Theory, General Equilibrium and Political Economy in Development Economics

I discuss the role of economic theory in empirical work in development economics with special emphasis on general equilibrium and political economy considerations. I argue that economic theory plays (should play) a central role in formulating models, estimates of which can be used for counterfactual and policy analysis. I discuss why counterfactual analysis based on microdata that ignores general equilibrium and political economy issues may lead to misleading conclusions. I illustrate the main arguments using examples from recent work in development economics and political economy. JEL Classi…cation: O10, O12, B41, D50, P48. Keywords: economic development, economic theory, methodology of economics, political economy. Daron Acemoglu is Charles P. Kindleberger Professor of Applied Economics, Massachusetts Institute of Technology, Cambridge, Massachusetts. His e-mail address is [email protected]. Development economics investigates the causes of poverty and low incomes around the world and seeks to make progress in designing policies that could help individuals, regions, and countries to achieve greater economic prosperity. Economic theory plays a crucial role in this endeavor, not only because it helps us focus on the most important economic mechanisms, but also because it provides guidance on the external validity of econometric estimates, meaning that it clari…es how we can learn from speci…c empirical exercises about the e¤ects of similar shocks and policies in di¤erent circumstances and when implemented on di¤erent scales. General equilibrium and political economy issues often create challenges for this type of external validity. General equilibrium refers to factors that become important when we conduct (or ask questions involving) counterfactuals in which large changes are contemplated. The di¢ culty lies in the fact that such counterfactuals will induce changes in factor prices and technology which we hold …xed in partial equilibrium analysis and create di¤erent composition e¤ects than in partial equilibrium. Political economy refers to the fact that the feasible set of interventions is often determined by political factors and large counterfactuals will induce political responses from various actors and interest groups. General equilibrium and political economy considerations are important because partial equilibrium estimates that ignore responses from both sources will not give the appropriate answer to counterfactual exercises. In this essay, I …rst explain why it is important to think of external validity in policy analysis, particularly in development economics, and the role of economic theory in this exercise. I then illustrate the importance of general equilibrium reasoning in several major problems in development economics. Finally, I argue that political economy considerations have to be central to any investigation of development problems and that inferences that ignore political economy can go wrong. The online appendix includes a discussion of some additional issues that arise in the context of using theory in guiding estimation. Why Development Economics Needs Theory There is no general agreement on whether we should use economic theory for formulating and then subsequently attempting to estimate “structural parameters”. I argue that the answer is largely “yes”because otherwise econometric estimates would lack external validity, in which case they can neither inform us about whether a particular model or theory is a useful approximation to reality, nor would they be useful in providing us guidance on what the e¤ects of similar shocks and policies would be in di¤erent circumstances or if implemented in di¤erent scales. I therefore de…ne structural parameters as those that provide external validity and