# Economic Misconceptions

on October 12, 2010 at 7:31 am

Students typically come to an economics class with many misconceptions, not just random errors but systematic biases (see especially Caplan 2002).

Bill Goffe recently (2009) surveyed one of his macro principles classes and found, for example, that the median student believes that 35% of workers earn the minimum wage and a substantial fraction think that a majority of workers earn the minimum wage (Actual rate in 2007: 2.3% of hourly-paid workers and a smaller share of all workers earn the minimum wage, rates are probably somewhat higher today since the min. wage has risen and wages have not).

When asked about profits as a percentage of sales the median student guessed 30% (actual rate, closer to 4%).

When asked about the inflation rate over the last year (survey was in 2009) the median student guessed 11%.  Actual rate: much closer to 0%.  Note, how important such misconceptions could be to policy.

When asked by how much has income per person in the United States changed since 1950 (after adjusting for inflation) the median student said an increase of 25%.  Actual rate an increase of about 248%, thus the median student was off by a factor of 10.

I would add that there are also theoretical misconceptions that are probably even more important than factual misconceptions.  For example, I think it would be useful to ask questions such as:

1.  A number of new furniture manufacturers open in North Carolina, since the new competition forced existing manufacturers to reduce prices the effect of this additional competition was to reduce wages for workers in the furniture industry.

Rate this argument on a 1 to 10 scale from least to most plausible or likely.

2.  Competition from Korean automobile manufacturers caused US manufacturers to cut quality in order to reduce their costs.  Rate this argument on a 1 to 10 scale from least to most plausible or likely.

3.  A law that prevents supermarkets from advertising the prices of their products will reduce the supermarket costs and in turn this will reduce prices to consumers. Rate this argument on a 1 to 10 scale from least to most plausible or likely.

Note that the point here is not to say that an answer is wrong but to understand the implicit models that students are using. It can help a teacher to know what these conceptions and misconceptions are in advance so that they can be addressed.

To further this research, Bill Goffe is putting together a colloborative database on economic misconceptions that teachers are welcome to contribute towards.  See also Bill's page on the large literature on teaching in physics much of which is also relevant to economics.

1 Tom West October 12, 2010 at 4:02 am

I have to say that I find the % working at minimum wage highly misleading. As a student, I never knew anyone who worked at exactly minimum wage. Instead, it was minimum wage + 50cents or the like.

When minimum wage rose, so did their wages. I think if you measured how many people's wage rates depend directly on the minimum wage, you would get a far more relevant answer.

Honestly, if economists are actually measuring the impact of minimum wage by the number of people earning exactly that wage, I'd be very surprised at their carelessness. I hope to be corrected, but using the figure feels more like a rhetorical device to minimize the impact that raising minimum wage has on people's lives. (At least I don't hear the same 2.3% figure bandied about by those supporting minimum wage, although I suppose you could argue the other direction – so few earn it, raising it can hardly do much harm…)

2 Ricardo October 12, 2010 at 4:14 am

Has anyone tried surveying economics professors to see how they do by comparison? I bet academics who do not regularly follow macroeconomic policy controversies in the U.S. would get these almost just as wrong.

3 Jens Fiederer October 12, 2010 at 4:56 am

1 + 3 seem completely implausible to me – I would expect the opposite effects – I'd rate them "1".

2 seems barely plausible – I'd expect competition on both costs and quality, but companies that find themselves unable to compete on quality might conceivably focus on costs instead at quality's expense – maybe "3"?

4 Xmas October 12, 2010 at 5:04 am

For number 2. I think it's a 10, using your explicit examples. In the US, labor costs are pretty fixed, so they're left with…Gremlins, K Cars, Pacers, ad nauseum.

5 Ed Dolan October 12, 2010 at 5:11 am

I agree, students do have some far-out misconceptions about economics, but sometimes they have intuitions that are better than those of their professors.

A case in point: Years ago, when I was teaching money and banking at a US university with a mostly middle-class clientele, I happened to meet with a colleague who was teaching the same course at an inner city university. "My students know nothing about banks," he said. "They have never been in a bank. They have never owned a bank account. They only know one thing about banks: they know banks are BAAAD!"

I laughed at this anecdote, and repeated it many times over the years to others in our esteemed profession, who always laughed knowingly in turn. However, now, in the year of our Lord 2010, it has dawned on me that those students were right. Banks really are BAAAD!

