Economist Noah Smith has a recent article titled “Most of What You Learned in Econ 101 Is Wrong.” He doesn’t actually make the case that would support that title. But he also probably didn’t choose the title. However, he did choose this statement:
But [N. Gregory] Mankiw’s book, like every introductory econ textbook I know of, has a big problem. Most of what’s in it is probably wrong.
Here’s what’s striking. In an article that purports to show that Mankiw is wrong on many issues, he doesn’t point out how he’s wrong on ANY issues.
Moreover, he doesn’t even try. At no point in his piece, does Smith ever relate anything he says to specific things that Mankiw claimed.
Of course, it’s possible that Smith doesn’t think he needs to do so because he takes as given that his audience knows what’s in Mankiw’s text.
So let’s look at that. On the minimum wage, Smith writes:
For example, Econ 101 theory tells us that minimum wage policies should have a harmful impact on employment. Basic supply and demand analysis says that in a free market, wages adjust so that everyone who wants a job has a job — supply matches demand. Less productive workers earn less, but they are still employed. If you set a price floor — a lower limit on what employers are allowed to pay — then it will suddenly become un-economical for companies to retain all the workers whose productivity is lower than that price floor. In other words, minimum wage hikes should quickly put a bunch of low-wage workers out of a job.
And Smith gives his criticism in the next paragraph:
That’s theory. Reality, it turns out, is very different. In the last two decades, empirical economists have looked at a large number of minimum wage hikes, and concluded that in most cases, the immediate effect on employment is very small. It’s only in the long run that minimum wages might start to make a big difference.
In other words, in most cases there is a small, presumably negative, effect on employment. And presumably in the other cases there is a large effect. How, exactly, does this contradict the claims that Mankiw makes and that many of us teach in our equivalents of Econ 101? It doesn’t.
Now it is true that in the 5th edition (2009) of his text, Mankiw writes:
Although there is some debate about how much the minimum wage affects unemployment, the typical study finds that a 10 percent increase in the minimum wage depresses teenage employment [by] between 1 and 3 percent.
In light of the more recent studies that Smith is referring to, Mankiw might need to soften that statement. But he need not change his conclusion that the minimum wage puts some teenagers out of work. So Smith, in an article purporting to disagree with Mankiw on this, finds himself agreeing.
The other issue on which Smith takes issue with how Econ 101 is taught–or is it Mankiw’s text?–is on welfare. Smith writes:
Another example is welfare. Econ 101 theory tells us that welfare gives people an incentive not to work. If you subsidize leisure, simple theory says you will get more of it.
What’s Smith’s objection? He writes:
But recent empirical studies have shown that such effects are usually very small. Occasionally, welfare programs even make people work more. For example, a study in Uganda found that grants for poor people looking to improve their skills resulted in people working much more than before.
But here he’s attacking a straw man. Economists who have claimed that welfare discourages work have generally had in mind welfare programs that impose a very high implicit marginal tax rate because the people on welfare lose a lot of their welfare payments when they work more. Go to the link he cites and you find that the kind of welfare he’s talking about that economists have studied is typically in the form of unrestricted cash grants that, presumably they don’t lose if they work more. That means that the welfare programs do not, repeat do not, subsidize leisure. That certainly doesn’t contradict the standard exposition in Econ 101 or the exposition in Mankiw’s text. Mankiw discusses a hypothetical welfare program in which the government guarantees an annual income of $15,000 and then takes away one dollar of welfare for every dollar earned. He writes:
The incentive effects of the this policy are obvious: Any person who would make under $15,000 by working has little incentive to find and keep a job.
Why? Mankiw explains:
In effect the government taxes 100 percent of additional earnings.
Do the studies the linked article that Smith cites contradict this? No. In fact, here’s what the linked article states:
There’s no doubt that poorly designed social programs can deter work. Aid to Families With Dependent Children, the pre-welfare reform welfare program, was found to decrease hours worked by 10 to 50 percent among recipients; that likely has something to do with the fact that AFDC benefits were taken away at a rate of 100 percent, so every dollar earned on the job was a dollar not received from AFDC. Who would work under that condition? [italics in original]
Exactly.
