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THE CHRONICLE REVIEW
What’s Wrong With Econ 101
By James Kwak JANUARY 22, 2017
If you are a Wall Street master of the universe or a billionaire hedge
fund manager, you face the same challenge as the aristocrats and
industrialists of the past: How do you justify the vast economic chasm
that separates you from the people you pass on the street every day?
Appeals to Christian theology or evolutionary necessity may have worked
in previous centuries, but they are unlikely to be convincing today.
Instead, you can turn to another source of economic truth: Economics 101.
From taxes to wages to government regulation, our political discourse
is dominated by a lesson that economics students learn in their first
semester: the model of a competitive market driven by supply and demand.
Introduced to the world by the French mathematician Antoine-Augustin
Cournot in 1838, this now-ubiquitous analytical tool shows how many
units of a product are demanded and supplied at any given price — and
how prices automatically adjust so that supply exactly equals demand.
This core insight dates back at least to Adam Smith, who explained in
his 1776 book The Wealth of Nations that market prices are determined by
the individual, self-interested decisions of buyers and sellers.
By the late 19th century, supply and demand curves became a dominant
feature of economics education, thanks in large part to a textbook,
Principles of Economics, by the British economist Alfred Marshall.
Marshall showed how buyers and sellers, acting in their own interests,
converge on an equilibrium price that maximizes social welfare, defined
narrowly as the difference between the value consumers place on goods
and the total cost of producing those goods.
Marshall, however, rejected the idea that we should simply let markets
work their magic and accept whatever outcomes they produce. Instead,
because people differ in wealth, he argued that "aggregate satisfaction
can prima facie be increased by the distribution … of some of the
property of the rich among the poor."
“If we were to redesign Economics 101, what would it look like? One
possibility is to begin not with abstract models, but with the real
world.” That view was echoed in the 1948 first edition of the textbook
that would dominate the market for the next three decades. In Economics,
Paul Samuelson wrote, "John D. Rockefeller’s dog may receive the milk
that a poor child needs to avoid rickets. Why? Because supply and demand
are working badly? No. Because they are doing what they are designed to
do, putting goods in the hands of those who can pay the most." For
Samuelson, the competitive market model of Economics 101 was simply a
useful analytical tool.
For his contemporaries Friedrich A. Hayek and Milton Friedman, however,
it was something more: the heavy artillery in an ideological battle
against the New Deal. In the 1940s and ’50s, Hayek and especially
Friedman built a comprehensive theory of society on the foundation of
competitive markets. In his 1962 book Capitalism and Freedom, Friedman
explained how virtually any social or political issue could be analyzed
in terms of supply and demand — and concluded in each case that
government should get out of the way and let free markets produce the
best of all possible worlds.
Both Hayek and Friedman saw themselves as participants in a battle of
ideas against encroaching socialism. In their hands, an analytical
framework became a universal worldview: Economics 101 became economism.
Economism is the belief that basic economics lessons can explain all
social phenomena — that people, companies, and markets behave according
to the abstract, two-dimensional illustrations of an Economics 101
textbook. Ideally, students should learn that the competitive market
model is just that — a model, which by definition abstracts from the
real world. According to the rhetoric of economics, however, the lessons
of Economics 101 can be transplanted directly into the real world. The
central idea that free markets generate the greatest possible economic
well-being for society becomes a universal framework for understanding
and answering any policy question.
Economism may not accurately describe reality, but its reduction of
complex phenomena to simple concepts was a major asset in the battle of
ideas. The political landscape of the United States after World War II
was dominated by the shadow of the New Deal and the idea that the
government could and should play a major role in managing the economy.
Businesses that opposed intrusive regulations and wealthy individuals
who feared higher taxes needed an intellectual counterweight to the New
Deal, a conceptual framework that explained why an activist government
was bad not just for their profits and their pocketbooks, but for
society as a whole. Economism filled that need.
The rhetoric of economism was taken up first by think tanks such as the
Foundation for Economic Education and the American Enterprise Institute,
then by the National Review of William F. Buckley, who helped make
free-market economics part of the conservative synthesis. From Barry
Goldwater to Ronald Reagan, the conviction that all economic problems
could be boiled down to first principles and solved by the magic of
competitive markets became a central tenet of conservative ideology. In
the memorable words of Dick Armey, the former House majority leader,
"The market is rational and the government is dumb."
As the mantra of free markets, small government, and lower taxes became
more popular with voters, Democrats adapted by also paying homage to
competitive markets. It was Bill Clinton who said, "The era of big
government is over." And Barack Obama’s signature health-care-reform
program is centered on the idea of using (regulated) market competition
to expand access to health insurance.
Economism presents itself as an abstract, value-neutral representation
of the world — one that invokes the prestige of economics, a discipline
that many people find intimidating. "It’s just Economics 101," one often
hears. The role that it plays in contemporary society, however, is
deeply ideological. Economism naturalizes one possible state of affairs
— in which individuals and companies are left to compete in unregulated
markets — and, like Doctor Pangloss in Voltaire’s Candide, celebrates
the outcomes that result as the best of all possible worlds.
