Basic economics: a citizen's guide to the economy

BASIC ECONOMICS

BY THE SAME AUTHOR

Economics: Analysis and Issues Classical Economics Reconsidered Knowledge and Decisions Mmxism: Philosophy and Economics Say's Law

BASIC ECONOMIC

A Citizen’s Guide to theEcon

THOMAS SOWELL

A Member of the PerseusBooks Group

Copyright 0 2000 by Thomas Sowell Published by Basic Books, A Member of the PerseusBooks Group

All rights reserved. Printed in the United States of America. No part of thi reproduced in any manner whatsoever without written permissionexcep brief quotations embodied in critical articles and reviews. For information Books, 10 East 53’dStreet, New York, NY 10022-5299.

Library of Congress Cataloging-in-Publication Data Sowell, Thomas, 1930Basic economics : a citizen’s guide to the economy/ Thomas Sowell. p. cm. Includes bibliographical references and index. ISBN 0-465-08 138-X

1. Economics. I. Title. HB171 .S73 2001 33O--dc21

FIRST EDITION

010203/10987

A few lines of reasoning can changethe way we see Steven E. Lansburg

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CONTENTS PreJace Acknowledgements

1 What Is Economics? PART I: PRICES 2 TheRoleof Prices

3 PriceControls 4 An Overview

PART 11: INDUSTRY AND COMMER

5 The Rise and Fall of Businesses 6 The Role of Profits-and Losses 7 Big Business and Government 8 AnOverview PART 111: WORK AND PAY

9Productivity

and Pay

10 ControlledLaborMarkets 11 An Overview

...

Contents

V211

PART IV: TIME AND RISK 12 Investment and Speculation

13 Risks and Insurance 14 AnOverview

PART V: THE NATIONAL ECONOM

15 National Output 16 Money and the Banking System 17 The Roleof Government

18 An Overview

PART VI: THE INTERNATIONAL ECO 19 International Trade 20

International Transfers of Wealth

21 An Overview

PART VII: POPULAR ECONOMICFALL ~

22 "Non-Economic" Values 23 Prices and Purchasing Power 24

Business and Labor

25 An Overview

Sources Index

PREFACE

This is an introduction to economics for the general pu growing sophisticationof professional economistshas no companied by any greater spread of knowledge about nomic principles amongthe population at large. There very few incentives for economists to spend their time the basics of economics to the public. Indeed, even the education of college students is not likely to get much from economists,if those students are not majoring in ec The net result is that complex and high-powered analysis within the profession co-existswith utter igno gross fallacies dominating the public, the media an branches of government. Even scholars with Ph.D.s fields are often ill-informed or misinformed about ec though that seldom deters them from having and voic ions on economic issues. Most of us are necessarily ignorant of many compl from botany to brain surgery. As a result, we simply d tempt to operate in those fields. However,every voter politician that they vote for has something to say abou ics. In that case, we need to know the basics. Explainin sics isthe purpose of this book. It so happens that the first book of mine that was p back in 1971, was anintroductory economics textbook kinds of graphs and equations that such books are sup have. Today, however, Basic Economics does not contai graph or equation to express the kinds of ideas that e deal with. Nor does it contain such common jargonam omists as ”oligopoly,” ”marginal revenue product” or ”P timality.” This book about is economics, not about the v or visual aids of economists. Having taught introduc nomics more timesthan I can remember,at colleges and ties across the country, I know how handy those visua

Preface

be and how easy it is to lapse into familiar jargon. things has made it harder for meto write this book, point is to make it easier for youto read it. What I have also learned over the years is that th highly intelligent peoplewho want to understand m way their country’s economy works,but who have the paraphernalia of the economics profession. This for such people-and also for those high school an dents who are taking introductory economics as part to becomeeducated women and men, not necessarily major in the subject. It is also written with the hope th omists might discover how much of what they sayin incomprehensible tooutsiders could also be said in p In keeping with the nature of this book as an in economics for the general public, I have left out th dreds of footnotes or end-notes in some of my other ever, those who wish to check up on some of the su they will learn about can find the sources listed at book. This will also be a place for those who simp plore further in some subject that they find intriguin While it is advisable to understand the role of pric economy before going on to other subjects, each c book has been written to stand alone, so that these c read in any order that your own interest dictates. Although many of the examples of basic economi action are drawn from market economies, such a United States, many others are not. One of the best w stand what a market economy does is by seeing w when the same economic activity takes place in economy, such as that of the late Soviet Union. Eco ences from every inhabited continent appear in the follow, for basic economicprinciples are not limited society orpeople. Thomas Sowell

Rose and Milton Friedman Hoover Institution Stmzford University

!

ACKNOWLEDGEMENT

Strictly speaking,nothing is ever the product of just on as explained in Chapter 9. This book owes much to people for me to thank them all. Those who taught m was a student, many years ago, deserve great credit, for the times when they carefully explained things th have been obvious without anexplanation. I can onlyh had as much patience with the students I later taught academic career at U.C.L.A., Cornell, Rutgers, How Amherst. Among those who contributed more directly to thi reading it in manuscript and making comments and su were my wife Mary and my colleagues Professors Williams of George Mason Universityand William R. A C. L. A., as well as myfriend and New York attorney J gins. It goeswithout saying that they are not to blame maining errors or shortcomings of mine.

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Chapter 1

What Is Economics?

T

o know what economics is,we must first know wha omy is. Perhaps most of us think of an economy a for the production and distribution of the goods and s use in everyday life. That is true as far as it goes, but go far enough. The Garden of Eden was a system forth tion and distribution of goods and services, but it w economy, because everything was available in unlim dance. Without scarcity, there is no need to econom therefore no economics. A distinguished British econo Lionel Robbins gavethe classic definition of economics

Economics is the study of the useof scarce resources whi alternative uses.

What does "scarce" mean? It means that people w than there is. This may seem likea simple thing, but i tions are often grossly misunderstood, even by highly people. For example, a feature article in the New York Ti gust 1, 1999 laid out the economic woes and worries class Americans-one of the most affluent groups beings ever to inhabit this planet. Although the story picture of a middle-class familyin their own swimmin main headline says: "The American Middle, Just Ge Other headings in the article include: Wishes Deferredand Plans Unmet Goals That RemainJust Outof Sight Dogged Savingand Some Luxuries

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BASIC ECONOMICS

In short, middle-class Americans’ desires excee can comfortably afford, even though what they al would be considered unbelievable prosperity by peo other countries around the world-or even by earlie of Americans. Yet both they and the reporter regard getting by” anda Harvard sociologist spoke of ”how strained these people really are.” However, itis not man-made asa budget which constrains them: Real them. There has never been enough to satisfy ever pletely. Thatis the real constraint. That iswhat scarc Although per capita real income in the United creased 50 percent in just one generation, these mid lies ”have hadto work hardfor their modest gains,” a Fordham professor quoted in the same article. W they could not get manna from heaven! As for the their gains, this suggests that people not only adjust t tions upward with growing prosperity, but also ad rhetoric as to what it means to be ”just getting by.” Times reporter wrote of one of these middle-class fa

After getting in over their heads in credit card spen ago, their finances are now in order. ”Butif we mak move,” Geraldine Frazier said, ”the pressure we ha bills will come back, and that is painful.”

To all these people-from academia and journalis the middle-class people themselves-it apparently s somehow that there should be such a thing as scarci should imply a need for both productive efforts on personal responsibilityin spending. Yet nothing has be vasive in the historyof the human race than scarcity a quirements for economizingthat go with scarcity. Not only scarcitybut also ”alternative uses’’ are a economics. If each resource had only one use, econ be much simpler. But water can be used to produce by itself or innumerable other mixtures and compou nation with other things. A virtually limitless numbe can also be produced from wood or frompetroleum, How much of each resource should be allocated t

What Is Economics?

many uses? Every economy has to answer that ques each one does, in one way or another, efficiently or in Doing so efficiently is what economics is all about. Whether the people in a given economy will bepro poverty-stricken depends in large part on how wel sources are allocated. Rich resources often exist in countries, simply because the country lacks the econom nisms, as well as specific skills, for efficiently turning sourcesinto abundantoutput. Conversely, count relatively fewnatural resources-Japan or Switzerland ple-can have very high standards of living, if their p their economy are well adapted for allocating and us ever resources it has or canpurchase from other countr Among the many misconceptions of economics i something that tells youhow to make money or run a b predict the ups and downs of the stock market. But ec not personal finance or business administration, and the ups and downsof the stock market has yet to bere set of dependable principles. Economics is not about the financial fate of individ about the material well-being of society as a whole cause and effect relationships involving prices, ind commerce, work and pay, or the international balance all fromthe standpoint of how this affects the allocatio resources in a way that raises or lowers the material s living of the population as a whole. Money doesn’t evenhave to be involved to make ad economic. When a military medical team arrives on a where soldiershave a variety of wounds, they are conf the classic economic problemof allocating scarce resou have alternative uses. Almost never are there enoug nurses, or paramedics to go around, nor enough medica of the wounded are near death and have little chanc saved, while others have a fighting chance if they get care, and still others are only slightlywounded and wil recover whether they get immediate medical care or If the medical teamdoes not allocate its time and m efficiently, some wounded soldiers will die needlessly, w is being spent attending to others not as urgently in ne

4

BASIC ECONOMICS

or still others whose wounds are so devastating t probably die in spite of anything that can be done f an economic problem, though not a dime changes ha Most of us hate even to think of having to make Indeed, as we have already seen, some middle-cla are distressed at having to make much milder choic offs. But life does not ask what we want. It present tions. Economics is just one of the ways of trying most of those options. While there are controversies in economics, as th ence, this does not mean that economics is justa matt There are basic propositions and procedures in e which a Marxist economist like Oskar Langedid not fundamental way from a conservative economist lik man. It is these basic economic principles that this bo Much of what follows in the chapters ahead is a what happensin an economy coordinated by prices a sulting flows of money and goods in a competitive m also considers what happens when markets are not operate in thatway, whether because of business, un ernment. One of the best ways of understanding the for example, is by understanding what happens w not permitted to play their rolein the market. How d omy respond when prices are set or controlled by ment, rather than being allowed to fluctuate with demand? What happens in an economy that is cent as distinguished from onein which decisionsabout h sources and distributegoods and services are made b separate individuals, whose decisions are coordin their responses to pricemovements? All sorts of economies-capitalist, socialist, feuda determine in one way or another how the available directed toward their various uses. But how well the to poverty or affluence for a whole country. That isw of economics is all aboutand that is what makes itim

PART I: PRICES

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Chapter 2

The Role of Prices

I

n a market economy prices play a crucial role in de how much of each resourcegets used where. Yet this dom understood by the public and itis often disregard by politicians. Many people see prices as simply obstacles to th the things they want. Those who would like to live i front home, for example,may abandon such plans whe cover how expensive beach-frontproperty is. But high not the reason we cannot all live onthe beach front. O trary, the inherent reality is that there are not nearly beach-front homes to go around andprices are just a w veying that underlying reality. When many people bid tively few homes, these homes become very expensive supply and demand. But it is not the prices that cause th which would exist under whatever other social arra might be used instead of prices. If the government were to come up with a "plan" f sal access" to beach-front homes and put "caps" on the could be charged for such property, that would not c underlying reality of the ratio of people to beach-front a given population and a given amount of beach-fron rationing without prices would now have to take pla reaucratic fiat, political favoritism random or chance-bu tioning would still have to take place. Even if Congr Supreme Court were to decree that beach-front hom "basic right" of all Americans,that would still not chan derlying reality in the slightest. Prices are like messengers conveying news-somet news, in the case of beach-front property desired by fa

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BASIC ECONOMICS

ple than can possibly liveat the beach, but often als For example, computers have been getting both che ter at a very rapid rate, as a result of the developme logical ingenuity. Yet the vast majority of beneficia high-tech advances, insights, and talents have not idea of what these technical changes are specificall convey to them the end results-which are all that m own decision-making and their own enhanced prod well-being fromusing computers. Similarly, if vast new rich iron ore deposits were perhaps no more than one percent of the populati likely to be aware of it, but everyone would discove made of steel were becoming cheaper. People thinki desks, for example, would discover that steel desks more of a bargain compared to wooden desks and undoubtedly change their minds asto which kindof chase because of that. The same would be true whe various other products madeof steel tocompeting pr of wood, aluminum, plastic or other materials. In short, price changeswould enable a whole so automatically to a greater abundance of iron ore, ev percent of the people in that society were whollyun new discovery. Prices not only guide consumers, they guide p well. When allis said and done, producers cannot p what millions of different consumers want. All tha manufacturers, for example,know is that when they with acertain combinationof features they can sell price that covers their production costs and leaves t but when they manufacture cars with a different co features, they don’t sell as well.In order to get rid o cars, they must cut the prices to whatever level is n them off the dealers’ lots, evenif that means taking a ternative is to take a bigger lossby not selling thema While a free market economic system is someti profit system, it is reallya profit-and-loss system-an are equally important for the efficiency of the econo they tell the manufacturers what to stop producing

The Role of Prices

ally knowing why consumers like one set of features r another, producers automatically produce more of wh profit and less of what is losing money. Thatamounts ing what the consumers want and stopping the pr what they don’t want. Although the producers are on out for themselves and their companies’ bottom line less from the standpoint of the economy as a whole th using its scarce resources more efficiently because de guided by prices.

PRICES AND COSTS

The situation we have just examined-where the want A and don’t want B-is the simplest example of lead to efficiency in the use of scarce resources. But p least equally important in situationwhere consumers A and B, as well as manyother things, some of which same ingredients in their production. For example, not onlywant cheese, theywant ice cream and yogurt of which are made from milk.How do prices help the e determine how much milk should go to each of these p In bidding for cheese, ice cream,and yogurt, consu effect also bidding for the milk that produces them. T than comes in from the sales of these products is what producers to buy more milkto use to continue produc spective products. When thedemand for cheese goes u makers bidaway some of the milk that before went into cream or yogurt, in order to increase output the of their uct to meet the rising demand. In other words, the coo to everyone when cheese-makers demand more, so users have to cut back on howmuch milk they buy. As ducers then raise the prices of ice cream and yogurt to higher price of the milk that goes into them, consume to buy less of these otherproducts at these higher pric How will each producer know just how much m Obviously they will buy only as much milk as wil higher costs from the higher prices of ice cream and

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BASIC ECONOMICS

consumers who buy ice cream are not as discourag prices as consumers who buyyogurt are, then very lit ditional milk that goes into making more cheese wil expense of ice cream and more will comeat the expen What this all means as ageneral principle is that t one producer is willing topay for milk (orany other i the price that other producers are forced to pay for t gredient. Since scarce resources have alternative us placed on one of these uses by one individual or c comes a cost that has to be paid by others who wan of these resources away for their own use. Whatthis the standpoint of the economy as awhole, is that res flow to their most valued uses. This does not mean that one use categorically p other uses. On the contrary, adjustments are increm that amount of milk which is as valuable to ice crea or consumers of yogurt as it is to cheese purchasers to make ice cream or yogurt. Whether considering c cheese, ice cream, or yogurt, some will be anxious to tain amount, less anxious to have additional amo nally-beyond some point-indifferent to having a even unwilling to consumeany more after becoming Prices coordinate the use of resources, so th amount is used for one thing which is equal in value worth to others in other uses. Thatway a price-coord omy does not flood people with cheese to the poin are sick of it, while others are crying out in vain cream oryogurt. Absurd as such asituation would b pened many times in economies where prices do scarce resources. The Soviet economy, for exampl salable goods piling up in warehouses while people w in long lines trying to get other things that they wan cient allocation of scarce resources whichhave altern not just an abstract notion of economists. It determin or how badly millions of people live. Again, as in the example of beach-front property vey an underlying reality. From the standpoint of socie the "cost" of anything is the value that it has in alternat

The Role of Prices

cost is reflectedin the market when the price that one is willing to pay becomes a cost that others are forced order to get a share of the same scarce resource or th made from it. But, no matter whether a particular so capitalist price system or a socialist economy ora feud system, the real cost of anything is still its value in uses. The real cost of building a bridge are the other could have been built with that same labor and mater also true at the level of a given individual, even when is involved. The cost of watching a television sitco opera is the value of the other things that could have with thatsame time. Different economic systems deal with this underly in different ways and with different degrees of efficien underlying reality exists independently of whatever economic system is used. Once we recognize that, w compare how economic systems which use prices to f to share scarce resources among themselves differ in from economic systems which determine such things kings, politicians orbureaucrats issues orders saying w how much of what. During the brief era of glasnost (openness) and pere structuring) in the last years of the Soviet Union,two S omists named Nikolai Shmelev and Vladimir Popo book giving a very candid account of how their econom and this book was later translated into English. As Sh Popov put it, enterprises in the U.S.S.R. “always as than they need” in the way of raw materials, equip other resources used in production. ”They take every can get, regardless of how much they actually need, worry about economizing on materials,” according to t omists. ”After all, nobody ’at the top’ knows exactly wh requirements are,” so “squandering” makes sense. The consequence was that far more resources we produce a given output in the Soviet economy as com price-coordinated economic system, such as that in States. Citing official Soviet statistics, the Soviet e lamented:

BASIC ECONOMICS

According to the calculations of the Soviet Institute Economy and International Relations, we use 1.5 ti materials and2.1 times more energy per unit of nation than the United States.. . . We use 2.4 times more me of national income than the U.S. . . . This correlation even without special calculations: we produce an to 2 times more steel and cement than the United lag behind by at least half in production of items der them. . . . Recently, in Soviet industry the consump cal energy exceeded the American level, but the vo dustrialoutputinthe U.S.S.R.is-bythemostgenerous estimates-only 80 percent of the American level.

The Soviet Union did not lack for resources, bu one of the most richly endowed nations on earth. W was an economic system that made efficient use sources. Because Soviet enterprises were not under nancial constraints as capitalist enterprises, they ac machines than they needed, ”which then gather d houses or rust out of doors,” as the Soviet econom short, they were not forced to economize-that is, t resources as both scarce and valuable in alternative u Such a waste of inputs as these economists des not of course continue in the kind of economy where would have tobe purchased and where the enterpris survive only by keeping its costs lower than its sale such a price-coordinated capitalist system, the amo ordered would be based on the enterprise’s most a mate of what was really needed, not onhow much could make sound plausible to higher government o cannot possibly be experts on all the wide range of in products they oversee. The contrast between the American and the Sovi is just one of many that can be made’betweenecono which use prices to allocate resources and those whic on government control. In other regions of the world in other political systems, there have been similar tween places that used prices to ration goods and

The Role of Prices

sources versus places that have relied on heredita elected politicians orappointed planning commissions When many African nations achieved independe 1960s, a famous bet was made between the presiden and the president of the neighboring Ivory Coast a country would be more prosperous in the years ahe time, Ghana was not only more prosperous than the Iv it had more natural resources, so the bet might have se less on the part of the president of the Ivory Coast. H knew that Ghana was committed to a government-ru and the Ivory Coast to a freer market. By 1982, the Iv had so surpassed Ghana that the poorest 20 percent of had ahigher real incomethan most of the people in Gh This couldnot be attributed to any superiority of t or its people. In fact, in later years, when Ivory Coast eventually succumbed to the temptation to have the g control more of their country’s economy, while Gha learned from its mistakes and began to loosen govern trols, these two countries’ roles reversed-and now economy began to grow, while that of the Ivory Coast Similar comparisons could be made between B Thailand, the former having had the higher standard o fore instituting socialism and the latter a much higher s living afterwards. Other countries-Germany, Korea, S New Zealand-have experienced sharpupturnsin economies when they freed these economies fromma ment controls and relied more on prices to allocate re In China,government controls were relaxed in part nomic sectorsand in particular geographic regions dur forms of the 1980s, leading to stunning economic contr the same country, as well as rapid economic growth 1978, less than 10 percent of China’s agricultural outpu in open markets but, by 1990,80 percent was. The net more food and agreater variety of food available to c in China and a rise in farmers’ income by more than within a few years. In contrast to China’s severe econ lems under heavy-handed government control under died in 1976, the subsequent freeing up of prices in t

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place led to an astonishing economic growth rate of 9 year between 1978 and 1995. While history can tell us that such things happen ics helps explain why they happened-what there is that allows them to accomplish what political contro omy can seldom match. There is more to economics but understanding how prices function is the found derstanding the rest of economics. In a society of millions of consumers, no given i set of government decision-makers sitting around a ta sibly know just how much these millions of consume product to another,much less thousands of products of other products. In an economy coordinated by pr has to know. Each producer is simply guided by wh producer’s product can sell for and by how much m for the ingredients that go into making that product. Knowledge is one of the most scarce of all reso pricing system economizes on its use by forcing th most knowledge of their own particular situation to m goods and resources based on that knowledge, rat their ability to influence other people. However much may be valued by intellectuals,it is not nearly as effic conveying accurate information as confronting pe need to ”put your money where your mouth is.” Human beings are going to make mistakes in any nomic system. In a price-coordinated economy, any p uses ingredients that are more valuable elsewhere is cover that the costs of those ingredients cannot be what the consumers are willing to pay for the produ he has had to bid these resources away from altern paying more than these resources are worth to some ternative users. If it turns out that these resources a valuable in the uses to which he puts them, he is g money. There will be no choice but to discontinue product with those ingredients. For those producers blind or too stubborn to change, continuing losses w businesses into bankruptcy, so that the waste of sources will be stopped that way.

The Role of Prices

In a price-coordinated economy, employees and c sist on being paid, regardless of whether the managers ers have made mistakes. This means that businesse only so many mistakes forso long before theyhave to or get stopped-whether by an inability to get the labo plies they need or by bankruptcy. In a feudal economy ist economy, leaders can continue to make the same indefinitely. The consequences are paid by others in th standard of living lowerthan it would be if there were ficiency in the use of scarce resources. As already noted, there were many productswhich unsold in stores or in warehouses in the Soviet Union, were desperate shortages of other things. But, in a pr nated economy, the labor, management, and physica that went into producing unwanted products wouldh go into producing something that could pay its own sales-that is, into producing something that the con wanted more than they wanted what was actually pr the absence of compelling pricesignals and the threat o losses to the producers that they convey, inefficiency could continue indefinitely or until such time as e reached proportions big enough and blatant enough to attention of central planners in Moscow, who were p with thousandsof other decisions. Ironically, the problems caused by trying to run an by fiat or by arbitrarily-imposed prices created by g dictates were foreseen by Karl Marx and Friedrich Eng ideas the Soviet Union claimed to be following. Enge out that price fluctuations have ”forcibly brought ho commodity producers what things and what quantito ciety requires or does not require.” Without such a m he demanded to know ”what guarantee we have that quantity andnot more of each product will beproduce shall not go hungry in regard to corn and meat wh choked in beet sugar and drownedin potato spirit, th not lack trousers to cover our nakedness while trous flood us in millions.” Marx and Engels apparently u economics much better than their latter-day followers.

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PRICES IN ACTION

There is perhaps no more basic or more obvious economics than the fact that people tend to buy mo price and less at a higher price. By the same token, produce goods or supply services tend to supply mor price and less at a lower price. Yet the implications principles, singly or in combination, cover a remarka economic activities and issues-and contradict an markable range of misconceptions and fallacies. When people try to quantify the country’s ”need that product of service, they are ignoring the fact tha fixed or objective ”need.” The fact that people dema lower price and less at ahigher price may be easy to but it is also easy to forget. Seldom, if ever, is there a tity demanded. Likewise, there is no fixed supply. Statistics on th petroleum, iron ore, or other natural resources seem that this is just a simple matter of how much physical in the ground. In reality, most natural resources are varying costs of discovery, extraction, and process some oil that can be produced for $10 a barrel and o cannot pay for all its costs at $20 a barrel, but which barrel. The quantity supplied varies directly with the pri quantity demandedvaries inversely with the price. When the price of oil falls,certain low-yield oil down because the cost of extracting and processing these wellswould exceed the price it would sell forin If the price later rises-or if the cost of extraction or lowered by some new technology-then such oil we back in operation again. There is no fixed supply most other things. When people project that there will bea shortage or teachers or housing in the years ahead, they usua nore prices or implicitly assume that there will be a sh day’s prices. But shortages are precisely what cause At higher prices, it may be no harder to fill vacanc neers or teachersthan today and no harder to find ho

The Role of Prices

ing rents cause more homes and apartmentbuildings t Price fluctuations are a way of letting a little knowledge way. Price changesguide people’s decisionsthrough tr ror adjustments to what other people can and will pa sumers, as well as whatthey canand will supply aspro The producer whose product turns out to have the tion of features that are closest to what the consumers r may be no wiser than his competitors. Yet he can grow his competitors who guessed wrong go bankrupt. But result is that society as a whole gets more benefits from resources by having them directed toward where those produce the kind of output that millions of people wan of producing things that they don’twant.

Rationing by Prices

There are all kinds of prices. The prices of consum are the most obvious examples but labor also has pri wages or salaries, and borrowed money has a price ca est. In addition to prices for tangible things, there are services ranging from haircuts to brain surgery and fr ogy to advice onspeculating in gold or soybeans. In so far as these prices result from supply and de free market, they play very similar roles in allocating sources whichhave alternative uses. So long as people spend their money for what they see fit, price chang sponse to supply and demanddirect resources to wher most in demand and direct people to where their desi satisfied most fully by the existing supply. Simple as all this may seem, it contradicts many w ideas. For example, high prices are often blamed on ”g people often speak of something being sold for more tha value, orof workers beingpaid less than they are ”real To treat prices as resulting from greed impliesthat set prices wherethey wish, that prices are not determin ply and demand. It may well be true that some-or allprefer to get the highest price that they can. But it is eq that buyers usually wish to pay the lowest price th

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goods of a given quality. More important, the comp merous buyers and numerous sellers results in pric each individual buyer and seller with very little leew depends onboth parties agreeing to the same terms. doesn’t offer as good a deal as a competitor is likely self with nobody willing to make a deal atall. The factthat prices fluctuate over time, and occas sharp rise or a steep drop, misleads some people in that prices are deviating from their ”real” values. B level under usual conditions is no more real or val much higher ormuch lower levelsunder different co When a large employer goes bankrupt in a smal or simply moves away to another state or country, business’ former employees may decide to move a selves-and when their numerous homes go on sal small areaat the same time, the prices of those house be driven downby competition. But this does not m are selling for less than their ”real” value. The valu this particular community has simply declined with job opportunities, and housing prices reflect that un The new and lower prices reflect the new reality a previous prices reflected the previous reality. A sur prices in a number of upstate New York cities tha population in the 1990s found that home prices w these communities, while home prices were rising the state and around the country. Thisis exactly wha expect on thebasis of basic economicprinciples. Conversely, when some natural disaster such asa flood suddenly destroys many homes in a given are hotel rooms in thatarea may suddenly rise, as many pete for a limited number of rooms, in order to av outdoors or having to double up with relatives an having to leave the community. People who charge higher prices for hotel room things in short supplyin the wake of some disaster, likely to be condemned for ”greed,” but in fact the between supply and demand haschanged. Prices ar forming one of their most important functions-ratio

The Role of Prices

resources. When some disaster suddenly makes these even more scarce than usual, it is important that prices underlying realit5 so as to reduce the demand thateac ual makes on the reduced supply. Regardless of what hotel owners charge, a sudden spread destruction of housing in a given area means may be not nearly enough hotel rooms for all the disp ple to get the kinds of accommodations they would lik had remained at their previous levels afterthe hurrican of four might well rent two rooms-one for the paren for the children. But when hotel prices shoot up well be usual level, allfour family members may crowd into on order to save money, leaving the other room forother p have likewise losttheir homes and are equally in need The more stringent scarcity of housing in the wake spread destruction of homes is inherent, even if temp prices merely reflect that underlying reality. If the go were to impose price controls under these conditions, who happenedto get tothe hotels first would take up m and leave more latecomers without a place tosleep ind Similarly, if local electricpower lines wereput out o sion for a few days, the demand for flashlights in that c might suddenly increase, causing prices to rise before ments of flashlights could arrive. Had prices remaine previous level, a family might buy several flashligh each member couldhave one. But, at the suddenly hig they would more likelybuy only one ortwo, leaving m lights for others with a similarly urgent need. In short, prices forcepeople to share, whether or no aware of sharing. Prices perform this function both times and in emergency times. While sharply higher p be resented during emergencies, their functions are e urgently needed at such times.

Prices and supplies

Prices not only ration existing supplies, they also a erful incentives to cause supplies to rise or fall in re

20

BASIC ECONOMICS

changing demand. When a crop failure in a given reg sudden increase in demand for imports of food into food suppliers elsewhere rush to be the first to get th to capitalize on the high prices that will prevail unt plies arrive to drive food prices back down agai means, from the standpoint of the hungry people in t that food is being rushed to them at maximum speed suppliers, probably much faster than if the same foo transported to them by salaried government employ humanitarian mission. Those spurred on by greed may well drive thr night or takeshort cuts through rough terrain, while ing ”in the public interest”are more likelyto proceed a pace and by safer or more comfortable routes. In short to do more for their own benefit than for the bene Freely fluctuating prices can makethat turn out to b others. In the caseof food supplies, earlierarrival can ence betweentemporary hunger and death by starvat Where there are local famines in Third World c not at all uncommon for food supplied by internatio to the national government to sit spoiling on the doc ple are dying of hunger inland. Much as we may de greed, it is likely to move food much faster, saving fa In other situations, the consumers may not wa less. Pricesalso convey this. When automobiles bega horses and buggies in the early twentieth century, the saddles, horseshoes, carriages and other such parap clined. As the manufacturers of such products faced of profits, many began to abandon their occupatio lines of work in which higher incomes could be had effort, investment, and risk. In a sense, it is unfair when some people are una much as others with similar skills, diligence, and o Yet this unfairness to particular individuals is wh economy as a whole operate more efficiently for t vastly larger numbers of others.

