Category Archives: Introductory Economics

Question from a reader

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He writes,

I have not been able to find a causal account as to why information failures (particularly with regards to quality) lead to market failures

In textbook economics, a market failure is when the private incentives lead to either too little or too much of a good being produced.

In terms of information, consumers make purchases based on what they can observe. If what they observe is highly correlated with quality, they should do well. But not necessarily otherwise.

Consider a high school student making a college visit. The appearance of the facilities can be observed relatively accurately, but it is not very highly correlated with quality. The quality of classroom instruction cannot be observed so accurately, because the high school student will not sit in on very many classes. But suppose that the quality of classroom instruction is highly correlated with the value that the student gets out of college.

We can predict that colleges will over-spend on the appearance of facilities, because that factors heavily into the decision of the high school student. We can predict that colleges will under-spend on classroom instruction. Market failure.

The public policy response should be to tax college facilities and/or subsidize quality classroom instruction.

I am not offering this as a realistic picture of a market failure in the market for higher education. My point is to answer the reader’s question about connecting information failure to textbook market failure.

McCloskey on teaching economics

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She (then he) wrote,

I think economics, like philosophy, cannot be taught to nineteen-year olds. . .comes directly from a socialized economy (called a family), and has no feel on his pulse for those tragedies of adult life that economists call scarcity and choice.

Thanks to a commenter for reminding me about the article, which I recall reading a few years ago.

I am not as pessimistic as that. But this may be an instance where the demand side of the market is actually in control. That is, students feel like they are learning something when they can define and use economic jargon and diagrams. Deeper, more philosophical points, like the way that economic growth resembles evolution, or the challenge of achieving cooperation in large-scale society, don’t sell as well to a 19-year-old market.

Mike Munger on non-ownership

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You can watch the podcast at Cato (I watched it live yesterday, so the link may be different). The book is Tomorrow 3.0: Transaction costs and the sharing economy. It can be summarized by a remark from one of my commenters.

The commenter writes,

Ownership is a form of market failure:

– Your car being parked 23hrs a day just to ensure that it’s there when you need it.
– Transaction costs of selling/buying your house tying you down and decreasing efficiency of your human capital.

This reminds me of my line to my high school students that “Do It Yourself is market failure.” I had an economist friend who built a deck for his house to “save money.” I pointed out that if he could get paid his economist’s wage rate while working more hours and then paid someone to build the deck, then that would have saved a lot more money. His inability to get paid for marginally more hours worked as an economist was the market failure.

Transaction costs and agency costs related to land are fundamentally important. In theory, the best way for me to own land is to include a well-diversified mutual fund that invests in real estate as part of my portfolio. In practice, transaction costs make me want to stay in a particular dwelling much longer than might otherwise be optimal, and agency costs make it more likely that a property will be well cared for by an owner than by a renter. Overcome those sources of market failure and you make it feasible to own a diversified real estate portfolio instead of being stuck with one home.

Human beings are social

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The essay is a very concise reply to the often-made criticism of economics and markets that human beings are social.

At a large scale, tribal solidarity does not suffice. We do not know how to coordinate to deliver the goods and services that we enjoy without using market prices. We do not know how to motivate people to choose occupations that serve the needs of the larger community except through self-interest.

Because the essay is concise, read the whole thing.

Which concepts work in economics?

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On Quora, I was asked where economics works. I changed the question to “which concepts work?” My answer was

The laws of supply and demand work. The principle of substitution works (we do not run out of resources—we substitute away from resources as they become scarce). The idea that economic growth involves creative destruction works. The idea that specialization and trade are fundamental elements of economic behavior works.

Concepts that do not work, in my opinion: aggregate demand and aggregate supply; neoclassical model of income distribution; theory of public goods–it is clearly wrong as a positive theory of how government behaves, and because it is wrong as a positive theory its normative value is also quite dubious.

I would be curious about how other economics bloggers might answer this question.

Russ Roberts on middle-class income stagnation

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Using an animated format, he starts to delve into the statistics. It is aimed at people without formal education in economics, but it struck me that some of the points that it makes might be best appreciated by a trained economist. Kind of like a children’s book with jokes mixed in that only adults can get. I imagine that if this had been available when I was teaching high school economics, then I would have used it.

Recall that Russ conceived and scripted the famous Keynes-Hayek rap videos.

