Sunday, November 22, 2015

Noah's unlearning economics

So now Noah Smith is unlearning economics; he put together a list of Econ 101 fails (quoted below with commentary from the information transfer framework). First one first:
1. If you slap some quick supply-and-demand graphs on the board, it looks like minimum wages should harm employment in the short term. But the data shows that they probably don't.
Supply and demand graphs are incorrectly used in this situation by economists (as I talk about in this post on Seattle's new 15 dollar/hour minimum wage). What is comes down to is that when they set a price floor in the Econ 101 supply and demand diagram, the "solution" determined by the demand curve and the price floor and the "solution" determined by the supply curve and the price floor are no longer a solutions of the same general equilibrium equation. If this is treated correctly, then if you set a price floor X in a single market then prices generally shift to p + X and the general equilibrium is higher (supply and demand both increase).

There is also the potential that the labor market might not be ideal (the true information equilibrium price may be higher than the realized price), so a price floor actually makes the market more ideal.

Also, with Malaney and Weinstein's gauge invariant approach (linked to here with some discussion), a constant shift shouldn't do anything (except instantaneously at the time of the shift) on its own. The constant shift can only matter relative to every other market. That means it becomes model dependent: Can you shift from minimum wage labor to machines in your specific business/industry? Or will you just have to eat higher labor costs or pass them on through as higher prices? These questions cannot be solved with Econ 101 supply and demand diagrams.

And that is the key in understanding the difference. If the price rises for labor in a market, in Econ 101, it would be interpreted as a positive demand shock or a negative supply shock -- if you didn't know about the minimum wage. That implies firms should view the situation (if they just look at the price) as if there was a shortage of workers. But there aren't fewer workers in the labor pool ... in fact, there are probably more because they'd be incentivized to enter the labor pool based on people making more money (assuming they also didn't know about the minimum wage increase).

From a rational behavior perspective, this would actually massively increase employment. Firms would think labor is a scarce commodity, but there would be lots of it. The Econ 101 picture says that firms don't interpret this price increase as scarcity, but instead just hire fewer workers.

That is to say there is a radical difference in behavior based on whether you know that the going wage was because of a minimum wage law as opposed to a supply or demand shock. Which means that somehow the price is somehow carrying information outside of a simple number. This is inconsistent with Econ 101 -- the price aggregates the effects of supply and demand shocks and doesn't categorize them as to whether they are due to regulation or part of the natural functioning of the market.

So traditional Econ 101 analysis cannot be used for minimum wages (or taxes, tariffs, subsidies, etc). It's necessarily more complicated. Info Econ 101 reasoning with supply and demand diagrams would say that it shouldn't do anything. But you should really look at it as a much more complicated problem not amenable to naive analysis.

I hope that is clear, because it's important.

Now for Noah's #2:
2. If there's any sort of limits to mobility, then simple labor demand theory says that a big influx of immigrants should depress the wages of native-born workers of comparable skill. But the data shows that in many cases, especially in the U.S., the effect is very small.
I am not sure why any economist would think of this as a short run pure supply shock in partial equilibrium.

In the information equilibrium model, a positive labor supply shock would lower the price level (i.e. lower nominal wages, but not real wages) if it was unaccompanied by nominal output increase. If NGDP was constant (a requirement for the partial equilibrium analysis), that actually means since the price level goes down RGDP increases since NGDP/P = RGDP.

However, how do you add people to the labor market without increasing output unless all of them remain unemployed? Their wages are NGDP. Their output is NGDP. It is impossible to add labor without taking into account the at least possibility of adding output, so the labor market should never be considered partial equilibrium. Therefore you can't use supply and demand diagrams. You should use general equilibrium -- something more like the Solow production function -- which says extra labor means extra output.

Of course at this point you say: but the question is about the effect on native born workers.

Ah, but since output is in information equilibrium with total nominal wages (NGDP ⇄ NW) with a constant price (at least for Info Econ 101 analysis), if output goes up then total nominal wages must go up as well. If NW goes up by X ... NW → NW + X, if the wages of one group goes down, then we must have X = Y - Z (immigrants add Y > X to NW and take Z away from the existing labor force). This becomes two competing general equilibrium effects. That may be what happens, but it's not a simple Econ 101 supply shock. The Info Econ 101 tells you something more complex must be happening (if it is happening at all).

On to #3:
3. A simple theory of labor-leisure choice predicts that welfare should make recipients work less. But a raft of new studies shows that in countries around the world, welfare programs barely reduce observable work effort.
Level of work (like hours per week) is a social norm (below), so is hard to budge. In fact, it is one of the most constant things in economics. There is no way you can understand a few percent effect like this until you understand larger effects like the price level.

And finally #4:
4. Most standard econ theory doesn't assume the existence of social norms. But experiments consistently show that social norms (or morals, broadly conceived) matter to people.
So you should assume you don't know how people make decisions at the micro level. Don't worry -- this doesn't mean you have to get rid of utility maximizing agents; instead they are emergent and therefore the behavioral implications don't apply at the micro level.

Update 11/24/2015

Noah follows up at Bloomberg View. He suggests a focus on empirics to protect against naive application of theory. I think "scope conditions" would be better. On a related note Cameron Murray has a good post up comparing economics to religion where I commented:
It pretty amazing to me how much economists think Econ 101 applies to real world problems ... as a contrast Physics 101 is almost universally considered an idealization of real world problems. An academic physics professor naively applying frictionless motion to the real world would be considered a nutcase.