6 Khoth October 12, 2010 at 5:40 am

My uninformed opinions on the questions:

1. About 5. Without competition, it's likely that the existing companies haven't found the minimum price they can pay their workers, and increasing the number of furniture companies won't incraese the demand for furniture enough to offset this.

2. About 5 in the abstract, but more concretely 2. If the foreign imports are competing on cost, then yes, if they're competing on quality, then no. Either situation sounds plausible, but IIRC in real life the imports competed on quality.

3. About 2. Supermarkets will still advertise, just not about price. Leaving the price tags off the adverts won't decrease cost much, and will make it harder for a shop to compete on price.

7 J Thomas October 12, 2010 at 5:48 am

"If you actually look at the BLS data that Alex linked, you'll see that there are more people who report earning less than minimum wage than earning right at minimum wage."

Etc. Good stuff.

So, John Thacker, do you have an theoretical conclusions from the data?

I tend to think the following from it: The minimum wage is currently set low enough not to matter a whole lot, but at past times it has been set high enough to make some kind of difference.

I would be very interested to see a comparison between times minimum wage was high versus low. According to one theory, the curve of wages versus number of people employed at those wages should simply be truncated to the left when the real minimum wage rises. All the jobs of people who used to work at wages that are now illegal, would simply be fired.

By a second theory, we should see many of the jobs that used to pay less now get paid minimum wage or somewhat more. So the left part of the map to the right of the truncation should pile up, increasing numbers of jobs at minimum wage or more, compared to the number of jobs at those same wages when the minimum wage was lower. That says that there was some flexibility in the system and employers valued those jobs more than they had actually paid, and when they had to pay more they were willing to.

It's sad that there are surely so many confounding variables that this work probably can't be done well enough to tell the difference.

Plus as you point out there are people who do work below minimum wage.

8 liberty October 12, 2010 at 6:18 am

FYI, who makes minimum wage?: http://www.bls.gov/cps/minwage2004.htm

9 Salem October 12, 2010 at 6:33 am

1. I disagree with Bill and Khoth, whose arguments seem to make little sense. More furniture manufacturers in South Carolina mean there is more demand for carpenters. The supply of carpenters is roughly fixed in the short term, so wages increase. In the long term, it causes more people to become carpenters, increasing the supply, so some of the wage increase is given back. I would rate the chances of wages falling as 2/10, highly implausible. I would expect to see the opposite.

2. The primary effect of increased competition would be to reduce profits. A secondary effect would be to fragment the marketplace. It would be possible that some end up selling to the low end of the market by cutting quality and costs, but note that you would have to cut prices by even more. Note that in fact American cars are rarely the cheapest, and car quality has gone up hugely over the past 20 years. I would give this a 4/10, unlikely but possible.

3. If you are unable to advertise on price, then competition on prices is reduced. There is no point me cutting prices to be lower than my rival, if their customers don't find out about. This appears to be a classic fallacy, that prices are set by costs, as opposed to supply and demand. I would rate this as 1/10, almost completely implausible.

10 jizay October 12, 2010 at 7:22 am

@Ryan – I think it's fair to call at least *some* of these answers misconceptions rather than poor estimates because they are systematically biased. Poor estimates have a broad distribution, but shouldn't be centered far from the truth. The estimates of increase in GPD per capita, for instance, are pretty tightly grouped at the very low end, an order of magnitude from the right answer.

11 Andrew October 12, 2010 at 7:38 am

Funny, I thought #2 was the hard one. The reason that American quality has gone up is because low quality was the problem last time around. Smaller cars are a reduction in 'quality' of features but not the reliability aspect often bundled into the term. So, Japanese cars were of both lower and higher quality- doing less well.

12 adam October 12, 2010 at 8:05 am

I immigrated to the US from Europe some time ago, and my US colleagues do not understand why I, a highly paid physician, am currently remodelling our own house.

I explain that in Europe this is pretty common. Physician specialists max expect to collect, per hour, somewhere like four times what a tiler expects to get in the shadow economy: 100 euro/h before taxes vs. 25 euro/h 'black' . Because of the size of the job, most tilers prefer to do such single bathroom jobs 'black'. At a marginal tax rate of 70%, 20% VAT, my insistence on paying 'white' and taxes/insurances the tiler would have to pay on his income to do this job legally, I would have to do three hours of surgical cases to pay for one hour of tiling. Rationally, I preferred to not do the surgical cases, instead spending two hours to do the tiling myself. Twice as slow as a professional tiler, I still came out ahead one hour.

