Valuable economics knowledge available, ironically, for free

by Stuart_Armstrong8 min read18th Jul 201337 comments

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I took an economics course recently. And by "took a course" I mean followed a series of online lectures. I can strongly recommend doing so, especially if you already think you have an intuitive grasp of economics.

I was in that situation. I knew about incentives, and revealed preferences. I understood that supply and demand curves crossed. I grasped some of the monetarist arguments about the lack of long run tradeoffs between inflation and employment. I could talk about Keynesian stimulus and sticky prices/wages. I understood bank runs. Externalities were obvious, public goods a bit less so. I even knew quite a lot about banks and the money supply.

I had it pretty good, I thought. And yet when I followed basic economics lecture, I learnt a lot. The models and concepts suddenly fit together. I understood concepts that I only thought I had understood before. Economists do know their stuff, their models and concepts are informative - more so than I ever expected.

So, bearing in mind that economics is a social science whose conclusions are not nearly as rigorous as its models, I can recommend to anyone on Less Wrong who's interested to follow a lecture series or take a course.

The lecture series I followed was this one, by Professor Kenneth E. Train (the first lecture can be skipped). The most useful potential insight of all was in a brief throw-away comment in lecture 22: many economist think that the unemployment rate is determined entirely by macro-economic policy (and probably by the business cycle). So all the articles you might read about new industries "creating" jobs, or about some people becoming unemployable because of the "loss" of certain types of jobs: according to some some economists, all these articles are wrong. These trends affect who is employed versus unemployed, and conditions and wages, but not the unemployment rate across the business cycle. An interesting idea, worth thinking about.

Here are some brief notes on each lecture (useful for revision):

  • Lecture 01 is a general introduction, touching upon scarcity and opportunity costs, and setting up class stuff. Can be skipped.
  • Lecture 02 introduces demand and supply curves, emphasising their hypothetical nature, and showing how the crossing of supply and demand act as an attractor. Illustrates by showing the idiocy of the war on drugs.
  • Lecture 03 looks at elasticity of demand/supply and the consequences of price controls and taxes, figuring out who actually pays for them.
  • Lecture 04 explains how demand/supply curves are constructed from individual marginal willingness to pay/marginal cost. From this, we can calculate the total consumer and supplier surplus, and the deadweight loss due to taxation.
  • Lecture 05 is about production costs for a firm, including fixed costs, total costs, average costs and marginal costs. The important points are that marginal costs eventually rise, and that the marginal and average costs cross at the minimum of the average cost curve. The social optimum is defined, when marginal willingness to pay and marginal costs are equal.
  • Lecture 06 presents the definitions and advantages of perfect competition (a surprisingly relaxed situation for the firms involved). In this situation, each firm faces a flat demand curve and has no market power. Because of this, price is equal to marginal cost (reaching social optimum). Due to free entry and exit, this is also the same as the average cost - which is automatically the minimal average cost.
  • Lecture 07 looks some extra features and issues concerning perfect competition, such as the fact that the producer surplus/profit is zero, once all workers and investors are paid, and the fact that consumers are paying the minimal possible cost. Waste and inefficiencies get eliminated, but firms will collude if they can. The shape of the average cost curve can tell us if the market is naturally competitive, naturally monopolistic or neither.
  • Lecture 08 concerns monopolies. Facing a non-flat demand curve, firms use marginal revenue rather than marginal cost: their prices and quantity produced are connected and vary inversely. Monopolists will produce so that marginal revenue equals marginal cost, producing less than is socially optimal, and pricing higher than is optimal (which would be marginal cost), capturing more of the surplus and making positive profits.
  • Lecture 09 introduces the (badly named) concept of monopolistic competition, with heterogeneous products. This gives firms some market power. Firms will produce till marginal revenue is equal to marginal cost, producing too few products (as in monopoly), but due to free entry and exit, they will not make a profit (as in competition). Collusion and the prisoner's dilemma are presented (nothing that Less Wrongers won't have seen before, apart from the fact that transparent prices make collusion easier).
  • Lecture 10 is all about the regulation of natural monopolies, how hard it is (mainly because regulators and firms don't have the same information and incentives), and why regulation must be fluid and often re-inspected. This lecture and the next are illustrated with historical examples which imply that regulators often reach the right conclusion - eventually.
  • Lecture 11 looks at anti-trust regulation in the United States. Of relatively narrow, American relevance, but the discussion and analysis are interesting.
  • Lecture 12 introduces externalities. Negative externalities (when social costs exceed private costs; e.g. pollution) cause too much of the product to be produced. Positive externalities (when social benefits exceed private profits; e.g. vaccinations) cause to little of the product to be produced. Describes potential solutions, each with advantages and disadvantages, and emphasises the point is not to get rid of things like pollution entirely, but to move closer to social optimum.
  • Lecture 13 is about public goods (e.g. National Defence), and seems to focus on the non-rivalrous aspect rather than the non-excludable. Public goods are under-produced by the market. The various attempts to remedy this have flaws, mainly because there is no effective way to force people to disclose their true valuation of the public good.
  • Lecture 14 considers inter-relations between markets, using the example of the labour market and the market for the good produced by that labour. Ideally, there would be a joint equilibrium in both markets, to which prices would converge (depending on whether the markets obey the properties of various fixed-point theorems). To illustrate mutual dependency, changes to demand are played out through the joint system.
  • Lecture 15 looks at time, uncertainty, utility, diminishing marginal utility, and why higher risk requires higher returns. It finishes with Moral Hazards, the only part of the lecture that might be unfamiliar to Less Wrongers.