HT to Don Boudreaux.
READER COMMENTS
Nick Bradley
Nov 26 2015 at 4:02pm
While I agree with Noah’s intention here, he didn’t do a very good job. “Econ 101” describes phenomena assuming mostly perfect conditions. Later on you learn that those conditions are usually far from perfect.
In addition, Mankiw has always been disingenuous when it comes to welfare critiques, creating straw men with quite extreme means testing (I know ADFC had extreme means testing).
The negative effects of a minimum wage depend on how much of the cost can be passed on, demand elasticities, etc.
Minimum wage studies are pretty weak and are locally focused, rife with confounds.
My own suspicion is that the minimum wage has almost no impact on employment, as the relative MW 40 to 50 years ago was the relative equivalent of $20 or $25 an hour. And if wage compression didn’t cause deleterious effects then, why now?
ThomasH
Nov 26 2015 at 5:54pm
Maybe he should have said that some of what you learn in economics books can be misinterpreted. Take the minimum wage. Draw those supply and demand curves and — Wow! Some people become unemployed. For a freshman who had never thought that a minimum wage could have any negative effect at all, this is a useful beginning. Unfortunately some people will conclude that since the minimum wage actually makes some people worse off that its a BAD THING and even that people who support it just “don’t understand economics.”
It’s beyond the scope of an introductory econ textbook to consider a more realistic case in which superior ways of transferring income to low wage workers are foreclosed and empirical estimates show that the harm is pretty small in relation to the amount of income transferred.
But Smith didn’t say that either, so only one cheer.
Jon Murphy
Nov 26 2015 at 11:13pm
If most of what you learn in Econ 101 is wrong, there is either something fundamentally wrong with Econ 101 or with its teachers.
Don Boudreaux
Nov 27 2015 at 7:12am
David: Nicely done.
I’m sure that most people who teach principles of microeconomics do what I do in class when I explain the effects of price changes on quantity supplied and quantity demanded: I offer, in the course of this discussion, an analysis of elasticity. (Having once used Mankiw’s text in my classes, I know that he does so, too.) I make clear to my students three points that are relevant here:
First and most trivially, supply and demand analysis – as is true of all analysis – requires judicious use of ceteris paribus assumptions.
Second, supply and demand analysis itself tells us only about the direction of changes and not about the magnitude of changes. “A rise in the price of apples reduces the quantity of apples demanded each month” is a typical statement that is correctly made using supply and demand analysis. I make crystal clear to my students that in order to discuss the magnitude of the resulting fall in quantity demanded requires an understanding of own-price elasticity of demand. It is careless for Noah Smith to suggest that the possibility of highly inelastic demand as a feature of reality that renders supply-and-demand analysis wrong, misleading, or unhelpful.
Third, when discussing elasticity I – like, I’m sure, most other econ-principles profs – explain that one of the determinants of elasticity is time. Specifically, both demand and supply are more elastic the longer the amount of time is available to adjust to price changes. I typically even use the minimum wage as an example, explaining that most of the jobs that are likely destroyed by a higher minimum wage are not destroyed immediately but, instead, are destroyed (or are not created) over time as employers have more time to adjust to the new, higher wage. And I do all this explaining not in a way that implies that differences in elasticity across outputs, across inputs, and across time somehow diminish the explanatory power of supply-and-demand analysis but, instead, as an integral part of making supply-and-demand analysis as explanatory as possible.
Nick Bradley
Nov 27 2015 at 10:48am
worth noting that the minimum wage to per capita GDP ratio was 2.5x higher in the late 1960s than it is today (4x MW-to-GDP). 2.5x works out to an $18 minimum wage today. 4x works out to a $29 an hour minimum wage today.
http://www.wolframalpha.com/input/?i=minimum+wage+as+a+percent+of+us+gdp+by+year
in lower income states this ratio was far higher; yet, we didn’t see these apocalyptic scenarios of unemployable low-skill workers.
what happened in reality is what progressives argue today: management and ownership absorbed a lot of the cost, the rest was passed on in higher prices, and workers spent their higher incomes back into the economy.