I think scope conditions may be the common factor. A person that naively applies an idealized religious framework is a fundamentalist. Someone who applies that framework with an understanding of its scope conditions is a 'religious scientist'. For example, the issue of abortion was not actually addressed by Jesus or the New Testament. A fundamentalist figures out a way to make the framework address an issue beyond the scope conditions of the original theory. A 'religious scientist' would recognize that the framework doesn't address the issue.

Econ 101 seems to be taught and followed more as religious fundamentalism in this regard. The limitations (scope conditions) of Econ 101 aren't taught and it is naively applied to problems outside its scope. That is economic fundamentalism in the same sense as religious fundamentalism.

Teaching the idealized theory along with its limits seems a better idea than teaching complex empirical analysis to me.

Update 11/26/2015

I just wanted to add this graph that simply illustrates the issue with the Econ 101 supply and demand diagram explanation of the effect of a minimum wage and the Info Econ 101 explanation:

In this diagram the equilibrium price is 1 at ΔQ = 0. In the Econ 101 explanation, if you set a minimum wage of 1.6 (horizontal line), then demand falls to the point indicated by the dashed line. However, the blue demand curve isn't the solution to the differential equation with a minimum price of 1.6, but rather the solution for a minimum price of zero. You can't change the boundary condition and assume the demand curve will be the same.


  1. Jason,

    The argument against minimum wage doesn't come from the analysis of the labor market equilibrium, but from the worker's utility maximization problem and his labor–leisure trade off. If income effects dominate the substitution effects of the wage increases, then optimally he will supply less labor. Supply and demand graphs are used merely to illustrate the effect of inefficient allocations induced by price distortions, and don't constitute the "meat" of the argument, which is an hypothetical argument, anyway.

    As for price distortions, you are aware that in Econ 101 they are exemplified by shifts in price without any corresponding shift in demand or supply curves, right?

    1. Sorry, these comments were put into spam for some reason.

      And yes -- the curves don't move and that is the problem. The solution to the differential equation (in the IT model) with a price floor is different if that price floor is zero or some finite value.

      It's kind of like trying to use the equations for a pendulum, but then limiting the swing to a certain height and trying to talk about the system with the same equations.

      I did the full utility version once here:

      Needless to say, it's model dependent.

    2. And regarding the labor-leisure trade-off, that is kind of my point. Illustrating this with supply and demand diagrams isn't correct ... maybe it even gives the right answer, but it isn't correct.

  2. Jason,

    The argument against minimum wage doesn't come from the analysis of the labor market equilibrium, but from the worker's utility maximization problem and his labor–leisure trade off. If income effects dominate the substitution effects of the wage increases, then optimally he will supply less labor. Supply and demand graphs are used merely to illustrate the effect of inefficient allocations induced by price distortions, and don't constitute the "meat" of the argument, which is an hypothetical argument, anyway. There is no agreement about which effects dominate.

    As for price distortions, they are represented in Econ 101 by shifts in price without any corresponding shift in supply and demand curves. The price floor doesn't change the firm's marginal benefit of hiring nor the worker's marginal cost of labor.

  3. O/T, Jason, I saw a link to this on Dave Giles blog:

    In introducing his new blog, Allan says:

    "The goal is to discuss, compare and even evaluate alternative methods and tools for forecasting economic activity in Canada. I hope others involved in the business of forecasting will share their work, opinions and so on in this forum. Hopefully, we can understand the interaction of forecasting theory and practical forecasting."

    Maybe there's somebody who's willing to accept your forecasting/modeling challenge.

    1. Thanks for the link. It will be good to get a look at the practice of forecasting.

  4. Hmmm. Unclear to me why utility satisficing agents would not be emergent.

    1. "Don't worry -- this doesn't mean you have to get rid of utility maximizing agents; instead they are emergent and therefore the behavioral implications don't apply at the micro level."

      I read that as utility maximizing agents ARE emergent. What's not necessarily utility maximizing are individual agents at the micro level. You read it differently?

    2. That's how I read it, too, Tom. But I don't see why specifically utility maximizers are emergent.

    3. More on maximizing vs. satisficing. AFAICT, economists preach naive utility maximization. For instance, I read some years ago in a book by an econ prof that he teaches his students to send all their charitable contributions to a single charity (if they do contribute to charity), because that way they maximize the utility of their contributions. No thought to any value in diversification. Now, I can't prove that diversification is a good strategy for charity, but I suspect that it is, just as it is a good strategy for investment. Utility satisficers are natural diversifiers.

      Now it may be that the IT approach produces nearly optimal results. To me that is not the same thing as an emergent utility maximizer, especially if diversity is important in producing results.

    4. I wasn't necessarily making a case for my specific model (I probably should have said "the could be emergent") ... just emphasizing the point that it was entirely possible micro agent behavior and macro behavior of a 'representative agent' might have nothing to do with each other. Regardless of whether agents are 'maximizing' or 'satisficing' -- both are assumptions about micro behavior that may not be true. The info eq approach says maximizing is a good approximation to aggregate behavior in certain cases (my link above).

      Additionally, satisficing is just maximizing with a different objective function.

      From an Econ 101 perspective, the assumption "micro leads to macro" is made for example in Krugman and Wells:

      From the Info Econ 101 perspective, it doesn't have to be ... and the evidence says that may be more realistic.

    5. Thanks Jason.

      BTW, "satisficing" ... is a new word for me. I thought that was a typo on Bill's part at first.

    6. Thanks... I'm not so lame that I didn't look it up!... Lol... I was just expressing surprise. But thanks.

  5. Thanks, Jason. :)

    BTW, satisficing works for non-numerical "utility". Cf. Keynes's non-numerical probability. :) In his "Treatise on Probability" he briefly discusses how businessmen try for the "good enough" in the face of uncertainty.


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