That's the end of micro-economics, the rest are about macro-economics:

  • Lecture 16 is the introductory overview of macroeconomics, introducing the basic concepts (aggregate output, employment, general price level, inflation...) and how they are measured. Fiscal policy (economic impact of government taxes/spending) and monetary policy (interest rate setting) are mentioned.
  • Lecture 17 analyses aggregate output, pointing out that in a closed economy, every expenditure is an income for somebody, giving an equilibrium aggregate output. This is a function of the rate of consumption and investment. It is pointed out that this equilibrium need not correspond to full employment, and multipliers are introduced: extra consumption becomes extra income, a part of which is then spent as more consumption, and so on. With a high marginal propensity to consume, changes in consumption have large effects (hence giving an argument for transferring income from richer people with low propensity to consume to poorer ones with a high propensity).
  • Lecture 18 looks at the role of government, pointing that tax reductions and government spending (fiscal policy) both have a (potentially large) multiplied stimulative effect on the economy (though there is a long term cost). Spending is more effective than tax reductions, so simultaneous equal tax and spending increases are stimulative (though subsequent lectures all reduce the impact of fiscal policy).
  • Lecture 19 studies the money supply and interest rates. The interest rate is the price of money; it's the desire for liquidity that determines the value of money (this is an attracting equilibrium process). The Federal Reserve and other central banks have ways of manipulating the interest rates (monetary policy).
  • Lecture 20 compares fiscal and monetary policy, showing that they affect both interest rates and aggregate output. The impact of both polices across the two markets is reduced by the interaction between them: decreased interest rates increases aggregate output which increase interest rates. This reduces the multiplicative impact of fiscal policy, especially over the long term. Monetary policy is more effective, except when in a liquidity trap: a situation where consumers and firms are so pessimistic they won't spend or invest, even if they could borrow money for free (at 0%).
  • Lecture 21 models inflation. "Aggregate demand" curves models how increasing prices reduces aggregate output (increasing prices increase demands for money, and hence interest rates). "Aggregate supply" models how increasing aggregate output increases employment, which puts an increasing pressure on prices. The crossing of these two curves is an attracting equilibrium. This reduces the impact of both fiscal and monetary policy, strongly when the economy is close to full employment (and weakly otherwise). The shape of the aggregate supply curve explains the difference between Keynesian and classical economics.
  • Lecture 22 (out of order on the playlist) is a hagiography of the benefits of free trade. It covers comparative advantage, and the fact that free trade doesn't destroy jobs (unemployment being determined by macroeconomic policy), but just moves around where those jobs occur. Jobs can only be outsourced to a country if they are also outsourced from it. Nothing really new, but well phrased.
  • Lecture 23 is the last lecture with new content. It completes the analysis of the macroeconomy, by adding the macroeconomic impact of trade: exchange rates. These are determined by the desire of people in one country to buy products, or invest, in another country. When the dollar depreciates, the US exports more, and their aggregate output climbs (and vice versa). Fiscal expansion increases interest rates, which causes the dollar to appreciate (thus weakening its expansionary impact), while monetary expansion causes it to depreciate (thus strengthening its expansionary impact). Monetary policy may cause trade wars and international tensions if used this way, however.

