D Angrist and Guido W Imbens. (Image: Twitter/ The Nobel Prize)
The Norwegian Nobel Committee awarded the 2021 Sveriges Riksbank Prize in Economic Sciences to three US-based economists: David Card, Joshua D. Angrist and Guido W. Imbens. The prize has been awarded - with one half to Card, and the other half jointly to Angrist and Imbens - for their work on drawing conclusions from unintended experiments or “natural experiments.”
What was the contribution of the three economists that won them the Nobel Prize?
The Nobel Committee awarded half the Prize to David Card for his “empirical contributions to labour economics” and the 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.”
What are 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. Does education impact income or is the causality in reverse with income levels impacting education?
Economists have used two kinds of experiments to study these causality and direction of causality questions: random experiments and natural 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.
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.
Can you explain the natural experiments conducted by David Card?
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.
To answer this question and untangle causality, Card, along with Alan Krueger, (sadly deceased, else would have been awarded as well) studied the impact of minimum wages via a natural experiment. In the early 1990s, the minimum wage in New Jersey was raised from $4.25 to $5.05 per hour. If the research studied the impact on New Jersey alone, it would not have sufficed because there are several other factors which could lead to changes in employment. The authors then compared New Jersey with neighbouring Eastern Pennsylvania where there was no increase in minimum wage and had a broadly similar labor market. They also analysed the impact of wage change on the fast food industry where the pay is low and minimum wages matter.
The research showed that an increase in minimum wages did not lead to any change in employment in New Jersey, which was at odds with the textbook model. Card later pointed to possible reasons for this behavior. First, compensation is divided in various components. If wages go up, employers can reduce other components leading to limited change in total labor costs and thereby on employment as well. Second, higher minimum wages reduces labor turnover, which minimises total labor costs and thereby does not impact employment. A third point, related to the second, is that higher wages help people stay in jobs, which may boost productivity.
The effect of increasing the minimum wage (©Johan Jarnestad/The Royal Swedish Academy of Sciences)
Apart from this seminal finding, Card used natural experiments to study the impact of immigration and education on labor markets. Every now and then, political forces blame immigration for the loss of local jobs. Card’s research again showed a contrarian result that immigration did not create a negative impact on local employment. In research on education, Card (along with Krueger) showed that states which make a higher investment in education achieve success in labor market outcomes in terms of better jobs and higher incomes.
Can you explain the contribution of Angrist and Imbens?
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.
What is the importance of the award today?
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.
Angrist even co-wrote a book named Mostly Harmless Econometrics
where he attempted to demystify the subject of econometrics, which holds terror for most economics students. Not sure whether Angrist succeeded in this rather noble cause!