So what *is* the most misleading term in Economics?

On Monday, I wrote disagreeing with John Quiggan’s piece on “Pareto optimality” being the most misleading term in economics. My disagreement was more with his argument than his conclusion, but nevertheless, it got me thinking about what is the most misleading term in Economics. I have four favourites, which I will list in reverses order. These are all misleading in some way, but to different audiences.

4. Efficiency.

As I said, I don’t entirely disagree with John’s conclusion. I believe that when economists use the term efficiency without an adjective, it (nearly) always refers to Pareto efficiency, which properly understood is a fairly innocuous concept. It simply refers to a situation where no-one can be made better off in terms of the things he or she values (more stuff, cleaner environment, better civic amenities, living in a civil society, whatever) without making anyone else worse off in terms of the the things they value.  But I always advise my students to never use the word efficiency when talking with non-economists. Exhibit A to explain why is the following quote from the 1962 verison of mutiny on the bounty. Captain Bligh (Trevor Howard) is explaining to Fletcher Christian (Marlon Brando) why he just had a sailor flogged for something he didn’t do, saying that it won’t be possible to run the ship in bad weather if sailors don’t fear their captain more than they fear the weather. He goes on to say: 

Now don’t mistake me. I’m not advising cruelty or brutality with no purpose. My point is that cruelty with purpose is not cruelty—it’s efficiency

This scene, which happens early in the movie, is important for setting up Bligh as a horrible person in the minds of the movie watchers (much like Joffrey’s encounter with the diawolf and the butcher’s boy in the second episode of Game of Thrones). The screenwriters knew that having Bligh use the word efficiency to describe the treatment of people would be chilling to viewers. It invokes notions of Dickensian eight-year-olds up chimney, of sacrificing human values to the end of maximising material production, the total opposite of the totally human-values-centric approach to welfare that Pareto efficiency invokes.

3. Aggregate Demand

Efficiency is a problematic term as it can mislead those outside the subject. Aggregate Demand is worse as it misleads our own students. I complained about this one here. A standard demand curve is a statement of intentions. It shows how much buyers would buy if they could buy as much as they wanted at a given price. At the equilibrium price, the desired demand will equal actual purchases. It is also possible, however, to be on the demand curve at points where desired demand and actual purchases are different (say as the result of a legislated maximum price). The so-called aggregate demand curve is not analogous. It shows different equilibrium combinations of price and quantity such that demand for output equals actual output. It is possible to be out of this equilibrium, through undesired changed in inventories or other quantity buffers, but that implies being completely off the curve. The aggregate demand curve is a useful graphical device for teaching some basic macro concepts, but its name pretty much guarantees that the majority of first-year students will misunderstand its properties.

2. Investment

Here we have a term that, I think, misleads even seasoned economists. Investment in economics, refers to the accumulation of capital goods. The term in general usage is often used to mean particular mechanisms that consumers use to save. So, for instance, buying a rental property is investment in this everyday use, but, if it is an existing house, it is not “investment” in the economics sense. I am convinced that slippage in the meaning of the word investment mid-sentence is the reason for some half-baked justifications for a capital gains tax, as in statements like “we need a capital gains tax so that people will switch from investing in houses to more productive investments”. As I noted here, buying an existing house is not “unproductive investment”; it isn’t investment at all. Once that is noted, the link between a capital gains tax and productive use of savings becomes extremely tenuous.

But these three misleading terms are trivial compared to the granddaddy of them all:

1. NAIRU

That is, the "non-accelerating-inflation rate of unemployment". This is just embarrassing. As a profession, we like to get smug and despondent about innumeracy in the press with respect to the number of derivatives, sighing every time we read statements “inflation rose by 3% in the year to March”, when what is meant is either that “prices rose by 3%” or “inflation was 3%”. But then we do the same thing ourselves with one of our technical terms. 

For goodness sake, it should be the non-accelerating-prices rate of unemployment (NAPRU) or the non-increasing-inflation rate of unemployment (NIIPRU). There is an alternative term—the natural rate of unemployment. If it weren’t for the existence of NAIRU, I would have the natural rate in my list of misleading terms. It conveys a notion of unemployment being something that is just given to us, not something that can be affected by policy, and certainly not something that has very real human consequences. Again, it is a term that misleadingly conveys economics as a cold, heartless subject. But I would rather our profession was incorrectly perceived as cold and heartless than correctly perceived as innumerate. So as long as NAIRU is the only alternative, I will champion the natural rate!

The lies we tell

Former Canterbury Professor, David Giles, now at Victoria University in Canada, recently posted on his blog about the pitfalls about teaching something you know to be wrong at a lower level requiring the students to unlearn it at higher levels. He then presented an example from econometrics courses regarding the necessity of the assumption of normally distributed errors for certain results in the standard linear regression model.

 

Being a microeconomist not an econometrician, this set me to wondering what are the common lies we tell in lower level micro. By this, I don’t mean statements about the world of which someone might contest the empirical validity (e.g. minimum wages cause unemployment), or even the assumptions we make or, more often, are accused of making but never do (e.g. “people are rational”). Instead, I am referring to things that are unambiguously conceptually wrong.

I can think of three common ECON 100 microeconomic lies:

1. Diminishing marginal utility: We have known since Pareto and Hicks that this concept is meaningless, and neither necessary nor sufficient to show either downward-sloping demand or even diminishing marginal rates of substitution, but it seems to be
2. Consumer surplus: The answer to no known economic question, this is typically taught at first year not as a useful approximation but the actual value of the difference between the willingness of consumers to pay and the amount they actually had to pay.
3. Deadweight losses of taxes constructed by comparing total surplus with and without a tax: The deadweight loss triangle corresponds quite nicely to the idea of Pareto inefficiency (at least in contexts where partial equilibrium analysis is reasonable), but the ECON 100 derivation that comes from adding up total consumer plus producer plus government surplus rests on no welfare foundation that I know of. It is not Kaldor-Hicks, since government revenue is considered as a separate entity to the surpluses of individuals.

Any others that anyone can think of? How about the lies we tell in macro?

Note: Please don’t get me wrong; what I am calling lies here are not attempts to pull the wool over students’ eyes or sell a political viewpoint. I don’t think there is ever any justification for diminishing marginal utility, but consumer surplus and deadweight losses are useful concepts to teach that give appropriate conclusions if used in the right contexts. It certainly is better for students to have to unlearn these concepts slightly, than to be hit with duality theory and general equilibrium in their first year.