Which economic theories are especially widely misunderstood?

A lot of them are, actually.  The efficient markets hypothesis might be one, as I’m not sure I understand it myself!  (Would the existence of just one investor “beating the market” disprove it?  Probably not, but then how many are needed?  How many of them have to beat the market “for the right reasons”?  And for how long?  How many dimensions exactly does this problem consist of?)

But today I’ll nominate Rudi Dornbusch’s exchange rate overshooting model.  When I see it cited, and I mean by professional economists or economics writers, more than half the time  people seem to get it wrong.  They use it to refer to all sorts of back and forth exchange rate movements, whereas the Dornbusch logic requires that the overshooting be in line with covered interest parity and thus the subsequent adjustment of the exchange rate is both expected and predicted by interest rate differentials in advance.  That’s hardly ever how it happens.

What else?  How about real balance effects and price level determination, as analyzed by Patinkin, Pesek and Saving, Harry Johnson, and others in the 1960s and 70s?  Most people get the right answer, but if you push them on it they fall apart, quivering and begging for mercy.  “Hey bud, that explanation sounded nice!  How about applying it to the difference between inside and outside money?  How does that shake out?”  Talk about microaggression.

Most economists do pretty well stating the Modigliani-Miller theorem.  They do less well when you ask them how it relates to the infamous “spanning condition,” which indeed it does.

Paul Krugman has remarked a few times on how many economists seem to get Ricardian Equivalence wrong.

At least half the time, in casual conversation, economists seem to forget that for a normal indirect utility function consumers are not risk-averse in terms of prices.

How about a Fisher effect question:? “If people expect prices to go up in the future, why don’t a lot of those prices go up right now?”  Thereby removing much of the inflation premium from the nominal interest rate.  Oops.

Or try this one: “Why is the interest rate a market price which can be expected to rise (fall) in the future, without rising (falling) now in anticipation of the future change? After all, liquid cash doesn’t have much of a storage cost.”  Unpack all of that in two sentences or less and set it straight.  Deadly.

Most economists who don’t do finance don’t know much finance.

Can one economist in forty properly define the “independence of irrelevant alternatives” axiom behind the Arrow Impossibility Theorem, taking care not to confuse intra- and inter-profile versions of the theorem, the latter of course being canonical?  Me thinketh not.  Wikipedia gets pretty close but is not fully clear.  The typical mistake is to think it is about “taking something off the menu,” and a resulting invariance of choice, when in fact the pairwise ordering alone should contain all of the relevant information.  Ah, but how exactly are those two conditions related?

How many people can define “rational expectations” correctly?  Is it: a) the market forecast is right on average, b) individual errors are serially uncorrelated over time, c) market forecast errors are serially uncorrelated over time, d) individual errors are normally distributed, symmetric around the mean, or e) individuals know the “correct model” of the economy (with what specificity?  That of God in the Quran?).  Maybe all of the above?  Some of the above?  Let’s put this one on the SAT.

Time consistency vs. subgame perfection anyone?

Sometimes economists confuse “the law of large numbers” with the potential risk benefits from subdivision of a gamble into many smaller parts.  Arrow himself made this mistake at least once.

How many people can get all of those right?  And how many other common but frequently misunderstood propositions in economics can you think of?  Nothing partisan or policy-based please, and please leave macroeconomics aside, let’s stick to analytics for this exercise.  I’ve already covered the Heckscher-Ohlin theorem.

I am sure this post contains several errors.


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