Six economics misconceptions of mine which I’ve resolved over the last few years
Here are six cases where I was pretty confident in my understanding of the microeconomics of something, but then later found out I was missing an important consideration.
Thanks to Richard Ngo and Tristan Hume for helpful comments.
Here’s the list of mistakes:
I thought divesting from a company had no effect on the company.
I thought that the prices on a prediction market converged to the probabilities of the underlying event.
I thought that I shouldn’t expect to be able to make better investment decisions than buying index funds.
I had a bad understanding of externalities, which was improved by learning about Coase’s theorem.
I didn’t realize that regulations like minimum wages are analogous to taxes in that they disincentivize work.
I misunderstood the economics of price controls.
In each, I’m not talking about empirical situations at all—I’m just saying that I had a theoretical analysis which I think turned out to be wrong. It’s possible that in many real situations, the additional considerations I’ve learned about don’t actually affect the outcome very much. But it was still an error to not know that those considerations were potentially relevant.
I used to believe that personally divesting in a company didn’t affect its share price, and therefore had no impact on the company. I guess my reasoning here was something like “If the share is worth $10 and you sell it, someone else will just buy it for $10, so the price won’t change”. I was treating shares as if they were worth some fixed amount of money.
The simplest explanation for why you can’t just model shares as being worth fixed amounts of money is that people are risk averse, and so the tenth Google share you buy is worth less to you than the first; and so as the price decreases, it becomes more worthwhile to take a bigger risk on the company.
As a result, divestment reduces the price of shares, in the same way that selling anything else reduces its price.
In the specific case of divestment, this means that when I sell some stocks, the price ends up lower than it was.
I first learned I was wrong about this from this Sideways View post, published May 2019.
2. Index funds
I used to think that it wasn’t possible for individuals like me to get higher returns than I’d get from just buying an index fund, because in an efficient market, every share is equally valuable.
This is wrong for a few reasons. One is that the prices of shares are determined by the risk aversion of other market participants; if your risk aversion is different from the average, some shares (specifically, risky ones) will be much better investments than others.
Secondly, because I’m risk averse, I prefer buying shares which are going to do relatively well in worlds where I’m relatively poorer. For example, if I’m a software engineer at a tech company, compared to a random shareholder I should invest more in companies which are as anticorrelated with software engineer salaries as possible. Or if I live in the US, I should consider investing in the markets of other countries.
I didn’t understand this fully until around April this year.
3. Prediction markets
Relatedly, I thought that the fair market price of a contract which pays out $1 if Trump gets elected is just the probability of Trump getting elected. This is wrong because Trump getting elected is correlated with how valuable other assets are. Suppose I thought that Trump has a 50% chance of getting reelected, and that if he gets re-elected, the stock market will crash. If I have a bunch of my money in the stock market, the contract is worth more than 50 cents, because it hedges against Trump winning.
(Here’s a maybe more intuitive way of seeing this: Suppose I could pick between getting $10 in the world where Trump won (in which we’re assuming the market would crash) and the world where Trump lost. Clearly the $10 would be more valuable to me in the world where he wins and my stocks are decimated. So the value of the “Trump wins” contract is higher than the value of the “Trump loses” contract, even though they correspond to events of equal probability.) And there is a potentially very high number of correlative outcomes that betters might be thinking about and hedging against, and the market computes these and reflects them in the price.
This is a more general version of the point that it’s hard to have a prediction market on whether the world will end. Paul Christiano has an old blog post on this topic which I first saw years ago but which I didn’t understand properly at the time.
I first understood this fully around March this year.
All of these first three mistakes were the result of me not really understanding basic portfolio theory; thanks to spending a bunch of time talking to traders over the last few years, I now understand it better.
4. Coase’s arguments about externalities
I used to have an overly simplistic picture of externalities—I believed the Econ 101 story: normally markets are efficient, but when a good has an externality the wrong amount will be produced, and this is resolved by putting a tax or subsidy on the good to internalize the externality.
I changed my mind about this after reading David Friedman’s essay. I’ll just quote a few paragraphs:
The first step is to realize that an external cost is not simply a cost produced by the pollutor and born by the victim. In almost all cases, the cost is a result of decisions by both parties. I would not be coughing if your steel mill were not pouring out sulfur dioxide. But your steel mill would do no damage to me if I did not happen to live down wind from it. It is the joint decision—yours to pollute and mine to live where you are polluting—that produces the cost.