Thoughts on profits

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I put this essay up on Medium. I like the concept of Medium. I would like to be able to reach some people who are on the left. Everyone seems to love the juvenile, anti-capitalist rants that people put up. I thought I would put up some different ideas. Based on statistics, hardly anyone who goes to the site seems to want to read what I write. If that continues to be the case, then I will just stick to this blog.

What I’m Reading

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Tim O’Reilly’s new book. He tries to grasp how technology affects the current business environment. He then proceeds to look at the overall economic and social implications. You can get some of the flavor of it by listening to his interview with Russ Roberts. And here is more O’Reilly, where he says,

Microsoft lost leadership because they had taken away the opportunities for their developer ecosystems, so those developers went over to the Internet and to Google. Now, we see this same thing playing out again.

I am not persuaded by these sentences. The Internet was quite a powerful phenomenon. I cannot envision an alternative history in which Microsoft does not lose a lot of its commanding position because of the Internet. You can make a case that Bill Gates could have positioned Microsoft better had he grasped the significance of the Internet sooner, but that would not have changed the game, only made Microsoft a more agile player. And you could argue that whatever Microsoft lost in terms of time, they made up for in terms of spending, so that they wound up doing about as well in the Internet environment as one could reasonably expect.

Overall, I disagree with O’Reilly quite a bit. Early in the book, he writes,

there are far too many companies that are simply using technology to cut costs and boost their stock price

Take this rhetoric and apply it to trade, and it could come from the lips of Donald Trump. In fact, good economists will explain that trade and technology are so intertwined as to be indistinguishable as economic phenomena. Austrian capital theory says that capital is roundabout production, i.e., roundabout trade. Suppose an economy consists of farm equipment and crops, and you want to explain its efficiency. Do you give the credit to farmers applying technology or do you give the credit to trade between the manufacturing sector and the agricultural sector? It’s the same phenomenon, just described differently.

Russ Roberts did not go after O’Reilly on the anti-corporate demagoguery. A charitable interpretation was that Russ wanted to focus on the Internet “platform model” that O’Reilly waxes eloquently about. A less charitable interpretation is that Russ switched to Tyler Cowen’s philosophy of interviewing.

Deirdre McCloskey on teaching economics

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She writes,

I think economics, like philosophy, cannot be taught to nineteen-year olds. . .A nineteen-year old has intimations of mortality, comes directly from a socialized economy (called a family), and has no feel on his pulse for the tragedies of adult life that economists call scarcity and choice. . .you cannot teach him a philosophical subject. For that he has to be say, twenty-five, or better, forty-five.

Read the whole thing. Pointer from Tyler Cowen. My thoughts:

1. By her definition, I was not a natural economist. (She would say that there is nothing wrong with that.)

2. My own teaching experience is consistent with her view. I do not believe that the undergraduates I taught at George Mason or the high school students for whom I taught AP economics really grasped what I wanted them to grasp.

3. I wish that McCloskey had spelled out more completely what it is that she believes is difficult to teach. I am inclined to believe that she is right, but I cannot be sure without more elaboration on her part.

4. I am inclined to believe that teaching economics in terms of the history of economic thought would be worth attempting. I had a great high school chemistry course in which the teacher started with the discover of the gas laws and then gradually added new theories and experimental findings as they took place chronologically. I wish that it were standard to teach economics that way. Of course, you might reach the end of the first semester and still not have finished Adam Smith–even if you start with him.

Heterodox introductory economics

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Samuel Bowles and Wendy Carlin write,

The Economy takes on board the fundamental innovations of Hayek and Nash used in contemporary economics research. But concerns about climate and other market failures as well as economic instability provide reasons to doubt Hayek’s argument that governments should limit their activities to enforcing property rights and other rules that permit markets to function.

Pointer from Mark Thoma. They refer to this free textbook. I can see that I disagree with a lot of it. For example, The Economy says,

Through most of their history, humans have regarded natural resources as freely available in unlimited quantities

This seems wrong to me. Prior to the invention of agriculture, humans had to take into account the limited availability of resources. If nothing else, when hunter-gatherers exhaust a food supply in an area, they have to move or face starvation.

Instead, I would emphasize that the price-and-profit system encourages humans to use our ingenuity to reduce our dependence on scarce resources. This natural tendency toward conservation in a capitalist economy is one of the most important concepts for economists to teach. Thus, the environmental lesson in their book is nearly the opposite of mine in Specialization and Trade.

Still, there are many ways in which their textbook strikes me as a constructive improvement over the textbooks in the Samuelson tradition. I am very sympathetic to their effort to bring more heterodox views into introductory teaching.