And in conclusion:

  • Lecture 24 is the general revision lecture. If you can follow it, you've learnt most of the course. It emphasises that monetary policy is generally much more effective than fiscal policy, except in liquidity traps, when monetary policy becomes ineffective.

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I would caution to be sceptical of undergrad-level economics, in particular macro. The usual models taught to students have huge problems dealing with the real world.

This is not to say that one should not study economics. However the state of this discipline is pretty bad right now (again, in particular concerning macro) and it's generally acknowledged that simple macro models are NOT how the world actually works.

Thanks for the warning! Do you have any references for this, btw, or is it just your own sentiment?

FWIW I'm a grad student in econ, and in my experience the undergrad and graduate macro are completely different. I recall Greg Mankiw sharing a similar sentiment on his blog at some point, but can't be bothered to look it up.

I would say that undergrad and grad econ are very different methodologically (at least at most schools), but a lot of the content is the same.

Stephen Williamson's intermediate macro textbook tries to bring in a lot of grad-level models/concepts, albeit in a "toy" form.

What do you mean by 'content' here? The basic narrative each model tells about the economy?

I think I agree with you. The big difference between the models I learned in undergrad and the models I learned in grad school was that in undergrad, everything was static. In grad school, the models were dynamic - i.e. a sequence of equilibria over time instead of just one.

What do you mean by 'content' here? The basic narrative each model tells about the economy?

Right. Plus most undergrad models have an analog in grad macro, i.e. the AD-AS model and the New Keynesian model, or Quantity theory of money and a basic cash in advance model.

The big difference between the models I learned in undergrad and the models I learned in grad school was that in undergrad, everything was static. In grad school, the models were dynamic

True in general. Some intermediate macro courses use a two-period framework to explore basic dynamics. Williamson's textbook does this.

If for no other reason, that macro has lots of political implications which winds up being mind killy. Micro OTOH, is instrumentally useful, in that people who understand it generally evade some common errors.

Micro has a lot of political implications as well (minimum wages, regulations, taxes, barriers to entry...)

That there is a danger, though, that people who study micro but don't study macro will end up with a bias that will mislead them, especially in political terms. I know people who took microeconomics 101 and nothing else, and there is a danger there in that people who did that now think they now understand how the whole economy works, but actually don't.

I think the danger of people thinking that they understand how the economy works rises with the amount of economic causes the person takes.

Are they any more wrong than people who study macro and think they understand how the whole economy works? Do these wrong beliefs cash out in actions that negatively impact them? The only thing macro impacts for most people is their conversations with other people about macro.

Do these wrong beliefs cash out in actions that negatively impact them?

Not directly. But in a collective tragedy of the commons style way, wrong beliefs about macro ultimately lead to had economic policy which in tern ultimately does negatively impact everyone.

Are complex macro models how the world actually works? What are our most successful macro models, and how successful have they been? My impression (based off not that much data, admittedly) was that this applied to all macro, not just undergrad.

It is true that this warning applies to all macro, not just undergrad. But by the time you get to the grad level and beyond you already understand (or should understand) the limitations of the models and the difference between academia and real world. At undergrad level you're still likely to be seduced by the simple narratives that these models offer.

Are complex macro models how the world actually works?

Nope! All models are huge simplifications.

What are our most successful macro models, and how successful have they been?

A controversial question!

The conventional approach in (academic) macro is to build (relatively) simple models that can match particular stylized facts. Thus we have lots of models that can predict certain patterns in the data, but don't pretend to explain everything. Some people think we shouldn't do anything beyond this! (See Caballero, Pretense of Knowledge Syndrome)

Other people do try to build models that can match all the data. A standard cite is Christiano, Eichbenbaum and Evans (2005), and for another approach see Smets and Wouters (2007) (they even call themselves Bayesians!).

