Beware of Economic Misconceptions – Econlib

HHerbert Stein, an economist who served in the Nixon Administration, wrote a memoir looking back on his experience. He wrote that the two main lessons he learned were:

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

In my experience, non-economists often have misconceptions about the nature of economics. Below, I will outline important misconceptions and basic information from economics that is needed to clarify them.

Unfortunately, professional economists are often eager to move beyond basic data to more speculative ideas. There are two ways that these “advanced” economic ideas can lead non-economists back to their erroneous views of the nature of economics. “Advanced” theories may be unreliable, causing the field of economics to lose credibility, or speculative theories themselves may serve to reinforce the misconceptions of environmental economics.

Setting the Price

Another common misconception is that prices are set by individuals, and especially by people who run businesses. After all, most businesses have a list of prices for the goods and services they offer.

This misconception arises when people see a business as inherently profitable, with absolute power over its consumers. If profits were given, no company would ever fail. The power of any one business is constrained by other businesses competing for their customers.

This misconception is evident when a political scientist blames high prices on “price gouging,” or “greed.” In fact, prices come from the interaction between supply and demand. Every greedy business is thwarted by greedy buyers unwilling to pay more and by greedy competitors trying to woo those buyers.

This misconception extends to general inflation. One might think that inflation increases when there is a sudden burst of greed, or that inflation decreases when greed decreases. But a little economic thinking can show that high inflation comes from putting more money into the government, and inflation goes down when the government manages its finances properly.

Creating a Job

Another common misconception is that jobs are created by certain businesses. Therefore, people complain about firms that “send jobs overseas.”

In fact, job creation does not come from one company. It comes from the combined actions of many people, allowing for specialization and trade. If you and I live off the food we grow in our different farms, there is nothing special about trading. But if you grow grain and I raise cattle, and we trade with each other, now we have a market.

In a modern economy, the process of creating new forms of market exchange involves many people, leading to complex patterns of expertise and trade. These patterns are only sustainable if everyone involved is making a total profit. New patterns are constantly being developed and tested, and some patterns become unsustainable and disappear.

Professional and commercial patterns characterize overseas businesses, but no firm determines these patterns. Economic analysis shows that changes in the production environment reflect the evolution of skills, production techniques, and domestic behavior.

On a final point, let’s say that China as a nation saves at a higher rate than the United States. Then Chinese purchases of American goods will increase the value of the dollar, making Chinese goods production more competitive, causing manufacturing jobs to expand in China, and American workers to move into various industries.

As America’s budget deficit contributes to our low national savings, Congress who blame business for “exporting jobs to China” should instead look in the mirror. It is the budget deficit that leads to the trade deficit, not one business.

Most discussions of the labor market ignore the complexity of the profession and trade. Instead, they look at aggregate job creation in simple terms: jobs create spending, and spending creates jobs. This simplistic, misleading view is unfortunately very widespread, even in elementary macroeconomics. It leads to the idea that government deficits are good for job creation, and that austerity will cause recession. In fact, the relationship between the government’s fiscal policy and the process of creating patterns of sustainable trade is not straightforward and very 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 the emergence of special patterns and trading. Policies influence this process, but in ways that are difficult to measure precisely.

Production Recipes

Another misconception is that manufacturing recipes are fixed. That is, the output requires a specific set of inputs.

In fact, there are many possibilities for exchange. Wants 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 misconception of a fixed recipe will tend to overestimate the effectiveness of bombing the industry or imposing economic sanctions. They will be amazed at the other country’s ability to adapt.

The misconception of a fixed recipe also distorts domestic policy. We think that resources must be managed, otherwise 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 misconception of a fixed recipe think that in order to achieve goals (such as reduced carbon emissions), we need to mandate certain aspects of products and processes. Instead, market incentives are often sufficient. The carbon footprint of our GDP continues to decline, largely due to natural market volatility.

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