The effects of these high marginal rates were thus

a) the waiting lists for patients needing surgery increased because a highly trained surgeon was tiling instead of doing what he was trained for

b) a tiler did not earn income on a job he was good at

c) lower tax revenues.

I think these effects are morally wrong, which lead me to eventualle emigrate. In the US, having done so many remodels, I keep doing smaller jobs, where the same calculations do not apply.

To pre-empt criticism, let me state clearly that the above explanation is not 'to complain', nor is it what I think is 'right'. I love my work and I love my patients. It just explains the arguments for why I did what I already have done. Some people may do the same in such a situation, others will not: neither are morally right or wrong.

In the US I thought I had arrived in a meritocracy, but the opprobrium over a) Fleischer's August letter in the WSJ b) the Todd Henderson 'affair' c) and now the 'Mankiw affair', as shown for example in the comments here, is starting to worry me.

The criticism seems to come down to either 'these people are selective in their use of numbers', 'they are too rich/do not deserve their income/should not complain' or some mixture of both. I am not convinced either is the case, but even if the criticisms were true, the people criticized still acted on what they wrote and what they believe is correct. As did I.

My brother emigrated to China, and he tells me that there a high income is a reward for hard work. Incentives matter.

13 josh October 12, 2010 at 8:37 am

Bernard,

Both Ivy League undergrad, economics and Industrial Labor Relations respectively.

Her, top tier law school, order of the coif, top five in her class.

Me, Masters in education at GMU after working for 3 years out of college.

Obviously, we aren't destitute. In fact, we're fine, but no nearly as fine as the 3 billion times the median income from 1950 that Alex would calculate.

We live in a town house with practically no yard, which is fine because its in a nice quiet neighborhood with a couple of parks in walking distance. But this feature, a safe clean neighborhood with some semblance of a sense of community (very little compared to 1950 in fact) means that my small townhouse (and putting money away for college and retirement) requires both of us to work and very carefully monitor our expenses.

14 Lord October 12, 2010 at 9:50 am

30% is common for gross margins. Many are just misinterpretations.

15 Mo October 12, 2010 at 10:25 am

Isn't the problem with minimum wage that most people live in states where the state minimum wage is higher than the federal minimum wage? My guess is the 2.3% applies to the federal minimum wage rather than the state/municipal minimum wage. Bill Goffe wouldn't count \$10.50/hour as minimum wage, but back in 2001, that's what it was in Santa Monica.

1) I would rate this as 2. Due to increased competition overseas at the low end of the market, the manufacturers in NC would have to move into the higher end, more custom furniture market. This requires more skilled labor, pushing wages up.

2) 3. This would only be true if Korean manufacturers were selling low quality vehicles. If the Koreans are making higher quality vehicle, than the Americans will either have to move into a less penetrated market, move manufacturing to a lower cost locale or find ways to improve quality without raising costs significantly.

3) 2. If supermarkets can't advertise, then comparison shopping becomes much more difficult. As a result, you would expect everyone to raise their prices a little because more shopping would be done based on things like geography or where they like to shop rather than who has the best prices in the circular.

16 Tomasz Wegrzanowski October 12, 2010 at 11:44 am

Is any of these demonstrably wrong? I'd be curious to find out if it was.

I'll rate #3 as very plausible if all ads are banned this way.

I know some toy research contradicts it, but I've seen far too many cases of expensive retailers running massive ad campaigns with cherry-picked or made up numbers that claimed to be cheap. And cheapest ones almost never have much ads at all.

It probably wouldn't work much if price ads were banned, but other kinds of ads were still allowed. Ad spending would mostly shift, and whatever little effect price ads had on prices, other ad kinds have none.

(People claiming ads benefit rather than harm customers somehow cannot explain how everyone is getting out of their way trying to avoid ads, instead of actively seeking ads.)

#1 requires big assumptions to answer either way. If furniture industry had oligopoly premium, workers might have very well captured big part of it, and so their wages will decrease. Or maybe we got rid of oligopsony of furniture companies and wages will increase as more companies compete for same worker pool. We know it was not perfectly competitive from prices falling significantly after entrance of new competition – but was effect of oligopoly with customers or oligopsony to workers more significant? It's very easy to give plenty of historical examples both ways.

