1st and 2nd Lectures, STV4346B: Introduction to Comparative Political Economy: Approaches, theory an

1
1st and 2nd Lectures, STV4346B Introduction
to Comparative Political Economy Approaches,
theory and methodology(some of the slides will
probably be skipped in class and used in seminars
1 and 2)

• Carl Henrik Knutsen, Department of Political
  Science, UiO
• 10/11 and 13/11-2008

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Politics and the economy
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Topics for the course

• Methodology and theory
• Different traditions of political economy
• Basic rational choice/microeconomics other
  theoretical approaches
• Statistical techniques/econometrics
• Substance, general
• Allocation of resources states and markets.
  Positive and normative issues. The interaction
  among Politicians, bureaucrats, voters,
  consumers and producers.
• The economic factors that influence regime change
  and regime stability (mainly democracy)
• The economic effects of political institutions
• Substance, specific (with geographic focus)
• Varieties of capitalism, fiscal policy, economic
  voting
• Industrial policy, land reform, the effects of
  inequality
• Neo-patrimonialism, corruption, natural resources

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Practical advice

• Read through everything once, quickly
• ..Then selective reading
• Read all abstracts at least four times
• Know thy lecture notes
• Systematize the readings into a broader framework
• Dont get bogged down in details. Focus on
  concepts, general arguments (theoretical) and
  general empirical findings.

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The exam

• Approximately
• 25 Short questions Concepts, sketch out theory
  quickly, empirical findings
• 25 Short essay Related to 2-3 concrete
  contributions from reading list.
• 50 Long essay (choice between two alternatives)

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Political economy

• Empirical interrelations between economy and
  politics? We need theoretical and methodological
  frameworks that are able to deal with such
  interrelations Political economy.
• Political economy different meanings for
  different groups of academics and different
  traditions.
• My view They are not as incompatible as they
  might look. Dont pick your favorite! Choice of
  framework depends on research question and focus.

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Thematical and methodological definitions of
political economy

• Methodological definitions
• Study of politics with the tools of an economist
  (political economics)
• Study of economics with the tools of a political
  scientist, focus on power etc, qualitative
  methodology.
• Thematical definition (favored in this course)
• Political economy is the study of the
  interrelations between political institutions and
  processes and economic structures and processes.
• No restrictions on methodology or theoretical
  approach in this course we will be eclectic.
• The definition is very general! Specifications
  will be made at the topic level

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Definitions continued

• COMPARATIVE political economy comparative
  studies of political-economic interrelations.
• Differences in political institutions?
  Differences in economic effects.
• Differences in economic structures? Different
  effects on politics.
• Focus on the national level.
• Even though we are here operating with a broad
  definition of political economy, we need to know
  the various definitions and political economic
  theories in the literature to not be confused
  when reading.

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State-centered political economy (CL 8)

• Key point of departure Other political economy
  approaches have underappreciated the importance
  of the state.
• State as independent actor or (at least) state
  structures matter for political and economic
  outcomes.
• States are not only vehicles for social
  interests.
• Sharp separation state and private sphere/society
  (including economic actors). Politics conducted
  mainly within state-structures.
• States as actors States interests. Some go
  even further states assumed to follow national
  interests (whatever this means).
• Metaphysical description or analytical
  simplification? My view States are not actors
  metaphysically, but we can model the state as an
  actor in some instances for analytical
  simplification.

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State autonomy

• State autonomy is the key concept in much of this
  literature.
• State autonomy refers to the ability of the
  state to define and pursue an agenda not defined
  for it solely by private interests (CL181)
• Ability to pursue own agenda and not be trumped
  by societal pressures, private interests when
  formulating public policy.
• Contrast with CLs Utilitarian and Marxist
  approaches.
• Specifications If we do not buy that the state
  is an independent actor, how do we think of state
  autonomy?
• State officials and bureaucrats as autonomous?
  But why do these not act in private interest?
• Rules, regulations and norms matter. These are
  created through the years and are results of long
  processes. Norms and rules can be intentionally
  created by private actors, but not always. Often
  gradual modification of rules and norms, and
  strong inertia in institutional structures.
• For analytical purposes therefore, we can often
  (but certainly not always!) take the rules and
  norms as given. Contrast with endogenous
  institutions and regulation.
• Degrees of state autonomy rather than either-or.
• Determinants of state autonomy power
  concentration, checks and balances, structure of
  bureaucracy, nature of social interest groups.

