The world is more complicated than ‘Econ 101’ (lessons from my 6th grade math class)

I visited my childhood home this past weekend. One afternoon I toured the school I attended from kindergarten through 12th grade. Although a lot has changed (and improved) since my time, many of the classrooms remain the same. One of these classrooms was the room where I took middle school math. Upon entering this room one memory that came back clearly was a presentation we had to make about how one of our parents used math in their every day work or life. (I suppose this was an attempt to try to convince middle schoolers of the practical need to actually learn algebra.) For this project I interviewed my dad who owned a small business in town.

My dad talked about how he used math to manage the margins within his business. In ways that my middle school mind could barely comprehend my dad explained how he marked-up the price of the goods for sale, how he figured out how much to pay his employees, how he decided how much inventory to keep in the warehouse, and how he decided whether or not to build a new building for the business. Wide-eyed, I was amazed at how my dad used math every day to navigate the complex business world. (I guess my teacher’s assignment worked for me.)

Years later I was in college and taking my introductory economics classes. Following the curriculum in the textbook the professor sketched an X on the board and explained the concepts of supply and demand. The key point: if things are more expensive people buy less of these things. This was an incredibly simple model of how the world works and one that seemed remarkably applicable to almost everything.

In an article written a few months ago in The Atlantic, James Kwak (a Law Professor from the University of Connecticut) writes about The Curse of Econ 101,* explaining how simple ‘Econ 101’ models have contributed to divisive debates about important economic public policies. Focusing on the topic of minimum wage policies Kwak writes:

… a pair of supply and demand curves proves that a minimum wage increases unemployment and hurts exactly the low-wage workers it is supposed to help. The argument goes like this: Low-skilled labor is bought and sold in a market, just like any good or service, and its price should be set by supply and demand. A minimum wage, however, upsets this happy equilibrium because it sets a price floor in the market for labor. If it is below the natural wage rate, then nothing changes. But if the minimum (say, $7.25 an hour) is above the natural wage (say, $6 per hour), it distorts the market. More people want jobs at $7.25 than at $6, but companies want to hire fewer employees. The result: more unemployment.

The rub is that existing empirical research in labor economics suggests that this ‘Econ 101’ explanation may not be quite right. In a paper, published in the American Economic Review in 1994, David Card and Alan Kruger examine the change in unemployment between New Jersey (where the minimum wage increased in 1992) and Pennsylvania (where the minimum wage remained constant). They find “no indication that the rise in the minimum wage reduced employment”.

So, what is going on here?

The answer (or at least part of it) is embedded in a lesson I learned from my dad way back in 6th grade. Although it is true that when markets are complete and perfect, information is symmetric, and transaction costs are zero that all else equal an increase in the minimum wage will necessarily decrease employment, these assumptions and therefore this result need not hold in reality. Instead the world is complicated by incomplete and imperfect markets, asymmetric information, and non-zero transaction costs. Additionally all else is not equal.

As my dad patiently explained to me when I was in 6th grade, there are many margins that anyone who manages a business must consider. One response to an increase in the minimum wage could be to reduce the number of people the business employs. The business could also respond differently by raising prices of the goods for sale, changing the inventory and stocking schemes, investing in new and more cost effective capital, and on and on. This response decision is influenced by countless specific factors and the profitability of the next best alternative.

This is why although the models taught in introductory ‘Econ 101’ courses predict that an increase in the minimum wage will unequivocally reduce employment, research economists from across the political spectrum still disagree about the relationship between minimum wage policies and unemployment. In reality the real world is complicated and the introductory models taught in ‘Econ 101’ are often too simple to help us make sense of the world.

At the end of the day we would all do well to move past simple arguments about economic policy based on lessons learned in the fictional world used to teach the basic principles of economics in introductory classes. Rather, we should acknowledge that the impacts of the minimum wage on employment, economic inequality, and poverty are complicated and still relatively unknown. It could very well be that in some situations an increase in the minimum wage will lead to a reduction in employment. Indeed this is what seems to have occurred in Seattle where the minimum wage increased but the number of hours worked for low-wage workers decreased – resulting in a reduction of earnings in the poorest households. It could also be, however, that the minimum wage has little to no effect on employment.

The fact is we just don’t know yet. This is why I find myself at odds with both sides of the minimum wage debate. Both those who unequivocally advocate for or against minimum wage policies are making judgements based on incomplete evidence.

* This article is adapted from a chapter form James Kwak’s book, “Economism: Bad Economics and the Rise of Inequality“.

1 thought on “The world is more complicated than ‘Econ 101’ (lessons from my 6th grade math class)

  1. Thanks Jeff (as usual). Being such a neophyte to behavioral economics I find your insights always stimulating and often helpful. Here is a thought from my system studies. Simply put complicated is understandable if given enough computing power and the right information. This works for many things in life. But complex is the product of emergent properties that, for the most part, cannot be explained simply by any form of linear understanding. The parts interact in such a way to produce the effect, but are so many and with various impact that computational models will not work on them. I would offer that at certain levels economic models (as most models) break down simply because of the complexity and number of the interactions leading to emergent properties that can be identified but very difficult to quantify in any really measurable way. So it would seem that unless we get a better handle on quantum mechanics we will continuously run into a wall of sorts.

    Forgive my simplicity, but it is the world I need to tread in.

    *From:* Jeff Bloem [mailto:comment-reply@wordpress.com] *Sent:* Wednesday, November 8, 2017 2:05 AM *To:* pwalker@icmusa.org *Subject:* [New post] The world is more complicated than ‘Econ 101’ (lessons from my 6th grade math class)

    Jeff Bloem posted: “I visited my childhood home this past weekend. One afternoon I toured the school I attended from kindergarten through 12th grade. Although a lot has changed (and improved) since my time, many of the classrooms remain the same. One of these classrooms was “

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google photo

You are commenting using your Google account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s