[I should first explain the “part 1.” The hope is that you will read this before the political art post which follows. They are separate issues, but the second is easier to understand if you read this first. Mankiw visitors: I do off-topic posts every Sunday, early next week I’ll do a monetary post that gives you an idea of my views on the crisis.]
Last Sunday I discussed the counter-intuitive nature of “the economic way of thinking,” which I termed (perhaps incorrectly) the ‘economistic worldview.’ Here I’d like to speculate on why so many economic principles violate common sense.
It is easy to find numerous examples of where common sense views differ from the economistic perspective. Some of these do not even involve empirical judgments, but rather seem to merely reflect logical errors. For instance, in Pop Internationalism Krugman pointed out that people often worry about a net loss of jobs both from U.S. investment flowing overseas, and from Americans buying foreign goods, even though (as a matter of accounting) both the current and capital accounts cannot be in deficit at the same time. (A U.S. trade deficit can only be financed by a capital account surplus.)
Krugman also claimed that many prominent pundits don’t really understand the logic behind comparative advantage. This is especially perplexing because two children playing in a sandbox understand that when trading toys the point is to give away as little as possible and get back as much as you can. I don’t have much to add to what others have said about this, I presume it is because the costs of trade are more visible than the benefits.
I often find news articles, even in respected publications, which confuse the most basic principles of supply and demand. Thus in a recent LA Times piece entitled “Americans may be losing faith in free markets” Peter Gosselin (2008) argued that:
Most mainstream economists assert that these [gasoline price] increases are simply the logical outcome of booming global demand meeting limited global supply. But the price run-ups seem out of whack with demand, which has increased only about 1% worldwide.
Actually, a small rise in “demand” (i.e. consumption) is exactly what one would expect if rapidly rising demand was pushing up against a highly inelastic supply.
And this sort of misuse of supply and demand occurs almost every day in major media outlets. I think the problem is that people want to reason from a price change; “the price went up therefore,” or “the interest rate rose therefore,” or “the exchange rate appreciated therefore.” But in fact, there is no “therefore,” no implications that flow from price changes. The impact of higher prices depends entirely on whether it was caused by a shift in supply or demand, the impact of higher interest rates on investment depends entirely on whether it was caused by a shift in the supply or demand for loanable funds, and the impact of exchange rate appreciation on exports depends entirely on whether it results from a change in export supply or import demand. Even many economists (including me) occasionally forget this.
If I ask students (or adult non-economists) how a firm would respond to a rise in its costs, they almost always say that firms will pass on the higher costs to consumers. But they are much less likely to say that firms would pass on lower costs in the form of lower prices. This sort of reasoning makes little sense to economists, as the profit function is symmetrical. I assume that the average person’s reasoning goes as follows:
1. Companies are greedy.
2. It would be altruistic for the company to absorb higher costs without a price increase.
3. It would be altruistic for the company to pass on lower costs to consumers.
4. Therefore, companies don’t absorb higher costs and don’t pass on lower costs.
The flaw in this reasoning is point #3, although it would seem that a greedy company would not want to pass on lower costs in the form of lower prices, in fact that is exactly what a greedy company would want to do. (I.e., if moving from cost situation A to B causes companies to raise prices from X to Y, then logically moving from cost situation B to A should cause companies to want to reduce prices from Y to X.) Why don’t people see this as obvious? Perhaps reasoning about causality somehow gets entangled with moral reasoning.
An experimental philosopher named Joshua Knobe reported some interesting findings in an interview on Bloggingheads.tv. (I believe this example is mentioned in his new book, Experimental Philosophy, but I am not sure. (And, no, the title is not an oxymoron.)) Knobe said that two groups of people were given two slightly different stories, and then asked a question. The first group heard a story where an engineer went to the CEO of a company with a project that he said would dramatically boost profits. But there was one drawback; it would seriously harm the environment. The CEO said “I don’t care about the environment, I only care about profits. Do the project.” For the second group, everything in the story was exactly the same except that project was said to actually help the environment. Again the CEO said “I don’t care about the environment, I only care about profits. Do the project.” In both cases the listener was asked whether the CEO intentionally hurt (or helped) the environment. Most people in the first group said the CEO did intentionally hurt the environment, but most in the second group said that he did not intentionally help the environment.