Then there are macro forecasters who try to accurately predict the future using non-theoretical statistical models. An example of this would be the work of Frank Diebold at Penn. These models can do a lot better than the above at predicting future data absent changes in the policy regime, but are presumably less effective at predicting the effects of novel policies (see the Lucas Critique).

My own opinion is that if you want to predict the next data point, use a forecasting model, but if you want to know the effects of a new policy, your best bet is to rely on simple models plus judgement. Good economists know more than any model!

My own opinion is that if you want to predict the next data point, use a forecasting model, but if you want to know the effects of a new policy, your best bet is to rely on simple models plus judgement.

How do you know?

I would caution to be sceptical of undergrad-level economics, in particular macro.

This is my primary rationalization against learning some economics. How worried should I be?

You definitely should learn economics. While learning you should be sceptical of what you are being told -- more than usual in the case of macro models.

Just treat it as some shady characters spinning you a tale :-D Use your brains and make frequent checks against observable reality.

I would caution to be sceptical of undergrad-level economics, in particular macro. The usual models taught to students have huge problems dealing with the real world.

Name three.

Contemporary Japan, and America; the Great Depression; business cycles in general.

(I threw in a fourth one for free because I love the 'name three' heuristic even if you chose a really bad topic to use it in.)

Lumifer said (1) the state macroeconomics as a whole is bad, (2) what you learn in a principles course is not how the world actually works, and (3) macro models have huge problems dealing with the real world. These are extreme claims, and I think I was justified in calling him on them.

To your examples -- the AD-AS model (or IS-LM in older textbooks) can be used to think about business cycles in general, and the liquidity trap in particular, which covers most of your examples. The Great Depression needs discussion of monetary policy (gold standard, Friedman-Schwartz, etc), and all of your examples need some discussion of financial crises, banking panics, and asset bubbles. Japan is not that mysterious once you consider demographics and per-capita growth rates.

A good principles class will spend quite a bit of time talking about each of your examples, and show how to think about them using the standard tools.

These are extreme claims, and I think I was justified in calling him on them.

You demanded examples where macro does not work well in the real world. I named 4: Japan remains a mystery to macro, and 'Abenomics' hasn't helped eluicidate it; the US crash was unexpected and falsified the 'Great Moderation', casting doubt on the entire structure of macro that didn't predict it; the Great Depression is only partially understood even if a lot of people think Friedman cracked it; and business cycles remain mysterious with panics and bubbles being not explanations but excuses. The growing influence of the macro views of Scott Sumner, who was a marginal figure at best a few years ago, offers another practical bit of evidence that macro is far from a settled science when it comes to contemporary economies.

A good principles class will spend quite a bit of time talking about each of your examples, and show how to think about them using the standard tools.

I'm sure it would. Doesn't mean it is right or that macro has a consensus view on each such as how to fix and prevent and predict them.

You demanded examples where macro does not work well in the real world. I named 4

I demanded examples of models taught to undergrads that have "huge problems dealing with the real world." The same poster went on to say that these models are so dangerously wrong one must be intellectually inoculated against them!

You've given several examples where our knowledge is incomplete. I agree! And I hope that any economist would explicitly say that there's no settled explanation for the Great Depression, or the Great Recession, or Japan's Lost Decade. But that is quite different from saying that the models we DO teach have "huge problems dealing with the real world" and "are NOT how the world works". I think the basic models ARE effective tools for understanding how the world works, and a good teacher will explain both their uses and their limitations.

In brief, the fact that there are things we don't know does not mean that what we do know is wrong, and a good principles class should teach both what we know, and what we don't.

You've given several examples where our knowledge is incomplete. I agree! And I hope that any economist would explicitly say that there's no settled explanation for the Great Depression, or the Great Recession, or Japan's Lost Decade.

If the state of the art cutting edge economic research is that "there's no settled explanation" for Japan's Lost Decades (plural, since we're well into multiple decades, I think), then how on earth could the simple models taught to undergraduates not have "huge problems" dealing with these "real world" events?

If the state of the art...is that "there's no settled explanation" for Japan's Lost Decades...then how on earth could the simple models taught to undergraduates not have "huge problems" dealing with these "real world" events?

I don't see how this follows.

Suppose we teach a theory that says things in set X can be caused by things in set Y={A,B,C}. Then I say "there's substantial argument about whether major event x in X was caused by A or by B."