Chapter 3

Price Controls

N

othing shows the role of price fluctuations in a fr like the absence of such price fluctuations. Wha when prices arenot allowed to fluctuate freely accordin and demand, but instead are set bylaw, as under variou price-control legislation? Price controls have existed, at o another, in countries around the world over a period of c in fact, for thousands of years-and have applied to e from food tohousing to gasolineand medical services. Typically, price controls are imposed in order to ke from rising to the levels that they would reach in respon ply and demand. The political rationales for such laws ied from place to place and from time to time, but there a lack of rationales whenever it becomes politically ex hold down someone’s prices in the interests of som whose political support seems more important. Examples include rent control, food price ceilings, controls on medical services-all designed to set a lim high prices cango. In addition to laws putting a ”ceilin high prices willbe allowed to rise,there are also laws es ”floor” prices, which limit how far prices will beallowe Many countries have set limits to how low certai tural prices will be allowed to fall, sometimes with th ment being obligated to buy up the farmer’s output free market prices go below the specified levels. Equa spread are minimum wage laws, which set a lower lim low a worker’s wage rate may be. Here the governme offers tobuy up the surplus labor which the free marke employ, though it usually offers unemployment comp

22

BASIC ECONOMICS

covering some fraction of the wages that might ot been earned. To understand the effects of price control, it is derstand how prices rise and fall in a free market. T ing esoteric about it, but it is important to be ver what happens.Prices rise becausethe amount dem the amount supplied at existing prices. Prices fall amount suppliedexceeds the amount demanded at The first case is called a "shortage" and the secon "surplus"-but both depend on existing prices. Simple as this might seem, it is often misunders times with disastrous consequences. A closer exam why shortages persist when the government sets a price lowerthan whatit would be in a free market an plus persists when the government sets minimum p products higher than these priceswould be in a free

PRICE CEILINGS AND SHORTAGES

When there isa "shortage" of a product, there is ily any less of it, either absolutely or relativeto the nu sumers. During and immediately after the Second W example, therewas a very serious housing shortage States, even though the population and the housin both increased about 10 percent from their prewa there was no shortage when the war began. In other words, even though the ratio between people had not changed, nevertheless many Amer for an apartment during this period had to spend we months in an often vain search for a place to live, o to bribes to get landlords to movethem to the top of Meanwhile, they doubled up with relatives, slept used other makeshift livingarrangements. Although there was no less housing space per fore, the shortage was very real at existing prices, wh artificially lowerthan they would have been becaus laws that had been passed during the war. At these

Price Controls

prices, more people had a demand for morehousing spa fore rent control laws were enacted. This a practical is co of the simple economic principle already noted in Cha the quantity demanded varies with how high or low t Some people who would normally not be renting apartments, such as young adults still living with their some single or widowed elderly people living with were enabled by the artificially low prices created by re to moveout andinto their own apartments. These arti prices also caused others to seek larger apartments would ordinarily be living in. More tenants seeking b apartments and larger apartments created a shortag greater physical scarcity of housing relative to the p When rent control laws expired or were repealed, th shortage likewise quicklydisappeared. As rents rosein a free market, some childless coup four-bedroom apartments decided that they could livein room apartments. Some late teenagers decided that t continue living with mom and dad a little longer, unti rose enough for them to afford their own apartments apartments were no longer artificially cheap. The net that families looking for a place to stay found more pl able, now that rent-control laws were no longer kee places occupied by people with less urgent requirement None of this was peculiar to the United States. The nomic principles can be seen in operation around the down through history. Rent control had very much th fects in Sweden. As of 1940, there were 6,330,000 peopl Sweden and there were 1,960,000 dwelling units to hou about 31 housing units for every 100 people. Over the number of housing units rose relative to the populati units per 100 people in 1965 and 43 units per 100 1973"and yet the average waiting time forgetting a pl also rose. Therewas a 9-month wait in 1950, a 23-mon 1955 and a 40-month wait by 1958, for example. In longer waits for housing was not due to any less hous portion to the population. There wasno grenter scarcity bu

a greater shortage.

24

BASIC ECONOMICS

As incomes in Sweden rose much faster than r lowed to rise under rent control laws, more and mo gan to occupy their own independent housing uni harder for others to find places to live, even with a m ernment-sponsored program to build more dwelling unmarried young adults, who would normally still b their parents or renting a room from someone else, they could afford to get theirown apartments.Before less than one-fourth of all unmarried adults in Swe own separatehousing units in 1940, but thatproport just overhalf did by 1975. Not only was the actual physical amount of ho than before, Sweden was in fact building more hou son than any other country in the world during this ertheless, the housing shortage persisted and got 1948, there were about 2,400 people on waiting lists f Sweden but, a dozenyears later, the waiting list had times asmany people, despite afrantic building of m When eventually rent control laws were repealed housing surplus suddenly developed, as rents rose curtailed their use of housing as a result. Again, th "shortages" and "surpluses" are matters of price, n physical scarcity,either absolutely or relative tothe p With rent control ended, private developers in began building more housing as rents rose-and pro ing more in keeping with what the public wanted, a guished from the kind of housing produced by the under political and bureaucratic incentives. Therefo government-sponsored housing which became vaca so as to become a drainon the public treasury. Think of all the needless grief and wasted resourc have been avoided if the Swedish voters had been basic economic principles and understood that the s housing problems were the very attempts to make h "affordable" by rent control. Nodoubt there were S mists who understood this, but there are seldom en mists in any country to have enough votes to sw made by politicians.

Price Controls

During the period when rent control laws were i Australia, they had the same effect as they had in Swed people per dwelling unit and long waits for others see ing. Similarly, a study of housing in New York City fou apartments where one person occupied 4 or more room elderly people in rent-controlled apartments. In the normal course of events, people’s demand f space changes overa lifetime. Their demand for space creases when they get married and have children.But, after the children havegrown up and moved away, the mand for spacetends to declineand it often declines ye a spouse dies and a widow or widower moves into sm ters or goes to live with relatives. In this way,a society’s of housing is shared and circulated among people ac their changingindividual demands at different stagesof The individuals themselves do not do this out of a s operation, but because prices-rents in this case-convey the value that other tenants put on housing. Young cou growing family are often willing to sacrifice some goods and services in order to have enough money lef more housing space. Parents may go out to restaurants less often, or buy new clothes or new cars at longer in order that each child may have his or her own bedr once the children are grown and gone, such sacrific longer make sense,when additional other amenities c enjoyed byreducing the housing space being rented. Given the crucial roleof prices in this process, supp the process by rent control laws leaves elderly people incentive to vacate apartments that they would norma if that would result in a significant reduction in rent an sponding enhancement of their living standards in othe Moreover, the chronic housing shortages which accom control greatly increase the time and effort required to a new and smaller apartment, while reducing the fin ward for finding one. In short, rent control reduces housing turnover. New York City has had rent control longer and m gently than any other major American city.One conseq

26

BASIC ECONOMICS

been that the annual rate of turnover of apartments is lessthan half the national average and the proporti who have lived in the same apartment for 20 yea more than double the national average. As the Ne summarized the situation in 1997:

New York used to be like other cities, a place where tena moved frequently and landlords competed to rent e ments to newcomers, but today the motto may as migrants Need Apply. While immigrants are crowd in illegal boarding houses in the slums, upper-m pay low rents to live in good neighborhoods, oftenin l ments they no longer need after their children m

Rent control has effects on supply as well as on d years after the end of World War 11, not a single new been built in Melbourne, Australia, because of rent which made buildings unprofitable. Declines in b struction have likewise followed in the wake of rent elsewhere. After rent control was instituted in Santa fornia in 1979, building permits declined to less th what they were just five years earlier. In Paris, subje trol beginning in the First World War and continuin Second World War, new apartment buildings becam a 1948 survey showed that 90 percent of the city’s bu built before the First World War, more than half bef more than a quarter before 1850. Not only isthe supply of new apartment construc rent control, even the supply of existing housing ten as fewer people are willing to rent to others after artificially low by law. During 8 years of rent controli during the 1970s, the city’s available housing stock solutely from just over 199,000 units on the market 176,000 units. After rent control was introduced in B fornia, thenumber of private housing units available the university there declined 31 by percent in five ye Sometimes the reduction in housing units on th curs because people who had been renting rooms o

Price Controls

in their homes, orbungalows in their back yards, decid no longer worth the bother at rents kept artificially l rent control laws. In addition, there are often conv apartments to condominiums and an accelerated deter the existing housing stock, as landlords provide less ma and repair under rent control, sincethe housing shortag unnecessary for them to maintaintheappearance premises in order to attract tenants. Studies of rent con United States, England, and France found rent-contro ing to be deteriorated far more often than non-renthousing. Typically, the rental housing stock is relatively fi short run, so that a shortage occurs first because mo want more housing at the artificially low price. Later, be a real increase in scarcity as well, as rental units d more rapidly with reduced maintenance, while not en units are being built to replace them as they wear ou new privately built housing would be unprofitable u control. Under rent control in England and Wales, for privately-built rental housing fell from 61 percent of a in 1947 to 14 percent by 1977. A study of rent contro America and in Britain, France, Germany, and the Ne concluded: ”New investment in unsubsidized rented essentially nonexistent in all the European countries except forluxury housing.’’ In short, a policy intended to make housing afforda poor has thenet effect of shifting resourcestoward hous able only by the affluent, since luxury housing is oft from rent control. Among other things, this illustrates importance of making a distinction betweenintentions quences, which means analyzing economic policies in te incentives created by them, rather than the hopes tha them. In terms of incentives, it is easy to understand pened in England when rent controlwas extended in 19 furnished rental units. According The to Times of London

Advertisements for furnished rental accommodations Lolldon Evezzing Stnndavd plummeted dramatically in th

28

BASIC ECONOMICS

week after the Act came into force and are now run 75 percent below last year’s levels.

Since furnished rooms are particularly likely to homes, these represent housing units that are easil from the market when the rents no longer compens conveniences of having renters living with you. Ho when rent control applies to separate apartment buil the landlord typically does not live, eventually the p reached where the whole building becomes sufficie itable to be abandoned. In New York City, for exa buildings have been abandoned after their owners possible to collect enough rent to cover the costs of they are legally required to provide. Such owners disappeared to escape the legal consequences of th ment, and such buildings often end up boarded up, t ically sound enough to house people if maintained. The number of abandoned buildings taken over York City government runs into the thousands. It h mated that there are at least four timesas many aban ing units in New York City as there are homeless p streets there. Such inefficiency in the allocation means that people aresleeping outdoors on the pave winter nights-some dying of exposure-while t housing them already exist, but are not being use laws designed to make housing ”affordable.” Onc demonstrates that the efficient or inefficient allocat resources is not just some abstract economic notion, real-and sometimes very painful-consequences, even include matters of life and death. It also illust goal of a law-”affordable housing,” in this case-is portant than its consequences. Just as rent control reduces the housing stock, th control oftenmarks the beginning of private buildin Sweden. In Massachusetts in the 1990s, a state ban control laws led to the building of new apartments rent-controlled cities forthe first timein 25 years.

Price Controls

In short, with housing as with other things, less iss a lower pricethan ata higher price-less both quantita qualitatively. Polls of economists have found virtual mous agreement that declines in product quantity and q the usual effects of price controls in general. Of course not enough economists in the entire country for thei matter very much to politicians, who know that there a more tenants than landlords and more people who do n stand economics than there are who do. Politically, rent often a big success, however many serious economic a problems it creates. Often it is politically effective to represent rent co way to keepgreedy rich landlords from "gouging" the "unconscionable" rents. In reality, rates of return on in in housing are seldom higher than on alternative inv and landlords are often people of very modest means. pecially so for owners of small, low-end apartment buil are in constant need of repair, with many of these landlo handymen who use their own skills and labor to ma premises. In short, the kind of housing likely to berent poor often also has owners who are by no means rich. Where rent control applies to luxury housing, th may be quite affluent, even though their rents are kept fraction of their free-market value. In Manhattan, for the chairman of the New York Stock Exchangepaid less a month for a rent-controlled apartment on fashionab Park South. Another tenant on Central Park South paid a month for a six-room apartment. Hollywood star She ters, who owned a home in Beverly Hills, also rented a room apartment in Manhattan for a rent-controlled pr than $908 a month. New York Mayor Ed Koch paid less of that for his rent-controlled apartment in Washingto which he kept during the entire 12 years when helived Mansion, the official residence of the mayor. Thereare n other examples of members of the economic, political tural elites renting apartments-sometimes multiple a for the same individual -at a fraction of what such a

30

BASIC ECONOMICS

cost to someone new to the city who is seeking a p buildings that are not covered by rent control. Meanwhile, city welfare agencies pay far more r poverty-stricken family in some cramped and ro apartment in a run-down hotel. The idea that rent co poor tenants from rich landlords may be politically it bears little resemblance to the reality. Where ren apply on a blanket basis to all housing in existence the law goes into effect, luxurious housing beco housing. Then, after it becomes clearthat no new ho to be built unless it is exempted from rent control, tions or relaxations of the rent control that still appl apartments means that even new apartments that ar in size and quality may rent for far more than old cious and more luxurious apartments. This non-com rents is not peculiar to New York City. It is commo cities under rent control. Ironically, cities with strong rent control laws, York, tend to end up with higher average rents than rent control. Where such laws apply only to rents specified level,presumably to protect the poor, build incentives to build only apartments luxurious enoug the rent-control level. Rich and poor alike who mov after rent control has created a housing shortage typ find a rent-controlled apartment, and so have availab ing that costs more than it would in a free market, housing shortage. Not surprisingly, homelessness greater in cities with rent control. In order to demonstrate in a different way the c tion between an increased scarcity-where fewer go able relative to the population-and a ”shortag phenomenon, we can consider a case where the actu housing suddenly declined ina given area without a trol, as happened in the wake of the great San Fra quake and fire of 1906. More than half the city’s ho was destroyed during this catastrophe in just three d single major hotel remained standing. Yet there wa shortage.

Price Controls

When the Son Francisco Clzvonicle resumed publi month after the earthquake, its first issue contained 64 ments of apartments or homes for rent, compared to o from people seeking apartments to live in. Of the 200,0 suddenly made homeless by the earthquake, temporar housed 30,000 and an estimated 75,000 left the city. Sti nearly 100,000 people to be absorbed into the local hou ket. Yet neither the newspapers nor other documents of mention any housing shortage or any of the things th pany housing shortages, such as lengthy searches or b to landlords. Rising prices not only allocated the exist ing, they provided incentives for rebuilding. In short, just as there can be a shortage without an physical scarcity, so there can be a greater physical sca out any shortage. People made homeless by the San earthquake found housing more readily than people ma less by New York’s rent control laws that took thou building off the market. Similar economic principles apply in other market the gasoline ”crisis” of 1972 and 1973, when oil prices artificially low by the federal government, there were of automobiles waiting at filling stations in cities a United States, but there was in fact 95 percent as much sold in 1972 as there was in the previous year, when t no gasoline lines at the filling stations, no shortage and atmosphere. Similarly, during the gasoline crisis of amount of gasoline sold was only 3.5 percent less th record-breaking yearof gasoline salesin 1978. In fact, th of gasoline sold in 1979 was greater than the gasoline tion in any other previous year in the history of the co cept 1978. In short, there was a minor increase in scar major shortage, with long lines of motorists waiting at tions, sometimes for hours, before reachingthe pump. Just as price controls on apartments cause a cutback ing, maintenance,and other auxiliary services that go w ments, so price controls on gasoline led to a cutback auxiliary services as checking tires, cleaning windshie

32

BASIC ECONOMICS

above all-on the hours that filling stations remai their customers’ convenience. Because of the long lines of automobiles waiting line during the shortage, filling stations could sell al had continuously for a relatively few hours and the for the day when their pumps were empty, instead stay open aroundthe clock to dispense the same am line at a normal pace, with cars stopping in at wh were convenient to the motorists. In New York City the average filling station was open 110 hours a wee ber 1978, before the shortage, but only 27 hours a 1979, during the shortage. Yet the total amount pumped differed by only a few percentage points b two periods. In short, the problem was not a gre scarcity but a shortage at artificially low prices. Sh that the seller no longer has to please the buyer. Tha lords can let maintenance and other services deter rent control. In this case, the filling station owners c the hours during which they had to pay attenda money they had to spend on electricity and other co ing open long hours. No doubt many or most of whose daily lives and work were disrupted by hav hours waiting in line behind other cars at filling st gladly have paid a few cents more per gallon of gaso to avoid such inconveniences and stress, but price vents buyers and sellers from making mutually a transactions on terms different fromthose specified i Bolder and less scrupulous buyers and sellers m advantageous transactions outside the law. Price co invariably produce black markets, where prices higher than the legally permitted prices, but also hig would be in a free market, since the legal risks must pensated. While small-scale black markets may fu crecy, large-scale black markets usually require brib to look the other way. In Russia, for example,a loca shipment of price-controlled food beyond regiona was dubbed the ”150-ruble decree,” since this wa bribing police tolet the shipments pass through chec

Price Controls

PRICE FLOORS AND SURPLUSES

Just as a price set below the level that would preva ply and demand in a free market tends to cause more manded and less to be supplied, creating a shorta imposed price, so a price set above the free market lev cause more to be supplied than demanded, creating Simple as this principle is, it is often lost sight of in th more complexevents and more politically popular belie One of the classic examples of a lower limit to p posed by government have been the American ag price-support programs. As often happens, a real bu problem led to the establishment of enduring govern grams, which long outlived the conditions that initia them to be created. Among the many tragedies of the Great Depress 1930s was the fact that many farmers simply could enough money from the sale of their crops to pay their prices of farm products fell much more drastically than of the things that farmers had to buy. As many farmer farms because they could no longer pay the mortgag other farm families sufferedprivations as they struggle on to their farms and their traditional way of life, the fe ernment sought to restore ”parity” between agriculture sectors of the economy by intervening to keep farm p falling so sharply. This intervention took various forms. One approa reduce the amount of various crops that could be g sold, so as to avoid driving the price below the level t government had decided upon. Thus, the supply of pe cotton were restricted by law. Thesupply of citrus fruit various other farm products were regulated by local farmers, backed up by the authority of the Secretary o ture to issue ”marketing orders” and prosecute those lated these orders by producing and selling more than authorized to produce and sell. Sucharrangements con decades after the poverty of the Great Depression wa by the prosperity of the boom following WorldWar 11.

34

BASIC ECONOMICS

These indirect methods of keeping prices artifici only part of the story. The key factorin keeping farm cially higher than they would have been under free ply and demand was the government’s willingness t surpluses created by its control of prices. This they farm products as corn, rice, tobacco, and wheat, amo Price controlin the form of a ”floor” under price them from falling further, produced surpluses as dra shortages produced by price control in the form of a ” venting them from rising higher. In some years, the ernment bought more than one-fourth of all the wh the country and took it off the market, in order to ma at a pre-determined level. During the Great Depression of the 1930s, agric support programs led to vast amounts of food being destroyed at a time when malnutrition was a seriou the United States and hunger marches were taking across the country. For example, the federal governm million hogs in 1933 alone and destroyed them. Hug farm produce were plowed under, in order to keep io and maintain prices at the fixed level, and vast amo were poured down the sewers for the same reason children were suffering from diseases caused maln by Still, there was a food surplus. A surplus, like a price p1zemrnenu1z. It does not mean that there is som tive to the people. There was not ”too much” food r population during the Great Depression. The peopl not have enough money to buy everything that was the artificially high prices fixed bythe government. The food surpluses under ”floor” prices were a housing shortages under ”ceiling” prices. The vas storage space required to keep surplus crops off the m times led to such desperate expedients as storing thes ucts in unused warships, when all the storage facil had been filled to capacity. A series of bumper crops the federal government’s having more wheat in stor grown by American farmers all year.

Price Controls

How to get rid of all this surplus farm produce was ing question for which all sorts of answers were devise years. In theory, the surpluses built up duringbumper could be sold in the marketplace during years when t smaller crops, without driving the price down below support level. In practice, however, this provided little ten the surplus food was either sold to other countrie prices than the American government had paid for it given away overseas to meetvarious food emergencie in various countries from time to time. The costof agricultural price support programs to t ers reached a peak of more than $16 billion in 19 changes in the laws and policies cut that in half by 1 ever, this does not count the additional billions paid by in the form of artificially higher food prices.For examp the mid-l980s, when the price of sugar on the world m four cents a pound, the wholesale price within the Un was 20 cents a pound. Although the original rationale for such program save the family farm, in practice more of the money w agricultural corporations, some of which received mill lars each, while the average farm received only a few dollars. What is crucial from the standpoint of understandin of prices in the economy is that surpluses are as much keeping prices artificiallyhigh as shortages are of keep artificially low.Nor were the losses simply the sums of tracted from the taxpayers or the consumers for the agricultural corporations and farmers. These are simp transfers among Americans, which do not directly redu tal wealth of the country. The real losses the to country come fromthe misallocation of scarce resourceswhich h native uses. Scarce resources such as land. labor, fertilizer, and are needlessly used to produce more than the consume ing to consumeat the artificially high prices decreed by government. Poor people,who spend an unusually hig

BASIC ECONOMICS

age of their income on food, are forcedto pay far mo sary to getthe amount of food they receive, leaving money for other things. Thoseon food stamps are ab food with those stamps when food pricesare artificial From a purely economic standpoint, it is working poses to subsidize farmers by forcing food prices subsidize some consumers by bringing their partic food down with food stamps. However, from a po point, it makes perfect sense to gain the support of sets of voters, especially since most of them do not un full economic implications of the policies. Setting a "floor" under prices has not been con culture, nor to the United States. Most of the leadi nations of the world subsidize agricultural prices, la same political reasons that led the United States to when these subsidies and controls originated durin as a humanitarian measure, they have persisted lon times because they developed an organized constit threatened to create political trouble if these subsid trols were removed or even reduced. Farmers have streets of Paris with their farm machinery when the ernment showed signs of scaling backits agricultura allowing more foreign farm produce to be imported farmers protesting low wheat prices blocked hi formed a motorcade of tractors to the capital city of O It has not been uncommon for governments in t Community to spend more than half of their budge tural subsidies. While roughly one-fifth of farming i United States comes from government subsidies, m percent of farming income in countries of the Eur comes from. such subsidies, as does an absolute m farming income in Japan.

THE POLITICS OF PRICE CONTROLS

Simple as basic economic principles may be, th tions can be quite complex, as we have seen with th

Price Controls

fects of rent control laws and agricultural price sup However, even this basic level of economics is seld stood by the public, which often demands political " that turn out to makematters worse. Nor is this a new non of modern times in democratic countries. In 1628, vest shortfall in Italy led to reduced supplies of food turn led to this public reaction:

People implored the magistrates to take measures, me which the crowd considers simple, just and certain t the hidden, walled-up, buried grain, and to bring b The magistrates did do something: fixed the max various foodstuffs, threatened to punish those who re sell, and other edictsof the sort. Since such measures vigorous, do not have the virtue of diminishing the n food, growing crops out of season, or attracting suppl areas of surplus, the evil lasted, and grew. The cr that effect to the incompleteness and weakness of the r and shouted for more generous and decisive one

Since this was a local food shortage, the ordinar supply and demand would have been to cause local p attracting more food into the area. Price controls prev Nor was this perverse reaction peculiar to Italy. The has happened in many countries and in many centuri teenth-century India, for example, a local famine brought a government crackdown on food dealers an tors, imposing price controls on rice, leading to w deaths by starvation. However, when another famine dia in the nineteenth century, under the colonial rule of ficials and during the heyday of classical economic policies were followed,with opposite results:

In the earlier famine one could hardly engage in without becoming amenable to the law. Inrespecta 1866 in vast numbers went into the trade; for the Govern publishing weekly returns of the rates in every distr dered the traffic both easy and safe. Everyone knew

38

BASIC ECONOMICS

buy grain cheapest and where to sell it dearest a cordingly brought from the districts which could be and carried to those which most urgently needed

As elementary as all this may seem, in terms principles, it was made possible politically becaus colonial government was unaccountable to local pub In an era of democratic politics, such actions would re lic familiarwith basic economics.

Chapter 4

An Overview

E

conomics is defined, not just by its subject matter methods and its purposes. Just as a poetic discuss weather is not meteorology, so an issuance of moral p ments or political creeds about the economy is not e Economics is a study of cause-and-effect relationships i omy. Its purpose is to discern the consequences of var of allocating scarce resourceswhich have alternative u nothing to say about philosophy or values, any more t anything to say about music orliterature.

CAUSE AND EFFECT

Analyzing economic actionsin cause-and-effect ter examining the logic of the incentives being created, r simply the goals being sought. It also means examinin pirical evidence of what actually happens under such i Moreover, the causation at work in an economy is ofte causation, rather than causation determined by perso tion. For example, if the stock market closes at 12,463 day, that is the end result of systemic interactions am merable buyers and sellers of stocks, none of whom ma tended for the market to close at 12,463, even though i actions in pursuit of other intentions which caused it to Just as primitive peoples have tended to attribute s as the swaying of trees in the wind to some intentiona an invisible spirit, rather than to such systemic cause tions in atmospheric pressure, so there is a tendency tentional explanations of systemic events in the econo

40

BASIC ECONOMICS

people are unaware of basic principles. While risin likely to reflect changes in supply and demand, peo of economics may attribute the rises to "greed." Su tional explanation raises more questions than it an does greed vary so much from one time to another place to another? In the Los Angeles basin, for example, homes ne sell for much higher prices than similar homes lo smog-chocked interior. Does this mean that fresh a greed, while smog makes home sellers more reason that prices are due to greed isto imply that sellers ca an act of will. If so, no company would ever go bank could simply raise its prices to coverwhatever its co to be. People shocked by high prices in stores in low-in borhoods or by the much higher interest rates charg brokers and the small finance companies that ope neighborhoods, as compared to the interest rates c banks, have been quick to blame greed or exploitatio of the people who run such businesses. Yet studie profit rates are no higher in innercity businesses tha and the fact that many businesses are leaving such hoods reinforces that conclusion. The painful fact th ple end up paying more than affluent people for man services has a very plain-and systemic-explanati more to deliver goods and services in low-incom hoods. Higher insurance costs and higher costs for var precautions, due to higher rates of crime and vanda some of many systemic reasons that get ignored by an explanation in terms of personal intentions.In addi of doing business itself tends to be higher per dollar Lending $50 each to a hundred low-income borrow shops or local finance companies costs more than lend a bank to one middle-class customer. An armored c money in small denominations to a small check-cash a ghetto costs just as much as an armored car deliveri times as much value of money to a Bank of America

An Overview

suburban shopping mall. With the cost of business be per dollar of business, it is hardly surprising that these are passedon in higher pricesand higher interest rates Higher prices for people who can least afford them end-result, but its causes are systemic. Thisis not mere sophical distinction. There are major practical conse the way causation is understood. Treating the causes prices and higher interest rates in low-income neighbo being personal greed and trying to remedy it by impo controls and interest rate ceilings onlyensures that eve be supplied in low-income neighborhoods. Just as rent duces the supply of housing, so price controls and in controls can reduce the number of stores, pawn shops finance companies willing to operate in neighborhoods costs that cannot be covered by legally permissible pric terest rates. If stores and financial institutions close down in lo neighborhoods, more people in such neighborhoods w forced to travel to other neighborhoods to shop for g other goods, paying money for bus fare or taxi fare. L borrowers who no longer have pawnshops or check-ca cies and finance companiesin their neighborhoods are to be denied loans at banks used to dealing with high people who have less riskof default. If people from po hoods can get their checks cashed at all at banks in other hoods when they are unable to keep large amounts of their accounts, theirbus or taxi fares there can be mo they would have paid to a check-cashing agency nearb The Hippocratic oath taken by doctors begins: "Fi harm." Understanding the distinction between system tion and intentional causation is one way to do less h economic policies. It is especially important to do no ha ple who are already in painful circumstances. Periods of crisis often generate emotions which se by blaming personal and intentional causes, rather tha causes, which provide no such emotional release forth moral melodrama for the media and politicians. Gaso ages in the 1970s were blamed on oil company mach

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BASIC ECONOMICS

which were never substantiated, despite extensiv tions-rather than on gasoline price controls, even t controls have a record of creating shortages going b turies. In addition, personification of ”society” introd pearance of intention in metaphors about how societ its income inequitably or does other things that peop but which are often the results of systemic causes. Intentional explanations of cause and effect may ural, in the sense that less sophisticated individuals phisticated societies tend to turn first to such expl some cases, it has taken centuries for intentional expl bodied in superstitions about nature to give way to planations based on science. It isnot yet clear whethe that long for the basic principles of economics to rep ural tendency to explain systemic results by someone Although the basic principles of economics are n plicated, the very ease with which they can be learne them easy to dismiss as ”simplistic” by those who do accept analyses which contradict their cherished beli of the obvious are often far more complicatedthan t is it automatically true that complex effects must h causes. The ramifications of something very simple enormously complex. For example, the simple fact t is tilted on its axis causes innumerable very complex plants, animals, and people, as well as in such inanim ocean currents, weather changes and changes in t night and day. If the earth stood straight up on its axis, night an be the same length all year around andin all parts of the same time. Climatewould still differbetween the the poles but, at any given place, the weather would in winter as in summer. The fact that the earth is tilte means that sunlight is striking the same country at gles at different timesduring the planet’s annual orb sun, leading to changing warmth and changing len and day. In turn, such changes trigger complex biologica plant growth, animal hibernations and migrations, as

A n Overt7iez.v

chological changes in human beings and many season in their economies. Changing weather patterns affect rents and the frequency of hurricanes, among many nomena. Yet all of these complications are due to the fact that the earth is tilted on its axis, instead of being s In short, complex effects may be a result of either us which. A complex causes. The specific facts can tell nouncements about what is "simplistic"cannot. Few things are more simple than the fact that peo buy more at lower prices and buy less at higher p putting that together with the fact that producers tend more at higher prices and less at lower prices, that is predict all sorts of complex reactions to price control ample in the housing market. Moreover, these reac been found on all inhabited continents and over tho years of recorded history. Economic principles apply a ical borders and among wide varieties of peoples and c The tendency to personalize causation leads not charges that "greed" causes high prices in market econ also to chargesthat "stupidity" among bureaucrats is for many things that go wrong in government program iiy, many of these things that go wrong are due to perf nal actions, given the incentives faced by those who programs and given the constraints on the amount of k available toany given decision-maker orset of decisio Where a policy or institution has been established litical leaders, those subject to their authority may well contradict their beliefs, much less topoint out the coun tive consequences that later follow from these policie tutions. Messengers carrying bad news would be ris careers or-under Stalin or Mao-their lives. Those ca particular policies may be quite rational, however neg policies prove to be for societyat large. During the Stalin era in the Soviet Union, for exam was a severe shortage of mining equipment,but the ma enterprise producing such machines kept them in sto they were produced, rather than sending them out to The reason was that the officialorders called for these

44

BASIC ECONOMICS

be painted with red, oil-resistant paint and the prod hand only green, oil-resistant paint and red varnish oil-resistant. Disobeying official orders in any respect offense and “I don’twant to get eight years,” the mana When the manager appealed to a higher offici green, oil-resistant paint, this official’s reaction was ” want to geteight years either.” However,he cabled to for their permission to give his permission. After a lo ministry granted his request and the mining mach nally shipped to the mines. None of these people was rationally. They wereresponding quite rationally to t and constraints of the system in which they worked.

