Lucas critique

From DDL Wiki

Quote from Lucas (1976, p. 41) [2]: "Given that the structure of an econometric model consists of optimal decision rules of economic agents, and that optimal decision rules vary systematically with changes in the structure of series relevant to the decision maker, it follows that any change in policy will systematically alter the structure of econometric models."

In the other words, Lucas critique states that when a new policy applied, it alters the structure of the econometric model. So the prediction based on the model, which is established based on the parameter estimated from the historical data, will not be correct.

However, Lucas critique are true under certain requirements in economics viewpoint, also the validation of reduced-form model in marketing research where consumer as a major role [2]:

No	Requirement in economics	Validation in reduced-form model
1	Economic agents are aware of the policy change	Consumers are not aware of policy changes
2	Economic agents are motivated to change their behavior as a direct consequence of policy change	Consumers are not motivated to act on policy change
3	Economic agents are able to change their behavior	Consumers are not able to act on policy change

Issues and Solutions

Problems caused when Lucas critique ignored when performing estimation:

No	Problem	General solution method
1	Biased parameters (ignoring endogeneity) – such as incorrect price elasticity Including endogeneity in the estimation	Including endogeneity in the estimation
2	Inefficient parameters due to ignoring autocorrelation and lead to serious model misspecifications	Using GLS (general least-square) instead of OLS (ordinary least-square)

In different models, there are approaches to

No	Model types	Solution
1	Reduced-form model	Account for varying parameter approach
2	VAR (vector autoregression)/VEC (vector error correction) model	Including endogeneity in model and superexogeneity test
3	Structural model	Structural models are "not subject to Lucas critique" but need to use it carefully (especially long-term effects)

The conclusion is that the essentials of Lucas critique need to be understood clearly with using proper approaches to handle the issues when performing estimation.

References

[1] Lucas, Robert E. (1976), "Econometric Policy Evaluation: A Critique," Carnegie-Rochester Conference Series on Public Policy, 1, 19-46.

[2] Harald J. van Heerde, Marnik G. Dekimpe and William P. Putsis Jr. (2005), "Marketing Models and the Lucas Critique."