Some Thoughts on Teaching Introductory Economics

Ramblings about teaching and a lesson about price controls

There is a common (and I believe odd) critique of introductory classes within universities. It seem pervasive across all fields. The critique is essentially that the introductory courses are too simple. In fact, in fields like history, where the introductory classes start in elementary school, the critique extends to those classes. History is more complicated, they say. I agree. History is much more complicated than what I learned in my fifth grade U.S. history course. But perhaps a 10-year-old student just needs the basic overview of events. There is plenty of time to dig into the details later once they have some basic idea of what happened and who was involved.

I see this a lot in economics. People really want to change how we teach introductory courses. Unfortunately, these changes are often attempts to bring research being done at the frontier of the field into the introductory class. I understand this impulse. If you teach at a university, you are likely also a researcher. However, even if you are in a teaching position and aren’t actively doing research yourself, you likely read and keep up with the literature. If so, you are likely pretty excited about what you and others in your field are working on. You want to share that with the world. Furthermore, you likely have the view that sharing this type of thing with students is likely to get them excited about your field as well.

Although this might spark an interest in students to pursue additional economics courses, it defeats the purpose of an introductory course. Sometimes specialists and experts seem unaware of how much of their discipline they have internalized. As a result, they don’t realize how difficult it is to communicate these ideas on the frontier of the field to students who still do not know the basics. (And this is not to mention the fact that some of the stuff currently at the frontier will prove to be wrong — at least in some ways — in the future.)

Others seem to think that all of the focus on supply and demand tends to lead students towards a pro-market bias. Students are presented with how markets work and they (allegedly) come away thinking that markets are great and always work and there isn’t enough time spent on things like market failure. Again, I find this argument lacking. Pro-market compared to what?

Nonetheless, I am also often a critic of introductory courses. I think that we could do a much better job introducing students to economics. I also think that we need much better textbooks. Too many textbooks try to be everything to everyone and end up not being particularly good at anything. The jack of all trades and the master of none, as they say.

Yet I have a very different critique. My own critique is that we do not make the introductory classes simple enough. Of course, this critique depends on what we mean by “simple.” My position is essentially that introductory courses try to introduce far too much information and far too many ideas into a single semester. On some level, one might argue that this does make things simple since the student doesn’t really have to learn much about any particular topic. Although it is true that the student might find such a class to be easy and thus conclude that economics is simple, there is a difference between easy and simple. I do not want the class to be easy. I want it to be challenging. However, I do want the class to be simple. Allow me to elaborate.

By making things simpler, I think that introductory courses should cover fewer topics. In doing so, one can continue to push on an introductory framework and really think carefully about what we can learn — and the limitations of what we can learn. The last time that I taught Principles of Microeconomics, for example, I taught the students two basic frameworks: supply and demand with price-taking firms and supply and demand with price-setting firms. That’s it.

This approach makes the class simple. However, it doesn’t make things easy. By focusing on supply and demand, the class can really push the boundaries of the framework. It turns out that you can answer a ton of practical questions using just supply and demand. Why do price-setting firms use coupons? If the government attempts to reduce the price of steak by putting a price ceiling on cows, will this make steak more affordable? In a market with price-setting firms that compete with one another, why might one of these firms lobby the government for a per unit tax instead of an ad valorem tax? Supposing you own a construction company, should you pay your workers per job, per hour, or a fixed salary?

Keeping things simple in terms of frameworks also allows one to spend a lot more time on particular topics. One topic that deserves much more attention than it often gets is the discussion of price controls. A number of introductory textbooks follow their chapters on supply and demand with a chapter on price controls. However, many of these chapters provide a very limited discussion of price controls. After describing how prices adjust to equate the quantity supplied with the quantity demanded, chapters on price controls point out that such controls (when binding) prevent price from serving this coordination function. Price ceilings thus lead to persistent shortages and price floors result in persistent surpluses. This is then followed by some handwaving about other costs of price controls and other allocation mechanisms when price is unavailable. This is unfortunate because these other costs and allocation mechanisms are actually where things get interesting. Furthermore, taking the time to get into these other costs and allocation mechanisms can really help students to better understand the basics of price controls.

This is especially important with respect to costs. Most introductory textbooks actually do a poor job of discussing the costs of price controls. In fact, most textbooks present the lower bound on the costs as the only costs.

I was reminded of this point recently when friend of the newsletter Chris Brunt published a paper on how to teach students about the costs of price controls. What Chris’s paper points out is that a basic supply and demand analysis can actually give us a lower bound and an upper bound on the costs of price controls. To understand why, let’s use an example from Chris’s paper on rent control.

Rent control is just a price ceiling on rent. The typical focus on the costs associated with rent control focus on the fact that there are gains from trade to be had that will go unrealized. Somewhere out there, a number of buyers are willing to pay more than the marginal cost of supplying an additional apartment for rent. However, the price ceiling prevents these transactions from occurring. These foregone gains from trade are one of the costs of rent control.

For most textbooks, they illustrate this with a supply and demand graph. Students learn about the Harberger triangle that illustrates the magnitude of these costs graphically. That is where the typical textbook stops.

