|
July 21, 2020 7:03 PM
Here are six cases where I was
pretty confident in my understanding of the microeconomics of something,
but then later found out I was missing an important consideration.
Thanks to Richard Ngo and
Tristan Hume for helpful comments.
Here’s the list of mistakes:
- I thought divesting from a company had no effect on
the company.
- I thought that the prices on a prediction market
converged to the probabilities of the underlying event.
- I thought that I shouldn’t expect to be able to
make better investment decisions than buying index funds.
- I had a bad understanding of externalities, which
was improved by learning about Coase’s theorem.
- I didn’t realize that regulations like minimum wages
are analogous to taxes in that they disincentivize work.
- I misunderstood the economics of price controls.
In each, I’m not talking about
empirical situations at all—I’m just saying that I had a theoretical
analysis which I think turned out to be wrong. It’s possible that in many
real situations, the additional considerations I’ve learned about don’t
actually affect the outcome very much. But it was still an error to not
know that those considerations were potentially relevant.
1. Divestment
I used to believe that
personally divesting in a company didn’t affect its share price, and
therefore had no impact on the company. I guess my reasoning here was
something like “If the share is worth $10 and you sell it, someone else
will just buy it for $10, so the price won’t change”. I was treating shares
as if they were worth some fixed amount of money.
The simplest explanation for
why you can’t just model shares as being worth fixed amounts of money is
that people are risk averse, and so the tenth Google share you buy is worth
less to you than the first; and so as the price decreases, it becomes more
worthwhile to take a bigger risk on the company.
As a result, divestment reduces
the price of shares, in the same way that selling anything else reduces its
price.
In the specific case of
divestment, this means that when I sell some stocks, the price ends up
lower than it was.
I first learned I was wrong
about this from this
Sideways View post, published May 2019.
2. Index funds
I used to think that it wasn’t
possible for individuals like me to get higher returns than I’d get from
just buying an index fund, because in an efficient market, every share is
equally valuable.
This is wrong for a few
reasons. One is that the prices of shares are determined by the risk
aversion of other market participants; if your risk aversion is different
from the average, some shares (specifically, risky ones) will be much
better investments than others.
Secondly, because I’m risk
averse, I prefer buying shares which are going to do relatively well in
worlds where I’m relatively poorer. For example, if I’m a software engineer
at a tech company, compared to a random shareholder I should invest more in
companies which are as anticorrelated with software engineer salaries as
possible. Or if I live in the US, I should consider investing in the
markets of other countries.
I didn’t understand this fully
until around April this year.
3. Prediction markets
Relatedly, I thought that the
fair market price of a contract which pays out $1 if Trump gets elected is
just the probability of Trump getting elected. This is wrong because Trump
getting elected is correlated with how valuable other assets are. Suppose I
thought that Trump has a 50% chance of getting reelected, and that if he
gets re-elected, the stock market will crash. If I have a bunch of my money
in the stock market, the contract is worth more than 50 cents, because it
hedges against Trump winning.
(Here’s a maybe more intuitive
way of seeing this: Suppose I could pick between getting $10 in the world
where Trump won (in which we’re assuming the market would crash) and the
world where Trump lost. Clearly the $10 would be more valuable to me in the
world where he wins and my stocks are decimated. So the value of the “Trump
wins” contract is higher than the value of the “Trump loses” contract, even
though they correspond to events of equal probability.) And there is a
potentially very high number of correlative outcomes that betters might be
thinking about and hedging against, and the market computes these and
reflects them in the price.
This is a more general version
of the point that it’s hard to have a prediction market on whether the
world will end. Paul Christiano has an old blog
post on this topic which I first saw years ago but which I
didn't understand properly at the time.
I first understood this fully
around March this year.
All of these first three
mistakes were the result of me not really understanding basic portfolio
theory; thanks to spending a bunch of time talking to traders over the last
few years, I now understand it better.
4. Coase’s arguments about externalities
I used to have an overly
simplistic picture of externalities—I believed the Econ 101 story: normally
markets are efficient, but when a good has an externality the wrong amount
will be produced, and this is resolved by putting a tax or subsidy on the
good to internalize the externality.
I changed my mind about this
after reading David
Friedman’s essay. I’ll just quote a few paragraphs:
The first step is to
realize that an external cost is not simply a cost produced by the pollutor
and born by the victim. In almost all cases, the cost is a result of
decisions by both parties. I would not be coughing if your steel mill were
not pouring out sulfur dioxide. But your steel mill would do no damage to
me if I did not happen to live down wind from it. It is the joint
decision—yours to pollute and mine to live where you are polluting—that
produces the cost.
