Beware of economic misconceptions – Econlib

HErbert Stein, an economist who served in the Nixon administration, wrote a memoir looking back on his experiences. He wrote that the two most important lessons he learned were:

• 1. Economists don’t know much.
• 2. Other people, including politicians who make economic policy, know even less about economics than economists.

In my own experience, non-economists often have some natural economic misconceptions. Below I will outline some key misconceptions and the basic insights from economics needed to clear them up.

Unfortunately, trained economists often want to move beyond basic insights to theories that are more speculative. There are two ways in which these “advanced” economic ideas can cause non-economists to fall back on their natural economic fallacies. The “advanced” ideas may prove unreliable, causing the economics profession to lose credibility, or the speculative theories themselves may serve to reinforce natural economic fallacies.

Pricing

A natural misconception is that prices are set by individuals, and especially by the individuals who run businesses. After all, most companies have a price list for the goods and services they offer.

This misconception emerges when people view business as inherently profitable, with complete power over consumers. If profitability were a given, no company would ever go bankrupt. The power of a given company is limited by other companies competing for its customers.

This misconception is evident when a politician blames high prices on “price gouging” or “greed.” In fact, prices arise from the interaction between supply and demand. Every greedy company is held back by greedy consumers who don’t want to overpay and by greedy competitors who try to win over these consumers.

This misconception extends to general inflation. You might think that inflation increases when there is a sudden outbreak of greed, or that inflation decreases when greed decreases. But a little economic reasoning would show that high inflation comes from the government putting too much money into circulation, and that inflation decreases when the government manages its finances more responsibly.

Creating jobs

A natural misconception is that jobs are created by specific companies. That’s why people complain about companies “sending jobs abroad.”

In fact, employment does not come from a single company. It results from the combined actions of many people, allowing specialization and trade. If you and I all live off the food we grow on our individual farms, there will be no specialization and trade. But if you grow grain and I grow cows, and we trade with each other, we now have market exchange.

In the modern economy, the process of creating new forms of market exchange involves many people, leading to complex patterns of specialization and trade. These patterns are only sustainable if everyone involved achieves a net gain. New patterns are constantly being developed and tested, and other patterns become untenable and disappear.

Patterns of specialization and trade include firms located abroad, but no single firm determines these patterns. Economic analyzes show that changes in the location of production reflect the evolution of skills, production techniques and household behavior.

On this last point, suppose that China as a nation is saving at a higher rate than the United States. Then Chinese purchases of American assets will increase the value of the dollar, making the production of Chinese goods more competitive, increasing manufacturing jobs in China and moving American workers to other industries.

Since America’s budget deficits contribute to our low national savings, a member of Congress who blames a company for “sending jobs to China” should look in the mirror instead. It is the budget deficit that leads to the trade deficit, not any individual company.

Many discussions about the labor market ignore the complexity of specialization and trade. Instead, they see overall job creation in simple terms: jobs create spending, and spending creates jobs. This simplistic, misleading idea is unfortunately very widespread, even in basic macroeconomics courses. It leads to the idea that government deficits are good for employment, and that austerity will cause recessions. In fact, the relationship between government fiscal policy and the process of creating patterns of sustainable specialization and trade is indirect and highly uncertain.

A related misconception is that President ____ has created X million jobs. Political leaders don’t create jobs. They have no control over the complex process of evolving patterns of specialization and trade. Policy influences this process, but in ways that are difficult to measure precisely.

Production recipes

Another misconception is that production recipes are fixed. That is, outputs require a given set of inputs.

In reality, there are plenty of options for replacement. Wishes can be satisfied in many different ways. Final goods and services can be produced in many different ways.

In foreign policy, decision makers with the fixed-prescription fallacy will tend to overestimate the effectiveness of bombing a factory or imposing economic sanctions. They will be surprised by the other country’s adaptability.

The fallacy of the fixed prescription also distorts domestic policy. We believe that resources must be managed, otherwise we will run out of something. Fifty years ago we were afraid that oil would run out. But today, oil and other resources remain cheap.

Policymakers also fall under the misconception of the fixed recipe that in order to achieve objectives (such as reduced CO2 emissions), we must mandate specific characteristics of products and processes. Instead, market incentives are often sufficient. The carbon intensity of our GDP has decreased, mainly due to natural market evolution.

We could have better economic policies if fewer people harbored these misconceptions about economics. Economists must work harder to explain and debunk these misconceptions.