Hasdrubal
Nov 27 2015 at 10:52am
@Jon Murphy
Most of the things you learn in economics 101 are wrong in the same way that most of the things you learn in physics 101 are wrong: They’re simplified models, stripped of the extraneous complexities of the real world, meant to illustrate the underlying dynamics of the real world.
Yeah, the results of a minimum wage aren’t so simple as a price floor in a graph. But, you’re never going to run into a series of springs and masses on a frictionless surface, either. That doesn’t mean the theories you learn in either field are wrong, or even that the intuitions you gain from learning those theories are wrong. It just means that the details in the real world won’t turn out as clean and clear as they do in freshman problem sets.
Yet, we get articles about “Everything you learned in Economics 101 is wrong” when there’s disagreement over how much employment will be affected by a 90% increase in the minimum wage. But nobody bats an eye when you try to teach your kid about gravity and come up with 7m/s^2 from dropping a ping pong ball but 9m/s^2 with a baseball.
Kevin Frei
Nov 27 2015 at 12:44pm
There are many attributes to the employment relationship of which wage is just one (paraphrasing Dan Klein here). If a pay raise is offset by cuts to those other attributes, you haven’t actually raised the price.
The implication of Noah’s article is that laypeople like me should just trust guys like him to tell us what is good policy. I think Noah Smith is what’s wrong with economics.
Nick Bradley
Nov 27 2015 at 12:49pm
@Hasdrubal,
you bring up a great analogy; but why does the economic right assume the economic environment is so darned frictionless?
Basically all supply side arguments assume we’re operating at full employment and well off the zlb, with tangible benefits to be had from deficit reduction; distributional effects are also assumed away (often). Arguments for capital gains tax cuts are totally detached from how firms actually raise capital in 2015 — its almost as if they’re working off a simple 101 model where General Motors issues common stock to finance a new factory…
Swami
Nov 27 2015 at 2:57pm
Nick,
Nice job of inserting a token “apocalyptic” into the discussion. I won’t try to engage on this word, other than to express that the severity of the harm probably depends upon whether you are the inner city minority teen who is part of the long term double digit unemployment (over forty percent in some poor areas).
Let me add though that you are missing the full effects. In reality the following unintended consequences occur:
1). The minimum wage affects employment levels extremely indirectly. It affects the supply and demand of HOURS, not workers. Econ 102 should actually stress that raising the cost of an hours work will result in less hours demanded, which may very well have no effect on unemployment, as employers have little incentive to reduce workers when they can just reduce hours worked per and have a larger, more flexible staff. The workers gain a higher hourly wage, but are left with fewer hours, less scheduling freedom, and a worse situation overall.
2). One reasonable response to a minimum wage is to hire similar numbers of employees but to upgrade the quality of the employee and the demands set on that employee. Thus we see LOWER unemployment with skilled employees and higher unemployment for lower skills. Again, there may be little or no change in hours work, but a bias in who is employed, with the unskilled, inner city poor minority educated by public service union teachers thrown out in the process.
3). Another response is to adjust all the non wage compensation. The employer can cut benefits, cut job perks, reduce freedom, increase job demands, reduce hours per employee (as above). Again, the benefit isn’t materializing as hoped by naive meddlers… It just shifts toward something more measurable.
Finally, you comment that higher minimum wage comes out of employer profits misses that profits act as a signal and incentive for investment. As the expected risk adjusted rate of return drops, the economics 102 solution is less investment in that market segment. Fewer new stores, fewer future works shifts, fewer new competitors and faster market exit. The attractor again is for fewer opportunities.
I will say it may actually lead to higher automation, and thus productivity, but that doesn’t usually make for a good progressive sound bite. “Help us put inner city black kids out of a job by replacing them with machines.”