Suppose that, in a particular case, the pollution does $100,000 a year worth of damage and can be eliminated at a cost of only $80,000 a year (from here on, all costs are per year). Further assume that the cost of shifting all of the land down wind to a new use unaffected by the pollution—growing timber instead of renting out summer resorts, say—is only $50,000. If we impose an emission fee of a hundred thousand dollars a year, the steel mill stops polluting and the damage is eliminated—at a cost of $80,000. If we impose no emission fee the mill keeps polluting, the owners of the land stop advertising for tenants and plant trees instead, and the problem is again solved—at a cost of $50,000. In this case the result without Pigouvian taxes is efficient—the problem is eliminated at the lowest possible cost—and the result with Pigouvian taxes in inefficient.
Moving the victims may not be a very plausible solution in the case of air pollution; it seems fairly certain that even the most draconian limitations on emissions in southern California would be less expensive than evacuating that end of the state. But the problem of externalities applies to a wide range of different situations, in many of which it is far from obvious which party can avoid the problem at lower cost and in some of which it is not even obvious which one we should call the victim.
My previous position was missing this nuance. I first read that David Friedman essay midway through last year.
5. Non-tax regulations that increase equality have disincentive effects on work
I used to think that the way to decide whether a minimum wage was good was to look at the effect on unemployment and the effect on total income for minimum wage workers, and then figure out whether I thought that the increase in unemployment was worth the increase in income. I think this was wrong in two pretty different ways.
The first mistake is that I was neglecting the fact that policies aimed at transferring wealth from rich people to poor people disincentivize making money. Taxes are just a special case of this, and can be seen as part of a category of wealth-transferal policies that includes minimum wage. So when you’re arguing that a minimum wage would be part of the optimal policy portfolio, you have to argue that it would be better than a tax. I did not understand that this was part of the calculation.
I first learned this from a post by Paul Christiano which I think he incorporated into Objection 2 here; that blog post was published March 2019.
6. Price and quality controls
The second of the ways I was wrong about the minimum wage comes from a misunderstanding of the economics of price controls; in hindsight I think that my high school economics curriculum was just wrong about this. I think that I realized my misconception after reading The Dark Lord’s Answer, published in 2016.
In high school economics, I was taught that when the government imposes a price floor (e.g., a minimum wage), you’ll end up with more supply than demand for the good. This is beneficial to suppliers who still succeed at selling the good, it’s harmful to suppliers who can no longer sell the good, and it’s harmful to buyers.
I now think that that understanding was overly simplistic. Here’s my current understanding.
In a market, the supply and demand of a good must equilibrate somehow—for every loaf of bread that someone buys, someone had to sell a loaf of bread. One way that the market can equilibrate is that the price can change—if the price is higher, selling is more attractive and buying is less attractive. So if more people want to buy than sell at the current price, we might expect the price to rise until things are in equilibrium.
But there are other variables than price which can change in a way that allow the market to equilibrate. One obvious example is product quality—if you decrease the quality of a product, consumers are less enthusiastic about buying but suppliers are more enthusiastic about selling (because they can presumably make it for cheaper).
Often, fluctuations in quality rather than price are what cause markets to equilibrate. For example, restaurants often don’t have price hikes at busy times, they just have long waits. Customers like it less when they have to wait more, and restaurants like having customers waiting (because it helps them ensure that their restaurant is constantly full).
So when we talk about the equilibrium state of a market, we can’t just talk about price, we also need to talk about all the other variables which can change.
In the case where we only consider price and quantity, there’s always only one equilibrium, because as price increases, supply rises and demand falls. (Actually, supply and demand could be constant over some range of prices, in which case there is an interval of equilibrium prices. I’m going to ignore this.)
But if we’re allowed to vary quality too, there are now many possible settings of price and quality where supply equals demand. E.g., for any fixed quality level, there’s going to be one equilibrium price, for the same reason as before.