INCENTIVES VERSUSGOALS

Because economics isa study of cause and effect, incentives and their consequences. Ithas nothing to s validity of social, moral, or political goals such as housing,” ”a living wage” or ”social justice.” Wha study the incentives and consequences of particular in the name of these and other goals. For example, if the desire for ”affordable housin form of rent control, then economics can examine t created for tenants, landlords, and builders by rent co and then see what the empirical consequences of the have been. For tenants, rent control creates incentiv occupy more housing than they would if they had to value of that housing, as measured by what others w ing to bid for it. For builders, rent control creates build less housing, including perhaps none at all. For creates incentives forthem not to maintain the existin well as they would in a free market, where they w compete for tenants, rather than in a rent-contro where there are more applicants than apartments, Given these incentives, it is not surprising to disc cally that rent control has been followed by housing reduction in the building of new housing, and a fas

An Overview

tion of existing housing as it receives lessmaintenance emphasized that these are empirical consequences, s people seem tothink that the role of prices in the econo ply a theory by those with ”faith in the market.” Howe a Swedish socialist-presumably lacking such ”faith” ket-who said that rent control ”appears to be the mo technique known to destroy a city-except for bombin an economist familiarwith the empirical evidence. Another comparison between bombing and rent c made by an official of the Communist government o some years after the Vietnam war. ”The Americans co stroy Hanoi,” by bombing it during the war, he sai have destroyed our city by very low rents.” As a Comm no bias toward the free market, he had learned the har artificially low rents encouraged demand while dis supply-a very simple principle, indeed, but one with pacts on those who fail toheed it. Bombing does more damage to a city,, but many cities have rapidly rebuilt i war world. Rent control does more long-lasting dama people do not understand the basic economicsof it. In economics, as elsewhere in life, while we are whatever we wish, we are not free to have the conse whatever we want them to be. We can leap off the to scraper, if we wish, but the law of gravity will deter the consequence will be. In economics as well, the ac quences of any specific economic policy must be disc analysis and evidence, and are wholly independent o might wish that these consequences would be. Econ study of the consequences of various ways of allocatin sources which have alternative uses. It isnot a study of and values. On the contrary, economics was christened ”the ence” precisely because its analysis frustrated so many desires. On the other hand, knowing what was not pos many disappointments and disasters. Our special focuson market economies, in which a key role in the allocation process, isdue to two cons First, this is the kind of economy with which most Am

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familiar. More important, this is the kind of econom produced higher standards of living for most people around the world. What needs to be understood are t features of this kind of economy that lead to such resu in Europe, Asia, Africa, the or Western Hemisphere. Incentives matter because most people will do m own benefit than for the benefit of others. Incentives concerns together. A waitress brings food to your t cause of your hunger, but because her salary and tip it. Giant corporations hire people to find out whatthe want, not because of altruism, but because they know the way to make a profit and avoid losses. Producin people don’t want is a road that leads ultimately ruptcy court. Prices are important because they convey inform form of incentives. Producers cannot read consumers when automobile manufacturers find it harder to sel ons at prices that cover their cost of production and sports utility vehicles at cost-covering prices, that i automobile manufacturers need to know in order to to produce. Prices not only help determine which particula produced, they are also one of the ways of rationing scarcity of all goods and service. However, prices d that scarcity, which will require some form of rationin other economic system. Simple as allthis may seem, it goes counter to ma designed to make various goods and services ”affo keep them from becoming ”prohibitively expensB itive is precisely how prices limit how much each pe everything weremade affordable, therewould still no to go around than when things were prohibitively ex would simply have to be some alternative method u the same amount that existed when things were no Whether that method was through ration coupons, p ence, black markets, or just fighting overthings whe sale, the rationing would still have to be done, sinc making things affordabledoes not create any more to

A n Overview

While scarcity is inherent, shortages are not. Scar means that there is not enough to satisfy everyone’sde in the Garden of Eden was there enough to do that. A however, means that there are people willing to pay t the good but are unable to find it. Price is an integral part of what a shortage is all a though many people mistakenly believe that there i physical scarcity of a good during a shortage. Howev den discovered, even the fastest rate of home-build world did not prevent an ever-worsening housing sh the waiting list for housing grew faster, as the artif prices of housing under rent control caused many pe more housing than they would have if they had had full value of the resources used in producing it. One of the fundamental problems of price control just what it is whose price is being controlled. Even so simple as an apple is not easy to define because appl size, freshness,and appearance, quite aside from the d rieties of apples. In a free market, those apples most in for whatever reason-are likely to have higher prices least in demand lower prices. Produce stores and sup spend time (and hence money) sorting out different qualities of apples, throwing away those that fall belo quality that their respective customers demand. Under price control, however, the amount of a manded at anartificially low price exceedsthe amoun so there is no need to spend so much time and money apples, as they will all be sold anyway. Some apples ordinarily be thrown away under free market condi under price control, be kept for sale to those people after all the good apples have been sold. As with apar der rent control, there is no need to maintain high qu everything will sellanyway during ashortage. Many apparentlyhumanitarian policies have throughout history because of a failure to understand prices. Attempts to keep food prices down by impo controls have led to hunger and even starvation, whet enteenth-century Italy eighteenth-century India, Fran

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French Revolution, Russia after the Bolshevik revolu number of African countries after they obtained i during the 1960s. Some of these African countries, l countries in Eastern Europe, once had such an abund that they were exporters of food before the era of and government planning turned them into countr feed themselves. The motivation behind price controls on food m to make food affordable to the poor, but affordab mean any more food. In fact, it led to less food be when the prices failed to repay the costs and labo grow crops or raise animals. Under the changed in ated by price controls,farmers tended to produce les keep much of what they produced for themselves an lies. Somefarmers even gave up farming entirely as and moved to the city, simultaneously reducing th food and addingto the number of urban consumers None of this is new or peculiar to a modern ca omy. Back in the days of the Roman Empire, the emp ianissuedimperialdecreeswhichsettheprices goods-and ”people brought provisions no more to a contemporary put it. It would be much the same two thousand years later, when price controls durin administration led to declining supplies of goods su controls. In Ghana, the country lost its long-standin the world’s number one producer of cocoa when the limited how much money would be paid to farmers coa-and Ghana regained that position after the d cline in the cocoa crop that followed forced the go change its policy. Failure to supply goods, as a result of political must be sharply distinguished from an inability top Food can bein short supplyin a country with extrao tile soil, asin post-Communist Russia that had not y free-market economy:

Undulating gently through pastoral hills 150 mile Moscow, the Plava River Valley is a farmer’s dream

An Overview

This is the gateway to what Russians call ”Chernozym””Black Earth Country”-which boasts some of the most fer soil in Europe, within three hours’ drive of a giant, hun tropolis . . . Black Earth country has the natural wealth an entire nation. But it can barely feed itself.

It ishard even to imagine,in a free market economy city, dependent on imports of foreign food, when there dinarily fertile farmland not far away.Yet the people on fertile farmland were as poor as the city dwellers we The workers harvesting that land earned the equivalen $10 a week, with even this small amount being paid sacks of potatoes or cucumbers-because of a lack of the mayor of a town in this region said:

We ought to be rich. We have wonderfulsoil. We have th tific know-how.We have qualified people. But what d up to?

If nothing else, it adds up to a reason for understa nomics as a means of achieving an efficient allocationof sources which have alternative uses. All that was lack market to connectthe hungry city with the products of land and a government that would allow such a mark tion freely. In some places, local Russian officials f movement of food across localboundary lines, in orde low food prices within their jurisdictions and therefor litical support for themselves. Again, it is necessary to that this was not a stupid policy, from the standpoint trying to gain local popularity with consumers by m low food prices. This protected their own political car ever disastrous such policies were for the country as a w While systemic causation is in one sense imperso sense that its outcomes are not specifically predeter anybody, ”the market” is ultimately a way by which p dividual personal desires are reconciled with one anoth ten a false contrast is made between the impersonal m and the compassionate policies of various government

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But both systems face the same scarcity of resources tems make choices within the constraints of that sca ference is that one system involves each indivi choices for himself or herself, while the other syste smaller number of people making choices forothers It may be fashionable for journalists to refer to the marketplace,” asif that were something differen sires of people, justas it was once fashionableto refe tion for use, rather than profit”-as if profits could producing things that people cannot use or do not The real contrast is between choices made by ind themselves and choices made for themby others wh define what these individuals ”really” need.

SCARCITY AND COMPETITION

Scarcity means that everyone’s desires cannot completely, regardless of what economic system or icy we choose-and regardless of whether an indiv ety is poor or affluent. Therefore competition amo these resourcesis inherent. It is not a question whether we like or dislike Scarcity meansthat we do not have the option choo to not to havean economy in which people compete kind of economy that possible-and is our only choic particular methodsthat can be used for this comp One way in which competition for scarce reso place would be for thosewho hold political power t resources should be allocated to different usesand s different people. This has happened in ancient de under modern communism. Conceivably, the peopl might decide voluntarily how to share things, asin s cieties, though it is hard to imagine how that could cieties consistingof millions of people. Yet another method of sharing resources amon uses and competing individuals is by having them resources and the products resulting from them. Inth

An Overview

price-coordinated economy-those who want to use produce furniture must bid against those who want t produce houses, paper, or baseball bats. Those who w milk to produce cheese must bid against those who wa to produce yogurt or ice cream. Most people may be that they are competing and simply see themselves dec much of various things to buy at whatever prices the scarcity ensures that they are competing with others, e are conscious only of weighing their own purchasing d One of the incidental benefits of competing an through prices isthat different people are not as likely themselves as rivals, nor to develop the kinds of hostil valry can breed.For example, much the same labor and tion materialneeded to build a Protestant church could build a Catholic church.But, if a Protestant congregatio money tobuild a church for themselves, they are lik occupied with how much money they can raiseand ho needed for the kind of church theywant. Construction p cause them to scale back some of their more elaborate p within what they can afford. But they are unlikely Catholics, even though the competition of Catholics fo construction materials makes their prices higher than ot If, instead, the government were in the business o churches and presenting them to different groups, Pr Catholics would be explicit rivals for this largess an would have any financial incentive to cut back on thei plans to accommodate the other. Instead, each would h centive to make the case, as strongly as possible, forthe of their desires and to resent any suggestion that they their plans. The inherent scarcity of materials and labor limit what could be built, but that limit would now be im litically and seen by each as due to the rivalry of the Constitution of the United States of course prevents th ment frombuilding churches for different groups, no do vent just such political rivalries and the bitterness, and bloodshed, to which such rivalries have led in other cou The same economic principle, however, applies to g are not based on religion but on ethnicity, geographic

BASIC ECONOMICS

or age brackets. All are inherently competing for sources, simply because those resources are scarc competing indirectly by having to keep your deman limits of your own pocketbook is very different from desires for government benefits thwarted by the ri some other group. Because economic resourcesare not only scarce b native uses, the efficient use of those resources requi sumers and producers to make trade-offs and s Prices provide the incentives for doing so. When the price of oranges goes up, some consum tangerines. When bacon becomes more expensive sumers switch to ham. When the cost of a vacation rises, some people decide to go on a cruise instea what is happening here is not just substitution-it substitution. Not everybody stops eating oranges w come more pricey. Somepeople continue to eat the s of oranges they always ate, some cut back a little, som lot, and others forget about oranges completely and ines or some other fruit. Although an orange is ph same thing to all, the value that each individual atta viously differs. When the price of oranges rises, it is very likely number of oranges demanded at the existing price number of oranges actually available. Something ha cremental substitution, because of price increases, ca to be minimized by being borne more by those who indifferent as between oranges and other substitutes by those who are so devoted to oranges that they wi the higher prices and continue to eat the same numb as before, cutting back somewhere else in their bud the additional money spent on oranges. Incremental substitutions take place in producti consumption. Petroleum, for example, canused be to oil or gasoline, amongother things. More petroleum heating oil during the winter, when the demand for greatest, and more into gasoline during the summer people are doing more driving to vacation spots. This

An Overview

substitution, since some petroleum is turned into both (and many others) throughout the year. It is incremental tion-somewhat more of A at the cost of somewhat less of facilitate this kind of substitution, as they reflect incre in sup changing demands, leading to incremental changes Trade-offs and substitution can take place either inte or systemically. Anintentional trade-off has been made steel manufacturer in Cleveland, whose equipment w shift automatically from oil to natural gas when the pr rose above a given level. Automobiles have also adjust tionally by becoming more fuel-efficient. Thus, the American car drove 2,000 miles more in 1998 than in of used about 200 gallons less gasoline. This is because equipment added to engines, obviously at a cost, but cost of this technology substituting for the cost of gasoli A systemic trade-off occurs when the economy as uses less oil becausethe composition of its output chan higher proportion of the output of the American econ consisted sf services, rather than material goods, le needed in their production. It takes less fuel to create vanced software than to manufacture steel or automob all, the amount of fuel used per dollar of national outpu clined steadily since the early 1970s, when prices were ra matically bythe international petroleum cartel. As important as it is tounderstand the role of substi is also important to keep in mind that the efficient allo resources requires that these substitutions be increment tal. For example, one may believe that health is more i than amusements but, however plausible that may soun litical slogan, no one really believes that having a twe supply of band-aids in the closet is more important tha to give up all music in order to pay for it. A price-coo economy facilitates incremental substitution, but polit sion-making tends toward categorical priorities-that is, one thing absolutely more important than another and laws and policies accordingly. When a political figure says that we need to "set nat orities" about one thing or another,what that amounts t

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ing A categorically more important than B. That is t incremental substitution, in which the value of eac how much of each we already have and therefore on amount of A that we are willing to give up in order Incremental substitution means that the relative v varies with how much of each we already have avai

The Meaning of ““Costs”

In light of the role of trade-offs and substitutions understand the real meaning of costs as the forego ties to use the same resources elsewhere. Prices all vidual to weigh his own changing rates of trade-off, his own circumstances. Thus a mother may forego in order to have her children vaccinated, but wil costly and painful rabies shots to guard against som sibility of someday being bitten by an animal with Because an economy deals with scarce resources w ternative uses, every benefit has a cost in the altern could have been made of the same resources that cr ular benefit. We do not simply ”put” a price on t have inherent prices and our political choice isonly ing to suppress thatfact bylaws or allowing these i to be expressed in the marketplace. Free-market prices are not mere arbitrary obsta what people want. Prices are symptoms of an unde that is not nearly as susceptible to political manip prices are. Prices are like thermometer readings-an with a fever isnot going to behelped by plunging t ter into ice water to lower the reading. On the contra to take the new readings seriously and imagine tha fever was over, the dangers would be even greater underlying reality was being ignored. Despite how obvious all this might seem, ther ending stream of political schemesdesigned to esca being conveyed by prices-whether through direct or by making this or that ”affordable”with subsidie the government itself supply various goods and

An Overview

"right." What all these schemeshave in common is tha empt some things from the processof weighing costs an against one another. Sometimes the rationale for removing particular th the process of weighing costs against benefits is exp some such question as: "How can you put a price on education, health, music, etc. The fundamental fallacy u this question is the belief that prices are simply "put" So long as art, education, health, music, and thousand things all require time, effort,and material resources, th these inputs are the prices that are inherent. These costsdo not go away because a law prevents t being conveyed through prices in the marketplace. Ult society as a whole, costsare the other things that could h produced with the same resources. Money flowsand pr ments are symptoms of that fact-and suppressing the toms will not change the fact.

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PART 11: INDUSTRY AN COMMERCE

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Chapter 5

The Rise and Fall of Businesses

e tend to think of businesses as simply money-m terprises, but that can be very misleading, in a ways. First of all, most businesses go out of busines very few years after getting started, so it is likely that many businesses are losing money as are making mo important, from the standpoint of economics, is not w the business owner hopes to make or whether he suc how all this affects the use of scarce resourceswhich ha tive uses-and therefore how it affects the economic of millions of other people in the society at large.

ADJUSTING TO CHANGES

The businesses we hear about, in the media and are usually those which have succeeded, and espec which have succeeded on a grand scale-General M crosoft, Kodak, Chase Manhattan Bank. In an earlie would have heard about the A & P grocery chain, onc retail chainin any field, anywhere in the world, with sa than the combined sales of leading contemporary re Sears, Penney,and Montgomery Ward. The factthat A & P has shrunkto a fraction of its fo and is now virtually unknown, suggests that industry merce are not static things, but dynamic processes, in w vidual companies and whole industries rise and fall, as relentless competition under changing conditions. Hal

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panies on the “Fortune 500” list of the biggest busin were no longer on that list just a decade later. At the heart of all of this is the role of profit-an Both are equally important from the standpoint of fo nies and industries to use scarce resources efficient and commerce are not just a matter of routine manag profits rolling in more or less automatically. Mas changing details within an ever-changing surroundi and social environment mean that the threat of losse even the biggest and most successful businesses. The why business executives usually work far longer hou employees, and why so many businesses fail within after getting started. Only from the outside does it lo Even companies superbly adapted to a given set can be left behind when those conditions change s their competitors are quicker to respond. During the ample, the A & P grocery chain was making a phenom profit on its investment-never less than 20 perce about double the national average-and it continue on into the 1930s and 1940s. But all this began to ch cally in the 1950s, when A & P lost more than $50 m 52-week period. A few years later, it lost $175 mill same span of time. Its decline had begun. A & P’s fate, both when it prospered and whenit val grocery chains, illustrates the dynamic nature of dinated economy and the role of profits and losses. was prospering up through the 1940s, it did so by ch prices than competing grocery stores. It could do th kept its costs lower and the resulting lower prices a numbers of customers. When it began to lose custom grocery chains, this was because the latter could n lower prices than A & P. Changing conditions in the society brought this about-together with differences with which different companies spotted the changes their implications. What were these changes? In the years followin World War 11, suburbanization and the American pu prosperity gave huge supermarkets in shopping ma

The Rise and Fall of Businesses

parking lots decisive advantages over neighborhood cated in the central cities. As the ownership of autom frigerators and freezers became far morewidespre completely changed the economics of the grocery indus The automobile, which made suburbanization pos made possible greater economies of scale forboth cust supermarkets. Shoppers could now buy far more groc time than they could have carried home in their arms f ban neighborhood store before the war. That was the c of the automobile. Moreover, refrigerators and free made it possible to stock up on perishable items like dairy products. This all added up to fewer trips to th store, with larger purchases each time. What this meant to the supermarket itself was a l ume of sales at a given location, which could now tomerswithautomobiles from miles around,whe neighborhood store in the central city was unlikely to tomers on foot fromten blocks away.High volume mea in delivery costs from the producer to the supermarke pared to delivering the same amount of groceries toma borhood stores, whose total sales would add up to supermarket sold. It also meant savings in the cost of selling within market itself, because it did not take ten times as lon out one customer buying $50 worth of groceries at a su as it did to check out ten customers buying $5 worth o each at a neighborhood store. Because of these and ot ences in the costs of doing business, supermarkets cou profitable while charging prices lower than those in hood stores that were struggling to survive. All this not only loweredthe costs of delivering gro consumer, it changed the relative economicadvantages vantages of different locations for stores. Some su chains, such as Safeway, responded to these radically n tions faster and better than A & P which, for example, the central cities longerand did not follow the shifts of p to California and other sunbelt areas, as well as being sign long leases or pay high prices for new locations w

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tomers and their money were now moving. After ye lowest-price grocery chain,A & P suddenly found its dersold by rivalswith even lower costs of doing busin Lower costs reflected in lower prices is what ma world’s leading retail chain in the first half of the tw tury. And lower costs reflected in lower prices is w other supermarket chains to take A & P’s customer second half of the twentieth century. While A & P one era and failed in another, what is more importa economy as a whole succeeded in both eras in getting at the lowest prices possible at the time-from wh pany happenedto have the lowest prices. Many other corporations that once dominated have likewise fallen behind in the face of changes gone bankrupt. For decades, the Graflex Corporati most of the cameras used by press photographers. newsreels of the 1930s and 1940s almost invariably s photographers using a big, bulky camera with a bel Speed Graphic, produced by Graflex. Then, in the outstanding photographs of the Korean war were 35mm Leica camera, using lenses produced by a Jap facturer that also made a new camera calledthe Niko Advances in lens design and optical technology possible for newspaper and magazine photographer tures with smaller cameras that had enough sharpne to compete with pictures taken by much bulkier cam a decade, smaller cameras rapidly replaced Speed G other large cameras made by the Graflex Corporat Speed Graphic was produced in 1973 and the Graflex itself became extinct, afterdecades of dominating its Similar stories could be told in industry after i American Airlines, which pioneered in commercial the Atlantic and the Pacific, went out of business in the deregulation of the American airline industry in mous newspapers like the New York Herald-Tribune, gree going back more than a century, stopped publish environment, after television becamea major source newspaper unions made publishing more costly.

The Rise and Fall of Businesses

Smith-Corona dominated the typewriter industry decades, but then laptop computers appeared on the displaced portable typewriters, while desktop compu displacing other typewriters. Like A & P before it, Sm began losing millions of dollars under changed con went five years in a row without making a profit d 1980s. Only by beginning to produce word processors half-way house between typewriters and computers, w Corona able tosurvive and begin making money again The great industrial and commercial firms that hav or become extinctare a monument to the unrelenting p competition. So is the rising prosperity of the consum The fateof particular companies or industries is not wh important. Consumers are the principalbeneficiarie prices made possible by the more efficient allocationof sources which have alternative uses. The key roles in all of this are played not only by profits, but also by losses. These losses force business with changing conditions or find themselves losing out t tors who spot the new trends earlier or who understan plications better. Knowledge is one of the scarcest of al in any economy, and the insight distilled from kno scarcer still.An economy based on prices, profits, and lo decisive advantages to thosewith greater knowledgean Put differently, knowledge and insight can guide tion of resources, even if most people,including the cou litical leaders, do not share that knowledge or do no insight to understand what is happening. Clearly this in the kind of economic system where political leade economic decisions, forthen the limited knowledge an of those leaders become decisive barriers to the prog whole economy. Even when leaders have more know insight than the average member of the society, they ar to have nearly as much knowledge and insight as exis among the millions of people subject totheir governan Knowledge and insight need not be technologicalo for it to be economically valuable and decisive for th well-being of the society as a whole. Something as m

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retailing has changed radically over the past century izing both department stores and grocery stores-and standard of living of millions of Americans by lower of delivering goods to them. Today, names like Sears and Ward’s mean depa chains to most people. However, neither of these en gan as departmentstore chains. Montgomery Ward-t name of today’s Ward’sdepartment stores-began as house in the nineteenth century. Under the conditio time, before automobiles or trucks and with most A ing in small rural communities, the cost of deliverin goods to widely-scattered localstores was very high was reflected in the high prices that were charged costs, in turn, meant that ordinary people could se many of the things that we today regard as necessiti Montgomery Ward cut these costs by operating der house, selling directlyto consumers all overthe c its warehouse in Chicago. Itshigh volume of sales red per sale and allowed itto cut its prices below those cal stores in small communities. Under these cond came the world’s largest retailer in the late ninete Sears then arose as a competing mail-order house an surpassed Montgomery Ward in sales and size. More important thanthe fates of these two busine fact that millions of people were able to afford a hig of living than if they had to be supplied withgoods t lier channels. Meanwhile, there were gradual chang can society,with more and more people beginning to communities. This was not a secret, but not everyo and even fewer had the insight to understand its im retail selling. It was 1920 before the Census showed first timein the country’s history,there were more A ing in urban areas than in rural areas. One man who liked to pore over such statistics Wood, an executive at Montgomery Ward. Now, he r ing merchandise through a chain of urban depart would be more efficient and more profitable than s sively by mail order. Not only were his insights not s head of Montgomery Ward, Wood was fired.

The Rise and Fall of Businesses

Meanwhile, a man named James Cash Penney had insight and was already setting up his own chain of de stores, almost 300 by 1920 and more than a thousandb of the decade. Their greater efficiency in delivering go ban consumers was a boon to consumers-and a big problem for the mail order giants Sears and Montgom both of which began losing money. The fired Robert W to work for Sears and convinced their top managemen building department stores of their own. After they d gomery Ward had nochoice but to do the same belatedl it was never able to catch up to Sears again. Rather than get lost in the details of histories of p businesses, we need to look at this from the standpo economy asa whole and the standard of living of the p whole. Oneof the biggest advantages of an economy co by prices and operating under the incentives created and loss is that it can tap scarce knowledge and insig when most of the people do not share such knowledg sights. The competitive advantages of those who are overwhelm the numerical, or even financial, advantage who are wrong. James Cash Penney began as just a one-third partner in a little town in Wyoming when Sears and Montgom were unchallenged giants of nationwide retailing. Yet hi into the changing conditions of retailing and chain-sto tions eventually forced these giants into doing things hi pain of extinction. Robert Wood failed to convince Mo Ward to change, but competition and red ink on the bo convinced them. In a later era, a clerk in a J.C. Pen named Sam Walton would learn retailing from the g and put his knowledge and insights to work in his o which would eventually expand to become the Wal-M with sales largerthan those of Sears and J. C. Penney c One of the great handicaps of government-run ec whether under medieval mercantilism ormodern comm that insights which arise among the masses haveno suc ful leverage as to force those in authority to change the do things. Under any form of economic or political sys at the top tend to become complacent, if not arrogant. C

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them of anything is not easy, especiallywhen it is so of doing things that is very different from what the The big advantage of a free market is that you don’ vince anybody of anything. You simply compete wit marketplace and let that be the test of what works be Imagine a system in which J. C. Penney had to vince theheads of Sears and Montgomery Ward to ex mail-order retailing and build a nationwide chain of response might well have been:”Who is this guy Pe owner of some little storein a hick town nobody ev tell us how torun the largest retail companies in the w In a market economy, Penney did not have to c body of anything. All he had to do was deliver the m the consumers at a lower price.His success and thei left Searsand Montgomery Ward no choice but to im start, in order to become profitable again and regain ship of the retail merchandiseindustry. The firing of at Montgomery Ward is all too typical of what ca those who tell people things they do not want to hea during the post-World War I1 era, a similar fate aw tives at Montgomery Ward who tried to tell its chief ficer, Sewell Avery,that the company needed to esta suburban shoppingmalls. Many things that we take for granted as features ican economy were resistedwhen first proposed and uphill to establish themselves by the power of the Even something as widely used today as credit ca tially resisted. When Mastercard and Bankameric peared in the 1960s, leading New York department s Macy’s and Bloomingdale’s said that they had no honoring credit cards, eventhough there were alread people with such cards in the New York metropolit after the success of credit cards in smaller stores di partment stores finally relent and begin accepting c and eventually issuing their own. What is important is notthe success or failureof dividuals or companies, but the success of particula and insights in prevailing despite the blindness or

The Rise and Fall of Businesses

others. Given the scarcity of such mental resources, an in which they have such decisive advantages is an which itself has great advantages in creating a higher st living for the population at large. A society in which o bers of a hereditary aristocracy, a military junta, or a ru can make major decisions aissociety that has thrown aw of the knowledge, insights,and talents of most of its pe Contrast that with a society in which a farm boy wh eight miles to Detroit to look fora job could end up cr Ford Motor Company and changing the face of Ame mass-produced automobiles-or a society in which a young bicycle mechanicscould create the airplane and l aviation industry. Neither a lack of pedigree nor a lack mic degrees nor even a lack of money could stop id worked, for investment money is always looking for a back and cash in on. A society which can tap all kinds from allkinds of sources has obvious advantages over which only the talents of a preselected few are allowed mine its destiny. No economic system can depend on the continuin of its existing leaders. A price-coordinated economywi tition in the marketplace does not have to, because tho can be forced to change course-or be replaced-whe cause of red ink, irate stockholders, outside investors take over, or becauseof a bankruptcy court. Given such pressures, it is hardly surprising that economies u thumbs of kings or commissars have seldom matched record of capitalist economies.

THE COORDINATION OF KNOWLEDGE

In medieval times, when craftsmen produced eve from swords to plowshares on a direct order from the there was no problem of knowing what was wanted b But a modern economy-whether capitalist or socialistentirely different situation. Today’s supermarket or de store stocks an incredible variety of goods without kno

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will buy how much of what. Automobile dealers florists, and other businesses likewise keep a stoc sell, without really knowing what the consumers w want. In a capitalist economy, wrong guesses can lea from clearance sales to bankruptcy. Under both capitalism and socialism, the scarc edge is the same, but the way these different econom it can be quite different. Theproblem is not simply w all scarcity of knowledge, but also with the fact tha edge is often fragmented into tiny bits and pieces, which is not known to anybody. Imagine the difficulties of an oil company head Texas trying to decide how much gasoline-and wha be needed in a filling station at the corner of Mark Streets in San Francisco during the various seasons well as in thousands of other locations across the people who actually own and operate the filling s these locations have far better knowledge of what th customers are likely tobuy atdifferent timesof the y body in a corporate headquarters in Texas can hope Variations can be great, even within a single ci time. If people who live in the vicinity of Marke Streets in San Francisco own more sports cars than live near the filling station at 19th Avenue and Irvin the filling station owner at Market and Castro is li more premium gasoline than the filling station owne people with cheaper cars that use cheaper gasoline who want diesel fuel. No single person at any giv whether at a filling station or in corporate headquarte sibly have all this information for the whole cou fingertips, much less keep updating it for thousands tions from coast to coast as the seasons and the ne change. But that is wholly unnecessary in an econom kind of fuel simply goes wherever the money direct The amount of such highly localized informati thousands of individual filling station owners scatte United States, is too enormous to be transmitted to point and then be digested in time to lead to gover

The Rise and Fall of Businesses

tions of fuel with the same efficiency as a price-coord ket can achieve.No oil company knows or caresabou formation. All they know is that orders are pouring i fuel in North Dakota this month, while Massachuset lots of premium gasoline and Ohio is buying mostly leaded. Next month it may be a totally different patt oil company may not have any more clue about the the new pattern than about the reasons for the old. Bu oil company has to do is to supply the demand, wh and for whatever reason. The significanceof prices in the allocation of resou seen most clearly by looking at situations where price lowed to function. Two Soviet economistsdescribed a which their government raised the price it would pa skins, leading hunters to sell more of them:

State purchases increased, and now all the distribu are filled with these pelts. Industry is unable to use t and they often rot in warehouses before they can The Ministryof Light Industry has already requested sten twice to lower the prices, but ”the question has decided” yet. This is not surprising. Its members decide. They have no time: besides setting prices o they have to keep track of another 24 million prices.