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The State, a special organization

• Monopoly of force within defined boundaries
  (Weber)
• Ability to make binding decisions on issues which
  private actors cannot (laws and regulation)
• Ability to tax
• Implementor of policy

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Some approaches in CL (read quickly through
184-196)

• Statism and national interest (Krasner)
• States define (and act upon) national interest
• Transformational view of state (Skocpol among
  others)
• Differences in states organizational structure
  impacts policy outcomes even when initiative from
  private sphere
• State affects private agendas and make-up of
  social groups
• State as historical specific organizational
  structure

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Rational choice

• A theory of human action
• Optimal choice under constraints
• Preferences are exogenously given
• Predictable irrationality from behavioral
  economics
• Beliefs/understanding of probabilities, some
  systematic biases
• Loss aversion, reference points
• Time preferences and hyperbolic discounting
• Reciprocity rather than self-interest?
• Bounded rationality (Simon)

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Rational choice

• A deceptively simple sentence that summarizes
  the theory of rational choice When faced with
  several courses of action, people usually do what
  they believe is likely to have the best overall
  outcome (Elster, 198922)
• 1) Thin and 2) instrumental rationality
• Ad 1) No initial requirements on what type of
  goals that should be pursued.
• Ad 2) Actions are chosen because of intended
  consequences. Actions are not valued because of
  themselves (contrast with Kant)

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Przeworski (ch 1)

• Decentralized and centralized allocation
  mechanisms final allocation results from
  decisions by many agents vs allocation depends on
  one decision. Examples
• Decentralized Grab all you can, market exchange
• Centralized Dictators allocation, voting,
  lottery
• Does the allocation mechanism result in an
  equilibrium outcome (no one has incentive to
  deviate). Descriptive question.
• Does the allocation result in a Pareto Optimal
  outcome? Normative criterion.
• Is the allocation equitable? Normative criterion.

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Przeworski contd

• State vs market as a too crude dichotomy. More
  fruitful questions What are the properties of an
  allocation mechanism? How are states and markets
  organized?
• Always some role for government. Enforcement
  institutions must underpin markets.
• Political economic game
• 1) Political actors reveal preferences for
  policies through menu of actions (votes, bribes,
  threats etc)
• 2) State maximizes its objectives (whatever this
  is), given beliefs of economic actors actions, by
  setting policy
• 3)Economic actors max utility (and profit) in
  markets, given the specific policy chosen
• Political economic equilibrium
• Set of policies by state and political and
  economic actions by voters/producers/consumers so
  that no one would act different given beliefs and
  actions of others.

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A political economic game of voting and taxation
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Political economics (Ch6 in CL)

• The Robbins-definition of economics The study
  of human behavior as a relationship between ends
  and scarce means..? Opens up for studying other
  aspects of human life than production and
  consumption of goods
• Preferences, beliefs and constraints
• Individually rational behavior? Efficiency (or
  collective rationality)?
• Not necessarily Depends on interaction structure
• Holds in perfect markets (invisible hand)
• Does not hold for example in prisoners dilemma
  games or voting in some instances

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Normative political economics

• Normative Analysis of desirable properties of
  the political system
• Condorcets paradox
• Vote on alternatives pairwise A gtBgtCgtA
• Transitive individual preferences but no
  transitivity in collective preferences (desired
  property)

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Arrows impossibility theorem

