Elements of economic theory -- some common fallacies

[ClaytonB]

Understanding common logical fallacies is a powerful way to improve one's reasoning ability. Similarly, understanding common economic fallacies can be useful for improving one's economic reasoning. While economists disagree on many points of methodology and the implications for economic science (both praxis and theory), it is safe to say that all economists agree that the popular mind holds to many economic fallacies.

Let's start with one of the simplest economic fallacies, often termed the Broken Window Fallacy. This common economic fallacy makes a plausible case that a certain amount of destruction of goods is actually good for the economy since those people in the profession of repairing the destroyed goods are benefited by employment or revenue whenever an event occurs that requires them to be hired. The trouble with this fallacy is that it ignores the other valuable uses to which the time and energy of repairmen could be put if no repairs were ever needed.

Another common economic fallacy is the belief that import tariffs can "protect" domestic producers and that they are a net benefit to the nation who imposes them, when necessary. But this is an incorrect picture and no serious economist will defend the import tariff as anything but a tool for political maneuvering. The costs of the import tariff are actually paid by the domestic citizenry since they are forced to buy at a higher price the same good that can be purchased at a lower price on the open market. The beneficiaries of the import tariff are not the general public (since they are paying higher prices for the same good that, just yesterday, was less expensive) but, rather, the domestic producers of the protected good. While we may all wish to see steel workers or auto workers have happy, successful lives, it hardly makes sense to pay for the welfare of this tiny minority of workers out of the pockets of all other domestic workers, which is where the money is really coming from. There is also another, less obvious, beneficiary of the import tariff -- foreign consumers. When an import tariff is imposed in country A, the overall demand for the protected good goes down somewhat in country A, in response to supply and demand. This decrement in local demand is also a decrement in global demand, which can cause prices for the protected good to come down somewhat for foreign consumers of that good. In short, by imposing a tariff on some good (say, steel), the citizens of country A are subsidizing the global consumers of that good out of their own pockets. This is precisely the opposite of how politicians talk about tariffs. Politicians talk about "getting tough" on foreign producers that engage in "anti-competitive practices", and so on, threatening to tariff their goods.

A very old, yet still common, economic fallacy is the fallacy of the just price. Today, this fallacy lives on in the language of "price-gouging". The medieval concept of just price was based on moral philosophy stemming from biblical considerations, namely, that you ought to treat others the way you would want to be treated so you ought not charge an extortionate price for something that your neighbor desperately needs, and so on and so forth. This very reasonable sounding argument overlooks a simple fact -- everyone who is not selling is actually charging the highest price of all! Let's consider the case where a terrible hurricane has wreaked destruction on an American city. In the wake of the hurricane, local grocers open their doors and start selling water bottles... at $10 each. Now, $10 is nearly 10 times the typical price for a small bottle of water. But before we start condemning the damnable price-gougers, let's consider all the other grocers and private individuals who have water but are not selling it. Unlike the generous grocers who are only charging $10 per bottle, these selfish, anti-social cretins have set their price to infinity! No price is good enough to persuade them to part from their water, they will hold on to it for themselves. This shows that there is something wrong with the way that we are naturally inclined to think about the moral implications of prices.

Another common economic fallacy is that of price-controls. The idea is that, when businesses start to get too greedy and start charging exorbitant rates, the government sometimes has to step in and stop the madness by capping the prices that can be charged. Or, on the flip side, when certain "essential sectors" are hit by economic depression and prices begin to fall precipitously, the government must step in and set price-floors that prohibit goods from being sold at "anti-competitive" or "unfair" low prices.

One of two things happens when the government implements price-controls. If the government imposes a price-ceiling, this results in shortages as producers close up shop and move their resources to other industries where production is still profitable. Consumers are unable to signal their demand by offering higher prices. If the government imposes a price-floor, this results in surpluses (rotting, spoilage, excess inventory, etc.) as producers are unable to slough off excess inventory by slashing prices until they are low enough to persuade consumers to move the product. Producers are unable to entice consumers to buy, by slashing prices.

One of the most common forms of price-ceiling or price-cap is rent-control. The imposition of rent-controls causes urban blight. Swedish economist (and socialist) Assar Lindbeck asserted, “In many cases rent control appears to be the most efficient technique presently known to destroy a city—except for bombing.”[1]

One of the most common forms of price-floor is the minimum wage. The minimum wage illustrates the impotence of legislation to suspend economic laws -- no employee whose job produces less value than the minimum wage continues to be employed in that role (whether in the short-run or long-run). The mandate that no one shall be employed at less than such-and-such wage is as much a restriction on employees willing to work below the new minimum wage as it is on employers seeking to pay less. In short, government simply cannot raise anyone's wage. All it can do is prohibit employment arrangements between $0 and the minimum wage.

Another common economic fallacy is the idea that increasing the amount of money in circulation can increase the actual wealth of a country. Hume suggested the thought-experiment of doubling the account balances and cash holdings of all citizens overnight (say by fairy or genie).[2] As long as it is done instantly and has an equal effect on every balance, it doesn't really harm anything except we have to print new price labels and adjust the prices showing on websites. But it doesn't help anything, either, and that leads us to Ludwig von Mises's observation regarding the optimum quantity of money: "Each individual and all individuals together always enjoy fully the advantages which they can derive from indirect exchange and the use of money, no matter whether the total quantity of money is great or small... The quantity of money available in the whole economy is always sufficient to secure for everybody all that money does and can do."[3]

If we continued in this way, we could write an entire book on this topic and, in fact, entire books have been written on these topics. Economics in One Lesson by Henry Hazlitt, The Law by Frederic Bastiat, Basic Economics by Thomas Sowell, and many more. For anyone who is new to thinking about economics, I hope that this brief survey of common economic fallacies will be sufficient to motivate deeper digging. Much of the "common sense" about economics -- things that we all "just know to be true" -- is simply false. In closing, I will quote the ever-quotable Hazlitt:

Economics is haunted by more fallacies than any other study known to man. This is no accident. The inherent difficulties of the subject would be great enough in any case, but they are multiplied a thousand fold by a factor that is insignificant in, say, physics, mathematics or medicine—the special pleading of selfish interests. While every group has certain economic interests identical with those of all groups, every group has also, as we shall see, interests antagonistic to those of all other groups. While certain public policies would in the long run benefit everybody, other policies would benefit one group only at the expense of all other groups. The group that would benefit by such policies, having such a direct interest in them, will argue for them plausibly and persistently. It will hire the best buyable minds to devote their whole time to presenting its case. And it will finally either convince the general public that its case is sound, or so befuddle it that clear thinking on the subject becomes next to impossible.

In addition to these endless pleadings of self-interest, there is a second main factor that spawns new economic fallacies every day. This is the persistent tendency of men to see only the immediate effects of a given policy, or its effects only on a special group, and to neglect to inquire what the long-run effects of that policy will be not only on that special group but on all groups. It is the fallacy of overlooking secondary consequences.

In this lies almost the whole difference between good economics and bad. The bad economist sees only what immediately strikes the eye; the good economist also looks beyond. The bad economist sees only the direct consequences of a proposed course; the good economist looks also at the longer and indirect consequences. The bad economist sees only what the effect of a given policy has been or will be on one particular group; the good economist inquires also what the effect of the policy will be on all groups.[4]

[1] https://www.adamsmith.org/blog/plann...n-rent-control
[2] https://mises.org/library/david-hume-and-theory-money
[3] https://mises.org/library/human-action-0/html/pp/780
[4] https://fee.org/resources/economics-in-one-lesson/

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[r3volution 3.0]

Excellent work @ClaytonB, +rep