Suppose that, in a
particular case, the pollution does $100,000 a year worth of damage and can
be eliminated at a cost of only $80,000 a year (from here on, all costs are
per year). Further assume that the cost of shifting all of the land down
wind to a new use unaffected by the pollution—growing timber instead of
renting out summer resorts, say—is only $50,000. If we impose an emission
fee of a hundred thousand dollars a year, the steel mill stops polluting
and the damage is eliminated—at a cost of $80,000. If we impose no emission
fee the mill keeps polluting, the owners of the land stop advertising for
tenants and plant trees instead, and the problem is again solved—at a cost
of $50,000. In this case the result without Pigouvian taxes is
efficient—the problem is eliminated at the lowest possible cost—and the
result with Pigouvian taxes in inefficient.
Moving the victims may
not be a very plausible solution in the case of air pollution; it seems
fairly certain that even the most draconian limitations on emissions in
southern California would be less expensive than evacuating that end of the
state. But the problem of externalities applies to a wide range of
different situations, in many of which it is far from obvious which party
can avoid the problem at lower cost and in some of which it is not even
obvious which one we should call the victim.
My previous position was
missing this nuance. I first read that David Friedman essay midway through
last year.
5. Non-tax regulations that increase equality have
disincentive effects on work
I used to think that the way to
decide whether a minimum wage was good was to look at the effect on
unemployment and the effect on total income for minimum wage workers, and
then figure out whether I thought that the increase in unemployment was
worth the increase in income. I think this was wrong in two pretty
different ways.
The first mistake is that I was
neglecting the fact that policies aimed at transferring wealth from rich
people to poor people disincentivize making money. Taxes are just a special
case of this, and can be seen as part of a category of wealth-transferal
policies that includes minimum wage. So when you’re arguing that a minimum
wage would be part of the optimal policy portfolio, you have to argue that
it would be better than a tax. I did not understand that this was part of
the calculation.
I first learned this from a
post by Paul Christiano which I think he incorporated into Objection 2 here; that blog post was published March 2019.
6. Price and quality controls
The second of the ways I was wrong
about the minimum wage comes from a misunderstanding of the economics of
price controls; in hindsight I think that my high school economics
curriculum was just wrong about this. I think that I realized my
misconception after reading The Dark
Lord’s Answer, published in 2016.
In high school economics, I was
taught that when the government imposes a price floor (e.g., a minimum
wage), you’ll end up with more supply than demand for the good. This is
beneficial to suppliers who still succeed at selling the good, it’s harmful
to suppliers who can no longer sell the good, and it’s harmful to buyers.
I now think that that
understanding was overly simplistic. Here’s my current understanding.
In a market, the supply and
demand of a good must equilibrate somehow—for every loaf of bread that
someone buys, someone had to sell a loaf of bread. One way that the market
can equilibrate is that the price can change—if the price is higher,
selling is more attractive and buying is less attractive. So if more people
want to buy than sell at the current price, we might expect the price to
rise until things are in equilibrium.
But there are other variables
than price which can change in a way that allow the market to equilibrate.
One obvious example is product quality—if you decrease the quality of a
product, consumers are less enthusiastic about buying but suppliers are
more enthusiastic about selling (because they can presumably make it for
cheaper).
Often, fluctuations in quality
rather than price are what cause markets to equilibrate. For example,
restaurants often don’t have price hikes at busy times, they just have long
waits. Customers like it less when they have to wait more, and restaurants
like having customers waiting (because it helps them ensure that their
restaurant is constantly full).
So when we talk about the
equilibrium state of a market, we can’t just talk about price, we also need
to talk about all the other variables which can change.
In the case where we only
consider price and quantity, there’s always only one equilibrium, because
as price increases, supply rises and demand falls. (Actually, supply and
demand could be constant over some range of prices, in which case there is
an interval of equilibrium prices. I’m going to ignore this.)
But if we’re allowed to vary
quality too, there are now many possible settings of price and quality
where supply equals demand. E.g., for any fixed quality level, there’s
going to be one equilibrium price, for the same reason as before.
In a competitive market, the
equilibrium will be the point on the supply-equals-demand curve which
maximizes efficiency. E.g., if there’s a way that producers could increase
quality that would make production cost $1 more, producers will only do
that if it makes the product worth more than $1 more valuable to consumers.