• These are incompatible
• Non-dictatorship
• Unrestricted domain
• Independence of irrelevant alternatives
• Pareto Efficiency
• All voting methods are flawed. Individual
  preferences do not add up to consistent social
  preference ordering. What is the will of the
  people?
• Ways out of the impossibility theorem
• Single-peaked preferences or other restrictions
  on preferences
• Agenda control (institutional structure imposed
  on decision procedure)
• logrolling

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Positive political economics

• Two examples in CL Mancur Olsons Logic of
  Collective Action and Anthony Downs An
  Economic Theory of Democracy.
• Downs (1957) Foreword Downs assume that
  political parties and voters act rationally in
  the pursuit of certain clearly specified goals
  it is this assumption in fact, that gives his
  theory its explanatory power
• Starting point for numerous models on party and
  voter behavior

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Assumptions A Downsian game

• Democracy
• Two parties/candidates
• Goal for parties Maximize political support
  (votes)? control government. Policy only as a
  mean for politicians.
• Goal for voters Policy (as close as possible to
  ideal point)
• Policy is unidimensional on a scale from 0
  (left-wing) to 1 (right wing)
• Voters vote on party that are closest to their
  ideological preference. They are distributed
  uniformly on the interval 0,1
• Party who wins majority forms government
• Rational and self-interested voters and parties.
  No uncertainty in the baseline model.
• Party cannot deviate from proposed policy once
  elected.

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Downsian game continued

• Strategy sets for two candidates/parties, S1S2
  0,1
• Choose policy (strategy) within this strategy
  set denoted s1 and s2
• If s2gts1 ? all voters to right of (s1s2)/2 votes
  for 2
• Example
• 2 chooses policy 0.7, 1 chooses 0.6. All voters
  to the right of 0.65 votes for 2?1 wins.
• Can this be a proper solution to the game? No!
  This is not a Nash Equilibrium
• Player 2 is not playing best response to 0.6.
  Will win majority if plays for example 0.59
• But then 1 will not play a best response.. Can
  for example choose 0.58
• (s1,s2) (0.5 , 0.5) is the only Nash
  equilibrium both strategies are best responses
  to other. (50 probability of winning when tie).
  Nobody wants to unilaterally deviate.
• In equilibrium Both parties propose the same
  policy. Policy convergence!

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What does Downs tell us? Remember that a model is
a model.

• The model can be extended to incorporate
  uncertainty about positions of the voters, and we
  can assume that parties are motivated by pushing
  a specific policy. If so, the convergence result
  does not necessarily hold.
• If interested See my homepage for a presentation
  of Games in the Normal Form for extended models
  where there is uncertainty and where politicians
  care about policy (and not number of votes)
• Simplest possible political economic model of
  voting and does not describe real-world politics
  precisely. BUT Captures central political
  mechanism Why did Obama talk more about tax cuts
  and killing Bin Laden in general election than in
  primaries? But What was McCain thinking when
  going to the right in the general election?

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Preference requirements and utility functions,
rational choice

• Preference requirements
• Actors must be able to rank different outcomes.
  gt, lt or . (Complete preferences)
• If agtb and bgtc ? agtc (Transitivity)
• Utility functions U(x), ordinal level of
  measurement
• Note that preferences are exogenous and given.
• Cost functions C(x).
• First-and second order derivatives. U(x)gt0,
  C(x)gt0, U(x)lt0 and C(x)gt or lt 0 (depends
  on production-technology)
• Optimization (minimize or maximize)
  Differentiate and set equal to zero.