However overwhelming it might be fora governm to try to keep track of millions of prices, a country wit of millions of people can farmore easily keep track of individually, because no one individual or business has to keep track of more than the relatively few pri to their own decision-making. The situation as regard common during the days of the Soviet Union’s centra economy, where a recurrent problem was a piling u goods in warehouses at the very time when there w shortages of other things that could have been produc same resources. Like oil company executives int States, the executives who ran Soviet enterprises had keep trackof all the thousands of local conditions and

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individual desires in a country that stretched all the the Eurasian land mass fromEastern Europe to the Pa Unlike American executives, however, their Soviet c did not have the same guidance from prices or the tives from profits and losses. Thenet result was that m enterprises kept producing things in quantities beyon body wanted, unless and until the problems became s so blatant as to attract the attention of central planners who would then change the orders they sent out to m ers. But this could be years later and enormous am sources would be wasted in the meantime. The wastefulnessof a centrally planned economic lated into a painfully low standard of living for millio citizens, living in a country with some of the riches sources in the world. Their standard of living was low, comparison with that in the United States,but also com standard of living in countries with far fewer natura such as Japan and Switzerland. Efficiency is more than stract concept of economists and accountants. It direc into the well-being of hundreds of millions of human b The problems faced by the Soviet economy were deficiencies peculiar to Russians orthe other peoples o Union. Americans faced very similar problems when government was controlling the price of gasoline an tion during the 1970s. While both individuals and bus to drastically curtail their use of gasoline in some loc as New York and Washington, in some other places-m areas-there was a surplus of unsold gasoline. This was not due to stupidity on the part of govern tors, but to the fact that a process that is relatively si prices direct resources and products where millions of want them togo, is enormously complex when a set of c ners seeks to substitute their necessarily very limited for the knowledge scattered among all those vast num ple in highly varying circumstances. The federal gov sued 3,000 pages of regulations, supplemented by var "clarifications," but none of this allocated gasoline as the ordinary operations of a free market price system

RiseThe

and Fall of Businesses

To know how much gasoline should be sent where requires an enormous amount of knowledge of when it is most in demand at any given moment-and th throughout the year, as well as varying from place to ple drive more to particular vacation spots during t and more diesel-powered trucks carryproduce to and places at harvest time, in addition to other changing u tor vehicles for allsorts of other reasons. Nobody in any kind of economic or political syst sibly know the specifics of all these things. The adv price-coordinated economy is that nobody has to. Th of such an economy comes from the fact that vast a knowledge do not ever have to be brought together, b dinated automatically by prices that convey in sum compelling form what innumerable people want. The between the limited knowledge of a business execut similarly limited knowledge of a government official business executive isreceiving instructions from others do-whom to supply, and when, with what kinds of case-while the government official is giving instruct ers and compelling them to obey. In short, economic decisions are ultimately being controlled by thosewho have specific knowledge in a dinated economy, while those decisionsmove in the o rection-from those with less knowledge, who are giv to those with more knowledge-in a centrally planne The difference is fundamental and profound in its im for the material well-beingof the population at large. During the episodic gasoline shortages of the 1970s experienced in oneindustry for a limited period of tim economic problems that were common across the bo viet Union for more than half a century. Because such ence was so rare and shocking to Americans, they we to all sorts of false political explanations and conspira for such an extraordinary situation, when in fact such were commonin other countries using government What was uncommon was for such methods to be United States. The rationale was that reduced oil sup

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the Middle East required government intervention chaos in American oil markets. Needless to say, polit not about to admit that it was precisely this interven brought chaos, sincethe reduction in the total amount in the country was just a few percentage points-the duction in supply that is routinely handled in all sor tries bya small price increasein a free market. Indeed, a previous Arab oil embargo in 1967 had such dislocations because it was not accompanied by price controls instituted by the Nixon administration ued by the Ford and Carter administrations. Nor wer lines of cars waiting for hours at filling stations in ot industrial nations or Japan, even though most of the tions produced a far smaller percentage of their own than the United States did. These other countries d price controlson gasoline, so they did not have the sh go with price controls. When government control of gasoline prices wa 1981-amid widespread warnings that this would lea cally higher prices-what followed was virtually a le mentary economics. Higher prices brought a greate gasoline and a smaller demand. Oil exploration shot u ing wells whose costs could not have been covered trolled prices began pumping oil again. Within mont prices fellbelow what they had been under complex controls. This fall continued over the years until gas reached an all-time lowin real terms. Additional taxe onto the prices at the pump, but the gas itself was c ever-and there were no waiting lines.

Chapter 6

The Role of Profitsand Losses

People often refer to an enterprise system as a profit system This is a great mistake. It is II profi and loss system, and the loss p&, in m y opinion is more important than theprofit part. The crucia difference is not in what ventures are undertaken The crucial difference is in what ventures are continued and which ones are abandoned . . . The cru cial requirement for maintaining growth and progress is that successful experiments be continued and unsuccessful experiments be terminated.

- Milton Friedman

W

hile part of the efficiency of a price-coordinated comes from the fact that goods can simply ”f money,” without the producers really knowing just w are buying one thing here and something else there a other thing during a different season. However, it is for them to keep track not only of the money coming i customers, it is equally necessary to keep track of h money is going out to those who supply raw materi parts, and other inputs. Keeping careful trackof these flows of money in and out can make the difference profit and loss.

BASIC ECONOMICS

74

PROFITS

Profits are perhaps the most misconceived subje ics. Socialists have long regarded profits as simply ” as Fabian socialist George Bernard Shaw called it, o value” as Karl Marx called it. From their perspect were simply unnecessary charges added on to the ducing goods and services, driving up the cost to t One of the great appeals of socialism, especiallywhe an idealistic theory without any concrete example world, was that it would eliminate these unnecess making things generally more affordable, especiall with lower incomes. Only after socialism went from ory to being an actual economic system in various co become painfully apparent thatpeople in socialist co harder time trying to afford things that most people countries could afford with ease and took forgranted With profits eliminated, prices should have been cialist countries, according to theory. Why then wa way in practice?

Profits as Incentives

Let us go back to square one. The hope for pro threat of losses is what forces a business owner in economy to produce at the lowest cost and sell w tomers are most willing to pay for. In the absence o sures, those who manage enterprises under socialism incentive to be as efficient as possible under given much less to keep up with changing conditions an them quickly, as capitalist enterprises must do if th survive. It was a Soviet premier who said that his country shied away from innovation ”as the devil shies aw cense.” But, given the incentives of a socialist ec should these managers have stuck their necks out b

The Role of Profits-and

Losses

methods, when they stood to gain little ornothing if it s and might have lost their jobs (or worse) if it failed?' Under capitalism, even the most profitable busine its market if it doesn't keep innovating, in order to av overtaken by its competitors. For example, in the 197 placed IBM computers that were 3,000 cubic feet in s chip smaller than a fingernail-and yet Intel itself was stantly forced to improve that chip at an exponential vals likeAdvanced Micro Devices, Cyrix,and others ke in on them technologically. More than once Intel po huge sums of money into the development of improve to risk the financial survival of the company itself. Bu native was to allow itself to be overtaken by rivals, wh have been an even bigger risk to Intel's survival. In short, while capitalismhas a visible cost-profit-tha not exist under socialism, socialism has an invisible co ciency-that gets weeded out by lossesand bankruptcy italism. The fact that most goods are available more ch capitalist economy implies that profit is less costly t ciency. Put differently, profit is a price paid for efficien the greater efficiency must outweigh the profit or else and greater pro would in practice have the lower prices its theorists expected,but which did not materialize in p While capitalists have been conceivedof as people profits, what a business owner really gets is a legal clai ever residual is left over afterthe costs have been paid money received fromcustomers. That residual can turn positive, negative or zero. Workers must be paid and

'During an earlier era, when Stalin ruled the Soviet Union by sheer ter even less initiative by managers of enterprises in the U.S.S.R., because disob ders could land a manager in a prison camp in Siberia or in front of a firing point, there was a severe shortage of mining machinery, while the manager produced such machines was keeping them in storage after they were pro than sending them out to the mines. The reason was that the official ord these machines to be painted with red, oil-resistant paint-and the producer only green, oil-resistant paint and red paint that was not oil-resistant. Pendi of the kind of paint he needed, he would just keep the machinery in storage b explained, "I don't want to get eight years" for disobeying orders.

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must be paid or they will take legal action to seizeth assets. The only person whose payment is contingen the business is doing is the owner of that business. puts unrelenting pressure on the owner to monito that is happening in the business and everything th ing in the market for the business’ products. In contrast to the layers of authorities monitorin of those under them in a government-run enterprise owner is essentially an unnzonitored r~zonitoras far as efficiency of the business is concerned. Self-inter place of external monitors, and forces far closer att tails and far more expenditure of time and energy any set of rules or authorities is likely tobe able to do fact givescapitalism its enormous advantages. More gives the people living in price-coordinated marke visibly higher standards of living. It is not just ignorant people, but also highly edu like George Bernard Shaw and Karl Marx, who h ceived profits as arbitrary charges added on to the pr and services. To many people, even today, high pro attributed to high prices charged by those motivated In reality, mostof the great fortunes in American his sulted from someone’s figuring out how to charge and therefore gain a mass market for the product. He this with automobiles, Rockefellerwith oil, A & P w Alcoa with aluminum, and Sears, Wal-Martand othe stores with a variety of products. A supermarket chain in a capitalist economy can cessful charging prices that allow about a penny of c each dollar of sales. Because several cash registers bringing in money simultaneously all day long in a b ket, those pennies can add up to a very substantial r on the supermarket chain’s investment, while adding what the customer pays. If the entire contents of the out in about two weeks, then that penny on a do more like a quarter on the dollar (26 cents, to be ex course of a year, when that same dollar comes back 26 times a year.

The Role of Profits-and

Losses

Under socialism, that penny would be eliminated, would be all the economic pressures on the manageme costs down. A customer in a socialist country paying t for what a customer under capitalism would get for could have the satisfaction of knowing that none of hi lars went for profits,but that might be small comfort f with a lower standard of living. When mostpeople are asked how high they think t rate of profit is, theyusually suggest some number m than the actual rate of profit. From 1978 through 1998 corporate profit rates fluctuated between a low of ju percent to a high of about 13 percent. As a percentage income, corporate profits after taxes never exceeded and was often below6 percent over a thirty-year period 1998. However, it is not just the numerical rate of profi people misconceive. Many misconceive its whole role coordinated economy, which is to serve as incentive plays that role wherever its fluctuations take it. Moreo people have no idea that there are vast differences betw its on sale and profits on investments.

Profit Rates

Profits on sales are very different fromprofits on in If a store buys widgets for $10 each and sells them fo some might say that it makes $5 in profits on each wid course, the store has to pay the people who work there company that supplies the electricity forthe lights, ca and other electrical devicesin the store, as well as othe of other goods and services needed to keep the stor What is left over afterall these people have been paid profit, usually a lot less than the gross profit. But that the same as profiton investment. When someone invests $10,000, what that person know is what annualrate of return it will bring, wheth vested in stores, real estate, or stocks and bonds. Profits ular sales are not what matter most. It is the profit o capital that has been invested in the business that matte

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can be sold at prices that are much higher than wh paid for them and yet, if those items sit in the store fo fore being sold, they may be less profitable than oth have less of a markup but which sell out within a w that sells pianos undoubtedly makes a higher perc on each salethan a supermarket makes selling bread sits in the store for a much longer time waiting to b loaf of bread does. Bread would go stale waiting for piano to be sold. When a supermarket chain buys $10,000 worth gets its money back much faster than when a piano $10,000 worth of pianos. The piano dealer must cha percentage mark-up on the sale of each piano than a charges on each loaf of bread, if the piano dealer is same annual percentage rate of return on a $10,000 When the supermarket gets its money back in a shor time, it can turn right around and re-invest it, buying or other grocery items. In the course of a year, the turns over many times in a supermarket, earning a time, so that a penny of profit on the dollar can pro profit for the year on the initial investment equal to w dealer makes charging a much higher percentage m investment that turnsover much more slowly. Profits on sales and profits on investment are no ferent concepts. They canmove in opposite direction keys to the rise to dominance of the A & P grocery 1920s was aconscious decisionby the head of the co profit margins on sales, in order to increase the prof vestment. With the new and lower prices made possib with lower profits per item, A & P was able to attra creased numbers of customers, making far more to cause of the increased volume of sales. Making a pro few cents on the dollar on sales, but with the inven over nearly 30 times a year, A & P’s profit rate on soared. This low price and high volume strategy set a spread to other grocery chains and to other kinds of e well. In a later era, huge supermarkets were able profit margin on sales still thinner, because of even

The Role of Profits-and

Losses

umes, enabling them to displace A & P from industry by charging still lower prices.

COSTS OF PRODUCTION

Since profits are the difference between what cons and whatthe products cost toproduce and distribute, tant to be very clear about these costs. Unfortunately misconceived almost as much as profits. First of all, there is no such thing as ”the” cost of p given product or service. Henry Ford proved long ag cost of producing an automobile was very different produced 100 cars a year than when you produced 10 a mass market for automobiles,it paid to invest in exp duction machinery, whose cost per car would turn out est when spread out over a huge number of automob you sold only half as many cars as you expected, then that machinery per car would be twice as much. It is that the minimum amount of automobile production r achieve efficient production levels today runs into the of thousands. Back in 1896, the largest automobile ma in the United States produced just six cars a year. At th output, only the truly rich could afford to buy an auto was Henry Ford whose mass production brought cars price range of ordinary Americans. Similar principles apply in other industries. It does much to deliver a hundred cartons of milk to one supe it does to deliver ten cartons of milk to each of ten neighborhood stores. Whenbuilding a beer brewery,co costs are about one-third less per barrel of beer when ery’s capacity is4.5 million barrels per year than when ity is 1.5 million barrels. Moreover there are other eco large-scale beer production. Although Annheuser-Bus millions of dollars advertising Budweiser and its othe huge volume of sales means that its advertising costs p beer are about two dollars less than that of its compet and Miller.

BASIC ECONOMTCS

In short, the cost of producing a given produ varies with the volume being produced. This is wha call ”economies of scale.” But that is only half economies of scale were the whole story, the questio have to be asked: Why not produce cars in even mor terprises? If General Motors, Chrysler, and Ford would they not be able to produce cars even more thereby make more profit than whenthey produce se Probably not. There comes a point, in every indu which the cost of producing a unit of output no long the amount of production increases. In fact, costs per rise afteran enterprise becomes so huge thatit is dif itor and control, when the right hand doesn’t know hand is doing. The coordination of knowledge with zation is as big a problem as it is in the econom within the organization there are usually no such eff as prices to convey information, so that coordinatio must take place through more cumbersome method ticulation and monitoring, both of which have seriou Back when the American Telephone and Telegra was the world’s largest corporation, its own chief e cer said: ”A.T. & T. is so big that, when you give it a k hind today, it takes two years before the head say General Motors is the largest manufacturer of autom world, but its cost of production per car is estimate dreds of dollars more than the costs of Ford, Chrysl Japanese manufacturers. In short, while there are economies of scale, th what economists call ”diseconomies of scale.’( Econo economies exist simultaneously at many different l put. That is, there may be things the business could were larger and other things it could do better if it Eventually, the diseconomies begin tooutweigh the e it does not pay a firm to expand beyond that point. industries usually consist of many firms, instead of o per-efficient monopoly.

‘I was an economist working for A.T.&T. at thetime and heardhim

The Role of Profits-and

Losses

In the Soviet Union, where there was a fascin economies of scale and a disregard of diseconomies of the industrial and agricultural enterprises in the U.S.S. largest in the world. The average Soviet farm, for ex ten times the size of the average American farm and more than ten times as many workers. But Soviet farm toriously inefficient. Amongthe reasons for this ineffi by Soviet economistswas “deficient coordination.” Economies and diseconomies take many forms. these economies and diseconomies mean that there given cost for doing a given thing. In the American ai try, for example, it would be cheaper to fly passeng from city A to city B than to have them fly to city C transfer to another plane to complete their journey-ot being equal. However, the reason other things are not e it is alsousually cheaper to fly 200 passengers on a 200 plane than ontwo 100-passenger planes or by flyingt half-empty 200-passenger planes. By incurring the extra costof flying passengers to diate ”hub” city, where they join other passengers cities going tothe same ultimate destinations, the airli to fill moreof the seats on a bigger plane flying out of ducing their costs per passenger. In other words, the economies and diseconomies of scale here, as in many ations. Whether one outweighs the other in a given si pends on the volume of traffic between different cit cost differences per passenger between airplanes o sizes. If there are enough passengers flying between city B to fill the larger planes, then direct flights bet cities would cost the airline less per passenger than se to a hub city to transfer. Again, there is no such thing a of flying passengers from one city to another, nor cheaper than another under all circumstances. That is major airlines have both hub cities and direct flights. The point at which the disadvantages of size be weigh the advantages differs from one industry to an is why restaurants are smaller than steel mills. A wellrant usually requires the presence of an owner with s

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centives to continuously monitor all the things neces cessful operation, in a field where failures are all to Not only must the food beprepared to suit the tastes o rant’s clientele, the waiters and waitresses must do th way that encourages people to come back foranother perience, and the furnishings of the restaurant must as to meet the desires of the particular clientele that it Moreover, these are not problems that can be sol for all. Foodsuppliers must be continuously monitore they are still sending the kind and quality of produce and other ingredients needed to satisfy the customer chefs must also be monitored to see that they are c meet existing standards-as well asadding to their re new foods and drinks become popular and old ones less often bythe customers. The normal turnover of employees also requires be able to select, train, and monitor new people on basis. Moreover, changes outside the restaurant-in neighborhood around it, for example-can make or b ness. All these factors, and more, must be kept in weighed by the owner, and continuously adjusted to ness isto survive, much less be profitable. Such a spectrum of details, requiring direct pers edge and control by someone on the scenewith ince beyond a fixed salary limits the size of restaurants, to the size of steel companies, airplane manufacturer companies. Even where there are nationwide restau often these are run by separate owners operating fra some national organization that supplies such things ing and general guidance and standards, leaving th monitoring tasks to local owners. Howard Johnson p restaurant franchising in the 1930s, supplying half with the local manager supplying the other half. Thi cal franchisee a vested interest in the restaurant’s rather than simply a fixed salary. Costs vary not only with the volume of output, a degrees from oneindustry to another, they alsovary the extent to which existing capacity is beingused. W

The Role of Profits-and

Losses

plane with 200 seats is about to take off with 180 pas board, the cost of letting 20 “standby” passengers get o is negligible. That is one reason for radically differen ing charged to people flying on the same plane. Some bought guaranteed reservations and others essentiall chance of getting on board. Different levels of proba different costs in airline tickets, as elsewhere. The themselves also differ in how important it is for them particular place at a particular time. Those on urgen may want a guaranteed reservation, even at a higher p others may be in a position where saving money is m tant than being on one particular flight rather than ano In many industries and enterprises, capacity must handle the peak volume-which means that there is ex ity at other times. The cost of accommodating more u product or serviceduring the times when there is exc is much less than the cost of handling those who ar peak times. A cruise ship, for example, must recei money from its passengers to covernot only such curr paying the crew, buying food, and using fuel, it must a to pay such overhead costs as the purchase price of th the expenses at the headquarters of the cruise line. twice as many passengers at the peak season may m another ship, as well as hiring another crew and buyi much food and fuel. However, if the number of passengers in the off sea one-third of what it is at the peak, thena doubling of the off-season passengers willnot require buying another ing ships can simply sail with fewer empty cabins. T pays the cruise line to try to attract economy-minded by offering much reduced fares during the off season retired people, for example, can schedule their cruise of the year, not being tied down to the vacation sched jobs or their children’s schools. It is common for discounts in off-season travel, both on land and at sea. in general can afford to do this because their costs are l each particular business is forceddoto it because their will take customers away from them if they don’t.

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BASIC ECONOMICS

SPECIALIZATION AND DISTRIBUTIO

A business firm islimited, not onlyin its over-all in the range sf functions it can perform efficiently. G makes millions of automobiles, but not a single tire. from Goodyear, Michelin, Firestone,and other tire ma Nor do automobile manufacturers own their own a dealerships across the country. Typically, automobil sell carsto local peoplewho in turn sell tothe public. automobile manufacturer specializes in manufactur biles, leaving other functions to people who develo knowledge and different skills needed to specialize i ticular functions. The perennial desire to ”eliminate the middleman ally thwarted by economic reality. The range of hum edge and expertise is limited for any given person manageably-sized collection of people, so that on number of links in the great chain of production and can be mastered and operated efficiently by the same agers. Beyond some point, there are other people w formthe next stepinthesequencemorecheaply effectively-and, at that point, it pays a firm to sell i some other businesses that can carry onthe next part o tion more efficiently. Newspapers seldom, if ever, ow atetheirownnewsstands,nor dofurnituremanu typically own or operate furniture stores. Most autho their own publishing, much less own their own books Prices play a crucial role in all of this, as in other market economy. Any economy must not only alloca sources which have alternative uses, it must determin the resulting products remain in whose hands b passed along to others who can handle the next stag ciently. Profit-seeking businessesare guided by their line, but this bottom line is itself determined by wha do and at what cost. When an oil company discover make more money by selling gasolineto local fillings by owning and operating its own filling stations, th line passes out of its hands andis then dispensed to t

The Role of Profits-and

Losses

others. In other words, the economy asa whole operate ficiently when the oil company turns the gasoline ove at this point, though the oil company itself does so o self-interest. What connects the self-interest of a com the efficiency of the economy as a whole are prices. Wh uct becomes more valuable in the hands of somebody somebody else willbid more forthe product than it is w current owner. Theowner then sells, not for the sake of omy, but for his own sake. However,the end result is a cient economy,where goods move tothose who value th Despite superficially appealing phrases about "el the middleman," middlemen continue to exist because do their phase of the operation more efficiently than should hardly be surprising that people who special phase can do that phase better than others. As in other cases, one of the best ways of understa role of prices and profits is to seewhat happens intheir Socialist economies not only lack the kinds of i which force individual enterprises toward efficiency an tion, they also lackthe kinds of financial incentivesthat given producer in a capitalist economy to limitits wor stages of production at which it has lower production alternative producers. Capitalist enterprises buy co from others who have lower costs in producing those components, and sell their own output to whatever m can most efficientlycarry out its distribution. But a soci omy may forego theseadvantages of specialization. In the Soviet Union, for example,many enterprises their own components, even though specialized pro such components could manufacture them at lower cos viet economists estimated that the costs of componen for a machine-building enterprise in the U.S.S.R. we three times asgreat as the costs of producing those sam nents in specialized enterprises. But what does cost m system where profits and losses are not decisive? This was not peculiar to machine-building enterp cording to these same Soviet economists, "the idea of ciency in supply penetrates all the tiers of the econ

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administrative pyramid, from top to bottom.” Just bricks in the U.S.S.R. were produced by enterprises set up for that purpose, but which made their own b to build whatever needed building to house their m activity. That was because these Soviet enterprises c on deliveries from the Ministry of Construction Ma had no financial incentives to be reliable in deliver time or of the quality required. For similar reasons, far more Soviet enterprises ing machine tools than were specifically set up to while, specialized plants set up for this purpose w their capacity-which is to say, at higher costs than head had been spread out over more output-becau other enterprises were producing these things for Capitalist producers of bricks or machine tools have to produce what is wanted by the customer, and to delivering it, if they intend to keep those customer tion with other producers of bricks or machine too monopoly has no such pressures. By contrast, General Motors canproduce million biles without producing a single tire to go on them, can rely on Goodyear, Michelin, or whoever else s tires to have those tires waiting to go on the cars wh off the production lines. To leave General Motors h with notires to go on their cars, would be financially tire company, since it would lose a customer for mi each year. Reliability isan inherent accompaniment of the p uct when keeping customers is a matter of econo death undercapitalism, whether at the manufacturin retail level. Back in the early 1930s, when refrigerat beginning to become widely used, there were many and production problems with the first mass-produ tors sold by Sears. The company had no choice bu money-back guarantee by taking back 30,000 refri time when they could ill afford todo so. This provid pressure on Sears to either stop selling refrigerato what some of its executives and many of its stor

The Role of Profits-and

Losses

wanted) or else greatly improve their reliability, whic they eventually did, becoming one of the leading seller erators in the country. None of this was painless. Nor is it likely that a so nopoly would have been forced to undergo such trauma to please its customers. There was a reason w enterprises could not rely on their suppliers and chose make many things for themselves, even though they specialists in making those things. The suppliers did n please their customers. All theyhad to do was follow o the central planning commission in Moscow.

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Chapter 7

Big Business and Government

T

hus far, we have been considering what happens nesses compete freely with one another in the ma But this is not always the case. Sometimesone company the total output of a given good or service. Formany y local telephone company was a monopoly in its reg country. For about half a century before World War 1 minum Company of America (Alcoa) produced all the got aluminum in the United States. Such situations ar but they are important enough to deserve some serious Most big businesses are not monopolies and not al lies are big business. Nor is this distinction a technica policies designed to deal with monopolistic behavior stricting the competitive advantages of large-scale e and thereby restricting consumers’ ability to ben economies of scale that produce lower prices.

MONOPOLIES AND CARTELS

Just as we can understand the function of prices b we have seen what happens whenthey are not allowe tion, so we can understand the role of competition in omy better after wecontrastwhat happens in co markets with what happensin markets that are not com Thus far, we have considered prices as they emerg market with many competing businesses. Such marke cause goods and services tobe produced at the lowest

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sible under existing technology and with existing re something as simple as apple juice. It undoubtedly thing to produce apple juice, but how do we know t being charged isnot far above those costs of producti most of us do not grow apples, much less process t and then bottle the juice and transport and store it, s idea how muchany or allof this costs. Competition in the marketplace makes it unnece to know. Those few among us who do know such thin are in the business of making investments, have every invest wherever there are higher rates of return a their investments where the rates of return are lowe If the price of apple juice is higher than necessary to for the costs incurred in producing it, then high rates be made-and will attract ever more investment int try until the competition of additional producers d down to a level that just compensates the costswith erage rate of return on similar investment availabl Only then will the in-flow of investments from other economy stop, with the incentives for these in-flow gone. If, however, there werea monopoly in producing this whole process would not take place. Chancesare oly prices would remain at levels higher than neces pensate for the costs and efforts that go into prod juice. Many people object tothe fact that a monopoli higher prices than a competitive business could. Tha true, but its ability to transfer money from other me society to itself isnot the sole harm done by a monop standpoint of the economy as a whole, these interna not change the total wealth of the society, eventhou tributes that wealth in a manner that may be objecti adversely affects the total wealth in the economyas a effect of a monopoly on the allocation of scarce res have alternative uses. When a monopoly charges a higher price than it if it had competition, consumers tend to buy less of than they would at a lower competitive price. In shor

Big Business and Government

list produces less output thana competitive industry w duce with the same available resources, technologyand ditions. The monopolist stops short at a point where c are still willing topay enough to coverthe cost of produ cluding a normal profit) of more output because the m is charging more than the usual cost of production an more than the usual profit. In terms of the allocation of which have alternative uses, the net result would be tha sources which could have been used to produce more a would instead go into producing other things elsewh economy, even if those other things were not as valua apple juice that could and would have been produced competitive market. In short, the economy’s resources inefficiently when there is monopoly, because these would be transferred from more valued uses to lessval Fortunately, monopolies are very hard to maintai laws to protect the monopoly firms from competition. T less searchof investors for the highest rates of return vir sures that such investments will flood into whatever s the economy is earning higher profits, until the rate o that segment is driven downby the increased competiti by that flood of investment. It is likewater seeking its o But, just as dams can prevent water from finding its ow government intervention can prevent a monopoly’s p from being reduced by competition. In centuries past, government permission was req open businesses in many parts of the economy, especi rope and Asia, and monopoly rights were granted t businessmen, who either paid the government directly rights or bribed officials who hadthe power to grant su or both. However, bythe end of the eighteenth century, opment of economics had reached the point where in large numbers of people understood how this was detr society as a whole and counter-pressures developed tow ing the economy from monopolies and government co nopolieshave therefore become much rarer, at lea national level, though it remains common in many cit restrictive licensinglaws limit how many taxis are allow

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BASIC ECONOMICS

erate, causing fares to be artificially higher than n cabs less availablethan they would be in a free mark Again, the loss isnot simply that of the individua The economy as a whole loses when people who willing to drive taxis at fares that consumers are will nevertheless prevented from doing so by artificial r the number of taxi licensesissued, and thus either d work of lesser value or remain unemployed. If th work were of greater value, and were compensated then such people would never have been potential t the first place. From the standpoint of the economy as a whol that consumers of the monopolist’s product are fore of scarce resourceswhich would have a higher value in alternative uses. That is the inefficiency which cau omy as a whole to have less wealth under mono would have under free competition. It is sometimes said that a monopolist “restricts this is not the intent. The monopolist would love to sumers buy more at its inflated price, but the con short of the amount that they would buy at a lowe free competition. It is the monopolist’s higher price the consumers to restrict their own purchases a causes the monopolist to restrict production to wha But the monopolist may be advertising heavily to try consumers to buy more. Similar principles apply to a cartel-that is, a g nesses which agree among themselves to charge hig otherwise avoid competing with one another. In th could operate collectively the same as a monopoly. dividual members of cartels tend to cheat on one cretly-lowering the cartel price to some customer take business away from other members of the cart becomes widespread, the cartel becomes irrelevan not it formally ceases to exist. Because cartels were once known as ”trusts,” le signed to outlaw monopolies and cartels became kn trust laws.” However, such laws are not the only wa

Big Business and Government

I

monopolies and cartels. Private businesses that are not p cartel have incentives tofight them in the marketplace. private businesses can take action much faster than the quired for the government can bring an anti-trust case cessful conclusion. In the nineteenth-century heyday of the trusts, Mo Ward was one of their biggest opponents. Whether th volved agricultural machinery, bicycles, sugar, nails Montgomery Ward would seek out manufacturers that part of the trust and buy from them below the cartel selling to the general public below the retail price of produced by members of the cartel. Since Montgomery the number one mail-order business in the country at th was also big enough to set up its own factories and product itself if need be. The later rise of other huge retailers like Searsand A wise confrontedthe big producers with financial giants ther produce their own competing products to sell in stores or to buy enough from some small enterprise o cartel to enable that enterprise to grow into a big co Sears did both. It produced stoves, shoes, guns, and w among other things, in addition to subcontracting the p of other products. A & P imported and roasted its ow canned its own salmon, and baked half a billion loaves year forsale in its own stores. While giant firms like Sears, Montgomery Ward a were unique in being able tocompete against a number simultaneously, smaller companies could also take a from cartels in their respective industries. Their incen same as that of the cartel-profit. Where a monopoly maintains prices that produce higher than normal pro businesses are attracted to the industry. This additiona tion then tends to force prices and profits down. In o monopoly or cartel to succeed, it must find ways to pre ers from entering the industry. This is easiersaid than d way to keep out potential competitors is to have the go make it illegal forothers to operate in particular industr granted or sold monopoly rights for’centuries, and mo

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BASIC ECONOMICS

ernments have restricted the issuance of licenses f dustries and occupations, ranging from airlines t trucking to the braiding of hair. Politicalrationales a ing for these restrictions, but their net economic effe existing enterprises from additional potential com therefore to maintain prices at artificially high levels In the absence of government prohibition of e clever schemes can be used privately to try to ere keep out competitors and protect monopoly prof businesses have incentives to be just as clever at e barriers. Accordingly, the effectiveness of barriers varied from industry to industry and from one era the same industry. The computer industry was on enter, backin the days when a computer was a hug ing up a major part of a room, and the costs of m such machines was huge. But the development o meant that smaller computers could do the same wo be manufactured by smaller companies. One sma unknown computer manufacturer-MSE Engineering computers to the Hoover Institution at Stanford Un In addition to private responses to monopoly which arise more or less spontaneously in the ma federal government began to respond to monopoli in the late nineteenth century. These responses incl rectly regulating the prices which the monopolist we charge and taking legal action against these monop tels under the Sherman Anti-Trust Act of 1890 and o titrust legislation. When railroads were first built in the nineteenth were many places where only one rail line existed, railroads free to charge whatever prices would m profits where they had a monopoly. Complaints ab tion led to the creation of the Interstate Commerce C 1887, the first of many federal regulatory commissi the prices charged by monopolists. During the er phone companies were monopolies in their respectiv Federal Communications Commission controlled phone service.

