Six economics misconceptions of mine which I've resolved over the last few years

Regarding externalities, I think the correct way to calculate Pigovian tax is as the value the rest of society will lose, provided that they can react to the existence of the externality. So, in Friedman's example, the actual damage of pollution (and the tax to be levied on the steel mill) is only $50,000, because of the possibility to shift land use. Of course it does make it harder to evaluate externalities in practice, but the principle seems solid at least.

It’s embarrassing that I was confidently wrong about my understanding of so many things in the same domain. I’ve updated towards thinking that microeconomics is trickier than most other similarly simple-seeming subjects like physics, math, or computer science. I think that the above misconceptions are more serious than any misconceptions about other technical fields which I’ve discovered over the last few years

For some of these, I'm confused about your conviction that you were "confidently wrong" before. It seems that the general pattern here is that you used the Econ 101 model to interpret a situation, and then later discovered that there was a more complex model that provided different implications. But isn't it kind of obvious that for something in the social sciences, there's always going to be some sort of more complex model that gives slightly different predictions?

When I say that a basic model is wrong, I mean that it gives fundamentally incorrect predictions, and that a model of similar complexity would provide better ones. However (at least minimally in the cases of (3) and (4)) I'm not sure I'd really describe your previous models as "wrong" in this sense. And I think there's a meaningful distinction between saying you were wrong and saying you gained a more nuanced understanding of something.

For the externalities in (4), it’s important to remember that not internalizing the externality creates a lot of moral hazard, though, because Coase’s theorem rarely applies in practice. For example, the steel mill could often have been built at a different location for slightly more cost (say, $10k), which they will not do if they know the efficient move will be to not tax them. Thus a $40k inefficiency. And the theorem would rejoin with “well, the owners of the resorts will pay the mill >$10k to initially build on the new spot, which makes things efficient again”, but then of course you open up the opportunity for all sorts of inefficient [LW · GW] blackmail if you don’t fulfill the perfect information requirement of Coase.

Obviously none of this contradicts the nuance you were adding, but I just wanted to spell this out lest we see anyone waver in their moral resolution to internalize most externalities.

My understanding of banking and monetary policy was pretty wrong until very recently. Apparently the textbook I read in the 90s was explaining how banking and central banking worked in the 50s. John Wentsworth pointed me to a Coursera course by Perry Mehrling and here are the same lectures without having to register for the course.

Another big update for me is that according to modern EMH, big stock market movements mostly reflect changes in risk premium [LW(p) · GW(p)], rather than changes in predicted future cash flows. (The recent COVID-19 crash however was perhaps driven even more by liquidity needs.)

Curated – and for the first time, edited!

(The LW team hired a professional editor to make line edits to the above post. Buck went through and accepted/rejected the edits, and we updated the post before curating, so that the many people on the curated email list got the edited version. This was an experiment, we may do more of this.)

Overall I continue to think it's very healthy to write down your major updates and mistakes, and I'm curating this for similar reasons I curated Buck's last piece [LW · GW]. It feels to me like records of these updates allow one to do something like actually update on the highest level. Related, something about the insights in this piece feel very 'hard-earned', in a way where I think a person can only write this kind of post after a lot of time and effort and cycles of thought have passed. (Ray's Sunset at Noon [LW · GW] feels similar to me, where I think that Ray will only be able to write that specific kind of post every 5 years or so, and shouldn't try to write another one much faster.)

And I learned a ton from this post. Everything is explained very simply and concisely, no section is written in a way that signalled to me "You should be afraid of math and experts" which happens to me often for stuff about econ, and I think I basically understood all your updates. I mean, I need to read Friedman's essay in full and think on it, and I also need to actually use the insight about there being many dimensions on which markets compete other than price (e.g. quality, employee work standards, etc) to feel like it's truly-part-of-me, but they were at least very effective pointers to ideas that I want to use when thinking about these questions.

I also really like your predictions at the end and meta-level updates.

Any ideas on how software engineers can specifically hedge against the risk of software salaries declining? I ask because in the case of software specifically it isn't intuitive to me whether in worlds where software salaries have gone down we should expect tech company valuations to have gone up or down. In any other industry it feels clearer cut to me that the way to hedge against your own career capital risk and salary risk is to divest from the industry your work experience is in.

Perhaps one aspect of minimum wage that you are missing is that this is different from price control of fungible goods is several important aspects, that everything else being equal:

1. Higher minimum wage means higher demand for goods consumed by minimum wage employees.
2. Higher minimum wage incentivises employers to invest more in their employee productivity (training, better work conditions, etc)
3. Same employees may be more productive if you pay them higher wages, and you may be able to get better employees.