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Example A single market, partial equilibrium

• One good x. Price for good x is p.
• Demand side of the market Consumers will buy
  until U(x)p because
• Max U(x)-px ? U(x)-p0?U(x)p
• Supply side of the market Assume C(x), the
  marginal cost, is increasing in x (C(x)gt0).
  Producers will supply until C(x)p. Because
  profits p is given by
• ?(x) px c(x) ? ?(x) 0 ?pc(x)
• Market equilibrium The price clears the market.
  Assume one consumer and one producer, both take
  prices as given. They will both adjust their
  demand and supply so that U(x)p and C(x)p?
  U(x)C(x)
• In equilibrium Marginal utility of consumption
  equals marginal cost of production

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The choice between two goods (Knutsen, 2008a)

• Max U( x1, x2)
• Subject to the constraint p1 x1 p2 x2 m,
  where m is income
• U( x1, x2) U( x1, m/p2 - p1/p2x1)
• Optimum condition U(x1) U(x2)- p1/p2 0
• ? U(x1) /U(x2) p1/p2
• Marginal rate of substitution is equal to
  relative prices in optimum
• It can be shown that also marginal rate of
  transformation (relative cost of producing two
  goods on the margin) is equal to relative price
  ratio Prices carry information about opportunity
  costs
• ? In equilibrium Marginal rate of substitution
  is equal to marginal rate of transformation.
• Prices enable consumers and producers to adjust
  so that relative production costs equal relative
  subjective evaluation of goods.

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Graphical sketch of general equilibriumEquilibriu
m relative prices and equilibrium production and
consumption of X1 and X2
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Normative criteria for efficiency Pareto
optimality

• A movement from one allocation to another that
  can make at least one individual better off
  without making any other individual worse off is
  called a Pareto improvement.
• An allocation is Pareto optimal when no further
  Pareto improvements can be made that is, when no
  one can be made better off without anyone else
  being made worse off.
• First welfare theorem Market equilibrium is
  Pareto optimal (given a set of conditions)
• Second welfare theorem Any Pareto optimal
  allocation can be supported by a market
  equilibrium (given set of conditions including
  cost-free redistributions)

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When does the first welfare theorem break down?

• Increasing returns to scale
• Market power
• Externalities
• Public goods
• Imperfect information
• Transaction costs
• Missing markets
• Property rights are non-existent or poorly
  enforced

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Monopoly

• Market power? Ability to influence prices
• When prices are not taken for given? 1st welfare
  theorem breaks down
• Why monopoly/oligpoly?
• Increasing returns to scale the role of fixed
  costs (innovation, investment, advertising etc),
• Regulation
• differentiated products
• The monopolys profit-maximizing equation
• ?(x) p(x)x c(x) ? ?(x) p(x)x p(x)
  c(x)0
• ?p(x)x p(x) c(x)
• The monopoly sets x lower than the social
  optimum (given by c(x)p).
• Intuition Monopoly reduces supply to keep prices
  high

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Externalities (actions with unintended
consequences on other actors)

• Externalities from consumption and production.
• Both positive and negative externalities
• Actor does not take ext. into account when making
  decisions? Does not provide the socially optimal
  amount of consumption/production in free market
• Examples

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Public goods

• 1) Non-rivalry One actors consumption does not
  reduce the utility of another from consuming.
• 2)Non-excludability Not possible to stop other
  actors from consuming.
• 1)? inefficiency in market because of positive
  externality (does not take into account other
  actors benefits from providing good)
• 2)?Free rider problem. Even if would like to have
  the public good, hope that others will provide
  and free-ride. In free market, no one has
  incentive to supply.
• Przeworski defines public goods only according to
  1). I prefer to call non-rival but excludable
  goods for club goods. Public goods are defined as
  non-rival and non-excludable
• Note that excludability and rivalry are
  continuous dimensions? Degrees of public goods.

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Neo-classical political economy

• Role for government and politics when markets
  fail/market equilibrium is not Pareto-optimal
• How can government correct the workings of the
  market?
• Example 1 Negative externalities? Taxation so
  that the actor bears the full cost (own cost
  externality)? will act so that optimum is
  realized
• Example 2 Assymetric information Provide
  regulation, issue standards etc so that f.ex
  consumers can identify quality of a product in
  the market
• Example 3 Public goods Tax and provide correct
  amount of public good.
• Example 4 Increasing returns to scale and
  natural monopoly Regulate price
• The states role of securing property rights to
  ensure voluntary exchange.

