Economics

How Ideologues Use Grade-School Economics to Distort Minimum Wage Debates

Introductory economics can be more misleading than it is helpful

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By James Kwak

Supply and demand curves were introduced to the world by the French mathematician Antoine-Augustin Cournot in 1838. These now-ubiquitous analytical tools show 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 dated back to 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. This principle—that free markets generate the greatest possible economic well-being for society—is familiar to any student of introductory economics today.

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.”

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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 Hayek and Milton Friedman, however, it was something more: the heavy artillery in an ideological battle against the New Deal. Beginning in the 1940s, 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 maximize social welfare 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 pay 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 former House majority leader Dick Armey, “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 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 did not appear until Chapter 19, more than 400 pages in.

Contemporary textbooks, however, have moved away from Samuelson’s example. Whether by the slightly right-leaning Gregory Mankiw or the slightly left-leaning William Baumol and Alan Blinder, they now lead with 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. According to a recent survey of undergraduate programs around the world by students at the University of Manchester, “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 teachers 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 in 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 to 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 non-majors 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).

2017 April 21

 


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  • Don McAllister

    There is no genuinely fair supply/demand contract. Unorganised labor cannot as mere individuals bargain equitably with organised capital. Simple models also neglect the relative mobility of labor (regional) vs. capital (multinational). Even if the simple supply/demand model worked, labor cannot readily relocate internationally.

  • “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.”

    This statement is at best misleading. I think a fair description of the current state of empirical work on small minimum wage increases is the following: a significant number of studies show a significant negative effect on certain types of employment and a significant number of studies show less or no effect on certain types of employment. There is significant disagreement (often along ideological lines) about which studies are more useful guides to policy.

    • MigT

      Nope, the first statement is pretty fair and accurate, yours is “at best misleading”

    • Economuse

      You’re leaving out that a huge pool of unemployed people distort the minimum wage curve towards zero.

      And that huge pool of unemployed people doesn’t show on the supply/demand curve, – so, like much of economics and definitely like your comment, it connects far too few dots.

      I suspect you are connecting too few dots deliberately…

      • My comment was about the state of empirical research, NOT a model of wage rates as you seem to suggest.

        I think the problems with your suggested model of wage rates are pretty obvious. One example: the whole idea of supply and demand CURVES for labor assumes the existence of people that are not working it therefore false to say “that huge pool of unemployed people doesn’t show on the supply/demand curve”.

        • Economuse

          Except that would be like saying the supply demand curve for iPhones includes free iPhones – which would clearly make a nonsense of the whole curve.

          A huge pool of unemployed – deliberately created – creates a zero price for labour, and it’s only welfare that then sets a price above zero.

          And with that pool of deliberately created unemployed setting a zero (or welfare) price, the rest of the wage curve then takes on this behaviour https://postimg.org/image/kpp6rwfvz/

          The result is that people then can’t afford to buy the things they just made.

          • Economuse

            And clearly there isn’t one supply/demand for labour – there are millions that overlap so that a road sweep has the choice of zero/welfare or 1 cent above that rate. The guy who flips burgers has the choice of the road sweep wage or 1 cent above that and so on…

            So that the deliberate pool of unemployment at the bottom is transmitted upwards to everyone.

          • So many fallacies that at this point you must be trolling…

          • Economuse

            Which ones?

            I’m trolling with a link to a chart that shows wages static in real terms since the 1970’s?

            Which fallacies do you identify, and let’s look at them…

  • jothwu

    Thank you for this excellent article and for the solution it offers.

    In my opinion, economics is easily understood, just not in terms of “the model of a competitive market driven by supply and demand”, as the author succinctly puts it. To understand economics one must recognize when money stops circulating, an economy suffers. To create and sustain an economy that works for all, excessive saving must be examined.

    Here’s a two-page essay on one approach to addressing this issue:
    http://jothwu.blogspot.com/2016/09/saving-parity-road-to-sufficiently.html

  • nielmalan

    A quote attributed to Ernest Rutherford goes “All science is either physics or stamp collecting”. While the phrasing is rather crude, there’s a lot of truth in it.

    At this point in history, economics is much closer to stamp collecting than to physics, and it should be taught as such.

  • Jim_Satterfield

    The rational actor model of economic transactions will only be true if we develop robots that will take care of all transactions for us and complete transparency and equality of information suddenly pops into existence. Far too many economists suffer from the delusion that economics is a science unlike other social sciences like sociology or psychology.

  • The true laws of economics are based in the actions of self interested communities. In real economic situations, there are no individuals, there are only communities. Communities make decisions that individuals can rationalize, but cannot understand. Every economic decision is a community decision, by definitition, because it has at least, a buyer and a seller.

    In some cases, the buyer and the seller are individuals, but in most cases, not. Most sellers in today’s economy are corporations. Most buyers are, at least, families.

    Economics fails to serve the larger community when one party a buyer-seller community constantly holds much more power than the other.

    Thus, farmer’s markets are more representative of healthy economy than Coca Cola.

    But then a problem arises, because huge corporations like Coca Cola influence, and ultimately drives the prices for all drinks and contents in drinks, due to their market domination. They exert similar influences on wages, because they do the majority of hiring.

    Corporations drive inequality by dividing buyers into individuals. The myths of the individual, of individual freedoms, serve the goals of larger communities. Individuals have no power to negotiate, except in individual situations. Divide and conquer.

    Corporations want to hire individuals, not communities (AKA unions and workers associations), because they don’t need to negotiate. They have the power. The minimum wage is not set by any negotiators, it is manipulated by large buyers, who deliberately force large sellers out of the market, by promoting the cult of the ‘rights of individuals’.

    Every little Coca Cola buyer has little or no power over the transaction. When a large store sells Coca Cola, they can gain power over individual buyers.

    Every Coca Cola worker has little power over their wage. Coca Cola does not negotiate wages.

    But when a farmer tries to sell their juice, or bottled water, their price is not set by cost or supply and demand, it is set in reference to the price of Coca Cola, and the farmer cannot compete – and goes out of business, and starts driving a Coca Cola truck instead.

    When one community controls a huge portion of the market, smaller communities suffer. The market is distorted, and everyone thinks Coca Cola ‘energizes’ them, even as it makes them sick and poor.

    Every community is an individual in economics. But in today’s economy, large corporations are individuals with inordinate amount of power. Power corrupts.

  • Excellent article. My advice to puzzled readers? Exercise your mind. Go and read (1) Kate Raworth’s Doughnut Economics and (2) Mariana Mazzucato’s Entrepreneurial State. Then go back and re-read item 1. At the very least you will then understand why some economists speak of the Real Economy. The stuff that most politicians and old-schooled leaders believe is mostly UnReal.