This does not mean the theory has "huge problems" dealing with real world events! It just lacks the power to distinguish between causes from within the set Y.

In the same way, economists argue about the causes of things like the Great Depression, Lost Decade, and Great Recession, but they mostly agree about the sort of causes they need to consider, and they have a common framework to think about them in (or at worst a few competing frameworks).

This does not mean the theory has "huge problems" dealing with real world events! It just lacks the power to distinguish between causes from within the set Y.

Then it's not a theory capable of explaining the event at all. If all you can do is throw together a variety of heterogenous contradictory theories, you haven't explained an event.

I'm reminded of Wittgenstein, now, on family resemblances - of course one could define "a game" as an indefinitely long disjunction of possibilities "a game is anything which is either Backgammon OR chess OR go OR Halo OR tossing a ball OR soccer..." but having giving this disjunction, in what sense has one actually conveyed what a game is? Same thing here.

In the same way, economists argue about the causes of things like the Great Depression, Lost Decade, and Great Recession, but they mostly agree about the sort of causes they need to consider, and they have a common framework to think about them in (or at worst a few competing frameworks).

I believe that however we explain the Lost Decades, it will involve materialism and not souls. Do I have a perfectly satisfactory theory capable of explaining the Lost Decades? No, of course not.

Then it's not a theory capable of explaining the event at all.

Are you really claiming that a theory that restricts the possible causes of an event to three has not explained the event "at all"?

Under this definition, I agree that undergraduate macroeconomics cannot explain the real world. But surely this is a rather restrictive standard for "explanation"?

I would rather say that a theory that allows us to concentrate a lot of probability mass on Y upon observing an element in X, or to concentrate a lot of probability mass on X after observing an element in Y, is doing quite a bit of explanatory work!

Are you really claiming that a theory that restricts the possible causes of an event to three has not explained the event "at all"?

This isn't a case of 1 theory which predict the cause as being 3 different possible causes. We're talking 3 entire competing paradigms, and then yeah, pretty much. "We think you're sick either because people get cancer, or they have 4 bodily humors which get imbalanced, or it's all due to malignant airs. We doctors haven't figured out which is the right paradigm, but rest assured as you die: probably one of the 3 paradigms is right!" I sure as heck wouldn't go around saying "medicine has it all figured out".

So. As I said originally: macro cannot agree on an explanation for any of the events I listed, and my examples fit your demand for examples.

We think you're sick either because people get cancer, or they have 4 bodily humors which get imbalanced, or it's all due to malignant airs. We doctors haven't figured out which is the right paradigm, but rest assured as you die: probably one of the 3 paradigms is right!

There isn't this much disagreement over macro. Especially undergrad macro.

As I said originally: macro cannot agree on an explanation for any of the events I listed, and my examples fit your demand for examples.

And I explained how one could use the models taught in macro principles to think about each example.

There isn't this much disagreement over macro. Especially undergrad macro.

The undergrad macro you've already described as so simplified that it doesn't apply to real world situations and ignores the controversy between feuding schools which bars any kind of consensus.

And I explained how one could use the models taught in macro principles to think about each example.

"With this undergrad course in the 4 humors, I hope that you will be able to use the basic principles of melancholy vs choleric etc to interpret the illnesses and personalities you see around you..."

Whatever. I'm done. I provided the relevant examples, you acknowledge that there is indeed no consensus about them, and that's all that was needed.

Should one skip right to graduate level macroeconomics, then? Or are there companion resources one might want to consume concurrently with learning undergraduate level macro? A previous poster recommended learning undergrad with a healthy dose of scepticism; if that scepticism were applied to half-truths taught in undergrad macro, would the supposed activity of 'learning about economics' become an exercise in comparing maps to their charted territory?

I am not sure that given the state of the art, macro is worth learning at all at any level for people who do not plan to go into academia specializing in macro.

This is a valuable post. I would take out the part of the title about contradicting itself, though. It's unnecessary and distracting.

Adjusted the title a bit to keep the same meaning but reduce distraction.

How does this lecture series compare with reading a good econ textbook (e.g. Greg Mankiw's "Principle of Economics")?

No idea! Haven't read a good econ textbook, probably don't have the learning style to get that much out of it.