And what to we see in reality — is it the rosy progressive narrative, or are we seeing high unemployment rates in inner cities, automation, fewer hours worked per employee, fewer benefits, and growing gaps between skilled and unskilled?
Hmmmm, makes you wonder about your narrative doesn’t it?
Nick Bradley
Nov 27 2015 at 3:23pm
@Swami,
I use the term “apocalyptic” to poke fun at flimsy claims coming out of AEI and Heritage. but to your points
1. that’s an assumption you’re making. if demand for goods produced at that business don’t change, even with a price increase, nothing changes. if there’s some combination of price increase and absorption by management and capital.
2. LOL Isn’t this considered a real gain in productivity? should the government just force wage hikes to push through capital investment and efficiencies?
3. wait, minimum wage workers get benefits?
* profits do not necessarily incentivize investment — you’re sort of proving my point: markets just aren’t this efficient.
And as @Hasdrubal stated, its really important to understand these 101 fundamentals, but you also need to realize that so, so many other factors are in play in the real world. It makes economists look really silly when they assume markets are this efficient.
EMH led to the financial crisis.
Jon Murphy
Nov 27 2015 at 3:30pm
Then they’re not wrong. They’re the foundation. Saying something is wrong means it’s incorrect. Nothing taught in an Econ 101 class is incorrect (assuming a competent teacher, of course). Supply and Demand doesn’t change based upon “real world complexities.” Their slopes might (see Don’s comment), but Demand doesn’t suddenly become upward sloping in “the real world.” People don’t suddenly stop responding to incentives or stop thinking on the margins. Oh no.
To keep the metaphor going, the “real world” doesn’t change the law of gravity, or make friction not a force.
With respect, those who argue that Econ 101 (or any 101) is wrong have either misapplied the lessons from the higher-level courses, or misunderstood their foundations (or had bad teachers and should get their money back).
Anonymous
Nov 27 2015 at 7:30pm
@Nick Bradley
1. It seems unlikely that demand doesn’t depend on price for all, even most, of the products of low skill work. People will buy the same number of hamburgers and coffees if they cost more? They’ll buy the same groceries? Hire the same number of cleaners at the same frequency?
Low skill work is such a broad category that this claim seems to call into question the whole of economics. Is the concept of the downward sloping demand curve really just outright wrong? Do people not actually respond to incentives after all? Of course the demand for some things will be constant no matter the price, but “everything produced by low skill workers” doesn’t strike me as one of them.
2. No, because those workers would otherwise have been working somewhere else, and the low skill workers they’re displacing would have their current jobs instead.
3. Yes, of course they do. When I worked in a grocery store, we had a cafeteria, vending machines, a store discount, lockers, a TV area with sofas, newspapers, fairly shiny and clean toilets. They pushed us reasonably hard in our work but certainly could have pushed harder. There are an enormous number of avenues an employer can economise on other than just wages.
rtd
Nov 27 2015 at 10:03pm
[Comment removed. Please consult our comment policies and check your email for explanation.–Econlib Ed.]
Brandon Berg
Nov 28 2015 at 12:27am
@Nick Bradley: you bring up a great analogy; but why does the economic right assume the economic environment is so darned frictionless?
I’m not sure that this is true. A better question might be why the economic left believes that friction changes the sign of an effect, rather than the magnitude.
Michael Byrnes
Nov 28 2015 at 6:45am
Do Econ101 students appreciate the distinction between movement along a curve versus a shift in the curve?
If apples are selling for a higher price this year than last, what does that say about the quantity of apples being sold? Nothing really. Maybe apples are “trending” and sales volume is actually greater. Or maybe there was a low crop yield and sales volume is down because of that. No way to know from the price alone.
This is a mistake that I see all the time in the media, I even make it myself, but perhaps Econ101 students are not that ones making this mistake.