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Some criticisms of NCPE

• Keynes (1936) and inherent rigidities of the
  market. Slow adjustment towards equilibrium and
  the benefits of activist macroeconomic policy.
• Schumpeter (1942) Dynamic efficiency is not
  ensured by a statically efficient market (profit
  goes towards zero). Monopoly/oligopoly surpluses
  and incentives for innovation. Innovation ? Long
  run economic growth.
• The utilitarian underpinnings. Other important
  normative concepts than efficiency/PO
  distribution and justice.

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Uncertainty

• Uncertainty General lack of knowledge about
  outcomes. Unproblematic for markets if
  uncertainty is symmetric (and actors are risk
  neutral).
• Instead of maximizing utility Maximize expected
  utility!
• Von Neumann-Morgenstern utility functions
• EU(p) p1u1 p2u2pnun
• We can take into account that actors are not risk
  neutral.
• Risk aversion, two outcomes
• u(px1(1-p)x2)gtpu(x1)(1-p)u(x2)
  u(50)gt0.5u(0)0.5u(100)
• Means that a risk averse actor would rather take
  the expected value for certain, rather than
  gamble between two extremes.

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Asymmetric information

• Markets in trouble when there is asymmetric
  information. Note that governments also would
  have trouble with asymmetric information. How to
  make actors reveal their private knowledge is a
  general phenomenon. However, governments might
  have other means to deal with such problems
• 1) Private information about actions, effort
• 2) Private information about quality, type
• 1) can lead to so-called moral hazard problems
• 2) can lead to so-called adverse selection
  problems

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Some concepts

• Moral hazard Incentives to act otherwise than
  agreed upon in contract, due to private
  information about own actions.
• Adverse selection The tendency of an agent (or a
  good) of a particular type to self-select into a
  contract in a way not desired by the other
  contracting party, due to private information
  about own type (quality).
• A contractual relation can be modeled as a
  principal-agent relationship. Principal wants a
  job to be done and agent is assigned to do the
  job

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Principal-agent theory

• Principal wants to maximize profits/utility, and
  so does agent.
• Principal moves first, and can post contract as
  ultimatum to agent.
• When full information
• Principal can design contract so that agent is
  pushed down to reservation utility (indifferent
  between accepting and rejecting contract).
• Can also choose to accept only good types of
  agents, or design different contracts to good and
  bad types.
• When private info
• Agent can shirk (moral hazard) to obtain a higher
  utility, to the despair of the principal.
• Agents can also pretend to be other types than
  they actually are to achieve a higher utility
  (adverse selection).
• Example voter-politician as principal-agent.

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Some solutions for the principal

• When moral hazard? Design contracts that make
  agents stake holder in the outcome.
• For example let agent have some of the surplus
  (part of profit instead of pure wage contract),
• or threaten to punish if moral hazard is
  detected/strongly suspected
• When adverse selection Design different
  contracts that make agents self-select into
  different contracts
• Impose costs on bad agent or reward good agent
  for revealing information about type

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Some comments from Evans (Ch2)

• Getting the prices right as an insufficient
  approach to development
• Neoclassical economics and focus static
  efficiency What about transformation and dynamic
  efficiency?
• Gerschenkron and late developers
• States role in amassing capital.
• Hirschman and late developers
• States role in inducing entrepeneurship
• The role state institutions for economic
  development. Structure of state and state-society
  relations matter.
• But rejection of naïve statism.

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Some comments on markets..

• Market/economic sphere is embedded in society
  (Polanyi).
• Norms and exchange. Granovetter and the
  non-existence of informalized market exchanges.
  Trust as crucial to non-contractual exchange.
• Repeated exchanges between actors that know each
  other, rather than anonymous one-shot exchanges
• Transaction costs (Williamson/Coase) In some
  instances, hierarchies reduce transaction costs
  related to exchange when compared to markets.
• ?Internalization of exchanges within firms and
  other organizations.

