The Baseline Scenario

Economics 101, Good or Bad?

By James Kwak

Over at the Washington Post, Michael Strain of the American Enterprise Institute is upset that people are picking on Economics 101. He singles out Paul Krugman and Noah Smith in particular for claiming that “the pages of economics 101 textbooks are filled with errors, trivia and ‘useless fables.'” Instead, Strain insists, “an economics 101 textbook is a treasure.” He continues by discussing some of the key insights that you can gain from the basic models presented in an introductory economics class.

Except, for the most part, Strain is rebutting an argument that no one is making. He is right to say that Economics 101 provides many valuable lessons—the competitive market model, opportunity cost, diminishing marginal returns, comparative advantage, the labor-leisure tradeoff, etc. But no one denies the analytical power of those abstract concepts.

Krugman’s argument was that for some policy issues, the lessons of Economics 101 are just not that important: correct sign but small magnitude, you might say. One of his examples was international trade; his point was that even if free trade is better than protectionism, the welfare gains from reductions in tariffs are relatively small, especially in a world where most trade is mostly free already, and especially when compared to the gains from other factors such as technological innovation.

Smith did say that most of what’s in an introductory textbook is “probably wrong,” but if you read his article it’s clear that he meant “probably wrong [if you expect it to accurately describe the real world].” Smith’s example is the minimum wage; his point is that while the supply-and-demand model predicts that a higher minimum wage will increase unemployment, empirical research shows that real labor markets often do not behave that way. The Economics 101 model is wrong as a description of reality; that doesn’t mean that it isn’t an important source of insight. Here’s how Smith puts it:

That doesn’t mean the theory is wrong, of course. It probably only describes a small piece of what is really going on in the labor market. In reality, employment probably depends on a lot more than just today’s wage level — it depends on predictions of future wages, on long-standing employment relationships and on a host of other things too complicated to fit into the tidy little world of Econ 101.

I think “small” might be an overstatement—statutory wage levels are probably a big factor in the low-skilled labor market—but otherwise Smith’s point should be uncontroversial. A friend and labor economist said to me that when thinking about the impact of a minimum wage, the natural starting point is the supply-and-demand diagram, because it’s so powerful—but you don’t stop there. The model is incomplete, like all models, and if you don’t realize that you will make mistakes.

Professional economists know all this, and hence many think that models need to be balanced by empirical research, even in first-year classes. Strain doesn’t buy this because “economists’ empirical studies don’t agree on many important policy issues.” I don’t understand this argument. The minimum wage may or may not increase unemployment, depending on a host of other factors. The fact that economists don’t agree reflects the messiness of the world. That’s a feature, not a bug.

People like Krugman and Smith (and me) aren’t saying that Economics 101 is useless; we all think that it teaches some incredibly useful analytical tools. The problem is that many people believe (or act as if they believe) that those models are a complete description of reality from which you can draw policy conclusions. As Smith says, “If economics majors leave their classes thinking that the theories they learned are mostly correct, they will make bad decisions in both business and politics.” In the first (1948) edition of his famous textbook, Paul Samuelson lamented that the simple model of the competitive market—you know, the one that says that markets maximize social welfare—is “all that some of our leading citizens remember, 30 years later, of their college course in economics.”

In the past forty years, simplistic applications of Economics 101 concepts, stripped of nuance or empirical verification, have swept the policy field in areas from labor markets to taxes to health care. They now constitute virtually the whole of the establishment Republican Party’s economic policy, as represented by Paul Ryan (who talks exactly like someone with an exaggerated faith in a handful of Economics 101 snippets). The problem isn’t Economics 101—it’s the transformation of Economics 101 into an ideology that, like most ideologies, claims the status of objective truth.