Jon Murphy
Nov 28 2015 at 7:23am
@nick
“1. that’s an assumption you’re making. if demand for goods produced at that business don’t change, even with a price increase, nothing changes. if there’s some combination of price increase and absorption by management and capital.
2. LOL Isn’t this considered a real gain in productivity? should the government just force wage hikes to push through capital investment and efficiencies?”
A gain in productivity does mean a loss in jobs (or reduction in jobs demanded). That’s its definition.
It’s also a huge mistake to assume “nothing changes.” If the price of an input rises, then there is incentive to look elsewhere to fulfill that need (such as electronic cashiers at McDonalds or self-serve kiosks at the movies). So, even if the demand for a good/service stays the same, that doesn’t necessarily mean its input composition will stay the same
TMC
Nov 28 2015 at 2:04pm
” it’s possible that Smith doesn’t think he needs to do so because he takes as given that his audience knows what’s in Mankiw’s text.”
Most likely he knows they DON’T.
Noah Smith, Sith Lord
Nov 28 2015 at 4:18pm
Thanks, David! Here is my reply!
http://noahpinionblog.blogspot.com/2015/11/econ-101-and-data-reply-to-david.html
Seth Wiggins
Nov 29 2015 at 1:56pm
In introductory physics, you learn what happens in a vacuum. In introductory biology, you learn what happens in a sterile environment. In introductory English, you learn how to use beginning tools like a thesis statement.
See my point? In every discipline you teach simple concepts in the field, which will become much more complicated with further study. Economics is no different.
Smith might be highlighting a real point here: Econ professors teach as if introductory principals are sacrosanct. And/or students take them as such. This is a problem, and deserves real attention by professors.
But that introductory economic concepts are presented in a simple fashion compared to the ‘real world’ is entirely appropriate and consistent with other fields.
Anonymous
Nov 29 2015 at 5:09pm
It seems to me that there are two claims being conflated here, one obvious and boring, the other exciting but implausible. The first is that the labor market doesn’t resemble the world’s most simple supply and demand graph. The second is that the entire concept of supply and demand, in its most elaborate and complex form, still describes almost nothing of the reality of the labor market.
Of course it’s not as simple as “when a minimum wage is set, everyone who previously earned less than it is immediately fired and is now unemployable”. If Econ 101 consisted of claims like that, most of them would indeed be wrong. But I think it would be dishonest to suggest that that sort of argument is the full extent of supply and demand theory. And inaccurate to claim that supply and demand really have almost nothing to do with wage levels.
Regarding empirical evidence, it seems obvious to me that you need some of it, that no economic analysis can be done at all without some idea of the relevant elasticities and so on, for which you need to know the details of the market you’re talking about. Who are these people who are apparently trying to do economics without knowing any real world information?
I suspect that at least some of the increased popularity of the minimum wage comes from welfare making unemployment a less unattractive option. Consider: if there was no welfare at all, what proportion of those left-inclined economists who currently argue in favor of minimum wages would still do so? I think it would be a smaller proportion than do now.
pgl
Dec 1 2015 at 12:14pm
Noah Smith’s reply to this is spot on. Question – have you read Economist Rules – the latest from Dani Rodrik? Excellent book and he is saying the same thing in many ways as Noah.
Joe Newton
Dec 1 2015 at 1:16pm
Nicely put.
Chris Neely
Dec 1 2015 at 3:53pm
Nick, I think that your figures about the minimum wage are misleading.
Comparisons about the real minimum wage across spans of 50 or 60 years become very sensitive to relatively small changes in the price measure used. For example, both the GDP deflator and PCE index have run much below the CPI since the 1960s — about 50 bp per year or about 25% lower in total over the last 50 years.
If one uses the GDP deflator or the PCE, one gets a much lower peak value of the real minimum wage in 2015 dollars.
And that 1968 peak in the real minimum did not last long, it was enacted at a time of historically high demand for labor at the peak of the Vietnam war and it was then eroded fairly quickly by inflation.
I don’t think that we want to return to that policy.
Comments are closed.