In a competitive market, the equilibrium will be the point on the supply-equals-demand curve which maximizes efficiency. E.g., if there’s a way that producers could increase quality that would make production cost $1 more, producers will only do that if it makes the product worth more than $1 more valuable to consumers. This is optimal.
(In real life, you usually have producers selling a variety of different similar goods at different price/quality points; I’m talking about this restricted case because it’s simpler.)
Now, suppose that the government imposes a restriction on price or quality. For example, they might set a maximum or minimum price, or they might make safety restrictions which restrict quality in certain ways. The market will reequilibriate by using whatever degrees of freedom it has left. Specifically, it will reequilibriate to the optimal point within the newly restricted space of points at which supply equals demand. In general, this will lead to a less efficient outcome.
For example, if the price of bread is $2 at equilibrium, and the government sets a maximum price of $1.50, then the equilibrium will move along the quality curve until it gets to the point where the equilibrium price is $1.50.
This analysis gets more realistic if you allow there to be more dimensions than price and quantity along which bread can vary. For example, I’d expect to see the following phenomena:
Producers trying to figure out ways to get paid under the table, e.g., by demanding favors in return for selling to people. This reduces efficiency inasmuch as producers weren’t already being compensated by miscellaneous favors.
Sellers changing in ways that are mildly more convenient for them but much more inconvenient for consumers. For example, having long lines outside stores, or treating customers worse.
Producers indulging weak preferences of theirs in who they sell to (e.g., nepotism).
In the case of minimum wages, I’d expect to see employers do things like engaging in wage theft which the employees tolerate (which is inefficient because it increases variance for employees) or being inflexible and unpleasant. This analysis would predict that wage theft is much more common among minimum wage employees than employees at higher wages.
One way of thinking about the efficiency of this is to think from the perspective of the producers. They have to pick some change that makes the price of the bread $1.50. There are many ways they could reduce the price to $1.50. They’re going to pick the way that is best for them.
In some cases, this leads to almost no value being destroyed at all. For example, in the bread case, sellers might sell smaller loaves, which might be almost as efficient if you dubiously assume that the main cost of bread is flour. The worst case is that there’s no way for the seller to change the product to keep it profitable which benefits them, and so they end up changing it in a way which makes them very little better off.
The welfare impact of this kind of regulation is also affected by redistributive effects. For example, if bakers decide to only sell bread to their friends and family, this has a positive redistributive effect if the friends and family of bakers are poorer than average.
An example where the redistributive effect might make the world much better: Suppose that there’s demand for 100 loaves of bread, where half of that comes from poor people who want to feed their children and the other half comes from a tech billionaire who wants to make a giant bread sculpture. If the baker ends up selling to people who are most willing to stand in lines, then this might lead to a better outcome. (Getting this result requires making some pretty strong assumptions about the shape of the relevant curves.)
Another example is that you might expect that in a world where the minimum wage causes low-paid jobs to be more unpleasant, teenagers will be less inclined to take the jobs and poor adults will end up having relatively more of the jobs. It’s possible to set things up such that this ends up increasing total welfare.
It’s embarrassing that I was confidently wrong about my understanding of so many things in the same domain. I’ve updated towards thinking that microeconomics is trickier than most other similarly straightforward-seeming subjects like physics, math, or computer science. I think that the above misconceptions are more serious than any misconceptions about other technical fields which I’ve discovered over the last few years (except maybe the aestivation hypothesis thing).
In three of these cases (4, 5, and 6), I had incorrect beliefs that came from my high school economics class. In those three cases, the correct understanding makes government intervention look worse. I think that this is not a coincidence—I think that the people who wrote the IB economics curriculum are probably leftist and this colored their perception.
On the other hand, in the other cases, I assumed that the equilibria of markets had a variety of intuitive properties that they turn out not to have.
One obvious question is: how many more of these am I going to discover over the next year or two?
I think my median guess is that over the next year I will learn two more items that I think deserve to go on this list. Of course, I’m now a lot more cautious about being confident about microeconomics arguments, so I don’t expect to be as confidently wrong as I was about some of these.
In most of these cases, there was a phase where I no longer believed the false thing but didn’t properly understand the true thing. During this phase, I wouldn’t have made bets. Currently I’m in the “not making bets” phase with regard to a few other topics in economics; hopefully in a year I’ll understand them.