This is optimal.
(In real life, you usually have
producers selling a variety of different similar goods at different
price/quality points; I’m talking about this restricted case because it’s
simpler.)
Now, suppose that the
government imposes a restriction on price or quality. For example, they
might set a maximum or minimum price, or they might make safety
restrictions which restrict quality in certain ways. The market will
reequilibriate by using whatever degrees of freedom it has left.
Specifically, it will reequilibriate to the optimal point within the newly
restricted space of points at which supply equals demand. In general, this
will lead to a less efficient outcome.
For example, if the price of
bread is $2 at equilibrium, and the government sets a maximum price of
$1.50, then the equilibrium will move along the quality curve until it gets
to the point where the equilibrium price is $1.50.
This analysis gets more
realistic if you allow there to be more dimensions than price and quantity
along which bread can vary. For example, I’d expect to see the following
phenomena:
- Producers trying to figure out ways to get paid
under the table, e.g., by demanding favors in return for selling to
people. This reduces efficiency inasmuch as producers weren’t already
being compensated by miscellaneous favors.
- Sellers changing in ways that are mildly more
convenient for them but much more inconvenient for consumers. For
example, having long lines outside stores, or treating customers
worse.
- Producers indulging weak preferences of theirs in
who they sell to (e.g., nepotism).
In the case of minimum wages,
I’d expect to see employers do things like engaging in wage theft which the
employees tolerate (which is inefficient because it increases variance for
employees) or being inflexible and unpleasant. This analysis would predict
that wage theft is much more common among minimum wage employees than
employees at higher wages.
One way of thinking about the
efficiency of this is to think from the perspective of the producers. They
have to pick some change that makes the price of the bread $1.50. There are
many ways they could reduce the price to $1.50. They’re going to pick the
way that is best for them.
In some cases, this leads to
almost no value being destroyed at all. For example, in the bread case,
sellers might sell smaller loaves, which might be almost as efficient if
you dubiously assume that the main cost of bread is flour. The worst case
is that there’s no way for the seller to change the product to keep it
profitable which benefits them, and so they end up changing it in a way
which makes them very little better off.
The welfare impact of this kind
of regulation is also affected by redistributive effects. For example, if
bakers decide to only sell bread to their friends and family, this has a
positive redistributive effect if the friends and family of bakers are
poorer than average.
An example where the
redistributive effect might make the world much better: Suppose that
there’s demand for 100 loaves of bread, where half of that comes from poor
people who want to feed their children and the other half comes from a tech
billionaire who wants to make a giant bread sculpture. If the baker ends up
selling to people who are most willing to stand in lines, then this might
lead to a better outcome. (Getting this result requires making some pretty
strong assumptions about the shape of the relevant curves.)
Another example is that you
might expect that in a world where the minimum wage causes low-paid jobs to
be more unpleasant, teenagers will be less inclined to take the jobs and
poor adults will end up having relatively more of the jobs. It’s possible
to set things up such that this ends up increasing total welfare.
Conclusion
It’s embarrassing that I was
confidently wrong about my understanding of so many things in the same
domain. I’ve updated towards thinking that microeconomics is trickier than
most other similarly straightforward-seeming subjects like physics, math,
or computer science. I think that the above misconceptions are more serious
than any misconceptions about other technical fields which I’ve discovered
over the last few years (except maybe the aestivation
hypothesis thing).
In three of these cases (4, 5,
and 6), I had incorrect beliefs that came from my high school economics
class. In those three cases, the correct understanding makes government
intervention look worse. I think that this is not a coincidence—I think
that the people who wrote the IB economics curriculum are probably leftist
and this colored their perception.
On the other hand, in the other
cases, I assumed that the equilibria of markets had a variety of intuitive
properties that they turn out not to have.
One obvious question is: how
many more of these am I going to discover over the next year or two?
I think my median guess is that
over the next year I will learn two more items that I think deserve to go
on this list. Of course, I’m now a lot more cautious about being confident
about microeconomics arguments, so I don’t expect to be as confidently
wrong as I was about some of these.
In most of these cases, there
was a phase where I no longer believed the false thing but didn’t properly
understand the true thing. During this phase, I wouldn’t have made bets.
Currently I’m in the “not making bets” phase with regard to a few other
topics in economics; hopefully in a year I’ll understand them.
Discuss
You are receiving this email because you have the "Email me new posts
in Curated" option enabled.
|
No comments:
Post a Comment