As with the case of greedy companies passing on higher prices, the two situations in Knobe’s experiment are symmetrical. Knobe was not able to ascertain the cause of the peculiar asymmetry in responses. But it struck me as interesting that in both this example and the previous cost/price example the public seemed to adopt such a highly skeptical view of the motives of big corporations that they were led to an irrational asymmetry in their worldview.
Economic philosophers have also addressed this problem. Wilkerson (2005) noted that human brains evolved under conditions far different from the modern economy:
because of the social nature of hunting and gathering, the fact that food spoiled quickly, and the utter lack of privacy, the benefits of individual success in hunting and foraging could not be easily internalized by the individual, and were expected to be shared. The EEA [i.e. Stone Age] was for the most part a zero-sum world, where increases in total wealth through invention, investment, and extended economic exchange were totally unknown. More for you was less for me. Therefore, if anyone managed to acquire a great deal more than anyone else, that was pretty good evidence that theirs was a stash of ill-gotten gains . . . Our zero-sum mentality makes it hard for us to understand how trade and investment can increase the total amount of wealth. We are thus ill-equipped to easily understand our own economic system.
Confusion about whether firms pass on costs in the form of higher prices, leads to another common misconception; that the debate over regulation is primarily a question of who gains and who loses. Certainly that is how it portrayed in the media (consumer interests vs. business interests.) In fact that is almost never the key issue—it is generally one group of consumers pitted against another, often with consumers as a group being hurt by regulations designed to help them (as the costs are passed on by companies in the form of higher prices, and absent externalities, if consumers valued the mandate at more than the cost of production, companies would already be providing it.)
In addition to logical errors, much common sense reasoning reflects serious underestimates of the relevant elasticities. After my previous post on economistic reasoning, I received several challenges to my defense of speculation, price gouging, etc. I think I also would have received challenges to my views on elasticities, if the readers had understood just how counter-intuitive they were.
Don’t many economics textbooks use examples of the demand for drugs when they want to illustrate a perfectly inelastic demand curve? I use these examples when I want to illustrate elastic, or unit elastic demand. A few years ago I read that a highly effective medication for AIDS was being taken by only about 10% of all HIV positive patients worldwide. Why? It is too expensive. This is a surprising example of just how elastic is the demand for life-saving drugs. Or take the example of highly addictive drugs. I find many students assume the demand would be perfectly inelastic. But if the addict was so addicted that he spent his entire income on the drug, the demand would actually be unit elastic.
I knew a heavy smoker who used to argue that high taxes would stop people from smoking, as cigarettes were very addictive. Later I learned that his wife had stopped smoking after their getting married, on grounds that the family couldn’t afford two smokers. That’s when it hit me that introspection is a horrible way of thinking about elasticities. I don’t pay much attention to prices when I go grocery shopping, so if I used introspection I would assume that people aren’t very responsive to food price changes. My students often write short essays on a market they choose, and almost invariably they say “my product has an inelastic demand, because there aren’t any good substitutes.” And they often say this when there are good substitutes.
Why is this important? Because it affects even professional economists. Although the more fervent supply-siders sometimes overstate their case, the responsiveness of output to marginal tax rates is probably much greater than most economists suspect. Why do I say this? After all, aren’t economists’ views shaped by scientific research, not introspection? Unfortunately, the data can never resolve an issue this complex, with lags that may last for many decades (think about how a high MTR makes college students less likely to go to school for 12 years in order to become a brain surgeon.) Because the data are so indeterminate, researchers ultimately go with their priors (Robert Barro in one direction, Austan Goolsbee another.)
To summarize, we have logical errors, reasoning about morality entangled with moral reasoning, invisible effects being ignored, the assumption of zero sum games, the extremely confusing identification problem, and faulty estimates of elasticities based on introspection. This is just off the top of my head, and I presume Bryan Caplan’s book has a much more complete analysis.