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Evans contd

• The neo-utilitarian depiction of state failure
• Politicians and bureaucrats as self-interested
  agents and not as altruistic and omniscient
  welfare maximizers. Can the people (principal)
  ensure that the agents (buer and pol) act in
  their best interest?
• Capture of state by interest groups
• Rent seeking Wasteful use of resources to
  redistribute gains/affect policy to own benefit
• Collective action problems
• Implications The nightwatchman state? Does the
  conclusion follow from the premise of state
  failures? (I dont think so..)
• Weber Bureaucracy and capitalism together How
  does the state operate and how does it regulate
  and interact with the economy. Not how much state!

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Evans contd why need other approaches than
neo-utilitarianism

• Differences in state structures and state society
  relations matter for the selection and the
  effectiveness of policies.
• Context contingencies and comparative approach
  necessary. Need to draw on concrete historical,
  case-based knowledge
• Methodological individualism at the root of
  failure to understand states.
• Weber and the structure and norms of the
  idealized bureaucracy? Bureaucrats do not follow
  private agendas (more on this next lecture)
• Differences bureaucratic structures? Diff
  development

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Evans contd

• Institutionalist revisions of neo-utilitarian
  model
• Institutions as rules of the game. Creates
  incentives for economic actors and are thus
  crucial for economic outcomes.
• Douglass North (property rights, institutions and
  transaction costs, endogenous institutions and
  functionalism)
• Comparative institutional variation
• Migdal and strong vs weak state (state vs society
  in zero-sum game).
• Social power of local elites? Local, traditional
  elites related to rural interests often opposing
  industrial transformation.
• The transformative role of the stat Strong
  states transform economy and are not objects for
  rent seeking

46
Pierson

• The notion of path dependence is generally used
  to support a few key claims
• Specific patterns of timing and sequence matter
• starting from similar conditions, a wide range of
  social outcomes may be possible
• large consequences may result from relatively
  "small" or contingent events
• particular courses of action, once introduced,
  can be virtually impossible to reverse
• and consequently, political development is often
  punctuated by critical moments or junctures that
  shape the basic contours of social life

47
Pierson

• Path dependence related to increasing returns
  Self-reinforcing or positive feedback processes
• Other broader def History matters. Event at
  t0 affects events at t1.
• Switching costs or reversal costs increase as
  time passes
• Particular importance Formal institutional
  arrangements that are costly to alter once
  initiated and historically entrenched.
  Inflexibility.
• Potential path inefficiency
• A funny example QWERTY keyboards (David).
• Not so funny Dysfunctional institutional
  arrangements like neo-patrimonial political
  arrangements that are hard to break up, but
  clearly economically inefficient.

48
Technology and increasing returns

• Four features that generate increasing
  return-structures
• Large fixed costs
• Learning effects
• Coordination effects
• Adaptive expectations
• Direct analogies to politics, institutions
  Institutions are
• a) costly to generate,
• b) require learning as you go along (learning by
  doing) from different actors,
• c) interaction between actors within rule-based
  framework depend on coordination
• d) actions depend on beliefs about what others do

49
Pierson contd

• Read Piersons interpretation of North
• Institutional complementarity (see also Hall and
  Soskice) complementary organizational forms and
  institutions? A source of increasing returns
• North interdependent web of an institutional
  matrix

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Politics and increasing returns (A)

• Four aspects of political life that make it
  conducive to increasing returns
• 1) Central role of collective action
• (coordination and adaptive expectations plus
  difficulty of changing politics individually)
• 2) high density of institutions
• (legal constraints on behavior)
• 3) political authority and asymmetries of power
• (use initial position to entrench position and
  increase power even more)
• 4) intrinsic complexity and opacity
• (where are the prices? Multiplicity of political
  issues and goals of actors, long lags and complex
  causal chains)