But in reality, things do not always turn out so well. In practice,
economism often has the effect of increasing inequality, or at least
justifying it in today’s new Gilded Age. Consider the minimum wage. The
United States has the lowest minimum wage, as a proportion of average
wages, of any advanced economy — one reason for our wide gap between
rich and poor. But according to economism, raising the minimum wage
would only backfire and harm poor people. On a simple supply-and-demand
diagram, a minimum wage is a price floor in the labor market; like any
price floor, it must cause supply to exceed demand. Therefore, raising
the minimum wage must increase unemployment, and anyone who disagrees
simply doesn’t understand Economics 101.
In real life, however, employment levels are the result of many factors
— some businesses can pass cost increases on to customers, better-paid
workers are less likely to quit, and so on. Real economists study these
relationships in detail, and a significant body of recent research
indicates that modestly higher minimum wages have no discernible effect
on unemployment.
Despite this empirical evidence, the public-relations campaign against a
higher minimum wage remains clothed in the rhetoric of economism. What
goes unsaid is that the campaign is, in significant measure, funded by
industries that benefit from low wages for unskilled labor. This is but
one example of how economism provides a seemingly neutral perspective on
the world that can be deployed in the service of business interests and
the wealthy.
Economism is the reduction of social reality not just to Economics 101,
but to just one Economics 101 lesson: the model of a competitive market
driven by supply and demand.
Paul Samuelson bemoaned the fact that a single idea — that free
competition is always good and government intervention is always bad —
is often "all that some of our leading citizens remember, 30 years
later, of their college course in economics." Writing in the late 1940s,
Samuelson’s first concern was preventing another Great Depression and
the geopolitical turmoil that followed. In his textbook, which dominated
introductory courses during the decades following World War II, the
theory of supply, demand, and prices is not discussed until Chapter 19,
more than 400 pages in.
Contemporary textbooks, however, have moved away from Samuelson’s
example. Whether by the slightly right-leaning N. Gregory Mankiw or the
slightly left-leaning William Baumol and Alan Blinder, they emphasize
rational individuals pursuing their self-interest in competitive
markets, guided by Adam Smith’s invisible hand to maximize their
collective prosperity.
While economics professors know that the world is much more complicated
than an introductory textbook, many college students are still
inculcated with the simplistic dogma of competitive markets. As the
Times Higher Education summarized the results of a recent survey of
undergraduate programs around the world, "economics degrees are highly
mathematical, adopt a single narrow perspective and put little emphasis
on historical context, critical thinking or real-world applications."
This limited focus is even more true of business programs — the most
popular undergraduate concentration in the United States — whose
students often take little more economics than a required introductory
course.
Economists already know the cure for Economics 101: better economics.
Many advanced courses deal precisely with the differences between the
real world and the introductory models taught in the first year. No
doubt many instructors are able to give even casual students a healthy
skepticism regarding the ideology of free markets. People who are
familiar with the irrational behavior of human beings, the importance of
institutions, the techniques for analyzing real-world data, and the
vicissitudes of economic history will understand both the utility and
the shortcomings of the competitive market model.
The pedagogical problem is that the typical introductory course does not
allow enough time for anything more than a cursory introduction to these
vitally important subjects. Professors can and do emphasize the limits
of models, but even then a course centered around supply and demand
curves will often produce the students that Samuelson lamented, who
remembered only that competition is good and government is bad.
If we were to redesign Economics 101, what would it look like? One
possibility is to begin not with abstract models, but with the real
world. How do companies use technology to produce goods, and how are
those companies organized? How are products and services distributed,
and how do manufacturers, intermediaries, and retailers set prices? How
are wages determined — not in the theoretical model, but in real life?
What factors determine the set of opportunities available to different
people on different parts of the planet?
The economist Partha Dasgupta, for example, begins his "very short
introduction" to economics by describing the different material and
economic conditions of two families, one in the suburban United States
and one in rural Ethiopia. Students who begin with a grounding in the
way the world actually works will be better equipped to understand the
limitations of abstract models when they do learn them.
Alternatively, we could begin with real human beings. An introductory
course in behavioral economics would reveal that we all make decisions
irrationally, at least compared with the utility-maximizing entities who
populate the typical textbook. The same is true of organizations, which
are populated by fallible human beings who often have their own
interests at heart. Understanding the importance of habit, convention,
prejudice, and other factors will enable students to resist the allure
of models that assume superhuman actors and perfectly efficient firms.
Or, perhaps, we could do away with the idea of Economics 101 altogether.
I studied history and I teach law, neither of which has a single "101"
class. There could be one introductory class called "Economic
Institutions Around the World," another called "Decision Making by
Individuals and Organizations," a third called "Economic Development
Through History," and a fourth called "Abstract Economic Modeling" (what
is now "Economics 101"). Economics majors could take them in any order
they wanted, and nonmajors could take only those that interested them.
People who take only one economics class would not necessarily be
indoctrinated in the myth of the invisible hand; students who are
serious about the field would learn everything they need to learn, but
with the context necessary to understand the uses and limits of simple
models.
Such a program would also be more true to the extraordinary richness of
contemporary economic thinking, encouraging a more diverse range of
students to enter the field. The premise of economism is that
"economics" says only one thing: that unregulated competitive markets
produce the best outcomes for all people. One antidote is for people to
understand that economics is a fascinating discipline that provides many
answers to many different kinds of questions — and to seek out those
answers for themselves.
James Kwak is a professor at the University of Connecticut School of
Law. Portions of this essay are adapted from his new book, Economism:
Bad Economics and the Rise of Inequality (Pantheon).
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