Making Economics Too Simple

     Reading about the recent Nobel Prize in Economics (and the reaction to it) has got me thinking again about how I was taught introductory physics in high school.  They started with the basics of Newtonian mechanics, Force = Mass times Acceleration, and so on. In order to get these ideas across, you kind of have to simplify a lot. In particular, you need to pretend friction doesn't exist. Now, friction isn't an exception to Newton's laws, but rather just a complex manifestation of it, but it really does make the math much harder to grasp, and so it helps to just ignore it for the sake of explaining the basic concepts of mass and acceleration and momentum and all that.

    Why did the Nobel Prize talk remind me of this? Well, it comes down to the way we were taught introductory microeconomics, with those nice simple supply and demand curves, and how it was presented as practically a Law of Nature that as the price of a commodity goes up, demand goes down. That is such a simple, elegant and straightforward principle that it's really hard to imagine it being otherwise. It's almost as powerful as the idea of objects in motion tending to continue in a straight line. After all, if the price of apples goes up, you're gonna buy fewer apples, either looking for alternatives or just deciding to do without apples for now.

    Half of this year's Nobel Prize went to David Card "for his empirical contributions to labour economics". It had been assumed that, as with raising the price of apples leading to lower demand for apples, raising the minimum wage would reduce demand for labour and thus cause higher unemployment. But Card and his collaborator (the late Alan Krueger) decided to test this by comparing two very similar areas as one raised its minimum wage and the other left its unchanged. Surprisingly to the microeconomics dogmatists, there was no significant change in unemployment, and in some cases, employment went up.

    I'm not going to talk much here about Card's actual work, except to point out that it should have come as no surprise, even to the armchair theorists whose basic assumptions weren't wrong, but like the high schooler first learning physics and ignoring friction, neglected to think through all the ways the assumptions might actually play out in the real world.

    The principle assumption, of course, is that players in the economy are trying to maximize their utility with the scarce resources at their disposal. The simplest and most obvious way this plays out can be seen with the original apples example: if the price of apples goes up, then the utility I get per dollar from apples goes down, while the potential utility of my dollars remains more or less constant (that is, I can still get the same amount of stuff besides apples for those dollars). In other words, I'd rather keep a few dollars that I might otherwise have spent on apples.

    This is correct as far as it goes, but it doesn't go as far as it needs to to understand wages in all cases. Sure, it might apply to the wages you pay to someone to perform personal services for you, such as mowing your lawn or cleaning your house, and you might well consume less of those services as their price goes up. But for most businesses, labour is a factor of production; a business hires someone to produce value which is then sold to the consumer at a profit.

    Let's say I own a facility with enough space and equipment to have ten workers producing widgets. For simplicity's sake, assume each worker can produce 1 widget an hour, which I can sell for $20. And suppose I pay each worker $10 an hour, so I make a profit of $10 on each widget sold. (There are other costs, of course, such as the space and equipment, but we'll ignore those as constants that don't affect the analysis here.) If the wages I must pay to my employees go up to $15, all that means is that I only make $5 profit on each widget. It does not mean I lay off any of my workers, because that would just mean forgoing the $5 they earn me per hour. The only person who's losing out by a rise in wages in this case is me, because I'm making less profit.

    Now, it may be that my profit margin on each unit is already low. Maybe with all my other costs, I'm only making $4 profit per widget. In that case, raising my wages cost per unit by 5$ means I'll actually lose money on each widget I produce, and yes, in that case I'll probably shut down and lay off my workers. Aha! Unemployment goes up then, right?

    Well, no, not necessarily. Remember those supply and demand curves, and that they apply to the whole market, not just an individual producer. Maybe I'll drop out of the market, but that means production drops below demand, which means the price rises. It probably won't rise high enough to bring me back into the market, but one of my more efficient competitors will hire the workers I laid off and scoop up more profits until their increased production brings the price back down again.

    But yeah, maybe some workers will be laid off and not replaced, depending on a whole lot of factors, but once we start looking at a whole lot of factors and whole markets, another factor comes into play: workers (including workers in other industries and sectors) now have more disposable income, and will likely be spending that on buying stuff. So demand rises, and as production increases to meet that demand, workers get hired. 

    I'm not going to claim that this is exactly how it will play out in every case at all times when the minimum wage is raised. (In fact, I'm not actually in favour of minimum wages at all, since I much prefer the idea of a minimum income structured as a citizen dividend.) But the point here is that those who authoritatively intone very basic principles from Economics 101 as arguments for or against some policy are almost always committing the same kind of mistake as someone who tries to ignore friction, turbulence and all those other complications when trying to apply Newton's Laws. Real world economies are much more complex and those very same basic laws of supply and demand can produce results that seem utterly inconsistent with the simplest application of those laws.