In some cases 2+3 might means that there may be several equilibrium points that are roughly equally good for the employers - either hire high-turnover low-productivity people with lower wages, or hire lower-turnover higher-productivity people for higher wages, and effect #1 is enough for the higher minimum wage to just be a win-win (which is perhaps why some employers actually support minimum wage laws).

I don't get the divestment argument, please help me understand why I'm wrong.

Here's how I understand it:

If Bob offers to pay Alice whatever Evil-Corp™ would have paid in stock dividends in exchange for what Alice would have paid for an Evil-Corp™ stock, Evil-Corp™ has to find another buyer. Since Alice was the buyer willing to pay the most, Evil-Corp™ now loses the difference between what Alice was willing to pay and the next-most willing buyer, Eve, is willing to pay.

Is that understanding correct, or am I missing something crucial?

If my understanding is right, then I don't understand why divestment works.

Lets assume I know Bob is doing this and I have the same risk-profile as Alice. I know the market price to be distorted, Evil-Corp™ stocks are being sold for less than what they're worth! After all, Alice deemed the stock to be worth more than what the stock was sold for. If it was not worth the price Alice was willing to pay for it, she wouldn't have offered to give that price.

Why wouldn't I just buy the stock from Eve offering to pay the price set by Alice?

Why is it that riskier investments should give higher expected returns?

I ask not because I don't get that the avg person would rather invest on something safe than something unsafe, all else being equal. I get that. I ask because I imagine that investors could bring their total risk down through diversification without harming the expected returns, so big money would prefer the higher expected returns even if they are risky, and in doing that, they'd bring down the extra returns from the riskier investments.

Is it because investments options are so correlated that diversification isn't enough to bring the risk of a portfolio down to acceptable levels? Or some other reason?

re: Index funds, if it's just about risk tolerance, you're better off with options on indexes + index funds than you are picking stocks.

One thing this post makes me curious about: in the last section, you talk about the effects of price controls on people selling goods, and also jobs. Usually we think of the labor market as workers selling their labor, rather than companies selling jobs. But is there any problem with this inversion? I guess the former view is better when workers are very heterogeneous, whereas maybe in cases where the company cares less about worker quality (like minimum wage jobs) the latter is also viable.

Also, I expect service industries to in general adapt better to price controls, since worker time can often vary more continuously than other products. Although idk how helpful such generalisations are, since there will be many exceptions.

I think your update on divestment is in fact wrong; divestment has no or negligible effect.

There are two main cases:

1- Divestment without substantial coordination

This stands in for anything where you are divesting from a company you find distasteful, but with the expectation that there will not be substantial numbers of other people who follow the same logic. In this case, unless you control a large fund, your effect on the price will be nonzero, and downward, but negligible.

2 - Divestment with coordination.

(This covers both explicit coordination and amorphous implicit coordination like 'many people share my moral logic and this offense was made very public'.)

Assume for the moment that a mass movement to divest is not substantial evidence of the corporation's fundamentals being weaker. (This is often false, particularly for businesses which sell directly to consumers.) If so, the price will go down, but high-information observers (serious traders) will note the outside factor depressing prices, note that this outside factor is uncorrelated with future stock performance, and conclude that these stocks are now a substantially better deal than other stocks. Result: stocks bought up until the market price ~returns to the equilibrium price without divestment. (This is a longstanding phenomenon in the form of the 'sin fund'. There are mixed results on whether the P/E ratio is actually better for 'sin stocks' in a durable way, but they're not worse.)

If the company is actually likely to be negatively impacted on a non-stock level, the situation is more complicated, but not much better for the divestors. To the extent the skilled traders correctly estimate $A$, the size of the divestment movement, and $B$, the (size of the effect on the company's bottom line)/(size of divestment movement) quotient, the stock price will behave exactly as it would if the divestors had made some equally-costly signal of their opposition to the company but not actually divested. These estimates will be imperfect, but they seem likely to be a case where the EMH works well, and if they have errors don't seem likely to be systematically wrong in a particular direction.

Note also that if you want to lower the share price, the thing to do, given that competent traders will attempt to figure out the market price implied by the fundamentals and be fairly adequate in that task, is to maximize $A\cdot B$; increasing the size is no good if the 'heat/light' ratio goes down by a bigger ratio than the size went up. If you consider a slightly more complicated model where you have movement size $S$, fraction of movement which divests $D$, and fraction of movement which takes direct actions that hurt the company's fundamentals $F$, $A=DS$ and $B=\frac{F}{D}$, for a total effect of $A\cdot B=F\cdot S$, divestment totally falling out of the picture. Any movement only has a finite amount of energy to spend convincing its members to take actions, so we should further expect $F$ and $D$ to be anticorrelated, i.e. it's not worth actively discouraging people from divestment but whenever there is a choice you should always choose the other action if it has a meaningful chance of hurting the company's fundamentals, possibly even down to dust-speck-level negligible-but-nonzero effects.

