What is Wrong with Econ 101?

An antidote to the madness

A new popular trope in public forums is to denigrate Econ 101. We are told that it is overly simplistic or perhaps not even useful. We are told that Econ 101 spends too much time on competitive markets. We are told that Econ 101 should focus more on “evidence”, whatever that means.

In today’s Economic Forces, I would like to pile on. I am going to tell you what is wrong with Econ 101. Unfortunately, this is not likely to win me any fans with the other critics. Not only do I think that they are wrong, but I think that the things they often like about Econ 101 are the problem. Let the hate mail commence.

Problem #1: The Axiomatic Approach

One of the most frequent complaints about Econ 101 is that economists spend too much time talking about competitive markets. These critics claim that, in reality, very few markets fit the criteria required to be considered competitive.

Herein lies the problem. One place in which Econ 101 has gone wrong is by taking an axiomatic approach. A number of principles textbooks list a set of conditions that must be satisfied for the market to be considered competitive. However, assumptions about homogeneous goods and the number of firms in the market are all beside the point. The only assumption that one really needs to teach competitive markets is that the participants in the market are price-takers. All of this other stuff is window dressing.

What really matters when it comes to evaluating the competitive market is whether or not it provides good predictions about the world. Can supply and demand provide a meaningful prediction about what we observe? In many cases, the answer is yes, regardless of whether the market satisfies the axioms of a mediocre textbook.

Problem #2: The Supposed Limitations of the Competitive Model

A second critique, which is related to the first, is that we need to spend a lot more time discussing the limitations of the competitive model. We are told that things like externalities, public goods, and common resources reveal the limitations of the competitive market. All of these represent reasons that markets fail and we need to spend more time on these failures.

This seems like an odd complaint. Most introductory textbooks devote a good deal of space to explaining externalities and public goods. One has to wonder what it would look like to spend even more time on these things.

Nonetheless, I find the framing around these issues inadequate. The conventional textbook teaches competitive markets and then turns around introduces externalities and public goods as examples of market failure. When markets fail, we are told that we need policy to correct for these failures.

I think that this is the wrong way to present the material. Market failures are a necessary condition for a policy response, but they are not a sufficient condition. Governments do not make decisions. People make decisions. Policies can improve outcomes in theory, but not always in practice. It is important to question whether government policy actually produces the efficient allocation. And collective action does not always require government intervention.

My main concern, however, is not comparing market failures to government failures. In fact, those who are familiar with my work know that I think that governments tend to figure things out that even economists might not understand (see here and here). Instead, the term “market failure” has the source of the problem wrong. When it comes to externalities or public goods, the problem is related to property rights.

When I teach introductory microeconomics, I begin by talking about the role of property rights. When we trade, we are not really trading goods, we are trading property rights to those goods. My property right to a particular good gives me the ability to experience the flow of benefits that come from that good, to limit or exclude others from getting that benefit, and the ability to exchange those rights with someone else for some form of compensation.

After students have a grasp of how markets work and various applications of supply and demand, I start to introduce problems with property rights. What happens if I “own” something, but cannot limit or exclude someone from enjoying the benefits? What happens if I do not have the ability to exchange my rights? How far do property rights extend? What happens if others infringe on my rights?

The discussion of the answers to all of these questions opens the door to the issues that we want to discuss when we teach externalities and public goods. However, these questions are much more relevant to the topics we want to teach and don’t require overly simplistic classifications.

In addition, the way that we teach public goods often gives students the impression that we are teaching them a theory of publicly-provided goods. We are not. We still lack an accepted theory of publicly-provided goods.

Problem #3: A Lot of People Get Externalities Wrong

As I just noted, critics of Econ 101 often argue that we should spend more time on externalities. On this point, I don’t necessarily disagree. However, it is important that if people spend more time on externalities, I want them to get things correct.

Students, and it turns out a lot of economists, seem to get confused about what is and is not an externality. Externalities are often taught as simply costs or benefits that are created by the parties involved in the trade that are not (fully) allocated to those parties. An obvious example is something like pollution. I want electricity. A power plant creates electricity. I purchase electricity from the power company. However, in the process of production, the power company pollutes the air. This is a negative externality because the cost of pollution is borne by everyone who breathes the air or who is otherwise affected by environmental issues associated with pollution.

This seems straightforward enough. However, there are a lot of other examples that fit this definition that are not externalities. For example, suppose that I decide to write a principles textbook that presents all of the information the way that I want. If I am successful, I will sell some of these textbooks. Other textbook authors lose sales. Is this an externality? My customers and I are engaged in trade and we are imposing an external cost on a third-party. That seems to fit the definition, but this is clearly not an externality. This is what we call competition.

Another example relates to something I previously wrote about: “Keeping up with the Joneses.” A common argument is that so-called status games are zero-sum games and therefore result in a waste of resources. The basic idea is that if I buy a BMW, my neighbor will see that BMW and want to buy one of their own so that he or she does not lose status relative to me. By purchasing the BMW, I am imposing a cost on my neighbor. My neighbor either has to live with lower status or buy a BMW. Some even extend this to the natural conclusion that, like other externalities, governments should impose some sort of tax to discourage this sort of behavior.

Of course, this is not an externality either. When the factory pollutes, the environmental effects will impact me regardless of whether I want them to or not. On the contrary, anyone who wants to avoid the negative effects of a status competition can simply choose not to participate.

If we are going to spend more time on externalities, I would contend that we need to spend more time explaining what we mean by these external costs.

I am somewhat in agreement with critics of Econ 101 in the sense that we both think that the course could be taught better. Where we disagree is about what needs to be improved. The very things that critics want to be emphasized are the things that give rise to confusion. The false precision of our discussions of externalities and public goods is a limitation of these courses. Greater emphasis on these topics would require re-thinking how these things are taught.

Most students come into Econ 101 with little understanding of how markets work. Learning about resource constraints, trade-offs, opportunity costs, and market behavior is of great value to these students. It is easy to forget this value when one is lost in the weeds of a particular topic. Yet, it is important to remember that the price system is something of a marvel, as Hayek said. The ability of markets and the price mechanism to get things where they are valued most and to do so without “conscious direction” is something worth understanding, studying, and appreciating.

There is no doubt that this isn’t enough. However, we cannot explain how things might go wrong if students do not have a good understanding of when and how they go right — and what “going right” even means. We need a useful benchmark. We also need to be sure that we are not providing false precision and selling simplistic remedies.