If furniture workers come from generic worker pool, their wages shouldn't be affected at all, but that's an uninteresting case.

#2 wouldn't work if customers could easily observe quality before purchase. If reliable information about quality is not easily available, competing on price and race to the bottom on everything else might happen. ISPs are a pretty good example of this. I wouldn't really expect this on cars, but it's not that ridiculous

17 Lou October 12, 2010 at 12:18 pm

Ronald Reagan had an undergraduate economics degree and George W. Bush had an MBA from Harvard. I suspect they both would have done reasonably well, at least on the second part.

I have an issue with long-term comparisons of real income from the first part, because inflation statistics are not meant to provide long-term comparisons. The number of iPods I can afford today is useful when compared to the number I could afford last year, not when compared to the number of phonographs the average person could afford in 1950. Hedonic adjustments are only so useful. I would argue that 248% is meaningless and vastly underestimates the economic improvement of the last 60 years. The idea of a heart transplant was science fiction in 1950.

18 liberty October 12, 2010 at 12:42 pm

Anyone that doubts a ~2.5x increase in standard of living since 1950 simply does not value 15 years of life (life expectancy has risen from 64 to 79), many more years of healthy and active life; nor do they value personal computers and the internet, surround-sound CD or DVD, flat-screens, iPods, mobile phones or iPhones; they don't value cheap travel all over the world and instant communication; nor do they value advances in production that have made household appliances and other conveniences previously only avialbale to the rich available now to the poorest in our society… seems actually they don't appreciate much of anything. Kind of boring, soul-less people…

19 Two Things October 12, 2010 at 12:57 pm

Car quality? The actual response of US carmakers to foreign-carmaker competition was not to make higher-quality cars but to engage in "regulatory competition," i.e., rent-seeking.

US carmakers supported the CAFE standards which literally imposed fines on high-quality imported cars and discouraged the production of high-quality cars in US plants owned by foreign carmakers. Having hobbled their competition with CAFE, US carmakers then bifurcated the market into larger, better cars people actually wanted and small junky cars sold at a loss to "average up" fleet MPG numbers. Of course carmakers made up their losses on tin-can "compact" cars by increasing prices on the better cars.

CAFE fines act (as intended) to prevent foreign carmakers' competing on quality. They can't sell high-quality cars unless they also sell low-quality cars to average up their fleet MPG or else pay CAFE fines. Either way that forces the price of quality cars up, leaving room for the domestic automakers to sell junk.

Questions like #2 are bogus because they assume oversimplified microeconomic models of competition. In reality, big businesses commonly compete by rent-seeking rather than by tinkering with quality or price. They rationally calculate that bribing some government officials for regulatory favors will cost them less than revising manufacturing processes or reducing prices.

20 tamerlane October 12, 2010 at 1:04 pm

(1) 1: Ceteris paribus, more manufacturers –> moredemand for labor –> increased wages.

(2) 1: US manufacturers can't compete on labor cost. They must compete on capital productivity and quality of output. So quality will go up.

(3) 2: Decreased consumer information gives sellers an information advantage. Prices`will go up.

I barely passed my freshman macro course (Samuelson was the text and Keynes was a God). How'd I do here?

21 Salem October 12, 2010 at 1:22 pm

"People claiming ads benefit rather than harm customers somehow cannot explain how everyone is getting out of their way trying to avoid ads, instead of actively seeking ads."

This is mistaken thinking. The issue is that you are conflating "customers" with "everyone."

If I intend to buy a car, I will actively seek out adverts – such as manufacturers' brochures, websites, etc, in order to inform my choice. If I don't intend to buy a car in the near future, I will avoid such adverts. However, advertising is not so well-targeted that it reaches only potential customers, and businesses might want to advertise a certain amount to the second group anyway, in case they want to buy a car in the future. Therefore you see a situation where for most people most of the time, most advertising is something to be avoided, but yet it helps consumers.

22 nice strategy October 12, 2010 at 3:32 pm

When I first started teaching economics to HS seniors (a required course in CA), I got a lot of resistance to concepts in the introductory unit, mostly things like assuming a zero sum game or misunderstanding comparative advantage. However, their resistance to the rational actor presumption was especially strong and turned out to be essentially correct despite being based on nothing but their own intuition. Several years later I came across behavioral economics and appreciated their insight. Teens are sufficiently drenched in emotion to call bullshit on neoclassical nonsense right out of the gate.