Big Business and Government

Another approach has been to pass laws against th or maintenance of a monopoly or against various prac as price discrimination, growing out of monopolistic These anti-trust laws were intended to allow business ate without the kinds of detailed government supervis exist under regulatory commissions, but with a sort surveillance, like that of traffic police, with intervent ring only when there are specific violationsof laws.

REGULATORY COMMISSIONS

Although the functions of a regulatory commission straightforward in theory, in practice its task is far mo and, in some respects, impossible. Moreover,the politic in which regulatory commissions operate often lead and results directly the opposite of what was expecte who created such commissions. Ideally, a regulatory commission would set prices w would have been if there were a competitive marke practice, there is no way to know what those prices Only the actual functioning of a market itself could r prices, as the less efficient firms were eliminated by b and only the most efficient survived. No outside obs know what the most efficient ways of operating a giv industry are. Indeed, many managements within an ind cover the hard way that what they thought was the mo way to do things was not efficient enough to meet th tion. The most that a regulatory agency cando is acce pear to be reasonable production costs and allow the to make what seems to be a reasonable profit over a such costs. Regulatory agencies areoften set up after some po saders have successfully launched investigations or campaigns that convince the authorities to establish a p commission to overseeand control a monopoly or som firms few enough in number to be a threat to behave in as if they were one monopoly. However, aftera comm

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been set up and its powers established, crusaders an tend to lose interest over the years and turn their other things. Meanwhile, the firms being regulated take a keen interest in the activities of the commi lobby the state or federal legislature for favorable reg favorable appointments of individuals to these comm The net result of these asymmetrical outside inter agencies is that commissions set up to keep a given f try within bounds, for the benefit of the consumer morphose into agencies seeking to protect the existi firms from threats arising from new firms with new t new organizational methods. Thus the Interstate Com mission responded to the rise of the trucking indu competition in carrying freight threatened the econo of the railroads, by extending their control overtruck The original rationale for regulating railroads w railroads were often monopolies in particular areas o But now that trucking undermined that monopoly, of the I.C.C. was not to say that the need for regu portation was now less urgent or perhaps even unn stead, it sought-and received from Congress-broade under the Motor Carrier Act of 1935, in order to restr ties of truckers. This allowed railroads to survive un nomic conditions,despitetruckcompetitionthatwas efficient for various kinds of freight hauling. Truc permitted to operate across state lines only if they ha from the Interstate Commerce Commission decla trucks’ activitiesserved ”public necessity and conven fined by the I.C.C. In short, freight was no longer hauled in what quired the use of the least resources, as it would be competition, but only by whatever way met the arbit ments of the Interstate Commerce Commission. Th for example, authorize a particular trucking comp freight from New York to Washington,but not from to Baltimore, even though these citiesare on the way. cate did not authorize freight to be carried back from to New York, then the trucks would have to return other trucks carried freight from D.C. to New Yo

Big Business and Government

standpoint of the economy as a whole, enormously gr were incurred than were necessary to get the work d this accomplished politicallywas to allow far more co both truckers and railroads-to survive and make a pr there were an unrestricted competitive market, where portation companies would have no choice but to use t ficient ways of hauling freight. While open andunfettered competition would have nomically beneficial to the society as a whole, such c would have been politically threatening to the regula mission. Firms facing economic extinction because of c would be sure to resort to political agitation and intrig the survival in office of the commissioners and again vival of the commission and its powers. Labor unions vested interest in keeping the status quo safe from th tion of technologies and methods that might require fe ers to getthe job done. After the 1.c.C.’~powers to control the trucking were reduced by Congress in 1980, freight charges de stantially and shippers reported a rise in the quality vice. Thiswas made possible bygreater efficiency in th as there were now fewer trucks driving around empty truckers hired workers whose pay was determined and demand, rather than by union contracts. Becauset eries were now more dependable in a competitive indu nesses using their services were able to carry smaller in saving in the aggregate tens of billions of dollars. The inefficiencies created by regulation were ind only by such savings after federal deregulation, but a difference between the costs of interstate shipments an of intrastate shipments, where strict state regulation co ter federal regulation was cut back. For example, shi jeans within the state of Texas from El Paso to Dallas 40 percent more than shipping the same jeans inter from Taiwan to Dallas. Gross inefficienciesunder regulation were not pec Interstate Commerce Commission. The same was true Aeronautics Board, which kept out potentially comp lines and kept the prices of airfares high enough to insu

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viva1 of existing airlines,rather than force them to fac tition of other airlines that could carry passengers che better service. Once the CAB was abolished, airlin down, some airlines went bankrupt, but new airlines the end there were far more passengers being carrie time under the constraints of regulation. Savings to sengers ran into the billions of dollars. These were n sum changes, with airlines losing what passengers country as a whole benefitted from deregulation, for became more efficient. Just as there were fewer tru around empty after trucking deregulation, so airpla fly with a higher percentage of their seats filled aftera ulation and passengers had more choices of carrier route than bef0re.l The original rationale for regulation was to keep rising excessively but, over the years, this turned in restrictions against prices jaZZing to a level that would isting firms. Political crusades are based on plausib but, even when those rationales are sincerely believ estly applied, their actual consequences may be com ent. When major mistakes are made in a competiti those who were mistaken can be forced from the m But, in politics, those who were mistaken can often survive by doing things that were never contemplate positions and their powers were created.

ANTI-TRUST LAWS

With anti-trust laws, as with regulatory commiss distinction must be made between their original ra

'One of the continuing problems of the airline industry-airport co because landing fees have not been deregulated. Instead of being determin demand for landing rights at airports, landing feesare determined by a which allow small private planes to use a scarce resourceat less than its v carrying hundreds of passengers. The predictable net result is that small p rying a handful of people are able to land at overcrowded major airports just as easily land atsmaller airports where they would not either delay v bers of other passengers or preclude the scheduling of more flights in bigg

Big Business and Government

what they actually do. The basicrationale for anti-trus prevent monopoly and other conditions which allow rise abovewhere they would be in a free and competiti place. In practice, mostof the great anti-trust cases hav some business that charged lower prices than its comp ten it has been complaints from these competitors wh the government to act. The basis of many government prosecutions unde trust laws is that some company’s actions threaten co However, the most important thing about competition a condition in the marketplace. This condition cannot be by the number of competitors existing in a given ind given time, though politicians, lawyers and assorted o confused the existence of competition with the number ing competitors. But competition as a condition is pre eliminates many competitors. Obviously, if it eliminates all competitors, then the firm would be a monopoly and could charge far high in a competitive market. But that is extremely rare. Ho specter of monopoly is often used to justify govern intervention where there no is serious danger of a mono Back when the A & P grocery chain was the lar chain in the world, it still sold less than one-fifth of th in the country. Yet the Justice Department brought an action against it, using the company’s low prices, and ods by which it achieved those low prices, as evidenc competition against competitors. Throughout the histo trust prosecutions, there has been an unresolved con tween what is detrimentaltocompetitionandwhatis detrimental to competitors. In the midst of this con question of what is beneficial tothe consumer has ofte sight of. What has also been lost sight of is the question ciency of the economy as a whole, which is another w ingatthe benefits to theconsuming public. Few resources are used when products are bought and sold lots, as large chain stores are often able todo, than wh ments are sold and delivered in much smaller quant

BASIC ECONOMICS

merous smaller stores. Both delivery costs and sell less per unit of product when the product is bough large enough amounts to filla railroad boxcar. Production costs are also lower when the produce enough order to be able to schedule production far ah of finding himself forced to pay overtime to fill man unexpected orders that happento arrive at the same Despite such economies of scale, the governmen against the Morton Salt Company in the 1940s fo counts to buyers who bought carload lots of their p nesses that bought less than a carload lot of salt w $1.60 a case, those who bought carload lots were ch case, and those who bought 50,000 cases or more in were charged $1.35. Because there were relatively fe that could afford to buy so much salt and many mo not, ”the competitive opportunities of certain merch jured,” according to the Supreme Court, which uph eral Trade Commission’s actions against Morton Salt The government likewise took actionagainst the Company in the 1950s for allowing discounts to t who bought oil by the tank car. The Borden compa larly brought into court in the 1960s for having cha milk to big chain stores than to smaller grocers. In a the key point was that such price differences were ”discriminatory” and ”unfair” to those competing fir make such large purchases. While the sellers were allowed to defend themse by referring to cost differences in selling to differe buyers, the apparently simple concept of ”cost” is b simple when argued over by rivallawyers, accounta omists. Where neither side could prove anything about the costs-which was common-the accused lo In a fundamental departure from the centuries-old Anglo-American law, the government need only ma cial or prima facie case, based on gross numbers, to s den of proof to the accused. This same principle an was to reappear later in employment discrimination the civil rights laws. As with anti-trust cases, these

Big Business and Government

discrimination cases likewise produced many conse and large out-of-court settlements by companies wel the virtual impossibility of proving their innocence, re what the facts might be. The rarity of genuine monopolies in the American has led to much legalistic creativity, in order to defi companies as monopolistic or as potential or "incipien olies. How far this could go was illustrated when th Court in 1966 broke up a merger between two shoe that would have given the new combined company percent of the shoe sales in the United States. It lik same year broke up a merger of two local supermar which, put together, sold 7.5 percent of the groceries Angeles area. A standardpractice in the courts and in the literatu trust laws is to describe the percentage of sales made company as the share of the market it "controls." By dard, such now defunct companies as Graflex and Pan "controlled" a substantial share of their respective when in fact the passage of time showed that they nothing, or elsethey would never have allowed thems forced out of business. The severe shrinkage in size o mer giants as A & P andSmith-Corona likewisesugge rhetoric of "control" bears little relationship to reality rhetoric remains effective in courts of law and in th public opinion. Even in the rare case where a genuine monopoly e own-that is, has not been created or sustained by g policy-the consequences in practice have tended to b dire than in theory. During the decades when the A Company of America (Alcoa)was the only producer o got aluminum in the United States, its annual profit rat vestment was about 10 percent after taxes. Moreover,t aluminum went down to a fraction of what it had been coa was formed. Yet Alcoa was prosecuted under the laws and lost. Why were aluminum prices going dow monopoly, when in theory they should have been goi spite its "control" of the market for aluminum, Alcoa

l 02

BASIC ECONOMICS

aware that it could not jack up prices at will, withou substitution of other materials-steel, tin, wood, plas minum by many users. This raises a question that applies far beyond th industry. Percentages of the market "controlled" by company ignore the role of substitutes that may be products of other industries, but which can neverthe by many buyers, if the price of the monopolized prod nificantly. A technologically very different product m substitute, as laptop computers did when they repla typewriters, or as television did when it replaced m pers as sources of information and entertainment. A monopoly of Valencia oranges would mean little if free tobuy navel oranges, tangerines, and other simi sense, every company that sells brand-name merch monopoly of that particular merchandise. But a m Canon cameras means little when photographers ar Nikon, Minolta, Pentax,and other cameras. An extreme example of how misleading market tics can be was the case of a local movie chain that percent of all the first-run movies in Las Vegas. Itwa as a monopoly but, by the time the case reached th Court of Appeals, another movie chain was showin run movies in Las Vegas than the "monopolist" th prosecuted. Fortunately, sanity prevailed in this ins Alex Kozinski of the 9th Circuit pointed out that th nopoly is not market share-even when it is 100 perc ability to keep others out. A company which canno petitors out is not a monopoly, no matter what perc market it may have at a given moment. Focusing on market shares at a given moment ha pattern in which the government has prosecuted lea an industryjust when they were about to lose that lea world where it is common for particular companie fall over time, anti-trust lawyers can take years to against a company that is at its peak-and about to h hill. For example, an anti-trust case against the A chain ended in 1949, just three years before A & P los

Big Business and Government

and began a long and catastrophic economic decline. trol,” ”power,”and ”dominance” of A & P, which the g lawyers depicted so convincingly in court proved to consequence in the marketplace, when other supermar were able to provide better service at lower prices. A major anti-trust case can take a decade or m brought to a final conclusion. Markets often react m quickly than this against monopolies and cartels, as ea eth century trusts found when giant retailers like Se gomery Ward and A & P outflanked them long b government could makea legal caseagainst them. Perhaps the most clearly positive benefit of antihas been a blanket prohibition against collusion to fix is an automatic violation, subject toheavy penalties, re any justification that might be attempted. Whether weighs the various negative effects of other anti-tru competition in the marketplace is another question.

?Whydid A & P not adjust to the new conditions as fast as Safeway? Pa may be that there are always differences among individuals in how fast they and how quickly they respond. Another factor in the case of A & P was tha was owned and operated for morethan half a century by two brothers, and t last brother in 1951 brought to leadership a man who had served faithfully system. Was such a man at such a time, in the wake of his leader’s death, lik company upside down andthrow away the managerial legacy he hadreceiv

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Chapter 8

An Overview

P

erhaps the most overlooked fact about industry merce is that they are run by people who differ gr one another in insight, foresight, leadership, organiza ity, and dedication-just as people do in every other w If the economy is to achieve the most efficientuse of it sources, there must be some way of weeding out thos owners or managers who do not get the most from sources. Losses accomplish that. Bankruptcy shuts downthe terprise that is failing to come up to the standards of it tors or is producing a product that has been supersede other product. Before reaching that point, however, force a firm to makeinternal reassessments of its polici sonnel. These include the chief executive, who can be r irate stockholders who are not receiving the dividend pected. The whole management team can also be repl outside financial interests realize that the business worth more if managed by someone else, and whothe over the business, in order to run it better and more with a different set of managers. Because assets tend to move through a competitive those who value them most, and whoare therefore wi the most for these assets, a poorly managed compan valuable to outside investors, who are convinced tha improve its performance, than to existing owners. The investors can therefore offer existing stockholders mo stock than it is currently worth and still make a pro stock’s value later rises to the level expected when exi agement is replacedby better managers.

BASIC ECONOMICS

For example, if the stock isworth $80 a share und management, outside investors can start buying i share until they have a controlling interest in the cor ter using that control to fire existing managers and with a more efficient management team, the value might rise to $150 a share. While this profit is what m investors, from the standpoint of the economy as a matters is that such a rise in stock pricesusually mea the business is now serving more customers, or offer ter quality or lower prices, or isoperating at lower co combination of these things. Thus profits and losses work together in a marke replace personnel, products and whole companies an with better alternatives. The net effect of achieving of efficiency ishigher standards of living for the con lic. Moreover, this process is never-ending because can never be solved once and for all. Changes in te the company’s internal personnel and in the surrou omy and society present ever-changing challenges with, all under the constant threat of losses, as well a ties forprofit. As noted in Chapter 5, in the predominantly rura the late nineteenth and early twentieth centuries, t cient way to distribute many goods to a widely scatt tion was by mail. Montgomery Ward and then Sear biggest retailers in the country by selling through the catalogs from their respective headquarters in Chica below those charged by local stores, whose distri were higher. However, the growing urbanization of slowly but surely changed all that. A more concentrated urban population could n cheaply served by building chains of stores in their m early 1920s, both Montgomery Ward and Sears were survive financially, while chain stores like J. C. P springing up and prospering, taking away their custo only when these two giants of the mail-order cata built chain stores themselves that their fortunes reviv surged to the top again.

A n Overview

Just as the urbanization of early twentieth-century ically changed the relative costs of distributing general by mailand through stores, so the postwar suburbaniz ing prosperity of America changed the relative costs of groceries through neighborhood stores and through su located inshopping malls. Again, someindividuals and grasped this soonerthan others, allowing Safeway to of the new wave to leadershipof the industry, while leader-A & P-sank into virtual oblivion, though it had than twice the size of Safeway as late as 1962. The Great Depressionof the 1930s leftmany busin very cautious about expanding their operations, espec required borrowing money that might be hard to r economy turned down. Even highly profitable busine decide to save their money for a rainy day, rather tha new ventures. Against this background, it is not surp the dramatic change in the American economy and tween the Great Depression of the 1930s and the boo peritythatbegan after World WarI1 was perce differently by differentbusiness leaders. Fear that a new depression might be coming cause agements of Montgomery Ward and A & P to be reluc high prices forsuburban locations fornew stores, whil Safeway plunged ahead with expansion into such area much of the most affluent population was now mov case, those who gambled won and those who played In other cases under other circumstances, those who met disaster. TheW.T. Grant variety store chain, onc biggest retailers in America during the first half of th century, became in the 1970s one of the biggest bank the history of the country, after financing a costly which did not work out. Grocery stores and department stores were not the nesses presented with a radically changed environm sult of the rapid increase of automobile ownership post-World War I1 boom and suburbanization. McDo food restaurants were entirely a postwar phenomen from one hamburger stand in southern California oper

l os

BASIC E C O N O M I C S

McDonald brothers in 1955 to 4,000 nationwide just 2 and 8,000 a decade after that. Many of these McDo built on highways or at other locations from which draw customers in automobiles from milesaround. In previous decades-from the 1920s into the 1 Castle was the dominant hamburger chain in the cou walked to White Castle hamburger stands, which me stands had to be located in places with high populati so as to generatea large volumeof pedestrian traffic in rant, so that White Castle could sell to many peo wh a limited distance. Accordingly, White Castles were near factories or in crowded working class neighbor tral cities. And they stayed open around the clock. Financing was also very different in this differen later fast-food chains, White Castle did not have fra company owned each restaurant and built new ones had the money on hand to pay cash to do so. This en Castle to ride out the Great Depression of the 1930s, other businesses, homes, and farms were lost becaus could not be paid at a time when money was so sca White Castleexpanded during the Depression. Itwa ally adapted to the world in which it existed. But it lo lenged leadership of the industry and began a obscurity when the American economy and socie around them in the middle of the century. As middle-class and even working class people b prosperous and moved out of the central cities into White Castle could no longer count on the heavy u trian traffic on which it had thrived. Its conservativ policies meant that it could not expand as rapidly i urbs as other businesses which went into debt to do capital by requiring their franchisees toput uppart o needed. The rising crime and violence of the central 1960s was more of a problem for White Castlethan fo burger chains located on highways or in suburba malls. Staying open all night in low-income urban ne was no longer safe, financially orotherwise. At the heart of the changed environment for fast was the automobile. Unlike White Castle, McDona

An Overview

have to adapt to the world of the automobile, becaus began in the part of the country where automobile own most widespread-southern California-and was ge environment from the beginning. As automobile own suburbanization spread across the country, so did McD 1988, half of McDonald’s sales were made at drive-th dows, which were capableof handling a car every 25 well over a hundred per hour. As with the supermarke resented extremely low costsof selling, enabling price down to levels that were highly competitive. Dri restaurants in general require far less land per custo than does a sit-down restaurant. This of course lower doing business. Such economies enable prices to be while competition forces them to bekept down. Just as neighborhood grocery stores, catering to customers in central cities during the prewar era, were the postwar world by suburban supermarkets serving coming from milesaround in their cars, so local fast rants serving customers walking in off the street w passed-and sometimes forced out of business-by c from drive-in fast foodrestaurants, serving people arr tomobiles. By 1996, White Castle’s sales were just one McDonald’s. In a society that is constantly evolving, the cond rounding a given company or industry are always ch not all business leaders are equally quick to spot the grasp their implications. For example, the changing ag of the American population created a huge market fo ers as the baby boom generation reached adolescence adulthood. The number of Americans aged 18 to 24 y doubled between 1960 and 1980, but then began to dr ingly, the total number of hamburgers sold in the U dropped for the first timein 1989.

LEADERSHIP

Given the importance of the human factor and the among people-or evenwith the samepersonat

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times-it can hardly be surprising that dramatic cha relative positions of businesses have been the norm. teenth century, Montgomery Ward was the biggest re country at a time when Richard Sears was just a you agent who sold watches on the side. Yet the small co Sears founded grew over the years to eventually beco times the size of Montgomery Ward. Differences in m had much to do with the different fates of these two long after both Aaron Montgomery Ward and Rich Sears were gone. Some business leaders are very good at some aspe agement and very weak in other aspects. The success ness then depends on which aspects happen to be cr particular time. Sometimes two executives with ver skills and weaknesses combine to produce a very suc agement team, whereas either one of them might have pletely if alone. Some executives are very successful era in the country’s evolution, or during one period i lives, and very ineffective at alater time. Sewell Avery, for example, was for many years a cessful and widely praised leader of U. S. Gypsum Montgomery Ward. Yet his last years were marked by cism and controversy over the way he ran Montgom and by a bitter fight for control of the company that garded as mismanaging. When he resigned as chief ex cer, the value of Montgomery Ward’s stock rose imm .Neither individuals nor companies are success Death alone guarantees turnover in management. An utive during its declining phase summarized its probl ing: ”The simple fact is thatA & P had only management problem-the company was unable to John,” the name long used inside the company for Joh the last member of the founding family to run A & P. of A & P began with his death. His successors could continue his policies, forthe whole retail groceryindu society around it were changing rapidly. ”You cannot business from memory,” John Hartford himself once What was needed after his death were not the particu

An Overview

and practices that were geared to his day. What was n the same kind of foresight, dedication, and imaginatio raised A & P to its pinnacle in the first place-and such not readily available, certainly not continuously and i in one company. Like so many other things, running a business l from the outside. On the eve of the Bolshevik revolu Lenin declared that ”accounting and control” were th tors in running anenterprise and that capitalism had a duced” management to ”extraordinarily simple opera ”any literate person can perform”-that is, ”superv recording, knowledge of the four rules of arithmetic, a appropriate receipts.” Such “exceedingly simple ope registration, filing and checking” can, according to L be performed” by people receiving ordinary workmen’ After just a few years in power, however, Lenin co very different-and very bitter-reality. He himself ”fuel crisis” which ”threatens to disrupt all Soviet wor nomic ”ruin, starvation, and devastation” in the countr admitted that peasant uprisings had become ”a comm rence” under Communist rule. In short, the economic which had seemed to easy and simple before having t them now loomed menacingly difficult. Now Lenin saw people ”who are versedin the art of administration” an that ”there is nowhere we can turn to for such people old class”-that is, the capitalist businessmen.In his add 1920 Communist Party Congress, Lenin warned his ”Opinions on corporate managementare all too freque with a spirit of sheer ignorance,an anti-expert bias.” T simplicities of just three years earlier now required exp began Lenin’s New Economic Policy, which allowed m activity, and under which the economy began to rev

KNOWLEDGE AND DECISIONS

Knowledge is one of the scarcest of all resources. alities abound, but specific hard facts that are releva

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nomic decisions are something entirely different. spects, governments are able to assemblevast amoun edge, but the kind of knowledge involved is often in statistical generalities or verbal generalities known as while many economic decisions depend crucially on cific knowledge of particular things.

Central Planning

While many examples of the difficulties faced by planning of economic activity have come from the S similar results have marked the history of similar eff countries. One of the classic disasters of government volved the British government's attempts to grow pea nial Rhodesia after WorldWar 11. Yet ordinary farmer world had been deciding for generations whereand peanuts, each on his own particular land, whose indiv teristics wereknown directly from personal experie gle acre of land usually has variations in its chemical and its slope, whichdetermines how water runs off af and may vary as wellin the degree to whichis it sha hills, orother things. All this affectswhat will grow b No officials sitting in London could know land in timately. Even a trip to Rhodesia by "experts" could the widely varying qualities of the soil from place way each farmer could on his own plot of land, muc stand all the insects, birds, animals, and rainfall patt ous localities and whateffect theymight have on the Yet even an illiterate farmer would almost automat such things from experienceon his own farm. Theoretically, the experts could ask each individu Rhodesia about such things. But, aside from the imp experts with university degrees deferring to farmer less formal schooling, the accurate transmission of would depend crucially on how articulate and precis ers were in what they said. Since verbal precision is versal, even among highly educated people, this wou chancy way to gather information.

A n Overview

A price-coordinated economy does not depend on so fragile. Each farmer decides individually whether grow peanuts-and how many-at the prices that pean sold for in the marketplace. These prices are a much m rate means of communication because each farmer buyer of peanuts knows that one mistake in weighing a ious factors can spell economic disaster. When it is n question of talking to strangers, but of protecting your nomic future, there should be no surprise that markets work better than government planning. In the Soviet Union as well,what was lacking was tise but highly specific knowledge. There were Soviet who were as much aware of the same general principle ern economists. What the U.S.S.R. did not have were making individuals with the same rangeof hard fac disposal. Power and knowledge were separated in th Union, as in all centrallyplanned economies. Enterprise managers knew what the specific equip sonnel, and supplies at their disposal could and could n central planners in Moscow did not-and it was the ce ners who held the power to make the ultimate decis could the central planners possibly be sufficiently know about all the industries, technologies, and products u command to be able to determine what would be bes independently of what the respective enterprise man them. Central planners could be skeptical of the se statements and demands of the enterprise managers, b cism isnot knowledge. Moreover, changing circumstan almost inevitably be known first to the local manag scene and often much later, if at all, to the central plan had far too many industries and products to oversee keep up with day-to-day changes forthem all. A price-coordinated economy may have no more to edge over all than a centrally-planned economy, but th edge is distributed very differently, as is decision-mak When the owner of a gas station located on a highway the highway is being torn up for repairs, he knows to gasoline than usual from his supplier, because there w

BASIC ECONOMICS

114

nearly as much traffic going past his station as befor til the repair is completed. This local gas station ow need the permission of anybody to change how muc orders or what hours he will stay open. The knowl power are combined in the same person. Moreover, t operating under the incentives and constraints inh prospect of profits and the threat of losses, rather th ders from distant bureaucrats. Nor is this peculiar to The same instant and local decision-makingpower b the facts before their eyes is common throughout a nated market economy. That is one of its advantage trally-planned economy and one of the factors enormous differences inresultsbetweenthetwokinds economies.

Agents

As a scarce resource, knowledge can be bough various ways in a market economy. Thehiring of ag tially the purchase of the agent’s knowledge to guid decisions. Real estate agents commonly charge 6 p sale price of a home and literary agents typically c cent of a writer’s royalties. Whywould a writer surr cent of his royalties, unless 85 percent of what the a for him is worth more than 100 percent of what h himself? And why would a publisher be willing to pa agent than to a writer for the same manuscript? Si would a home-owner accept 6 percent less for his sold through a real estate agent, unless the agent co a higher price or a quicker sale,both of which amoun thing, since delay and its accompanying stresses are the home-owner? Let’s go back to a basic principle of economic physical object does not necessarily have the same va ent people. This applies to an author’s manuscript a house, a painting or an autographfrom a rock star. W agent knows is where a particular manuscript is like greatest value. If it is a cookbook, the agent knows w

An Overview

ers and which editors have the knowledge and the conn promote such a book in places that are very intereste things-gourmet magazines, cooking programs on t and the like. This cookbookwould be far more valuab editors and publishers than to others who specialize i ogy, social issues, or other subjects, or to editors who edge of food does not extend much beyond hamburgers chicken. Evenif an agent is not able to getany more mo a given publisher than a writer could have gotten, th knows which publishers are most likely to pay top d given book, because that particular publisher can pro more copies. A real estate agent is similarly more knowledgeabl average home-owner as to the channels through whic home can be marketed most quickly and for the hig price. Often there are little defects in the home that n corrected, or cosmetic changes that need to be made, house goes on the market. An agent who keeps up with fashions in houses is not only more likely to know w things are but also whether or to what extent money grading the house will be recouped in a higher sale whether it is better to sellthe house ”as is” as a bargain per.” The agent is also more likely to be knowledge which particular contractors are more reliable or more in price for doing whatever repairs or remodelling are as well as which financial institutions are best todeal w buyer and seller of this particular house. Therefore, house is likely tobring in more money when sold thro estate agent, just as a writer’s manuscript is likely to s through a literary agent.

