Welcome to The Nonlinear Library, where we use Text-to-Speech software to convert the best writing from the Rationalist and EA communities into audio.
This is: Six economics misconceptions of mine which I've resolved over the last few years, published by Buck on the effective altruism forum.
Here are six cases where I was pretty confident in my understanding of the microeconomics of something, but then later found out I was missing an important consideration.
Thanks to Richard Ngo and Tristan Hume for helpful comments.
Here’s the list of mistakes:
I thought divesting from a company had no effect on the company.
I thought that the prices on a prediction market converged to the probabilities of the underlying event.
I thought that I shouldn’t expect to be able to make better investment decisions than buying index funds.
I had a bad understanding of externalities, which was improved by learning about Coase’s theorem.
I didn’t realize that regulations like minimum wages are analogous to taxes in that they disincentivize work.
I misunderstood the economics of price controls.
In each, I’m not talking about empirical situations at all—I’m just saying that I had a theoretical analysis which I think turned out to be wrong. It’s possible that in many real situations, the additional considerations I’ve learned about don’t actually affect the outcome very much. But it was still an error to not know that those considerations were potentially relevant.
1. Divestment
I used to believe that personally divesting in a company didn’t affect its share price, and therefore had no impact on the company. I guess my reasoning here was something like “If the share is worth $10 and you sell it, someone else will just buy it for $10, so the price won’t change”. I was treating shares as if they were worth some fixed amount of money.
The simplest explanation for why you can’t just model shares as being worth fixed amounts of money is that people are risk averse, and so the tenth Google share you buy is worth less to you than the first; and so as the price decreases, it becomes more worthwhile to take a bigger risk on the company.
As a result, divestment reduces the price of shares, in the same way that selling anything else reduces its price.
In the specific case of divestment, this means that when I sell some stocks, the price ends up lower than it was.
I first learned I was wrong about this from this Sideways View post, published May 2019.
2. Index funds
I used to think that it wasn’t possible for individuals like me to get higher returns than I’d get from just buying an index fund, because in an efficient market, every share is equally valuable.
This is wrong for a few reasons. One is that the prices of shares are determined by the risk aversion of other market participants; if your risk aversion is different from the average, some shares (specifically, risky ones) will be much better investments than others.
Secondly, because I’m risk averse, I prefer buying shares which are going to do relatively well in worlds where I’m relatively poorer. For example, if I’m a software engineer at a tech company, compared to a random shareholder I should invest more in companies which are as anticorrelated with software engineer salaries as possible. Or if I live in the US, I should consider investing in the markets of other countries.
I didn’t understand this fully until around April this year.
3. Prediction markets
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 that 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.
(Here’s a maybe more intuitive way of seeing th...
view more