College students citing 11% inflation should be unsurprising considering how large a % of their budget is taken up by tuition and transportation.

23 josh October 12, 2010 at 5:14 pm

Economic misperception #1: That there exists some kind of cosmic economic backdrop against which we may measure things like the "value" of a dollar at different times. Somehow professional training only solidifies this misperception.

Cliff,

Don't get me wrong, I don't feel poor. It's just that numbers like these are made up nonsense. I have an Ipod. I've seen London. I've seen France. All of this was beyond the reach of someone of my father's generation.

But let's look at my father for a minute. He grew up poor (by the standards of the day) in Brooklyn, NY after his father died when he was 10. However, the area he lived had extremely low crime by today's standards, safe public transportation, walk to baseball stadium, walk to park, walk to dining. Close knit community of socially upwardly mobile citizens (ie, not the kind of people who you have to worry will drag your kids down), safe schools where students were motivated to learn. Now, what kind of price would such a place fetch on the market today. A 2-bedroom like my father's might go for a million plus. Does a place like this even exist today? Maybe parts of Manhattan if you also factor in private school tuition come close.

Now, where would somebody with Dr. Science's inflation adjusted income of my father's family live today? Probably here:

But maybe he would have had an ipod. Now tell me, what is the unitless ratio between these two situations.

24 Sayyid October 12, 2010 at 9:50 pm

People who can't understand why they "feel like they're running in place" and thus they must be in the same sort of economic situation as objectively poorer people from 50 years ago should go read The Great Gatsby, paying particular attention to the millionaires complaining about "just getting by."

It's the people who can't sit back and say "Yeah, whatever, don't need that" about the hip new uber-expensive fad who feel like they're "just getting by." The problem is spending decisions, not income. Income is higher. Spending is even higher than that. Poor money management is not an excuse for feeling like you're poorer.

25 Anonymous coward October 13, 2010 at 1:05 am

Salem,
there are two kinds of advertising which have become hopelessly confused: one that provides information to people who already perceive a want and one that creates or reinforces wants itself. Even their respective styles are different. When you do want a car, you want advertising with detailed information etc. instead of pictures of beautiful females riding cars against scenic backdrops. And being a savvy person you might even forgo actual advertising and go look at spec sheets.

26 a October 13, 2010 at 5:31 am

"Anyone that doubts a ~2.5x increase in standard of living since 1950 simply does not value 15 years of life (life expectancy has risen from 64 to 79), many more years of healthy and active life; nor do they value personal computers and the internet, surround-sound CD or DVD, flat-screens, iPods, mobile phones or iPhones; they don't value cheap travel all over the world and instant communication; nor do they value advances in production that have made household appliances and other conveniences previously only avialbale to the rich available now to the poorest in our society… seems actually they don't appreciate much of anything. Kind of boring, soul-less people… "

I value personal computers and the internet somewhat. I don't value CDs or DVDs, flat-screens, iPods, mobile phones or iPhones. Nor cheap travel all over the world nor instant communication (uh, telephones did exist for the "instant communication" which was essential). etc. Apparently your idea of an interesting, soulful person is (except for life expectancy) someone who likes to consume lots of things and products. Perhaps you should begin to read Thoreau, to begin to understand something about the soul? It's not too late.

"We are in great haste to construct a magnetic telegraph from Maine to Texas; but Maine and Texas, it may be, have nothing important to communicate."

27 jacob October 13, 2010 at 10:02 am

I would guess

1) More firms in an industry increases the demand for workers trained in that industry. Consumer prices may go down but firms will still have to bid more to fill their payroll. The supply curve in the labor market will slope more sharply upward if more skill is required (see Silicon Valley, where programmers are getting treated like rock stars at the moment).

2) This one is indeterminate, depending on the will of the consumer. US car manufacturers will have incentive to increase the value of the deal they are offering consumers, and consumers value both price and quality. The relative preference between price and quality will determine how US car makers react.

3) I would guess that a law forbidding price advertising would drive up prices. It reduces consumer information about prices at other stores, giving the stores pseudo-monopoly power.

28 moron December 31, 2010 at 5:40 am

@Ed Dolan

Is that a reference to Animal Farm?

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