Thank you for writing this, I had some of the same misconceptions.

A question about point 1, divestment: Does a similar principle apply when companies pledge to only use renewable energy? If they also build capacities so more renewable energy is generated, then obviously yes.

But otherwise I don't see how there is risk aversion in using more non-renewable energy for the other energy consumers that would shift the price.

It's interesting that the first three are aggregation error - a focus on the mean rather than the distribution. And that the last 3 are politically-entangled enough that I see incentive to believe/teach the naive version.

Amazing post. But I am stuck at the "prediction market does not reflect probability" point. Currently Trump futures sell for 0.36$ and Metaculus predicts a 22% winning chance of Trump winning in 2024. This difference is what one would observe if many people are used these futures contracts for hedging. However, couldn't I just issue lots of futures contracts to bring the price down? Assuming that my assets are not meaningfully linked to Trump winning, that means 0.36$-0.22$=0.12$ expected return per issued contract. 

Relatedly, I thought that the fair market price of a contract which pays out $1 if Trump gets elected is just the probability of Trump getting elected. This is wrong because Trump getting elected is correlated with how valuable other assets are. Suppose I thought that Trump has a 50% chance of getting reelected, and if he gets re-elected, the stock market will crash. If I have a bunch of my money in the stock market, the contract is worth more than 50 cents, because it hedges against Trump winning.

Isn't this effect going to be very small for almost all markets, and still fairly moderate for presidential ones?

Not that you talked about effect size either way, I'm just wondering how much I should adjust predictions from markets for this reason.

Cliche at this point but still fun as the vast majority get it wrong. If you take out a mortgage with a bank, where does the money come from to pay off the old home owner?

Excellent post. I have a small complaint on the Coase section though. Quoting for reference:

Suppose that, in a particular case, the pollution does $100,000 a year worth of damage and can be eliminated at a cost of only $80,000 a year (from here on, all costs are per year). Further assume that the cost of shifting all of the land down wind to a new use unaffected by the pollution—growing timber instead of renting out summer resorts, say—is only $50,000. If we impose an emission fee of a hundred thousand dollars a year, the steel mill stops polluting and the damage is eliminated—at a cost of $80,000. If we impose no emission fee the mill keeps polluting, the owners of the land stop advertising for tenants and plant trees instead, and the problem is again solved—at a cost of $50,000. In this case the result without Pigouvian taxes is efficient—the problem is eliminated at the lowest possible cost—and the result with Pigouvian taxes in inefficient.

With the numbers laid out, (and presuming the mill is more than $100k profitable), I agree that the "efficient" outcome is for the resort to convert to timber. However, the result with Pigouvian taxes is still efficient. This is because Friedman arrives at the wrong equilibrium result with taxes. It is possible this is because he has structured his taxes incorrectly -- they aren't properly taxing damages, but rather an intermediary which can cause damages.

I think the result that Coase would advocate is that in the presence of a tax on damages, the mill pays the resort owner $50k+1 to convert to timber. At that point, the damages are $0, and no Pigouvian tax is paid. This is central to Coase's realization. Conditional on the pre-existing endowments, we should arrive at the min-cost solution -- the question is who bears the cost. In this case, imposing a Pigouvian tax transfers the burden from the resort owner to the mill owner.

On the externalities example I have also worried that conventional economic treatments also completely ignore corruption. In real life I think you have to assume that the government does not always act like an angel, and therefore there is an additional cost to allowing governments to correct externalities at all. And this cost will not just be limited to the example itself (where the government introduces a sub-par solution to the specific externality in question as the result of corruption), but instead applicable to broad swathes of economic interactions where, once allowed the power to correct externalities, governments may corruptly "correct" situations where no externality truly exists.

Thanks for this.

I wonder how common these misconceptions are among the public.

Regarding divestment, *who* owns equity can materially affect value independent of transacted price because other equity owners adjust the models of their long-term position value based on this information. This is reflected in concepts such as "dead equity" (implied dilution risk) in small companies and the notional-only value of founder equity in big public companies e.g. Bezos.

Regarding index funds, the (anti-)correlations are much more complex and less obvious, particularly in the modern globalized economy, than classic diversification and risk management heuristics allow for. The level of diversification within some single companies today does not have precedent. There is an emerging school of thought that a concentrated portfolio of companies with extremely high levels of internal diversification will have lower risk and consistently higher performance than when trying to reduce risk by diversification at the portfolio level. Anti-correlation has become so difficult in practice that optimizing for diversification efficiency and adaptivity is often the more effective strategy.