Quantitative Theory and Econometrics

Q uantitative theory uses simple, abstract economic models together with a small amount of economic data to highlight major economic mechanisms. To illustrate the methods of quantitative theory, we review studies of the production function by Paul Douglas, Robert Solow, and Edward Prescott. Consideration of these studies takes an important research area from its earliest days through contemporary real business cycle analysis. In these quantitative theoretical studies, economic models are employed in two ways. First, they are used to organize economic data in a new and suggestive manner. Second, models are combined with economic data to display successes and failures of particular theoretical mechanisms. Each of these features is present in each of the three studies, but to varying degrees, as we shall see. These quantitative theoretical investigations changed how economists thought about the aggregate production function, i.e., about an equation describing how the total output of many firms is related to the total quantities of inputs, in particular labor and capital inputs. Douglas taught economists that the production function could be an important applied tool, as well as a theoretical device, by skillfully combining indexes of output with indexes of capital and labor input. Solow taught economists that the production function could not be used to explain long-term growth, absent a residual factor that he labeled technical progress. Prescott taught economists that Solow’s residual was sufficiently strongly procyclical that it might serve as a source of economic