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Miseducation

November 23, 1998

Gene Epstein of Barron's is one of the outstanding economic journalists of our time, and he also deeply influence by Misesian theory. Here are excerpts from his November 23, 1998, column on economics texts:

Wrong Lessons
The trouble with economics textbooks

By Gene Epstein

Now I know why it's called the Dismal Science. I just spent a few days at a
decidedly dismal task: reading and skimming nearly 5,000 pages in six
introductory textbooks on economics, four of them portentously called
Economics, the other two, Principles of Economics.

These fat and intellectually flabby tomes are aimed at a huge captive
market -- the approximately 900,000 hapless undergraduates who take
introductory economics courses every year. And at $75-$80 a copy, it's not
surprising that Harvard economist N. Gregory Mankiw (pronounced MAN-cue)
reportedly earned an advance of $1.4 million for his own recently published
Principles text.

I dutifully reviewed Mankiw's work and, of course, the textbook by legendary
author Paul Samuelson (undoubtedly a millionaire many times over), who has
picked up William D. Nordhaus as a collaborator. I looked at the offering
from Campbell R. McConnell, who long ago outdistanced Samuelson as the
field's No. 1 seller. (McConnell, too, has acquired a collaborator --
Stanley L Brue.) The other three books were written by Joseph Stiglitz,
David Colander and the team of Roy J. Ruffin and Paul R. Gregory.

Long passages and even whole chapters in these books can be read with profit
and even pleasure. But too much is either plain wrong or plainly misleading...

Start with what's plain wrong. All six works trot out the usual fairy tale
about the way money is created in the banking system. Even Stiglitz sets
forth the standard litany, although, as a former chairman of the President's
Council of Economic Advisers and as the World Bank's chief economist, he
presumably should know better.

According to this litany, cash is somehow deposited in a commercial bank and
because the bank has to keep only a fraction of that sum in reserve, it's
free to lend out the rest, thereby creating money that didn't exist before.
Then, via the "money multiplier," the monetary expansion continues.

But in real life, what usually happens is that a bank simply creates money
without holding any excess reserves at all, by setting up a line of creditfor a customer in the form of a checking account. Only then does the bank
look for a way to provide backing for that account, often by borrowing from
another bank at the overnight fed funds rate. That good old money
multiplier, to which these texts devote all those T-accounts and tables, is
quite irrelevant.

Next consider the dreary chapters in every one of these books that explicate
that old canard, "perfect competition." Way back in 1946, in an essay called
"The Meaning of Competition," Austrian economist and later Nobel laureate
Friederich von Hayek made a key point about this concept, one that our
textbook writers should have heeded: Under perfect competition, it would
simply be impossible for any competition to occur.

To begin with, a firm competes with another by undercutting, but under the
conditions stipulated by perfect competition, this can't happen. That's
because every firm must be a "price-taker," or, as Samuelson and Nordhaus
inform us, "no matter how much a firm produces, it can sell its entire
production at the going market price. A perfect competitor therefore has no
reason to undercut the market price."

But maybe our perfect competitor can use a brand name and advertise it, or
better yet, actually improve his product and then advertise. Or perhaps he
can get the jump on other firms by moving to a better location, by
delivering his product a day or two sooner than everybody else, or by
creating goodwill in some other way. No, none of those things can happen
either, since a PC market requires that all goods sold be exactly the same.
So any attempt at product differentiation is strictly forbidden.

Then, after having digested all those elegant little graphs depicting the
noncompetitive never-neverland of perfect competition, our student is ready
for the kind of competition that is "imperfect" or "monopolistic."

You're considered to be a monopolistic competitor if your product does have
some brand name on it, whether you're Joe's Garage, Harry's Barbershop or a
Volkswagen Beetle. So you're supposedly monopolistic in the sense that
you're peddling a differentiated product. And for reasons too complex to go
into here, the texts amazingly inform us that such firms are always
operating with excess capacity.

But as economist Murray Rothbard long ago pointed out, this bit of mythology
really depends on how the graphs are drawn. Draw them in some other way and
the excess capacity disappears. And logically speaking, why would any
businessman build a plant that is too big for his anticipated market? Also,
while excess capacity can be found in various industries, you'd be laughed
out of economic court if you tried to cite monopolistic competition toexplain it.

When you complain to members of the mainstream about these ridiculous
constructs, they generally utter lofty pronouncements about the need to make
assumptions that abstract from reality when building a theory. Of course --
but the question is whether you've assumed away so much of it that you've
abstracted yourself into a conceptual corner.

The Austrian theorists (readers of this column must have learned by now that
I've been deeply influenced by them) prefer to put the abstract idea of
entrepreneurship near the center of their market models. Our textbook
authors rarely use this word, and when they do, they usually associate it
solely with the act of improving technology. But they might have inferred
two key aspects of this activity in its more common and prosaic sense by
looking closely at themselves.

Take the new kid on the block, Mankiw. To begin with, he's acted like an
entrepreneur by trying to anticipate wants. In the belief that professors
and students will prefer a text that weighs less, he's made his about 30%
shorter than most of the other entries (although it still runs 797 pages).

And up to a point, he's also tried to create wants. For instance, he dreamed
up the idea to begin his text with a chapter that sets forth "Ten Principles
of Economics." (If this ploy starts to look like a winner, the rest of the
field might be induced to try a "Seven Aims of Economics" or perhaps "The
Economy's Eight Do's and Don'ts.") What's also noteworthy is that Mankiw's
publisher chose to compete not through price, since the book costs about as
much as the others, but by differentiating the product, which is what
entrepreneurs frequently do.

If I may hazard a theory of my own, it's that these theories of perfect and
imperfect competition are kept alive not because they're especially
enlightening, but because they lend themselves to the use of graphs and
formulae that are so dear to the hearts of economics profs. Try to speak of
the market as a dynamic process of discovery, with the entrepreneur as key
actor, and those little tools become a lot less useful.

Nowhere is this mathematical mania more apparent than in the way these books
present the theory of consumer choice. Maybe you know that consumers get
"utility" out of goods and services, which is fair enough. But you may not
be aware that economic scientists have managed to isolate the subatomic
particle known as the "util."

For instance, Colander writes about the choice between "spending another
dollar on a slice of pizza that gives you an additional 41 utils or spendinganother dollar on a hero sandwich that gives you an additional 30 utils."
The problem with this formulation is that while it's fine to say you prefer
the pizza, no one can put a number on how much you prefer it. We all like to
play those parlor games in which we rate things on a scale of 1 to 10 (or 10
to 100), but no one except economists would think to elevate this process to
the level of textbook science.

Then there's that graphical flight of fancy known as the "indifference
curve." As Mankiw quaintly puts it, "An indifference curve shows the bundles
of consumption that make the consumer equally happy. In this case, the
indifference curves show the combinations of Pepsi and pizza with which the
consumer is equally satisfied."

The curve shows that if we can get a whole lot of Pepsi, we'd be willing to
accept very little pizza and vice versa. But Mankiw's chosen example is a
bit unfortunate, since many of us think of these goods as complementary.
That is, the more pizza we eat, the more Pepsi we need to drink.

Finally, even where these books are right, they can fall short. They all
note the important fact that wages have historically risen with
productivity, but none of them bothers to explain why. And McConnell and
Brue, whose treatment is probably the worst of the lot, define the law of
comparative advantage in a mind-fogging way: "Total output will be greatest
when each good is produced by that nation which has the lowest domestic
opportunity for that good." This in italics, no less.

After having to regurgitate such words on their blue-book exams, how many
kids will remember their econ class with anything but revulsion?

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