Careful thinking about both supply and demand and the price control itself will quickly pose new questions. For example, what must we assume to believe that the Harberger triangle captures all of the costs of the price ceiling? That answer is simple. A binding price ceiling results in a shortage. The quantity demanded exceeds the quantity supplied at this artificially low price. Given the shortage, the Harberger triangle will measure the full cost of the price ceiling only if the renters with a low willingness to pay are the ones who do not get the apartments.

Is there any reason to think this would be true? After all, a persistent shortage results from the price being set too low. There is also no way to legally adjust that price to equate the quantity supplied with the quantity demanded. Nonetheless, there has to be some allocation process to determine who gets the apartments. Something must take the place of the price mechanism. It seems unlikely that some alternative mechanism for allocating the apartments will make sure they end up in their highest-valued use.

In fact, it is not hard to think of examples in which this will not be the case. Suppose available apartments are determined by making people stand in line. The allocation is then determined arbitrarily by how the line forms. One might argue that those with the highest willingness to pay will wait in the line the longest, but this isn’t necessarily true. Those with the highest willingness to pay are likely to also have the highest opportunity cost of their time. Thus, the amount of time they are willing to stand in line might be low.

Another alternative allocation might be nepotism. Landlords might notify their friends and family of available apartments before making the availability publicly known. In that case, it is also unlikely that apartments are allocated to those with the highest willingness to pay.

Finally, the explicit purpose of rent control stated by policymakers is to allow people to rent these apartments who otherwise wouldn’t be able to afford an apartment. This suggests the purpose of the law itself is to allocate these resources toward those with a lower willingness to pay.

Thus, we might think of there being two types of costs associated with price controls. There is the cost of foregone gains from trade and this other cost which results from misallocation. By misallocation, I mean that resources are allocated to those with a lower willingness to pay than those who are excluded from the resource.

But how can we teach this to our students? This seems complex. Well, we can teach this to students using the same supply and demand framework that we use for standard analysis of price controls. Chris provides some nice graphs in his paper, one of which I will now borrow.

Below is a supply and demand graph for apartments. Let’s assume that initial demand curve is illustrated by line D and the supply curve is illustrated by line S. The supply and demand curves intersect at the equilibrium price and quantity. This is point E on the graph. The gray shaded area is the total surplus from trade.

Suppose that government decides to institute a price ceiling. They set P_c as the maximum possible price one can pay for rent. Initially, this has no effect on the market since this is the price that people are already paying.

However, now suppose that people start moving into this city (possibly based on expectations of lower rent). Let’s assume that these newcomers have the same distribution of their willingness to pay as the existing residents. Now, the new demand curve is illustrated by line D’. At the price ceiling there is a deviation between quantity supplied and quantity demanded (the distance between points E and C).

The Harberger triangle is illustrated as it typically would be (the area shaded with lines). This area represents the value of the foregone gains from trade due to the price ceiling. To see why, consider that the total possible surplus from trade with these newcomers is the area GAF. However, when people are prohibited from charging a price above P_c, the total possible surplus is given as the area GEBF. The difference is the area shaded with lines, the Harberger triangle. In other words, there are buyers who are willing to pay a price above the marginal cost, but who cannot because they are prohibited from doing so by law. This is actually the lower bound on the costs associated with the price control.

In this scenario, because of the construction of this example, there is an easy way to think about the upper bound on costs associated with the price control and misallocation costs, more specifically. Since the market was already in equilibrium before the new people arrived in town, let’s assume that the previous quantity supplied continues to be inhabited by the original tenants. In that case, none of the new arrivals are able to find apartments. This is despite the fact that some of the newcomers have a higher willingness to pay than some of the current tenants. This assumption allows us to easily measure the costs of misallocation. The total potential surplus, given the price ceiling, is GEBF. We know that the total surplus prior to the arrival of the newcomers was GEF. Since the existing tenants all remain in their apartments and continue to pay the same price they did before, this is still the surplus from trade. Thus, the loss due to misallocation is the difference between the possible surplus with the price ceiling and the actual surplus associated with the existing tenants. In other words, the misallocation cost is measured by the area EBF.

In reality, it is likely that some of the newcomers would displace some of the existing tenants. In this case, the cost of misallocation would be lower. Nonetheless, we have derived an upper bound on these misallocation costs.

Overall, what this example shows is that we have a range of costs associated with the price ceiling. The lower bound on the cost of the price ceiling is the Harberger triangle, the area EAB. The upper bound on costs is the area EAF, which includes both the Harberger triangle and the misallocation costs.

This is a nice example and one that isn’t hard to teach students. Chris has other examples using different assumptions about the distribution of the willingness to pay of the newcomers as well as examples with price floors.

In my opinion, going through these types of examples and spending a lot of extra time on price controls is worth sacrificing the topics often covered at the end of the term. It is important to note that this requires spending a lot of time on supply and demand, how to measure the surplus from trade, and thinking critically about the scope of price controls and alternative allocation mechanisms.

In some ways, that is simple. Focusing on one framework and all of the questions that the framework can answer simplifies things. But it is not easy.