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Wednesday, January 4, 2012

Some Sins of Textbook Economics

People who are ignorant of economics are susceptible to all sorts of misunderstandings. Fortunately knowledge of even just the basics of sound economics is a powerful inoculant against many dangerous falsehoods and half-truths.

This fact, however, does not imply that exposure to more economics is necessarily good. The sad reality is that economists too often present their analyses of markets in ways that confuse not only unsuspecting non-economists but also—and too often—economists themselves.

A frequently encountered instance of this confusion is economists’ discussion of competition. What introductory economics textbooks describe as “perfect” (or “pure”) competition resembles nothing that occurs in the real world. In the world of the textbooks, firms don’t differentiate their products from those of their rivals. Firms never try to win more customers by improving the quality of their products. Also, firms don’t advertise. Indeed they don’t even cut prices because each “perfectly competitive” firm is a “price taker”: It’s too small to affect the market price and so can sell as much as it wishes at whatever price prevails in the market.

These and other problems with the model of “perfect competition” have been pointed out repeatedly, especially by economists steeped in the Austrian tradition—see, for example, Hayek’s essay “The Meaning of Competition.” Yet the typical economist still clings to the notion that “perfect competition” is perfect competition. This typical economist, it must be admitted, does understand that the conditions necessary for “perfect competition” to prevail in actual markets can never exist. But the model remains the ideal against which real-world markets are judged. The closer real-world markets appear to be to textbook “perfectly competitive” markets, the more competitive real-world markets are assumed to be.

And competition being a good thing, this typical economist presumes that policies advertised as moving real-world markets closer to the “perfectly competitive” ideal are desirable.

Assumed Conclusions

But such a presumption is unwarranted, in part because many of the conclusions of the analysis are snuck into the model’s initial assumptions.

Most important among this model’s foundational assumptions is that competitive forces play out only in the form of price cuts. Therefore anything that prevents prices from being cut (down to levels that the model specifies as appropriate) is regarded as an obstacle to competition—indeed, as an element of monopoly that prevents the economy from operating more efficiently.

To this day, many mainstream economists describe any firm that can raise, even modestly, the price it charges for its product without driving away all of its customers as possessing some monopoly power.

Note the confusion: A pest-control producer that aims to increase its sales by making a better mousetrap is regarded by this model as behaving monopolistically! Competing for customers by doing something other than simply cutting prices is, according to the model, not competitive.

You can’t make this stuff up.

Another example of how economists commonly confuse themselves (and others) involves the issue of “market failure.” That same introductory economics textbook that teaches the model of “perfect competition” explains a few chapters later that markets perform suboptimally whenever some groups of people act in ways that affect other groups of people without the consent of these third parties. The textbook then explains that, happily, economists know how to design taxes or regulations to fix the problem.

Externalities and Assumptions

Such situations—economists call them “externalities”—are indeed bad. If Smith pays Jones to hit me in the head with a hammer without my consent, I—the third party—am unquestionably made worse off. (A simple, and best, solution in this case is to give me an enforceable property right in my person: No one can hit me and get away with it without my consent.)

But the stories that economists typically tell of externalities—and of how to “solve” them—too loosely sneak in illegitimate assumptions.

Here’s an example: Smith pays Jones for pork chops whose production at Jones’s pig farm next door to where I live fills my house with obnoxious odors. The economist leaps to the conclusion that I am wronged. Perhaps I am. But suppose that I bought my house knowing that it was next door to a pig farm. Am I still wronged? No: The price I paid for my house was discounted because of its location within smelling distance of the farm. Not only have I consented to endure swinish odors in my home, I’ve been compensated for doing so (in the form of a lower price than that of a similar home located in a sweeter-smelling neighborhood).

Or suppose, alternatively, that the pig farm moves into my neighborhood by surprise, after I buy my house. Now am I harmed? The answer is unclear. If the location of my house is such that homebuyers should reasonably expect the possibility that farms might set up shop nearby, then when I bought my house there was an open question about whether or not home-owners have the right to odor-free air in the neighborhood. And because this question cannot be answered by economics alone, it’s illegitimate for an economist to conclude that the farm necessarily should be taxed or regulated for the purpose of cleansing the neighborhood air of stinky odors.

The Largest Externalities

Economists are correct to point out that externalities exist. But economists are far too frivolous in going about labeling this or that effect an “externality”—and, what is even worse, are far too glib in supposing that government can be trusted to “internalize” externalities in ways that improve the allocation of resources rather than making it worse.

Don’t forget what too many economists seem never to grasp: Collective decision-making itself—from citizens voting to politicians spending taxpayers’ money—is infected with what are perhaps the largest and most intractable externalities. Costs are imposed on third parties constantly.

Economics done properly would highlight the dangers of trying to cure externalities with a process that itself is deeply infected with externalities. Unfortunately economics is too often done improperly.

  • Donald J. Boudreaux is a senior fellow with the F.A. Hayek Program for Advanced Study in Philosophy, Politics, and Economics at the Mercatus Center at George Mason University, a Mercatus Center Board Member, and a professor of economics and former economics-department chair at George Mason University.