Beware of Economic Misconceptions

1. Economists do not know very much.
2. Other people, including politicians who make economic policy, know even less about economics than economists do.1

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

Unfortunately, trained economists are often eager to go beyond basic insights to theories that are more speculative. There are two ways that these “advanced” economic ideas can cause non-economists to fall back on their natural economic misconceptions. The “advanced” ideas can turn out to be unreliable, causing the economics profession to lose credibility, or the speculative theories themselves can serve to reinforce natural economic misconceptions.

Price-Setting

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

This misconception shows up when people see business as inherently profitable, with complete power over its consumers. If profitability were a given, then no firm would ever fail. The power of any one business is constrained by other businesses competing for its customers.

This misconception is evident when a politician blames high prices on “price-gouging,” or “greed.” In fact, prices emerge from the interplay between supply and demand. Each greedy business is held back by greedy consumers unwilling to pay too much and by greedy competitors trying to woo those consumers.

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

Job Creation

One natural misconception is that jobs are created by specific businesses. Hence, people complain about firms “sending jobs overseas.”

In fact, job creation does not come from a single firm. It comes from the combined actions of many people, enabling specialization and trade. If you and I each live on the food that we grow on our separate farms, there is no specialization and trade. But if you grow grain and I raise cows, and we trade with one another, we now have market exchange.

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

Patterns of specialization and trade incorporate businesses that are located overseas, but no one firm determines these patterns. Economic analysis shows that changes in the location of production reflect the evolution of skills, production techniques, and household behavior.

On the latter point, suppose that China as a nation saves at a higher rate than the United States. Then Chinese purchases of American assets will raise the value of the dollar, making Chinese goods’ production more competitive, causing manufacturing jobs to increase in China, with American workers moving to different industries.

Since American budget deficits contribute to our low national saving, a Congressman who blames a business for “sending jobs to China” should instead be looking in the mirror. It is the budget deficit that leads to the trade deficit, not any one individual business.

Many discussions of the labor market ignore the complexity of specialization and trade. Instead, they view aggregate job creation in simple terms: jobs create spending, and spending creates jobs. This simplistic, misleading idea is unfortunately very widespread, even in elementary macroeconomics courses. It leads to the idea that government deficits are good for job creation, 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 ____ created X million jobs. Political leaders do not create jobs. They do not control the complex process of evolving patterns of specialization and trade. Policies do influence this process, but in ways that are difficult to precisely measure.

Production Recipes

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

In reality, there are abundant opportunities for substitution. Wants can be satisfied in many different ways. Final goods and services can be produced by many different means.

In foreign policy, decision-makers with the fixed-recipe misconception will tend to over-estimate the effectiveness of bombing a factory or imposing economic sanctions. They will be surprised by the ability of the other country to adapt.

The fixed-recipe misconception also distorts domestic policy. We think that resources have to be managed, or else we will run out of something. Fifty years ago, we were worried about running out of oil. But today oil and other resources remain cheap.

Also, policy makers under the fixed-recipe misconception think that in order to achieve objectives (such as reduced carbon emissions), we need to mandate specific characteristics of products and processes. Instead, market incentives are often sufficient. The carbon intensity of our GDP has been shrinking, primarily because of natural market evolution.

We could have better economic policies if fewer people held these misconceptions about the economy. Economists should try harder to explain and debunk these misconceptions.

Footnotes

[1] Herbert Stein, Washington Bedtime Stories: The Politics of Money and Jobs, p. xi