51
Politics and increasing returns (B)

• Three aspects of politics that make it more
  susceptible to increasing returns than economic
  processes
• 1) weakness of competition and learning enhancing
  mechanisms
• (self correction possible, but difficult due to
  opacity of politics)
• 2) short time horizons of political actors
• (switching costs up front!)
• 3) status quo bias built into political
  institutions
• (constitutions as example, credible commitment
  devices, political consensus and uncertainty when
  change)

52
Pierson page 263 Effects of increasing returns
on politics

• 1. Multiple equilibria. Under a set of initial
  conditions conducive to increasing returns, a
  number of outcomes-perhaps a wide range-are
  generally possible.
• 2. Contingency. Relatively small events, if they
  occur at the right moment, can have large and
  enduring consequences.
• 3. A critical role for timing and sequencing. In
  increasing returns processes, when an event
  occurs may be crucial. Because earlier parts of a
  sequence matter much more than later parts, an
  event that happens "too late" may have no effect,
  although it might have been of great consequence
  if the timing had been different.
• 4. Inertia. Once an increasing returns process is
  established, positive feedback may lead to a
  single equilibrium. This equilibrium will in turn
  be resistant to change.

53
Some implications

• Historical causes ? Implications for analysis
• The role of time
• Problems with functionalist explanations
  (institutions are not necessarily efficient)
• Problem with the approach How to test hypotheses
  from path dependent arguments?

54
Statistics/econometrics

• OLS
• Pooled Cross Section - Time Series (OLS with
  Panel Corrected Standard Errors as example)
• Panel Data
• Fixed Effects
• (Random Effects)
• Instrumental Variable Analysis/2SLS
• Matching

55
Repetition of multivariate regression/OLS

• Remember interpretation of coefficient Average
  increase in Y when X increases one unit and all
  other variables are held constant.
• OLS as best linear unbiased estimator (BLUE) when
  certain conditions are satisfied
• The underlying relationship is linear
• No autocorrelation
• No heteroskedasticity
• No omitted variables (important Omitted variable
  bias!)
• No endogeneity (y affects x)
• No measurement error in x
• See Knutsen 2008b for full list

56
What to do when we have a panel data structure?

• Panel units assumed to be countries here, but can
  be regions, individuals, firms etc.
• If no country specific effects, and we want to
  use both intra-national variation (over time) and
  variation between countries OLS with PCSE.
• Interpretation Just as OLS!
• But takes into account heteroskedasticity
  between panels, contemporraneous correlation
  (between panels), and autocorrelation (within
  panels). These adjustments are crucial when using
  panel data.

57
Panel data Fixed Effects

• What if there are country specific effects?
• Control for these effects by using dummies for
  all countries? Fixed Effects
• Only intra-national variation is used
• Strict technique. Reduces omitted variable bias,
  but also reduces the amount of information used
  for inference

58
2SLS

• Main application endogenous independent
  variables
• Intuition Use only exogenous part of variation
  in X.
• Must find at least one instrument
• Instrument should be correlated with X, but not
  directly linked with Y. Instrument should be as
  highly correlated with X as possible.
• Method
• First run OLS regression with X as dependent
  variable and instrument(-s) and all control
  variables as independent
• Then take the predicted value of X from the first
  regression rather than the actual X and use in
  the second (original) regression.
• 2SLS is consistent, and does not run into the
  endogeneity bias problems of OLS
• The major problem with 2SLS is that it yields
  large standard errors (particularly when low
  correlation between instrument and X)? difficult
  to find significant results.

59
Matching

• Non-parametric Does not need to assume anything
  about the functional form of relationship.
• Treatment and control variables
• Find (one or more) most similar units to use as
  matches for each unit.
• Similarity calculated on the basis of control
  variables. BUT Unit and match must differ on the
  treatment variable (dichotomous)
• Find treatment effect for each comparison
  (difference in Y between unit and match)
• Calculate average treatment effect