Franchises

Knowledge is shared in both directions when hote rants and other businesses are franchised. The knowled by the chain that does the franchising is based on its e with similar businesses in various locations around the is also likelyto be more knowledgeable about where a

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advertise and how to deal with suppliers. Howev franchisee is likely to be more knowledgeable abou only someone on the scene can know-the local l changes in the surrounding community and of cour tails that have to be monitored on the premises day t Chains and franchises are not synonymous. Th hamburger chain-the chain that put the hamburger o the 1920s-was the White Castle chain, which owned dreds of restaurants. Its top management, however,ha experience before going regional and then nationa made many visits to their local outlets to keep in touc the franchised restaurant chain beganwith Howard J 1930s and the heyday of franchised hamburger stand McDonald's in the 1950s. By and large, franchisesha successful in these fields. By 1990, more than one-th enues from retail sales of goods and services in the went to franchise outlets. Nearly three-quarters of from hotelsand motels wereearned by those affiliate

EFFICIENCY AND ITS IMPLICATION

Economics is not about the fate of particular com about the fate of the economy and of the standard depends on that economy's performance. Competiti coordinated economy ends up with most people ge their goods and services from whatever companies what they want at prices they are willing to pay-wh companies happen to be Sears and A & P in one era and Safeway in another era. Keeping prices down usually means keeping cos tion and distribution down. Huge volumes of sales h Production costs are reduced when the fixed overh be spread out over a large volume of output, addin cost of each individual item. Scheduling also affect costs. Whena high-volume retailer signs a contract der from a given manufacturer, that manufacturer ca ule theworkevenlythroughoutthe year. This

An Overview

additional costs that go with ups and downs in the o come in unpredictably from the market, leaving the turer’s workforce idle during some weeks and working during others. When there are long lay-offs during a sla some of the workers may take other jobs and not come business picks up again, making it necessary tohire repl and spend time training them-all of which costs m adds to the costs of the goods being produced. Because of the savings made possible by advance sc of large orders, high-volume retailers have been able to tracts on terms that enable them to buy goods from the turer at prices lower than those charged to others. Th benefit toboth the producer and the retailer. More imp is a benefit tothe economy as a whole, by getting the mo from scarce resourceswhich have alternative uses. The fact that profits are contingenton efficiency in p what consumers want, at a price that consumers are w pay-and that losses are an ever-present threat if a bus to provide that-explains much of the economicprosper in economies that operate under free market competitio as a realized end-result are crucial to theindividual bus it is the prospect of profits-and the threat of losses-that to the functioning of the economy as a whole. For the e a whole, profits are a minor item, about 10 percent of American economyproduces. But it is a major itemas an to efficiencyin producing the other 90 percent. People in other countries with different economic may work very hard for longer hours than most Amer yet end up with far less toshow for their efforts. The b ing toil of Third World farmers seldom produces the p enjoyed by Americans working in air-conditioned offic relaxed work pace and coffee breaks. Efficiency is the between having the necessities, comforts and amenitie income countries and suffering the hunger and depriva often found in poorer countries. Some of these economic differences are due to tech education or to other favorable orunfavorable geograp torical conditions,but much of it is due to having a pric

BASIC ECONOMICS

nated economy with strong financial incentives to d ers to be right and ruthless elimination of those wh turn outto be mistaken too often.

MARKET VERSUS NON-MARKET ECONO

Although economics is oftenthought of as deal individuals and businesses make money, in reality of how a whole society uses scarce resourcesthat ha uses. Economics isabout how a society economizes viduals share, without even being aware of sharing. portant money may be to individuals, to societ money is just green pieces of paper printed by the and used to enable markets to allocate resourcesthr There are many other possible ways of allocat and many of these alternatives are particularly attra with political power. However,none of these altern organizing an economy hasmatchedthe trac economies where prices direct what resources go what quantities. The collapse of communism in Eastern Europe most dramatic example of the failure of econom sources are allocated by those with political powe through market prices determined by what millions ple know and want.Anyone who saw East Berlinan during the years when communism prevailed in th of the city and a market economy in the rest of it, c noticing the sharp contrast between the prosperity o and the poverty in East Berlin.Indeed, it was hardt shocked by it, especially sincepeople of the same ra culture and history lived in both parts of this city. Perhaps the most decisive evidenceof the role of p centive is the record of socialist economies which h it. The sums of money saved by eliminating profits lower pricesand make the consuming public betto absence of incentives has allowed many ineffic unchecked and technological and organizational cha

An Overview

Monopoly is the enemy of efficiency, whether und ism or socialism. The differencebetween the two syste monopoly is the norm under socialism. Even in a m omy with some economic activitiesbeing carried out b ment and others being carried out by private industry, government’s activities are typically monopolies, whi the private marketplace are typically activities carried val enterprises. Thus, when a hurricane, flood, or other natura strikes an area, emergency aidusually comes both from eral Emergency Management Agency (FEMA) and fro insurance companies whose customers’ homes and have been damaged or destroyed. FEMA has been n slower and less efficient than the private insurance c Allstate cannot afford to be slower in getting mone hands of its policy-holders than State Farm isin getting the people who hold its policies. Not only would ex tomers in the disaster area be likely to switch insuran nies if one dragged its feet in getting money to them, w neighbors received substantial advances from a diffe ance company to tide them over, word of any such would spread like wildfire acrossthe country, causing m people elsewhere to switch billions of dollars worth of business from the less efficientcompany to the more eff A government agency, however, faces no such pre matter how much FEMA may be criticized orridiculed ure to getaid to disaster victims in a timely fashion,the val government agency that these people can turn to fo service. Moreover,the people who runthese agencies a cording to a fixed salary schedules, not by how quick well they serve people hit by disaster. Inertia is commonto people under both capitalism a ism. In the early twentieth century, both Sears and Mo Ward were reluctant to begin operating out of sto decades of great success selling fromtheir mail order c was only when the 1920s brought competition from ch that cut into their profits and caused red ink to start app the bottom line that they had no choice but to beco

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stores themselves. (In1920, Ward lost nearly $10 mill was $44 million in debt.) Under socialism, they co mained mail order retailers and there would have centive for the government to pay to set up rival c complicate everyone’s life. Henry Ford likewisewanted to keep on doing w ways done-producing the same standard model c year, painted just one color (black). But, when a n named General Motors started changing the styling and painting them different colors, the Ford Mo started losing customers and GM replaced Ford a one auto maker in the industry. Only then did Ford begin to change their styling and become available colors the customers wanted. Socialist and capitalist economies differ not only tity of output they produce but also in the quality from cars and cameras to restaurant service and a were of notoriously low quality in the Soviet Union a happenstance. The incentives are radically differ producer has to satisfy the consumer, in order to s cially than when the test of survivability is carryin tion quotas set by central planners. The consumer is not only at quantity but quality. But a central plann sion is too overwhelmed with the millions of produ see tobe able tomonitor much more than gross outp That this low quality is a result of incentives, rath due to traits peculiar to Russians or other Eastern shown by the quality deterioration that has taken United States or WesternEurope when free market placed byrent control orother forms of price contro ment allocation. Whilesome businesses can and do c quality in a free market, they do so at the risk of t The great financial success stories in American indu ten involved companies almost fanatical about ma reputation of their products, even when these produ quite inexpensive. McDonald’s built its reputation on a standardize and maintained quality by having its own inspector nounced visits to its meat suppliers in the middle of

An Overview

see what was being put into the meat it was buying Sanders was notorious for showing up unexpectedly at Fried Chicken restaurants. If he didn’t like the way th were being cooked, he would dump them all into a ga put on an apron, and proceed to cook some chickens h demonstrate how he wanted it done. His proteg6 Dav later followed similar practiceswhen he created his ow Wendy’s hamburger stands. Although Colonel Sanders Thomas couldnot be everywhere in a nationwide chai franchise owner could take a chance on seeing his pro thrown into a garbage can bythe head honcho of the ch Quality control is of course even more important to success with more expensiveproducts and services. The of Linhof cameras-costing thousands of dollars eachbuy their lenses from the world’s leading optical com also subject each individual lens put on one of their c their own tests and standards, even though these lense ready passed testsmade by the manufacturers. Linhof’s are sufficiently morestringent that an identical makeand lens on a Linhof camera sells for a higher price,both new than the same lens sells for when bought independent the lens is being bought to beput on another camera, the came off a Linhof brings a higher pricethan the identic lens by the identical manufacturer that did not come fro Behind all of this is the basic fact that a business is only a physical product, but also the reputation which that product. Motorists traveling in an unfamiliar p country are more likely toturn into a hamburger stand McDonald’s or Wendy’s sign on it than one that does reputation translates into dollars and cents-or, in this lions and billions of dollars. People with that kind of stake are unlikely tobe very tolerant of anyone who w promise their reputation. Ray Kroc, the founder of th ald’s chain, would explode in anger if he found a M parking lot littered. When speaking of quality in this context, what ma kind of quality that is relevant to the particular clien served. Hamburgers and fried chicken may not be re others as either gourmet food or health food, nor can

BASIC ECONOMICS

wide chain mass-producingsuch meals reach q achievable by more distinctive, fancier, and pricie What the chain can do is assure quality within the li by their particular customers. What is called "capitalism" might more accura consumerism. It is the consumers who call the tun capitalists who want to remain capitalists have to l to it. The twentieth century began with high hopes the competition of the marketplace by a more effici humane economy, planned and controlled by gove interests of the people. However, by the end of th such efforts were so thoroughly discredited by their in countries around the world that even Commun abandoned central planning, while socialist govern mocratic nations began selling off government-run whose losses were a heavy burden to the taxpayers. Privatization was embraced as a principle by su governments as those of Prime Minister Margare Britain and President Ronald Reagan in the United most decisive evidence for the efficiency of the market even those who were philosophicallyopposed to cap back towards it after seeingwhat happens when indu merce operate without the guidanceof prices, profitsa

WINNERS AND LOSERS

Many people who appreciate the prosperity cre ket economiesmay nevertheless lament the fact that dividuals, groups, industries, or regions of the co share in the general economic advances, or some worse off than before. Political leaders or candida cially likely todeplore the inequity of it all and to pro government actions to "correct"the situation. Whatever the merits or demerits of various pol als, what must be kept in mind when evaluating th good fortunes and misfortunes of different sectorsof may be closely related as cause and effect-and th

An Overview

bad effects may prevent good effects. It was not accid Smith Corona was losing millions of dollars on its ty while Dell was making millions on its computers. It wa dental that Safeway surged to the top of the grocery while A & P fell from its peak to virtual oblivion. Itwa dental that coal-mining regions suffered economic de the rise of alternative fuel sources. The efficient allocation of scarce resources which h native uses means that some must lose their ability to resources, in order that others can gain the ability to Smith-Corona had to be prevented from using scarce re cluding both materials and labor, to make typewrit those resources could be used to produce computer public wanted more. Nor was this a matter of anyone’ matter how fine the typewriters made by Smith-Coro how skilled and conscientious its employees, typewrite longer what the public wanted after they had the achieve the same end result-and more-with compute Scarcity implies that resources must be taken fr places, in order to go to other places. Few individual nesses are going to want to give up what they have be doing, especially if they have been successfulat it, for t good of society as a whole. But, in one way or another, economic or political system,they are going to have to to relinquish resources and change what they themselv ing, if rising standards of living are to be achieved and The financial pressures of the free market are just ways in which this can be done. Kings or commissars stead simply order individuals and enterprises to ch doing A to doing B. No doubt other ways of pursuing goals are possible, with varying degrees of effectivenes ciency. What is crucial, however, isthat it must be don ferently, the fact that some people, regions, orindustries ”left behind” or are not getting their ”fair share” of th prosperity is not necessarily a problem with a politica as abundant as such proposed solutions may be, esp election years.

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PART 111: WORK AND PAY

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Chapter 9

Productivity and Pay

Do you yay your secretaries less than your engineers because you Like the engineers better, or because the Secretaries don’t need the dough?

-Thomas W. Hazlett

S

o far, we have been discussing the prices of goods and future, consumer goods and capital goods. But p part of the economy too, and not just as consumers. Pe key part of the inputs which produce output. Since mo are not volunteers, they must either be forced to work work, since the work has to be done in any case, if we at all, much less enjoy the various amenities that go modern standard of living. In a free society, people ar work. Simple as this may seem, its implications are often understood or accepted. The very idea of buying and s man labor is vaguely unsettling. The Clayton Act decla preamble: ”Thelabor of a human being is not a commo ticle of commerce.” Perhaps the long history of slavery, w plagued the human race on every inhabited continen this uneasiness with the idea of selling human labor, ore ing it. Nevertheless, most Americans earn their livings b their time and talents-and live much better than peopl other countries where most adults own their own land only for themselves. Stories about the astronomical pay of athletes, mov chief executives of corporations often cause journalists a to question how much this or that person is ”really” wo

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BASIC ECONOMICS

Fortunately, since we know from Chapter 2 tha such thing as ”real” worth, we can save all the energ put into such unanswerable questions. Instead, we c down-to-earth question: What determines how muc paid for their work? To this question there is a very d answer: Supply and Demand. However, that is just t Why does supply and demandcause one individual than another? Workers would obviously like to get the highest and employers would like to pay the least possible there is overlap between what is offered and what can anyone be hired. But why does that overlay ta pay rate that is several times as high for an engineer senger? Messengers would of course like to be paid wh are paid, but there is too large a supplyof people cap messengers to force the employer to raise his offer Because it takes a long time to train an engineer and is capable of mastering such training, there is no suc of engineers relative to the demand. That is the supp story. But what determines the demand for labor? mines the limit of what anemployer is willing to pay It is not merely the fact that engineers are scarc them valuable. It is what an engineer can add to earnings that makes an employer willing to bid for h and sets the limit to how high the bids can go. An e added $100,000 to a company’s earnings and asked f salary would not be hired. On the other hand, if added a quarter of a million dollars to a company’ would pay to hire him at $200,000. The term ”productivity” is sometimes used loose an employee’s contribution to a company’s earning lem is that this word is also defined in other ways an the implication is left that each worker has a certai ity” that is inherent in that worker, rather than bein on surrounding circumstances as well. A worker us modern equipment can produce more output thant worker employed in another firm whose equipmen

Productivity and Pay

as up-to-date or whose management does not have th nized as well. The same principle applies outside what we norm of as economic activities.In baseball, a slugger gets mo to hit home runs if he is batting ahead of another slugg the batter hitting after him is not much of a home r pitchers are more likely towalk the slugger in a tight si that he will get fewer opportunities to hit home runs course of a season. Ted Williams, for example,had one of the highest pe of home runs-in proportion to his times at bat-in the baseball, but he had only one season when he hit as m homers, because he was walked as often as 162 times a averaging more than one walk per game, during the 154-game season.By contrast, when Roger Marishit 61 h in 1961, breaking the existing record, he was walked l hundred times because Mickey Mantle was batting righ and Mantle hit 54 home runs that season. Therewas no p in walking Maris to pitch to Mantlewith one more ma Maris’ productivity as a home-run hitter was greater b batted with Mickey Mantlein the on-deck circle. In virtually all jobs, the quality of the equipment ment and other workers goes into determining a given productivity. Movie stars like to have good supporti good make-up artists and good directors, all of whom the star’s performance. Scholars depend heavily on thei assistants and generals rely on their staffs, as wellas th to win battles. Whatever the source of a given individual’s product productivity determines the upper limit of how far an will go in bidding for that person’s services. Thatis th side of the equation. Employers seldom bid as much as they would if th because there are other individuals willing and able tos same services for less. By the same token, consumers wo lot more for their food than they do, if there were no c sellers and their only choice was to pay what a m charged or starve. In short, it is the combination of supp

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mand which determines pay, as it determines the pr and services in general. Just as we can better understand the role of pric when we see what happens whenprices are not allo tion, so we can understand the role of workers’ p what happens when thatpay is not allowed to vary and demand. In Europe, for example, minimum w pay scales much higher than such laws do in the U The net result is that only those workers whose prod this higher level are likely to be hired or retained. experienced and otherwise less productive worker not hired to the extent that they are in the United S government-imposed higher prices for agricultural der New Deal farm programs (designed to help farm surplus of unsold farm products, so today’s governm higher prices for laborin Europe has led to unsold la unemployment rates roughly double those in the Un

FORMS OF PAYMENT

When we think of people being paid for their w ally think of someone drawing a paycheck every we for putting in a certain amount of hours on the job only one of the ways people get paid. Shoeshine boysget paid every time they shine a and doctors get paid every time a patient visits th Farmers get paid when they sell their crops. Busines whatever is left over from their sales after they ha employees, creditors, tax collectors, etc.-and the am be either positive or negative. Oil prospectors may lo more times than they make any, but the size of the they strike oil can cover all the losses before then. I would stop prospecting for oil. These and other ways of compensating people’s broken down into two broad categories-fixed guara ment and variable chances of payment. Wages and usually fixed guarantees. Those who work for an em

Productivity and Pay

to be paid what they were promised, regardless of w business is operating at a profit or a loss. If the busin stocks and bonds, then those who buy bondsexpect to fixed amount, just like the employees, regardless of ho how badly the business is going,while those who buys get nothing if things are going badly and can get very dividends if business is booming. By and large, those with guarantees receive less m those who take their chances. If the business goes ban only does the stockholder not get any dividends, he whatever moneyhe paid for the stock, which now becom less paper. The bondholder, however, is legally entitle of whatever assets the bankrupt business has left whe down. It ishardly surprising then that, in normal times, ers usually receive a higher rate of return than bondhol are taking a bigger risk and are being compensated fo Otherwise, no one would buy stocks when bonds are saf As in other areas of economics, the facts are fairly s straightforward, but the fallacies getvery complicated. most widespread fallacies is that only fixed payments costs of producing goods and services. There is thou something illegitimate about the money earned by bearing people as speculators. Profits in general have by some people as something arbitrarily added on to costs of producing things. However, the fact that a payment is variableand risk mean that it is any less necessary to causethings to get go into businessand work longand While someone may no income to show for that it, will continue to happen on as enough people makeenough money in such activitie others willing toput forth the effortsand take the risks. Even if profits area necessary costof producing thing we know that the amount of those profits isnot "too m same way we know that a worker is not receiving "too namely that,if someone else were willing do to his job f employer would not be paying him as much as he gets. Although profit levels are not decided byanyone-it what is left over after paying other costs-the same pri

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plies. If one company can manufacture widgets for sell them for $12,making $2 gross profiton each, any manufacture them for $9 dollars each will be able t gross profit, whether by selling them forthe same $1 more gross profit left over or by sellingthe same pr and making more gross profit by takingaway some petitor’s customerswith lower prices. In either cas money by satisfying customersat lower costs of prod this means from the standpoint of the economy as a they are using fewer of society’s resources to get ths If profits were nothing more than an arbitrary then things produced by organizations that do not would be cheaper than things produced by organiza In reality, one of the largest organizations that doe profit-government-usually produces things at than private, profit-making businesses. Many activ in by state, local, or national governments have be out in recent years to private businesses precisely businesses do the job cheaper, whether that job garbage or running prisons. There are fairly straightforward reasons for th A preneur whose own income depends on how much i paying the costs of production has far more incentiv ciently, in order to keep those production costs low, tha ernment official on a fixed salary. Often, governmen paid according to their level of responsibility-which i cording tohow many people they supervise and how they administer. Under these circumstances, the m use and the more money they spend to achievea given ier it will be for them to obtain promotion a level to wi Since the incentives facing a private business owner ing a government official are so different, itshould not that the results likewisetend to be very different.

PAY DIFFERENCES

Wages and salaries serve the same economic other prices-that is, they guide the utilization of sca

Productivity and Pay

which have alternative uses. Yet because these scarc are human beings, we tend to look on wages and sala ently. Often we ask questions that are quite emotiona ful, even if they are logically meaningless. For examp wages ”fair”? Are the workers ”exploited.”? Is thi wage”? Such questions seldom get asked about the price mate things, such as a can of peas or a share of stock Motors. But people are believed tobe entitled to pay th even if no one can define what that means. ”Exploitat living wage” are likewise emotionally powerful ex without concrete meanings. If a worker is living, how receiving less than ”a living wage”-unless he is, as said thoughtlessly, ”living below subsistence”? No one likes to see fellow human beings living in p squalor, and many are prepared to do something a shown by the vast billions of dollars that Americans wide range of charities every year, on top of the add lions spent by federal, state, and local governments in to better the condition of less fortunate people. These portant activities occur alongside an economy coor prices, but the two things serve different purposes. Attempts to make prices, including the prices of p bor and talents, be something other than signals to sources to their most valued uses, make those prices l for their basic purpose, on which the prosperity of the ety depends. Ultimately, it is economic prosperity th possible forhundreds of billions of dollars to be devot ing the less fortunate. It isalso economic prosperity w people born into poverty to rise to economic heights u of by their parents or perhaps even by themselves.

INCOME “DISTRIBUTION”

Nothing is morestraightforward and easy to under the fact that some people earn more than others, for a reasons. Some people are simply older than others, fo and their additional years have given them opportun

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quire more experience, skills, formal education and training-all of which allows them to do a given jo ciently or to take on more complicated jobs tha overwhelming for a beginner or for someone with lim ence or training. With the passing years, older indi also become more knowledgeable about job opportu more other people may become more aware of the abilities. Theseand other commonsense reasons for i ences among individuals are often lost sight of in abs sions of the ambiguous term “income distribution.” Most income is of course not distributed at all, in which newspapers, milk, or Social Security checks ar from some central place. Most incomedistributed is on tistical sensein which there isa distribution of heights tion-some people being5 foot 4 inches tall,others 6 f etc.-but none of these heights wassent out from som cation. Yet it is all too common to read journalists an cussing how ”society” distributes its income, rather th plain Englishthat some people make more money tha More is involved than a misleading metaphor. O units in which income differencesare discussed are a as the metaphor. Family income orhousehold incom individual income. Anindividual always means the s one person-but the sizes of families and household stantially from one time period to another, from o ethnic group to another, and from one income bracke For example, there are 39 million people in the bottom of households, but 64 million people in the top 2 households. Although many people assume that th represent dividing the country into ”five equal lay economists have misstated it, there is nothing equal layers. They represent grossly differentnumbers of pe These differences in the sizes of families and ho not incidental. They radically change the meaning of tribution” statistics that are thrown around in the m politics. For example, real income per American hou only 6 percent over the entire period from 1969 to 1 per capita income rose51 percent over the same perio

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and Productivity

age size of families and households was simply declini smaller households were now earning about the sam households had earned a generation earlier. As so often happens, the facts are not complicated, b derstandings abound nevertheless. A Washington Post example, declared in 1998 that ”the incomes of most households have remained stubbornly flat over the decades.” It would be more accurate to say that som have remained stubbornly blind to economic facts. W people in one household today earn the same total money that three people were earning in that househ past, that is a 50 percent increase in income per pers when household income remains the same. It is equally misleading to compare high-income f households with low income families and households more people per family in upper income families co lower income families-and more of those people wo part of the reason for some families having higher inc others. It isnot uncommon for familiesin the top 20 pe come-earners to supply several times as many man work per year as families in the bottom 20 percent. M latter work very little or not at all, whether due to illn ment, single mothers raising children on welfare, or f sons. Yet plain facts like these are often omitted by speak and write of how ”society” unequally or unfairl utes” its income. A closer look at these households re those in the top quintile contain more than 40 million working age-l8 to 64 years of age -while the botto contains fewer than 20 million people in such age brack Perhaps the most radical difference between indiv family or household statisticsare those used when com ferent American racial or ethnicgroups. For example, r per black household rose only 7 percent in the two dec 1967 to 1988, but real per capita incomeamong blacks r cent over those very same years. Average black h simply declining during these decades, so that a subs crease in real incomeper person appeared statistically a small increase perhousehold. Moreover, because black

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size was declining more sharply than white househol incomes appeared to be fallingbehind white incomes hold statistics were used,but were in fact rising faste incomes when individual statistics are examined. For both blacks and whites, rising prosperity wa for more people to be able togo set up their own indiv holds, instead of continuing to live with parents or as sharing an apartment with a roommate. Yet these con prosperity generate household statistics that are wi suggest that there has been no real economic progres Among individuals in the general population, age difference is income-and a huge difference in weal enced young people beginning their careers in their dom make as much money as their parents who are in and fifties. Having just begun to work, these younger usually not as valuable as older and more experien Having just begun to save, they are likely to hav money in the bank or in a pension fund, as compared ents, who have been saving for decades and acquir sets for decades. Although people in the top income brackets and income brackets-”the rich” and ”the poor,” as th monly called -may be discussed as if they were dif of people, often they are the very same people at dif of their lives. An absolute majority of the people in t percent in income in 1975 were also in the top 20 per point over the next 17years. This isnot surprising. After 17 years,people usua 17 years more experience, perhaps including on-the or formal education. It would be surprising if they w to earn more money as a result. It is not uncommon the people in the top 5 percent of income-earners to old and up. Although people in upper income brackets are o terized as ”rich,” in reality a family or household c top 10 percent with incomes that fall far short of wealthy people make. As of 1998, a household incom year was enough to put the people in that household

Productivity and Pay

percent. A couple making $38,000 each hardly seem rich.” Eventhe top 5 percent of households could be r a combined income of $133,000-comfortable, but ha same category as millionaires and billionaires. Even people in the top one percent in wealth bear l blance to ”the idle rich” conjured up in popular legen logical rhetoric. Theaverage person in the top one per 52 hours a week. At the other end of the scale, more t all thosein the bottom 20 percent do not have a full-tim Another common statistical illusion comes from de whether ”inequality” is increasing or decreasing by the incomes of those in the top 20 percent with the i those in the bottom 20 percent. Nothing is easier tofin dia and academic proclamations that the difference b comes in these top and bottom brackets has grown wid years. Even when the changes are only of a few p points, there may be much hand-wringing and mora tion. However, if our concern isnot with statistical cate with flesh-and-blood human beings, then we must fo brackets but on the people who are constantly moving of those brackets. Fewer than 3 percent of those in the bottom 20 perc were still there in 1991, while 39 percent of them were top 20 percent. Most of ”the poor” of the 1970s ha higher real income levels in the 1990s than most of American population had inthe 1970s.To compare the comes of these now ”rich” people with the current inco currently ”poor” ignores the likelihood that today’s ” continue to repeat this pattern and be even more pro 2010 than our current top 20 percent are today. Time has an even stronger effect on the accumu wealth. The average amount of wealth held by peo older age brackets is usually several times the amou people in their twenties. But these are not the kind of economic differences we usually have in mind when about classes. People in their forties or fifties are not class from people in their twenties, because all forty were once twenty-year-olds and all twenty-year-olds a

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be forty-year-olds,unless they die prematurely. Not o of them likely to be both ”rich” and ”poor” at differ their lives, even at a given moment many of the lowple are the children of high-income people-and thei Genuinely rich and genuinely poor people exist-p are going to be living in luxury or in poverty all the they are much rarer than gross income statistics wo when these statistics are not broken down by age. T was huge in all income brackets in just 17 years, less most people’sworking life. Just as most American ”poor” do not stay poor, Americans were not born rich but only achieved we point in their own lifetimes. Moreover, the genuin nearly as rare as the genuinely poor. Evenif we take a lars in net worth as our criterion for being rich, onlya cent of Americans are at thatlevel at a given time. T fairly modest level, given that net worth counts eve household goods and clothing to the total amount of individual’s pension fund. Nevertheless, the genuin the genuinely poor, put together, add up to less than the American people, even though political rhetoric gest that weare all either “haves” or ”have nots.” While, in some senses, those who are called ”the p as badly off as instantaneous statistics might suggest spects they are worse off. They must often pay high inferior goods and services, becauseof the higher cos ing those goods and services to low-income neighbor ready noted in Chapter 6, a suburban supermarke costs of delivering groceries to its customers than d neighborhood store in the inner city, and that tran higher prices charged to low-income customers than come customers. Similarly, banks serving middle-c have lower costs per transaction than institutions se in poverty, such as pawnshops or check-cashing age It does not cost a hundred times as much to pro loan to an affluent person as it does to make a $50 lo one in poverty. Cashing a check for an affluent perso ployment and credit history is known to the bank, a

Productivity and Pay

had anaccount in the bank for years, is much less risk ing a check for someone who walks in off the street in cashing agency in a low-income neighborhood and wh does not have a bank account or perhaps even a perm Thus affluent people have their checks cashed free of their banks and receive bank loans at a lower interes those charged the poor by pawn shops of other sourc that will take a chance on them. Being poor is expens nately, most Americansdo not remain poor very long.

