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Why 95% of Traders Fail

Don’t Assume What Is “Unseen” Doesn’t Exist

Economics / Economic Theory Aug 15, 2014 - 11:13 PM GMT

By: MISES

Economics

Gary M. Galles writes: The use of the ceteris paribus, or “other things equal” assumption is an essential aspect of economic education. It is an important caveat that helps make sense of a complicated world by clarifying the incentive stories that comprise the core of economics.

Unfortunately, the often unthinking acceptance of that phrase has also provided an opening for misrepresenting economic reality in analyzing government interventions. That is because governments cannot change just one incentive. As a result, assuming certain “other things equal,” when those other things inherently cannot remain equal, provides cover for omitting adverse effects.


At its heart, economics focuses on the implications of scarcity, which forces self-interested individuals to make choices. Since choices that advance one’s self-interest are ones for which their marginal expected benefits exceed the marginal expected costs at the time a decision is made, anything that can change someone’s marginal expected benefits or costs can change the choices made, which will in turn change the incentives and choices of others they interact with.

Since the world is complicated, providing many ways in which incentives can change, economics training begins with simpler incentive stories, which provide the building blocks for understanding more complex situations. So professors frame questions as: “If everything relevant other than this variable remained the same, how would changing this variable affect individuals’ choices?”

That approach leads us to the law of demand: If the price of a good rises (ceteris paribus), the opportunity cost of acquiring a particular good in terms of other goods foregone increases, so self-interested people would buy less of it. Similar assumptions also lead us to the parallel law of supply: If the price of a good rises (ceteris paribus), the benefits from producing and selling it rise, making self-interested people willing to incur higher opportunity costs to do so, increasing the quantity made available for purchase.

In all, ceteris paribus assumptions allow people to construct a powerful tool kit to identify and generalize the many incentive relationships that are important in our economic arrangements.

However, when people go from learning underlying economic principles, which “other things equal” is immensely helpful in clarifying, to the complicated real world, things get trickier. People must then also confront the problem of “adding up” or detangling multiple incentive stories, when more than one incentive determinant changes over a given period of time. And training focus on what happens, assuming other things are equal, offers inadequate protection from confusion and error when other things are unequal.

What if multiple incentive changes would each alter, say, the price of X in the same direction, other things equal? For adequate analysis, one would first have to recognize all of the relevant changes (which is very difficult when the number of possible incentives that could change is always immense), then tease out the effects of all the other incentive changes. When multiple incentive changes would change the price of X in opposite directions, both steps are again necessary. The analysis becomes much more complex.

This is one reason why translating underlying principles into more complex applications turns out to be both critically important and quite difficult. Missing just one important incentive story (an important “other thing” not equal) in an analysis can completely undermine many of its conclusions. For example, Motel 6 room rates are higher than when the chain was founded, leading one to expect fewer rooms to be rented if that was the only relevant change. But the prices of other goods and services and real incomes have also changed, along with other important determinants, resulting in more rentals at a higher money price than before.

Problems arising from simply presuming that other things are equal when evaluating situations or policies are particularly acute when one change requires other changes as well. Sometimes one change precludes another (as when spending resources on one good means they cannot be spent on others); sometimes one change requires other variables to change as well (as when government “stimulus” spending requires it to be financed via some combination of taxation, expropriation, borrowing, inflation or default). Both cases require an accurate analysis to incorporate those consequences, as well.

Unfortunately, the difficulty of recognizing all of the relevant changed incentives opens the door to ignoring important effects, hidden behind “other things equal” assumptions. That is why that trick is a mainstay of government “solutions.”

Perhaps the most common illustration of other things unequal is government stimulus spending. If someone simply ignores the question of how it will be financed and the effects that follow, people trained to accept “other things equal” as their starting point can be misled.

If government spending is paid for from current taxation, those forced to bear the burdens will take-home less purchasing power, which will adversely affect their demand for goods and services. If paid for by way of newly created money, the tax just takes a different form. If “paid for” with increased government deficits, the borrowing will leave less to fund investment. Because deficits also imply higher future taxes, whether to pay off or continue to fund the increased debt, they also crowd out future investment and consumption possibilities. Assuming that these other things will be equal when they cannot be, guarantees inaccurate analysis.

The supposed extra multiplier effects of such stimulus provide another other things unequal example. Government spending is counted as creating added income, and therefore spending, which creates more income, etc. But every iota of government-controlled resources is taken from someone. Therefore, there must be similar negative multiplier effects as well. But those can be overlooked when people don’t question whether such other things are equal.

Government regulatory interventions also suffer from ignoring other things that will be unequal.

Price floors such as the minimum wage are promoted by portraying the issue as “if you could just work for more money, you would be better off.” But that assumes workers’ hours and other terms of employment will remain equal. Unfortunately, mandating higher pay will reduce employment and/or worsen employment terms (by reducing fringe benefits, on-the-job training, work conditions, etc.). Further, overriding the market mechanism for allocating resources leads to a host of other adverse effects, such as increased discrimination.

Similarly, price ceilings such as rent control are promoted by portraying the issue as “if you could just pay less for rental housing, you would be better off.” But that assumes renters’ ability to find housing will remain equal. Unfortunately, mandating lower rents will reduce both the quantity and quality of housing available, as well as introducing other distortions.

The many forms of government protectionism justified as “economic patriotism” reflect the same error. The issue is portrayed as US producers versus foreign producers, so patriotism should lead us to favor US producers. But protectionism does not leave other things equal. In particular, it harms US consumers by taking away options they prefer (and patriotism does not justify helping some American producers beggar American consumers).

These examples illustrate how commonly “other things equal” assumptions can hide predictable adverse effects of government “solutions.” They remind us that while our analysis of policies must logically follow from our “other things equal” premises, that alone is insufficient protection from error. We must also avoid the misdirection of false premises. And an important part of our self-defense is recognizing that one cannot just assume something that must change does not.

Gary M. Galles is a professor of economics at Pepperdine University. Send him mail. See Gary Galles's article archives.

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© 2014 Copyright Gary Galles - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


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