JOB DISCRIMINATION

While pay differences often reflect differencesin s rience, or willingness to do hard or dangerous work also reflect discrimination against particular segments such as ethnic minorities, women, lower castes, or oth However, in order to determine whether there is disc or how severe it is, we need to define what wemean. Sometimes discrimination is defined as judging i from differentgroups by different standards whenhiri or promoting. In its severest form,this can mean refusa all. ”No Irish Need Apply” was a stock phrase in adve for many desirable jobs in nineteenth- and early twe tury America. Before World War 11, many hospitals in States would not hire black doctors or Jewish doctors prestigious law firms would not hire anyone who w white Protestant male fromthe upper classes. In other ple might be hired from a number of groups, but in from differentgroups were channeled into different jo None of this has been peculiar to the United State modern era. On the contrary, members of different gr been treated differently in laws and practices all a world and for thousands of years of recorded histor idea of treating individuals the same, regardless of w they come from,that is relatively recentas history is m Overlapping with discrimination, and often confu are employment differences basedon very substantial

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in skills, experience, and work habits from one grou Mohawk Indians, for example, have long sought been on the construction of skyscrapers, for they walk aro on the steel frameworkswith no apparent fear or dis their work. Italian workers were in such demand in ni tury Brazil that its government subsidized their impo ing the industrialization of the Soviet Unionin the 192 large numbers of German, American, and other fore technicians, and engineers were imported at attrac More than 10,000 Americans alone went to work in during a one-year period beginningin September 192 While preferences for some groups and reluctan ingness to hire others have often been described as d "stereotypes" or "perceptions," third-party observe easily dismiss the first-hand knowledge of those who their beliefs with their own money. Even in the abse ent beliefs about different groups, application of th ployment criteria to different groups can result in v proportions of these groups being hired, fired, or pro Distinguishing discrimination from differences tions and performances is not easy in practice, thoug tion is fundamentalinprinciple. Seldom do sta contain sufficiently detailed information on skills performance, or absenteeism, much less work hab tudes, to make possible comparisons between truly individuals from differentgroups. Women, for example, have longhad lower incom but most women givebirth to children at some point and many stay out of the labor force until their child age where they can beput into some form of day car mother works. These interruptions of their careers workplace experienceand seniority, whichin turn inhi their incomes over the years relative that to of men w working continuously. However, as far back as 1972, worked continuously from high school through earned slightly more than men of the same descriptio women as a group earned substantially lessthan men

Productivity and Pay

This suggests that employers are willing to pay wo same experience the same as men, and that women wit experience may even outperform men, but that differe mestic responsibilities prevent the sexes from havin workplace experience or identical incomes based on t ence. In1991, women without children earned 95 perce men earned, while women with children earned just 75 what men earned. Moreover, the very possibility of h dren makes different occupations have different attr women. Occupations like librarians or teachers, whic resume after a few years off to take care of small ch more attractive than occupations such as computer where a few years off can leave you far behind in th changing field. Inshort, women and men make differ tional choices and prepare for many of these occupatio cializing in a very different mixof subjects while being The question as to whether or how much discri womenencounter in the labor market is aquestio whether there are substantial differences in pay betwe and men in the same fields with the same qualifica question as to whether there is or is not income parit the sexes is very different, since differences in occ choices, educational choices, and continuous employm fect incomes. Men also tend to work in more hazardo tions, which tend to pay more than similar occupatio safer. As one study notes, "although 54 percent of the is male,men account for92 percent of all job-relatedde Similar problems in trying to compare comparable als make it difficult to determine the presence and ma discrimination between groups that differ by race or is not uncommon, both in the United States and in o tries, for one racial orethnic group to differ in age fro by a decade or more-and we have already seen how a big difference in income. While gross statistics show come differences between American racial and ethn finer breakdowns usually show much smaller differen ample, black, white, and Hispanic males of the same ag

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IQ (100) all have average annual incomes within a th lars of one another. Whatever the amount and magnitude of discrim important to beaware of what economic factorstend be larger or smaller. While it is obvious that discrim poses a cost on those being discriminated against, in lost opportunities for higher incomes, it is also true t nation can impose costs on those who do the disc where they too lose opportunities for higher income ple, when a landlord refuses to rent an apartment to the ”wrong” group, that can mean leaving the apart longer. Clearly, that represents a loss of rent-if this is a However, if there is rent control, with a surplus of app such discrimination costs the landlord nothing. Similar principles apply in job markets. An empl fuses to hire qualified individuals from the ”wrong” leaving his jobs unfilled longer in a free market. Tha he must either leave work undone andorders unfille overtime to existing employees to getit done, losing m way. However, in a market where wages are set artif the level that would exist through supply anddeman ing surplus of applicants can mean that discriminat employer nothing. Whether these artificially higher w by a labor union or by a minimum wage law does no principle. Empirical evidence strongly indicates tha crimination tends to be greater when the costs ar lower when the costs are greater. Even in South Africa under apartheid, where rac nation was required by law, white employers in com dustries hired more blacks and in higher occupatio were permitted to do by the government, and were when caught doing so. This was because it was in the economic self-interest tohire blacks. Similarly, wanted homes built in Johannesburg typically hired construction crews, often with a token white nomina to meet the requirements of the apartheid laws, rath the higher price of hiring a white construction crew as

Productivity and Pay

ment wanted them to do. Landlords likewise often blacks in areas where only whites were legally allowed The cost of discrimination to the discriminators is understanding such behavior. Employerswho are spen people’s money-government agencies or non-profi tions, for example-are much less affected bythe cost ination. In countriesaroundtheworld,discriminationby government has been greater than discrimination by operating in competitive markets. Understanding the nomics of discrimination makes it easier to unders American blacks were starring on Broadway in the time when they were not permitted to enlist in the U. S were kept out of many civilian government jobs as w way producers were not about to losebig money that make by hiring black entertainers, but the costs of g discrimination was paid by the taxpayers, whether th it or not.

CAPITAL, LABOR, AND EFFICIENCY

While everything requires some labor for its pr practically nothing can beproduced by labor alone. Fa land, taxi drivers need cars, artists need something t and something to draw with. Even a stand-up comedia inventory of jokes, which is his capital, as much as hy dams are the capital of utility companies that supplye Capital complements labor in the production pro also competes with labor for employment. Many goo vices canbe produced either with much labor and littl much capital and little labor. Whentransit workers’ u bus drivers’ pay rates much above what they would b petitive labor market, transit companies tend to add m in order to save on the use of the more expensive lab grow longer, sometimes becoming essentiallytwo bus flexible connection between them, so that one drive twice as much capital as before and is capableof movi many passengers.

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Some may think that this is more "efficient" but not so easily defined. If we arbitrarily define efficien per unit of labor, as the U.S. Department of Labo does, then it is merely circular reasoning to say tha bus driver moving more passengers is more efficie fact cost more money per passenger to move them, the additional capital needed for the expanded bu more expensive labor of the drivers. If bus drivers were not unionized and were paid n was necessary to attract qualified people, then undo wage rates would be lower and it would then be pro transit companies to hire more of them and use sh This would in turn mean that passengers would hav wait at bus stops because of the shorter and mor busses. This isnot a small concern topeople waiting ners on cold winter days or in high-crime neighborho "Efficiency" cannot be meaningfully defined wi to human desires and preferences. Eventhe efficienc mobile engine is not simply a matter of physics. A generated by the engine will be used in some wa moving the car forward, overcoming friction among parts, or shaking the automobile body in various wa when we define our goal-moving the car forwardregard the percentage of the engine's power that is task as indicating its efficiency and the other power various other ways as being "wasted." Europeans long regarded American agricultur cient" because output per acre was much lower in States than in much of Europe. On the other hand agricultural worker was much higher in the United S Europe. The reason was that land was far more ple U.S. and labor was more scarce. An American fa spread himself thinner over far moreland and would spondingly less time to devote to each acre. In Eu land was more scarce, and therefore more expensiv supply and demand, the European farmer concent more intensive cultivation of what land he could g more time clearing away weeds and rocks, or otherw more attention to ensuring the maximum output per

Productivity and Pay

Similarly, Third World countries often get more given capital equipment than do wealthier and more ized countries. Such toolsas hammers and screw-driv plentiful enough for eachworker in an American fact to have his own, but that is much less likely to be th much poorer country, where such tools are more li shared, or shared more widely, than among America the same products. Looked at from another angle, eac in a poor country is likely to drive more nails per year shared among more people and has less idle time. Th make the poorer country more “efficient.” It isjust th tive scarcities are different. Capital tends to be scarce expensive in poorer countries, while labor is more abu cheaper. Suchcountries tend to economizeon the more factor, just as richer countries economize on a different is more expensive scarce there, namely labor. It is ju richer countries, capital is more plentiful and cheaper, w is more scarceand more expensive. When a freight train comes into a railroad yard or ing, workers are needed to unload it. Whena freight tr in the middle of the night, it can either be unloaded there, so that the train can proceed on its way, or the b be left on a siding until the workers come towork the n ing. In a country where such capital as railroad box ca scarce and labor is plentiful, it makes sense to have th available around the clock, so that they can immediat box cars and this very scarce resource does not remai in a country that is richin capital, it may often bebette cars sit idle on a siding, waiting to be unloaded, rath have expensive workers sitting around idle waiting f train to arrive. It is not just a question about these particular wo checks or this particular railroad company’s expenses standpoint of the economy as a whole, the more fu question is: What are the alternative uses of these wo and the alternative uses of the railroad boxcars? Inothe is not just a question of money. The money only reflec ing realities that would be the same in a socialist, feud non-market economy. Whether it makes sense to leav

BASIC ECONOMICS

cars idle waiting for the workers to arrive or to leave idle waiting for trains to arrive depends on the relat of labor and capital and their relative productivity i uses. During the era of the Soviet Union and Cold War the Soviets used to boast of the fact that an average S moved more freight per year than an average Amer But, far from indicating that their economy was m this showed that Soviet railroads lacked the abunda the American railroad industry, and that Soviet la valuable alternative uses of its time than did America ilarly, a study of West African economies in the m century noted that trucks there "are in service twent a day for seven days a week and are generally tightly passengers and freight." For similar reasons, automobiles tend to have lo poor countries than in richer countries. Remember th is the study of scarce resources which have alternat alternative uses of American labor are too valuabl used keeping ten-year-old cars repaired-except for cans wealthy enough to be able to indulge a hobby vintage automobiles or those poor enough that the uses of their time are not very remunerative and the to afforda new car. By and large, it pays Americans to junk their ca tors, trolleys,and other capital equipment in a shorte would pay people in poorer countries to do so. Nor ter of being able to afford "waste." would It be a was pairing this equipment, when the same efforts else American economy would produce more than enou buy replacements. But it would not make sense for tries, whose alternative uses of time are not as produ their equipment at the same times when American Accordingly, many older American cars, trolleys,and chines may be bought second-hand and used for ye Third World countries after they have been junked i States. This can be an efficient way of handling the both kinds of countries.

Productivity and Pay

i

A book by two Soviet economists pointed out t U.S.S.R. ”equipment is endlessly repaired and patch that the ”average life of capital stock in the U.S.S.R. is years, as against seventeen in the United States.” The bragging. were They complaining. /

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Chapter 10

Controlled Labor Marke

P

ay and employment conditions arenot always a res market competition. Either orboth may be controll custom, or organizations of employers or employees. A major factors behind such controlshave been desires fo rity and for collectively-set limits on how high or how scales will be allowed go to in particular occupations oi Here as elsewhere, we are concerned not so much goals or rationales of such policies, but with the incen ated by these arrangements and the consequences to w incentives lead. These consequences extend beyond th themselves to the economy as a whole, where labor is scarce resourceswhich have alternative uses.

JOB SECURITY

Virtually every modern industrial economy has fa of job security, whether they have faced these issues re or unrealistically, successfully or unsuccessfully. At the plistic level,some people advocate that every worker b teed a job, with the government if necessary. In some laws make it difficult and costly for a private employ anyone. Labor unions try to do this in many industri many countries around the world. Teachers’ unions in t States are so successful at this that it can easily costa s trict tens of thousands of dollars-or even hundreds of t in some places-to fire just one teacher, even if that grossly incompetent.

”””“.””””

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BASIC ECONOMICS

The very thing that makes a modern industrial s cient and so effective in raising living standards-th quest for newer and better ways of getting work do goods produced-also makes it impossible to ke things the same old familiar ways with the same w the same jobs. For example, back at the beginning of century, the United States had about 10 million farm laborers to feed a population of76 million people. B the twentieth century, there were less than one-fif farmers and farm laborers, feeding a population mo times as large. Yet, far from having less food, Ame problems now included obesity and trying to find ex for their surplus food. All this was made possible b ing became a radically different enterprise, using chemicals and methods unheard of when the century requiring far fewerpeople. Farming is of course not the only sector of the e revolutionized during the twentieth century. Whol tries have sprung up, such as aviation and comput old industries like retailing have seen radical chan companies and which methods have survived. In decade, between 1985 and 1996, Sears lost131,000 jo Mart gained 624,000 jobs. Altogether, morethan 17 ers throughout the economy lost their jobs betwe 1995. Butthere were never 17 million people unemp this period, nor anything close to that. In fact, un rates fell to their lowest points in years. Americans from one job to another, rather than relying on "job one place. In Europe, where job security laws and practic stronger than in the United States, jobshave in fact b come by. During the 1990s, the United States created the rate of industrial nations in Europe. In the priva rope actually lost jobs, and only increased governm ment led to any net gain at all. This should not be su security laws make it more expensive to hire worke thing else that is made more expensive, labor is less a higher price than at a lower price. The one excep

Controlled Labor Markets

ment employment, where the employers are spending ple’s money-the taxpayers’ money. Job security policies save the jobs of existing work the cost of reducing the flexibility and efficiency of the as a whole, thereby inhibiting the creation of new jobs workers. Because job security laws make it risky to workers, existing employees may be worked overtime capital may be substituted for labor, such as using hu instead of hiring more drivers for regular-sizedbusses it is done, increased substitution of capital for labor le workers unemployed. For the working population as this is no net increase in job security. It aisconcentratio security on those who happento be on the outside look It is much the same story in the academic world, w ciate professors and full professors usually have lifetim while assistant professors, lecturers and instructors short-term contracts. The jobinsecurity of the latter fac bers can be far greater than in other sectors of the econo there is no tenure. Again, those on the inside looking o at the expense of those on the outside looking in. Even in the absence of formal laws and policies on rity, there are many efforts topreserve jobs threatened b logical change, foreign imports or other sources of c better products. Virtually allthese efforts likewiseignor ger that greater security for some given set of workers at the expense of lessened job opportunities for other w well as needlessly high prices forconsumers. One of the emotionally powerful arguments heard and the media during the ”down-sizing” of many lar can corporations during the 1990s was that workers w laid off in industries where sales and profits were goi the top executives were getting large and rising pay. ple, the workforce at General Motors was cut by 50,00 years, while sales were rising and the price of Gener stock increased 50 percent. From an economic standp meant that it was possible to do more business with fe ers, creating better prospects for profit, which in turn ing stock prices.

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BASIC ECONOMICS

Should General Motors have kept these worker manitarian good deed? The argument for doing thi been stronger if the workers had nowhere to go means of supporting themselves and their families usually low rates of unemployment in the econom during this period of widespread corporate down-si that these workers had plenty of places to go. These workers were classic examples of sca which have alternative uses. If unneeded workers tained at General Motors as disguised welfare case not have added to the output of other parts of the ec there was much genuine work for them to do. M sumers would have had to pay needlessly higher p mobiles to subsidize featherbedding, as well as losin of all the other goods and services that displaced workers produced in other sectors of the economy were forced to move. It has sometimes seemed especially galling that ecutives who got rid of thousands of workers were pay increases for themselves. However, it is worth the consequences of the situation in government, tives are likely to be rewarded according to how they supervise and how large a budget they adminis ferent situations create opposite incentives-to get a done with as few people and resources as possible dustry and with as many people and resources a government. This is one reason why it often costs private companies to perform the same tasks as a agency performs. The public pays the costs, whe sumers or as taxpayers.

MINIMUM WAGE LAWS

Just as we can better understand the economic r general when we see what happens whenprices ar to function, so we can better understand the econ workers’ pay by seeing what happens when that

Controlled Labor Markets

lowed to vary with supply and demand.Historically, a set maximum wage levels centuries before they set wage levels. Today, however, onlythe latter are widesp Minimum wage laws make it illegal topay less tha ernment-specified price for labor.By the simplest and m economics, a price artificially raised tends to cause m supplied and less tobe demanded than when prices are determined in a free market. The result is a surplus, w price that is set artificiallyhigh is that of farm produce

Unemployment

Because the government does not hire surplus labo it buys surplus agricultural output, the labor surplus form of unemployment, which tends to be higher un mum wage laws than in a free market. Because peopl many ways, those who are unemployed are not likely t dom sample of the labor force. In country after count the world, those whose employment prospects are redu by minimum wage laws are those who are younger, le enced, and less skilled. This same pattern has been foun Zealand, France, Canada, the Netherlands, and the Uni for example. As in other cases, a "surplus" is a price phenomen "shortages" are. Unemployed workers are not surp sense of being useless orin the sense that there isno wo that needs doing. Most of these workers are perfectly producing goods and services, even if not to the same more skilled workers. The unemployed are made idle rates artificially set above the level of their productivity idled in their youth, they are of course prevented from the job skills and experience which could make them ductive and higher earners later on. Although most modern industrial societies have wage laws, not all do. Switzerland and Hong Kong h among the exceptions-and both have had very low u ment rates, that in Hong Kong being as low as 1.5 perc mum wage rates in Europe tend generally to beset high

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the United States, and European countries tend to spondingly higher unemployment rates than the Un and job growth rates only a fraction of the Ame belated recognition of this connection has caused so to allow their minimum wage laws to be eroded avoiding the political risks of trying explicitly to laws. The huge financial, political, emotional, and id vestment of various groups in issues revolving arou wage laws means that dispassionate analysis is no norm. Moreover, the statistical complexities of sepa effect of minimum wages on employment from allth changing variables that also effect employment mean differences are possible. However, when all is sa most empirical studies indicate that minimum wage employmentin general, and especially theemp younger, less skilled and minority workers. A majo sional economists surveyed in Britain, Germany,Can land, and the United States agreed that minimum increase unemployment among low- skilled worker in France and Austria did not. However, the ma Canadian economists was 85 percent and among Am omists 90 percent. Those officially responsible for administerin wages laws, such as the U. S. Department of Labor an cal agencies, prefer to claim that these laws do not ployment. So do labor unions, for whom minimum serve as tariff barriers against potential competit members’ jobs. Even though most studies show un caused by minimum wages, those few studies that cate otherwise are hailed as having “refuted” this “ the devastating criticisms of the defects of such stud mists are ignored. One common problem with research on the em fects of minimum wage laws is that surveys of emp and after a minimum wage increase can survey on nesses which survive in both periods. Given the business failures in many fields, the results for the s

Controlled Labor Markets

be completely different from the results for the ind whole.' As Nobel-Prizewinning economist George St said about such surveys of survivors, using these me can prove that no soldier was killed in World War 11-a ing conclusion, but one whose validity is open to co doubt. It would be similarly comforting to believe that th ment can simply decree higher pay for low-wage work out having to worry about unfortunate repercussion validity of that belief is likewise in considerable doubt ponderance of evidence indicates that labor is not exe the basic economic principle that artificially high pri surpluses. In the case of surplus humanbeings, that can cial tragedy when they are already from low-income, or minority backgrounds and urgently need to get on th der if they are ever to moveup the ladder by acquiring experience.

Informal Minimum Wages

Sometimes a minimum wage is imposed not by la custom, informal government pressures, labor unions cially in the case of Third World countries-by internat lic opinion pressuring multinational companies to p World workers the kinds of wages usually found in m trially developed countries. Although organized public for higher pay for Third World Workersin Southeast A news in the United States in the late twentieth century,

'Imagine that an industry consists of 7 firms, eachhiring 1,000 workers mum wage increase, foran industry total of 7,000 employees. If two of these f business between the first and the second surveys and only one new firm en try, then only the five firms that were in existence both "before" and "after" c and their results reported. Both they and the new firm maynow have 1,100 em but the industry as a whole will have 6,600 employees400 fewer than before wage increase. Yet this study can show a 10 percent increase in employment in surveyed, rather than the 6 percent decrease for the industry as a whole. S wages can cause unemployment by (1)reducing employment among all th pushing a marginal firm into bankruptcy, or by (3) discouraging the entry o firms, false reports based on surveying only survivors are a clear danger.

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sures were not new. Similarpressures were put on c erating in colonial West Africa halfa century earlier. Informal minimum wages imposed in these ways fects very similar to those of explicit minimum w economist studying colonial West Africa in the m century found signs telling jobapplicants that there cancies” almost everywhere. Nor was this peculiar to The same economist-Professor P.T. Bauer of the L of Economics-noted that it was ”a striking feature der-developed countries that money wages are ma high levels” while ”large numbers are seeking but u work.’’ These are of course not high levels compar earned by workers in more industrialized econom relative to Third Worldworkers’ productivity and hi their alternative earning opportunities in sectors of not subject topressures to maintain an artificially in earnings, such as agriculture, domestic service, or ment as street vendors and the like. The magnitude of the unemployment created b high wages that multinational companies felt pressu West Africa was indicated by Professor Bauer’s firs vations:

I asked the manager of the tobacco factoryof the N bacco Company (a subsidiaryof the British-America Company) in Ibadan whether he could expand his without raising wagesif he wished to doso. He repl only problem would be to control the mobof applic much the same opinion was expressed by the Kan agent of the firmof John Hold and Company in res tannery. In December 1949 a firmof produce buyersin missed two clerks and within two days received be and sixty applications for the posts without havin the vacancies. The same firm proposed to erect a g crushing plant. By June 1950 machinery had not ye stalled; but without having advertised a vacancy received about seven hundred letters asking for I learnt that the European-owned brewery and the

Controlled Labor Markets

tablished manufacturersof stationery constantly receiv of applications for employment.

The misfortunes of eager but frustrated African joba are only part of the story. The output that they could duced, if employed, would have made a particularly i contribution to the economic wellbeing of the consumi in a very poor region, lacking many things that other granted in more prosperous nations. It is not at all workers as a class are benefitted by artificially high wag the Third World. Employed workers-those on the insid out-obviously benefit, while those on the outside l lose. The onlycategory of clear beneficiariesare people richer countries who enjoy the feeling that they are hel ple in poorer countries. Just as a price set below the free market level tend quality deterioration in the product that is being sold, shortage means that buyers will be forced to accept lower quality than they would have otherwise, so a above the free market level tends to cause a rise in aver ity, as the surplus allows the buyers to cherry-pick and only the better quality items being sold. What that me labor market is that job qualification requirements are rise and that some workers who would ordinarily be free market may become "unemployable" when there mum wage laws. Unemployability, likeshortages and s is not independent of price. In a free market, low-pro workers are just as employable at a low wage as high-p ity workers are at a high wage.

Differential

Impact

Some countries in Europe have lower minimum w teenagers than for adults and New Zealand simply e teenagers from the coverage of its minimum wage law u This was tacit recognitionof the fact that those workers mand were likely to behardest hit by unemployment c minimum wage laws.

BASIC ECONOMICS

Another group disproportionately affected b wage laws are members of unpopular racial or eth groups. Indeed, minimum wage laws were once a plicitly becauseof the likelihood that they would re nate the competition of particular minorities, wheth Japanese in Canada during the 1920s or blacks i States and South Africa at about the same time. Suc of overt racial discrimination were both legal an cepted in all three countries at thattime. Again, it is necessary to note how price is a f racial discrimination. That is, surplus labor resultin mum wage laws makes it cheaper to discriminate a ity workers than it would be in a free market, whe chronic excess supply of labor. Passing up quali workers in a free market means having to hire oth take the jobs they were denied, and thatin turn usu ther having to raise the pay to attract the addition lowering the job qualifications at the existing pay l which amount to the same thing, higher labor costs given amount of work done. The history of black workers in the United Sta the point. The American federal minimum wage l Labor Standards Act-was passed in 1938. Howeve flation had the effect of repealing this law for all nomic purposes during the 1940s, since the wag marketplace for even unskilled labor rose well ab law specified. The real impact of the law began to 1950, when the first major revisionof the Act began calations of the federal minimum wage. From the late nineteenth-century on past the m twentieth century, the labor force participation rate blacks was slightly higher than that of American w words, during this long period before the escalation wage rates, blacks were just as employable at the w ceived as whites were at their very different wages. T wage law changed that and those particularly hard sulting unemployment have been blackteenage mal

Controlled Labor Markets

Even though 1949-the year before the series of m wage escalations began-was a recession year, bl teenage unemployment that year was lower than it wa any time during the later boom years of the 1960s. T explanations of high unemployment among black tee inexperience, lack of skills, racism-cannot explain th unemployment, since allthese things were worse durin lier period when black teenage unemployment was mu Taking the morenormal year of 1948 as a basis for c black male teenage unemployment then was less than ha it would be at any time during the decade of the 1960 than one-third of what it would be in the 1970s. Moreo ployment among 16 and 17-year-old black males was than among white males of the same age in 1948. Itwas series of minimum wage escalations beganthat black m unemployment not only skyrocketeditself but became double the unemployment ratesamong white male teen

COLLECTIVE BARGAINING

So far we have been considering labor markets in w workers and employers are numerous and compete ind and independently, with supply and demand determi of pay and numbers of jobs. These, however, are not kinds of markets for labor. Somelabor markets are con laws or by collectivebargaining agreements, or both. So ers are members of labor unions which negotiate pay a ing conditions with employers, whether employers a individually or as members of some employers’ associa

Employer Organizations

In earlier centuries, it was the employers who w likely tobe organized and setting pay andworking con a group. In medieval guilds, the master craftsmen co made the rules determining the conditions under whic tices and journeymen would be hired and how much

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would be charged for the products. Today, major le owners collectively make the rules as to what is the tal salaries any given ball club canpay to its players. Clearly, pay andworking conditions tend to be d determined collectively than in a labor market whe compete against one another individually for worke ers compete against one another individually for jo obviously not be worth the trouble of organizing they were not able to keep the salaries they pay low would be in a free market. Much has been said about the fairness or unfairn tions of medieval guilds, modern labor unions or o collective bargaining. Here we are studying their eco quences-and especially their effects on the alloca resources which have alternative uses. Almost by definition, all these organizations exi price of labor from being what it would be otherwi open competition in the market. Just as the tenden competition is to base rates of pay on the produc worker, thereby bidding labor away from where it i tive to where it is more productive, so organized ef wages artificially low or artificially high defeat this thereby make the allocation of resources less efficien omy as a whole. For example, if an employers’ association keeps widget industry below the level that workers of sim ceive elsewhere, fewerof these workers are likelyto producing widgets than if the pay rate were higher. If ufacturers are paying $10 an hour for labor that wou hour if they had to compete with each other for wo market, then some workers willgo to otherindustrie an hour. From the standpoint of the economy as means that people capable of producing $15 an ho output are instead producing only $12 an hours’ wo This isa clear loss to the consumers-that is, to soc The fact that it is a more immediate and more v the workers in the widget industry doesnot make important fact from an economic standpoint. Loss

Controlled Labor Markets

between employers and employees are social or mo but they do not change the key economic issue,which allocation of resources affectsthe total wealth available as a whole. What makes the total wealth produced by omy less than it would be in a free market is that wag low the market level cause workers to work where th as productive. The same is true of wages set above the market lev bor union is successful in raising the wage rate for workers in the widget industry to $20 an hour, then e will employ fewer workers at this higher rate than they either the $12 an hour they set under employer collus $15 an hour that would have prevailed in free marke tion. In fact,the only workers it will pay the employers workers whose productivity is $20 an hour or more. T productivity can be reached in a number of ways, whe taining only the most skilled and experienced empl adding more capital to enable the labor to turn outmor per hour, or byother means-none of them free. Those workers displaced from the widget industry their second-best alternative. Those worth $15 an hourp widgets may end up working in another industry at $1 Again, this is not simply a loss to those particular wor loss to the economy as a whole, because scarce resour being allocated where their productivity is highest. Under these conditions, Widget manufacturers are paying more money for labor, they are also paying for capital or other complementary resources to raise the p ity of labor above the $20 an hour level. Higher produc seem on the surface to be greater "efficiency," but p fewer widgets at higher cost per widget does not b economy, even though less labor is being used. Other receiving more labor than they normally would, beca workers displaced from the widget industry, can exp output. But that expanding output is not the most prod of the additional labor. It is only the artificially-impo wage rate which causes the shift froma more productiv less productive use.

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Note that either artificially low wage rates caus ployer association or artificially high wage rates caus union reduces employment in the widget industry. of saying the same thing is that the maximum emplo industry is achieved under free and open market without organized collusion among either employer ees. Looked at more generally, the only individual can be made anywhere in a free market are those wh acceptable to both sides-that is, buyers and sellers o puters, shoes or whatever. Any other terms, whether lower, and whether set by collective actions of e unions or imposed by government decree, favors on other and therefore causes the disfavored side to transactions. From the standpoint of the economy as a whole, t that things that both sides wanted to do now canno cause the range of mutually acceptable terms has be narrowed. One side or the other must now go to thei alternative-which is also second-best from the stan economy as a whole, because scarce resources have n cated to their most valued uses. The parties engaged in collective bargaining areo occupied with their own interests, but those judging t a whole need to focuson how such a process affects interests of the entire society, rather than the intern economic benefitsamong contending members of the

Labor Unions

Labor unions often boastof the pay rate and other have gotten for their members and of course that is unions to continue to attract members. The wage rat typically a key indicatorof a union’s success,but the f cations of that wage rate seldom receive as much at endary labor leader John L. Lewis, head of the U Workers from 1925 to 1960, was enormously successf higher pay for his union’s members. However, an ec called him ”the world’s greatest oil salesman,” beca

Controlled Labor Markets

ing higher priceof coal and the disruptions in its produc numerous strikes caused many usersof coal to switch instead. This of course reduced employment in the coal By the 1960s, declining employment in the coal in many mining communities economically stricken and tual ghost towns. Media stories of their plight seldom their current woes with the former glory days of John L fairness to Lewis, he made a conscious decisionthat it to have fewer miners doing dangerous work undergr more heavy machinery down there, sincemachinery co killed by cave-ins, explosionsand the other hazards of To the public at large, however, these and other were largely unknown. Many simply cheered at what done to improve the wages of miners and, years later, passionate toward the decline of mining communities-b little or no connection between the two things. Yet wh volved was one of the simplest and most basic princip nomics, that less is demanded at a higher price than price. That principle applies whether considering th coal, of mine workers or anything else. Very similar trends emerged in the automobile i where the danger factor was not what it was in mining United Automobile Workers’ union was also very suc getting higher pay, more job security and more favor rules for its members. In the long run, however, all th tional costs raised the price of automobiles and made cars less competitive with Japanese and other imports, n the United States but aroundthe world. As of 1950, the United States produced three-qua the cars in the world and Japanproduced less than one what Americans produced. Twenty years later, Japan ducing almost as many automobiles as the United Stat years after that, more automobiles. By 1990, one-third sold in the United States weremade in Japan. In 1996, t Accord and the Toyota Camry each sold more cars in t States than any car sold by General Motors. All this of c its effect on employment. During the 1980s, the numbe the American automobile industry declined by m

BASIC ECONOMICS

100,000. By 1990, the number of jobs in the America industry was200,000 less than it had been in 1979. Political pressures on Japan to ”voluntarily” limi cars to the U.S. led to the creation of Japanese autom facturing plants in the United States, hiring American 1990, these transplanted Japanese factories were prod as many cars as were being exported to the United Japan. Many of these transplanted Japanese car co workforces that were non-union-and which rejec tion when votes were taken among the employees. This was partof a more general trend among ind ers in the United States. TheUnited Steelworkers of another large and highly successful union in getting other benefits forits members. But here too the num the industry declined by morethan 200,000 in a deca steel companies invested $65 million in machinery these workers, and while the towns where steel pro concentrated were economically devastated. The once commonbelief that unions were a bless cessity for workers was now increasingly mixed wi about the unions’ role in the economic declines and ployment in many industries. Faced with the prosp some employers going out of business or having to d duce employment, some unions were forced into ”g that is, relinquishingvariouswages and benef obtained for their members. Painful as this was, m concluded that it was the only way to save members The proportion of the American labor force tha ized began to decline as skepticism about their eco spread among workers who increasingly voted agai resented by unions. Unionized workers were 32 p workers in the middle of the twentieth century, but cent by the end of the century. Moreover, there w change in the composition of unionized workers. In the first half of the century, the great unions we automobiles, steel, and trucking. But, as the twent drew to a close, the large and growing unions were ernment employees. The largest union in the count

Controlled Labor Markets

the union of teachers-the National Education Assoc economic pressures of the marketplace, which had cr problems for unionized workers in industry and com not apply to government workers. Government emplo continue to getpay raises, benefits, and job security w rying that they would suffer the fate of miners, autom ers, and other unionized industrial workers. Those government workers were not spending their own mo taxpayers’ money,and so had little reasonto resist unio and faced no competitive forces in the market that c them to losebusiness to imports or substitute products In private industry, many companies remained no a policy of paying their workers at least as much as workers received. Such a policy implies that the cos ployer of having a union exceeds the wages and bene workers. The hidden costs of union rules on seniority other details of operations are for some companies w rid of, even if that means paying their employees mor would have to pay to unionized workers.

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Chapter 11

An Overview

E

mployee earnings are the largest category of inco American economy, constituting about 70 percent income fordecades on end. Because wages and salarie portant in the lives of most individuals, there is a te look at income solely from the standpoint of the indi ceiving it. However, this overlooks the important role o of labor in allocating resourcesin ways which determin dard of living in the society as a whole. Looking at inc from the standpoint of individual recipients also tends the economy as a zero-sum game, in which what is some is lost by others. But there would obviously n been the great rises in the general standard of living w occurred overthe years and generations if that were tru By 1994, for example, most American households l the o@id poverty line had a microwave oven and a vid recorder, things that less than one percent of all Amer holds had in1971. Forthe population at large, homes w bigger, automobiles were much better, and more pe connected tothe Internet at the end of the century than nected toa water supply at the beginning of the century clearly not a zero-sum game, in which what some wo by others. Fights overwhich individuals and groupsget how of the pie create the kind of emotions and controversy the media and politicians thrive. But the economic re the main reason most Americans have prospered is tha self has gotten much bigger, not because this gro changed a few percentage points in its share. The cha cation of scarce resources which makes continuing

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ECONOMICS BASIC

possible may change these percentages back and for as changing pay and employment prospects direct in where their productivity would be higher and awayf is lower.But it is changes in productivity and allocati crucial to the economic wellbeing of the population, percentage point changes in relative shares which att media, political, and other attention. So-called ”income distribution” statistics are very when we focus on comparisons between fixed inco such as the top 20 percent or bottom 20 percent, rathe actual flesh-and-blood people who are constantly m one bracket to another in the American economy. W percent of the people who were in the bottom 20 pe American income earners in 1975 had a higher stand by 1991. In fact, more than half of those at the bottom a higher standard of living in 1991 than the average A in 1975. Evenin relative terms, more of those who we tom 20 percent in 1975 were in the top 20 percent by mained in the bottom 20 percent. Indeed, an absolut those who were in the bottom 20 percent in 1975 had top 20 percent at some point during those 16 years. Media and even academic preoccupationwith inst statistics create major distortions of economic reality and ”the poor” have become staples of income discu though most of the people in the top and bottom inco are the same people at different stages of their lives fixed classesof people who remain at the top and bott out their lives. Even a couple of economists who s known better used analogiesthat treated peoplein va brackets as if they were permanently in those bracke come people were likened to ”dwarfs” less than th while people in the top brackets were likened to ”gi tall. A much more apt analogy would be between c adults, since children growup to becomeadults, whil giants remaindwarfs and giants throughout their live Even among millionaires, studies show that f them did not inherit their fortune but earned it durin lifetimes. The great historic American fortunes-Carne

A n Overview

Vanderbilt, etc.-were often created by people who modest or even humble circumstances. Richard Wa Aaron Montgomery Ward, and James Cash Penney working to support themselves in lowly jobs as teen young to be allowed to work under today’s child l though each eventually rose to become fabulously wea ators of the retail store chains which bear their respecti Similar stories could be told of teenage Henry For came fedup with farm work and walked eight miles t look for a job. David Sarnoff,who went on in later lif the NBC broadcasting network, also began working himself as a teenager. So did an immigrant lumberya named Frederick Weyerhauser, who went on to establ products empire. A middle-aged salesman making $12 went on to create the McDonald’s fast-food empire 25,000 restaurants that literally circles the globe. The l and on. While the great American fortunes may come to m speaking of ”the rich,” most people in the top 10 or 20 the income or wealth distribution have no such fortu people in the top one percent in wealth bear little resem ”the idle rich” conjured up in popular legend or i rhetoric. As of 1998, a household income of $75,000 a enough to put the people in that household in the top A couple making $38,000 each hardly seems like ”the r the top 5 percent of households could be reached w bined income of $133,000-comfortable, but hardly in category as millionaires and billionaires. As in so many other aspects of economics, the basic involved in work and pay are not terribly complicate facts particularly obscure. What gets complicated is gling a fairly straightforward story from a jungle of p tions and emotion-laden myths. Political movements whole nations have been seized by a vision of the id ploiting the toiling masses, of people mired in grindin from birth to death, and of labor unions or socialist orc movements as the only forlorn hope for those otherwis ically doomed. Plain factshave no such dramatic impa

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erate such excitement on television, or in politics, seminar table. Even when considering the top andbottom one p come earners, we are not talking about the idle explo toiling masses. Our social visions and our rhetoric ar rich” and ”the poor,” as if we were talking about peo born, live, and die in poverty or luxury, while the r most Americans do not stay in the same income qu long as a decade. However important payments to individuals ar standpoint of their own material wellbeing, these p also a means of allocating the work of those individ which affect the efficiency of the economy and theref dard of living in the society as a whole. In an ever-ch omy with new and more productive technologies em more efficient methods of organization being devi workers employed where they are already is to for forego the economic benefitsof such new developme Unless workers are to be ordered to move fromo region, or occupation to another, as under totalitar nomic incentives and constraints must accomplish th in a market economy. Higher pay may attract wo newer and more productive sectors or unemployme them out of sectors whose products or technologiesa obsolete. Simpleand obvious as this may seem, it is derstood by those who are shocked to see some se economy prospering at the same time when others ar behind” or are even suffering losses of business and ten there is no sense that these are all part of the sa rather than separate happenstances that are good fo bad for others. There were, for example, many laments in the nin tury for the plight of the handloom weavers, incre placed by power looms that mademore clothing mo to millions. Today, in an affluent age, when physica clothing is so widely available that only issues of sty name concern most Americans,it is difficultto imagi ships endured by many people unable to afford eno

A n Overview

to provide adequate protection against the elements-o blessing it was to them to have the prices of clothe down to a level where they could finally afford them advances in the mechanization of production. Their go and the misfortunes of the handloom weavers were i part of the same process. In our own time as well, "saving jobs"-whether placement by technological advances at home or fro from other countries-means forcing other people toha standard of living than what is available with the e sources and technology. However one might wish to r trade-off, it must first be recognized as a trade-off, n strange or sinister "unfairness" arbitrarily imposed on v Pay differentials are likewise typically reflections tivity differences and are part of the process of alloca labor resources which have alternative uses. Again, a f ous economic fact can become very confused when i with very different moral questions about whether on people merit so much more than others. Productivity are wholly different things. Someone born and raised favorable circumstancesmay find it easier to become a geon than someone born and raised in highly unfav cumstances may find it to become a skilled carpenter. very different from saying that brain surgeons are p much" or carpenters "too little." In policy terms, making it easier forpeople born in nate circumstances to acquire the knowledge and skills brain surgeons is very different from simply decreein differentials between brain surgeons and carpenters b or eliminated. The latter policy affects the allocation of affecting not only how hard existing brain surgeons w how early they will retire, but also how many replace will have, as young people decide whether or not it i the years and effort it takes to becomea brain surgeon. Those who have the biggest stake in all this are peo ing from medicalconditions that require brain surgery tendency in some quarters see economic choices as a game involving a trade-off between the interests of

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groups, very often the third parties who are ignored most of all. Moreover, seeing economic issues as s about how to divide up money ignores the larger rol incentives in allocating resources. Fromthe standpo as a whole, money is just an artifact used to get realt How well those real things are done is what de material wellbeing of the people in that society.

PART IV: TIME AND RIS

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Chapter 12

Investment and Specula

A tourist in New York’s Greenwich Village de cided to have his portrait sketched by a sidewal artist. Hereceived a very finesketch, for whichh was charged $100. “That’s expensive,” he said to the artist, “b I‘ll pay it, because it is a great sketch. But, reall it took you only five minutes.” ”Twenty years and five mimtes,” the artis said.

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rtistic talent is only one of many things which a lated over time for use later on. If the earlier sac risks are ignored, the reward for what was done with sent time period may often seen exorbitant. Oil wells their costs many times over-but they must also cov of all the dry holes that were drilled in the ground wh ing in vain for petroleum deposits before finallystrikin Add to this the cost of keeping people alive while their artistic talent to develop, their oil exploration to off, or their academic credits to finally add up to enou their degree, and there may be a considerable investme paid. The repaying of the investment is not a matter o but of economics. If the return onthe investment is no make it worthwhile, fewer people will make that pa vestment in the future, and consumers will therefore the use of the goods and services that would otherwise produced. No one is under any obligation to make ments pay off, but how many need to pay off, and to w

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is determined by how many consumers value the ben people’s investments. Where the consumers do not like what is being p investment should not pay off. Whenpeople insist on in a field for which there is little demand, their inv been a waste of scarce resourcesthat could have pro thing that others wanted. The low pay and sparse opportunities in that field are a compelling signal to to others coming afterthem-to stop making such in The same principle is involved in activities that through the marketplace, and are not normally thoug nomic. Putting things away after you use them is an of time in the present to reduce the time required to the future. Explaining yourself toothers can bea time and even unpleasant, activity but it is engaged in a ment to prevent greater unhappiness in the future derstandings. Economic activities, likeother activities, take plac ing spans of time and with varying risks. Time alon ”hope deferred maketh the heart sick”-but often must be sacrificedas well. Bothas individuals and as deny ourselves tangible benefits that are within our in order to save for other benefits in the future. Thes fits may not even exist at present. Sometimes we don what these non-existent benefitsare when they are pa are paying for health insurance, for example, then yo up some of the goods you could be enjoying today, you may in the future have the benefit of bandage blood transfusions, or whatever medical resource turn outto need. You don’t know which of these thin and you would just as soon never need any of th know that you might, which is why you are willing is, toinvest for future benefits, just as people invest on Like other things, investment has a price -namely est, dividends or other future returns on the investm these returns are in the future, risk is an inherent pa ment and the return mustbe higher when the risks a else people will refuse to part with their money. Mo

Iuvestnzent and Speculation

risks are constantly changing, as is our knowledge of risks. That is why the stock market is constantly fluc investors acquire more information (including misin about the condition of the companies they have inve the condition of other companies or industries which better place toput their money. Saving is usually thought of as putting things away ture, and especially putting money away for the future ever important money is for the individual, what ma for the society as a whole are the real things which t represents. The government could easily print twic money, but the country would not be twice as rich, b same amount of goods would then simply end up w numbers on their price tags. For the economy as a w these real goods and services that matter-and man goods and services cannot be saved for very long. Fo paper eventually turns yellow and brittle, machinery corrodes. Therefore the economy as a whole saves, no ily byputting things in inventory for years,but by crea the productive capacity needed to produce those thing ture, whether that means building a hydroelectric dam mobile factory ora computer software company. What is being saved and invested in the present goods and services that will be usedin the future, but t to produce those things in the future. That capacity ma machine toolsthat will produce an automobile five ye or accumulating experience that will allow an artist sketch worth $100 twenty years from now. The society invests forthe future by devoting resources to these pro pacities, instead of using those resources to produce goods directly for use during the current year. This istru that society is primitive or high-tech. Farmers have kno turies that they could either eat a potato or save it top ground to grow more potatoes next year.It is the sam ther way, so consumer goodsand investment goods ne physically, but only in the uses to which they are put. When economic actions taken at one time bear fru time, risk isintroduced or increased. Knowledge isnev

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and the longer the time between a decision and its c the wider the gray area of uncertainty. One of the wa with this uncertainty is to prepare alternative cour These may be in the form of contingency plans or in material goods stored to covera variety of possibiliti In short, inverrfory is a substitute for knowledge going into battle knew that he would fire exactly combat, he would not need to weigh himself dow bullets than that or with a variety of first aid and oth he would never use. Only his lack of knowledge mak for him to carry such an inventory. Speculation is another way of dealing with risk tainties.

SPECULATION

When an American wheat farmer in Idaho or Ne ting ready to plant his crop, he has noway of know price of wheat will be when the crop is harvested. T on innumerable other wheat farmers, not only in States but as far away as Russia or Argentina. If th fails in Russia or Argentina, the world price of whe up, causing American wheat farmers to get very hi their crop. But if there are bumper crops of wheat in gentina, there may be more wheat on the world mar body can use,with the excess having to go into expe facilities. That will cause the world price of wheat to that the American farmer may have nothing to sho work and be lucky to avoid taking a loss on the year he and his family will have to live on their saving from whatever sources will lend to them. This is oneof innumerable risky economic activi rise to the kind of specialized activityknown as spec fessional speculator makes contractsbuy to or sellat p day for goods to be delivered at some future date. T risk of the activity from the person engaging in itwheat farmer, in this case-to someone who is, in e

Investment and Speculation

that he can guess the future prices betterthan the other p has the financial resources toride out the inevitable wr make a profit on the betsthat work out as predicted. Speculation isoften misunderstood as being the sam bling, when in fact it is the opposite of gambling. Wha involves, whether in games of chance or in actions li Russian roulette, iscreating a risk that would otherwis in order either to profit or to exhibit one’s skill or la What economic speculation involves is coping with a risk in such a way as to minimize it and to leaveit to b whoever is bestequipped to bear it. When a commodity speculator offers to buy whe not yet been planted, that makes it easier for a farm wheat, without having to wonder what the market pr like later, at harvest time. A futures contract guarantee a specified price in advance, regardless of what the m may turn outto be at the time of delivery. Thisseparat from economicspeculation, allowing each tobe doneb people, in each case bythe person best able todo it. T tor uses his knowledge of the market, and of economic tical analysis, to try to arrive at a better guess than may be able to make, and thus is able to offer a pric farmer will consider an attractive alternative to waitin whatever price happens to prevail in the market at har Although speculators seldom make a profit on eve tion, they must come out ahead in the long run, in orde business. Their profit depends on paying the farmer a is loweron average than the price which actually emer vest time. The farmer also knows this, of course. In farmer is paying the speculator for carrying the risk other goods and services, the question may be raised whether the service rendered is worth the price charg individual level, each farmer can decide for himself w deal is worth it. Each speculator must of course bid ag speculators, as each farmer must compete with othe whether in making futures contracts or in selling at ha From the standpoint of the economy as a whole, comp termines what the price will be and therefore what th

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tor’s profitwill be. If that profit exceedswhat it takes vestors to risktheir money in this volatile field, mor will flowinto this segment of the market until compe profits down to a level that just compensates the expe and risks. Competition is visibly frantic among speculator their offers and bids in commodity exchanges. Pri from moment to moment and a five-minute delay deal can mean the difference between profits and lo modest-sized firm engaging in commodity speculat or losehundreds of thousands of dollars in a day, and rations can gain or lose millionsin a few hours. One of the most dramatic examples of what can commodity speculation involved the rise and fall of in 1980. Silverwas selling at $6.00 an ounce in early 1 rocketed to a high of $50.05 an ounce in early 1980. H price began a decline that reached $21.62 on March 2 just one day, that price was cut in half to $10.80.In the billionaire Hunt brothers, who were speculating hea lost more than a billion dollars within II few weeks. S perhaps the most extreme example of a price system a locating resources. Speculation may be engaged in by people who mally thought of as speculators. As far back as 18 Heinz food-processing company signed contracts to bers from farmers at pre-arranged prices, regardless market prices might be when the cucumbers were Then as now, those farmers who did ~ z o tsign futu with anyone were necessarily engaging in specula prices at harvest time, whether or not they thought o as speculators. Because risk is the whole reason for speculatio place, being wrong is a common experience,though too often means facing financial extinction. Predicti very knowledgeable people, can be wrong by vast a distinguished British magazine The Eco~zomistpredic 1999 that the price of oil would fall to $5 a barrel, b price of oil m e to $25 a barrel by December. Anyon

Speculation and Investment

in oil on the basis of The Economist’s prediction could h ruined financially. Futures contracts are made for delivery of gold, oil, foreign currencies and many other things at some pric advance for delivery on a future date. When the specula delivery at a price below the price prevailing when the c signed, he is said to be “selling short”-that is, betting price is going to go down so much in the meantime th still make a profit at the lower price. When he goes ”l means his contract charges more than the current price turn means that the other party expects the price to rise even higher than the amount in the contract. All these depend on different people having different estimate speculator’s survival depends on his being right more o the other party. Commodity speculation is only one kind of specula can also speculate in real estate, corporate stocks, oroth For example, the stock of the Internet bookseller Am rose sharply for years before the company made a cent Why were buyers bidding up the price of this stock, w yet topay a dividend, from a company which as yet had its from which dividends might be paid if they wanted reason was the belief that Amazon.com would eventuall profitable. Another reason was that the price of the stoc pected to continue to rise, so that the initial buyers coul profit by selling to subsequent buyers, regardless of Amazon.com made a profit or not. This second reason speculation. The full cost of risk is not only the amount of m volved, it is also the worry that hangs over the individ waiting to see what happens. A farmer may expect to ton for his crop but also knows that it could turn out to ton or $150. If a speculator offers to guarantee to buy h $90 a ton, that price may look good if it spares the farme of sleepless nights wondering how he is going to su family if the harvest price leaves him nothing to cover Not only may the speculator be better equipped fina deal with being wrong, he may be better equipped ps

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cally, since the kind of people who worry a lot do n into commodity speculation. A commodity speculat one year when his business was operating at a loss g cember, but things changed so much in Decembe ended up with a profit for the year-to his surpris anyone else’s. Thisis not an occupation for the faint Economic speculation is another way of alloca sources-in this case, knowledge. Neither the spec farmer knows what the prices will bewhen the crop But the speculator happens to have more knowled and of economic and statistical analysisthan the farm farmer has more knowledgeof how to growthe crop. ity speculator friend admitted that he had never a soybean and had no idea what they looked like, alt probably bought and sold millions of dollars worth the years. He simply transferred ownership of his so per to soybeanbuyers at harvest time, without ever possession of them from the farmer. He was not rea bean business,he was in the risk management bus Speculation means that complementary knowled ordinated, creating greater efficiency in the produc ucts which have inherent risks associated with the These risks can never be eliminated, but they can b by having them borne by those best able to bear the the standpoint of specialized knowledge and skills standpoint of having sufficient financialaccumulatio losing speculations while waiting for them to be offs speculations in the long run.

INVENTORIES

Inherent risks must be dealt with by the econ through economic speculationbut also bymaintainin Put differently, inventory is a substitute for knowl would ever be thrown out after a meal, if the cook hand exactly how much each person would eat and fore cook just that amount. Since inventory co

Investment and Speculation

business enterprise must try to limit how much inven on hand, while covering the possibility that its best g how much it will need may be inadequate. Clearly, those businesses which come closest to th size of inventory will have their profit prospects enhan important, the total resources of the economy will be more efficiently,not only becauseeach enterprise has a to be efficient, but also because thosefirms which turn right more often are more likely tosurvive and contin such decisions, while those who repeatedly carry far to inventory, or far too small, are likely to disappear from ket through bankruptcy. Some of the same economic principles involving ris activities far removed fromthe marketplace. A soldier battle does not take just the number of bullets he will the amount of first aid supplies he will need if wounde ticular way, because neither he nor anyone else has th foresight required to do that. The soldier carries an in both ammunition and medical supplies to cover vario gencies. At the same time, he cannot go into battle loa with huge amounts of everything that he might poss This would slow him down and reduce his maneuv making him an easier target for the enemy. In other w yond some point, attempts to increase his safety canma uation more dangerous.

RETURN ON INVESTMENT

Delayed rewards for costs incurred earlier are a ret vestment, whether these rewards take the form of divid on corporate stock or increasesin incomes resulting fro gone to college or medical school.One of the largest in in many people’s lives consists of the time and energy over a period of years in raising their children. At one return on that investment included having the children of the parents in old age, but today the return on this i often consists onlyof the parents’ satisfaction in seeing

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dren's well-being and progress. From the standpoin a whole, each generation that makes this investm spring is repaying the investment that was made by generation in raising those who are parents today. There are also investments made outside the fam fer wealth back and forth across the generations. Chapter 9, income varies greatly with age. People i and fifties tend to have much higher incomes than p twenties. People in the older generation often put into banks and other financial institutions, which in young people buying homes or getting an educatio means is that the amount of income that older and h people are entitled to spend is not in fact all spent by nificant amount of their money is spent by younge borrow through banks, for example, and use their e to pay for mortgages, tuition, and the like. Later, wh the older generation retire, they begin to consume m are currently producing by using money now bei banks and other financial institutions, which share w interest and principal they are receiving fromthe you tion, whose incomes have usually been rising over th Looking beyond money to the actual goods and changed over the years, the younger generation a cars, houses, education and furniture than they can moment and the older generation is paid back later cruises, medical care,and retirement homes. Although making investments and receiving th turn on those investments takes many forms and ha on all over the world throughout the history of the misunderstandings of this process have also been Sometimes these delayed benefits are called "unear simply because they do not represent rewards for made during the current time period. Investments factory may not be repaid until years later, after managers have been hired and products manufactu During the particular year when dividends finally paid, investors may not have done anything, but mean that the reward they receive is "unearned," si

Investment and Speculation

it was not earned that particular year. Yet elaborate and mass movements have been based on the notion th workers really createwealth, while others merely skim without having contributed anything to producing the which they unjustly share. Similar misconceptions have had fateful conseq money-lenders around the world. For many centurie lenders have been widely condemned in many cultu ceiving back more money than they lent-that is, for "unearned" income for waiting. Often the social stigm to money lending has been so great that only mino lived outside the existing social system anyway have ing to take on such stigmatized activities. Thus, for c Jews predominated in such occupations in Europe, as t did in Southeast Asia, the Chettiars and Marwaris in other minority groups in other parts of the world. A times and places, the hostility to such groups has re point where these minorities have been expelled bygo or have been forced to flee from mob violence. Altho depicted as useless parasites, the contribution of mon minorities has been demonstrated after their departur ages of credit and general economic declinesin the cou forced them out. Just as prices in general affect the allocation of reso one place to another at a given time, so returns on inve fect the allocation of resources fromone time period to high rate of return provides incentives forpeople to sa vest more than they would at a lower rate of return. same thing differently, a higher rate of return encoura to consume less in the present, in order to consume m future. It allocates resources over time. The individual not invest directly. Money saved in a bank, for exam lent out to someone else and invested in establishing o a business. Investment plays another very important role in the When teenage Henry Ford walked from the farm w worked all the way into Detroit, in order to look fo clearly did not have the kind of money needed to m

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ECONOMICS

BASIC

millions of automobiles. Where did he get that mon viously someone thought enough of his ideas and ab some money backing him to get started. As he prov one step after another, more and more people were w their money behind him, in order to cash in on the the mass-production industry that he was creating. a way of transferring resources to where they hav uses that are more valuable than where they are. Numerous other entrepreneurs, starting with lit an idea and determination, have found investors wil chance on them, just as investors take chanceson oil bean futures. Although willing to take risks, these i not be reckless or they will end up with nothing to i way, entrepreneurial talent gets a chance to prove marketplace, even if that talent originates in some money of his own andutterly unknown to the genera the political powers that be. It is yetanother way in market system taps knowledge and abilities that hav to emerge in more restrictive societies.

Present Value

Whether a home, business, orfarm is maintained improved today determines how long it will last an will operate, and therefore what it will be worth i However, the owner does not have to wait to seethe property’s value. These future returns are immedia in the property’s preselzt value. The ”present value” of fact nothing more than its anticipated future return and discounted for the fact that they are delayed. Conversely, if the city announces that it is go building a sewage treatment plant next year, on a next to your home, the value of your home will de ately, before the adjoining land has been touched. value of an asset reflects its future benefits or detrim anything which is expectedto enhance or reduce tho detriments will immediately affect the price at which be sold today.

Investment and Speculation

Present value links the future to the present. It m for a ninety-year-old man to begin planting trees that w years before they reach their maturity because his land dilrtely be worthmore because of those trees. He can s six months later and go live in the Bahamas if he wishe he will be receiving additional value from the fruit pected to grow on those trees, years after he is no lo Part of the value of his wealth today consists of the val that has not yet been grown-and which will be eaten b who have not yet beenborn. Any series of future payments can be reduced to value that can bepaid immediately in a lump sum. Win teries who are paid in installments over a period of yea those payments to a financial institution that will gi fixed sum immediately. So can accident victims who awarded installment payments from insurance comp cause the present value of a series of payments due ov of decades may be considerably less than the sum total payments, the lump sums paid may be lessthan half o tals, causing some people who sold to relieveimmedia problems to later resentthe deal they made. Others, ho pleased and return to make similardeals in the future.

Natural Resources

Present value profoundly affects the discovery and ural resources. There may be enough oil underground centuries, but its present value determines how mu anyone to discover-and that may be no more than last fora dozen or so years. A failure to understand this nomic realityhas led to numerous false predictions tha "running out" of petroleum, coal, orsome other natura In 1960, for example, a best-selling book said that States had only a 13-year supply of domestic petroleum isting rate of usage. At that time, the known petroleum of the United States were not quite 32 billion barrels. At the 13 years, the known petroleum reserves of the Un were more than 36 billion barrels. Yet the original sta

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the arithmetic based on them were accurate. Why the run outof oil in 13 years? Was it just dumb luck that discovered-or were there more fundamental econom Just as shortages and surpluses are not simply a m much physical stuff there is, either absolutely or re population, so known reserves of natural resources ar a matter of how much physical stuff there is under natural resources as well, prices are crucial. So are pr How much of any natural resource isknown to e on how much it costs to know. Oil exploration, for costly. This includes not only the costs of geologica but also the costs of repeatedly drilling expensive dry finally striking oil. As these costs mount up while mo oil isbeing discovered, the growing abundance of kno of oil reduces its price through supply and demand the point is reached where the costper barrel of find exceeds the present value per barrel of the oil you find. At that point, it no longer pays to keep explorin on a number of circumstances, the total amount of o at that point may be no more than the 13 years' supp to dire predictions that we were running out. As one example of the kinds of costs that can be major oilexploration venture in the Gulf of Mexico s lion on the initial exploration and leases, and another for exploratory drilling, just to see if it looked lik enough oil to justify continuing further. Then there w lion spent for building drilling platforms, pipeline structure, and"finally-$370 million for drilling f there were proven reserves. Thisadds upto a total of Imagine if the interest rate had been twice as much money borrowed from banks or investors, mak cost of exploration even higher. Orimagine that the o had this much money of their own and could put it earn twice the usual interest in safety. Would they h much as they did into looking for oil? Would you? P A higher interest rate would probably have meant le ration and therefore smaller amounts of known reser leum. But that would not mean that we were any

Investment and Speculation

running out of oil than if the interst rate were lowe known reserves were correspondingly higher.' As more and more of the known reserves of oil ge the present value of the remaining oil begins to rise more exploration for additional oil becomes profitable any given time, it never pays to discover all the oil tha the ground or under the sea-or more than a minute that oil. What does pay is for people to write hysteric tions that we are running out of natural resources. It only in book sales and television ratings, but also in power and in personal notoriety. Even the huge usages of energy resources in the century have not reduced the known reserves of some o sources. Ithas been estimated that more energy was co the first two decades of the twentieth century than in a viously recorded history of the human race. Moreover, age has continued to escalate since then. Yet known p reserves have risen. The known reserves of petroleu world were more than twice as large in 1999 as they we The economicconsiderations which apply to petrole to other natural resources as well.No matter how muc there is in the ground, it will never pay to discover when its present value per ton is lessthan the cost of e and processing per ton. Yet, despite the fact that the century has seen vast expansions in the use of iron and proven reserves of iron ore in 1980 were nearly five t they were in 1950. Copper, aluminum, and lead rese also several times as great in 1980 as in 1950. The difference between the economic approach an terical approach to natural resource usage was shown b tween economist Julian Simon and environmenta

'Although an extreme example was used to dramatize a point, even a rise in the interest rate-say just one percentage point-would mean incr more than a million dollars a year on a venture with $1.1billion invested would be a number of years before the oil being sought actually comes out o gas station tobe sold to a paying customer, the million-plus dollars a year in terest charges would amount to several million dollars more in costs befo spent could begin to be repaid.

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Ehrlich. Professor Simon offered to bet anyone that a natural resources they chose would not have rise over any time period they chose. A group led by Pro chose fivenatural resources and chose ten years as t measuring how their real costschanged. At the end o not only had the real cost of that set of five resource had the cost of every individual resource they had rise in cost! Obviously,if we hadbeen anywhere clo out of these resources, their costs would have risen present value of these potentially more scarce reso have risen. In some ultimate sense, the total quantity of reso course be declining. However, a resource that is goin thousand years after it becomes obsolete, or a cen sun grows cold, isnot a serious practical problem. If run outwithin some time period that is a matter of vance, then the rising present value of the resource w tion looms ahead will automatically force conserva either public hysteria or politicalexhortation. Just as prices cause us to share scarce resourc products with others at a given time, present value share those resources overtime with future generati even being aware that we are sharing. It isof course to share politically, by having the government assu natural resources, as it can assume control of othe fact of the whole economy. The efficiencyof political controlversus imperso prices in the marketplace depends in part on which veys the underlying realities more accurately. As a the price controls and direct allocation of resources stitutions requires far more explicit knowledge b small number of planners than is required for a ma to be coordinated by prices to which millions respo to their own first-hand knowledge of their own in cumstances and preferences. Moreover,planners ca false projections, either from ignorance or from var motives, such as seeking more power, re-election, o During the 1970s, a government scientist was aske

Investment and Speculation

I

the size of the American reserves of natural gas and ho would last. His estimate was that the United States ha natural gas tolast for 4,000 years! Whilesome might con good news, politicallyit was bad news at a time when dent of the United States was trying to get public su more government programs to deal with the energy "cr estimate was repudiated by the Carter administration a study begun, which reachedmore politically acceptabl Sometimes the known reserves of a natural resourc pecially small because the amount available at current costs is in fact nearing exhaustion. There may be vast available at a slightly higher cost of extraction, but th tional amounts will of course not be touched until th available at a lower cost is exhausted. For example, s there were coal deposits available on top of the groun was going to the expense of digging even a few feetinto to get more, becausethe higher-cost coalunderground compete in the marketplace with the cheaper coal on th During the interim, someone could sound an alarm th "running out" of coal that is "economically feasible" to that can be gotten without "prohibitive costs." But a whole purpose of prices is to be prohibitive. In this case hibition prevented more costly resources frombeing u lessly, so long as there were less costly sources of resource available. This is just one of the ways in wh contribute to economic efficiency. If technology never improved, then all resources w come more costly over time, asthe most easily obtained were used up first and the less accessible, or less rich ficult to process deposits were then resorted to. Howe improving technology, it can actually cost less to acqu resources when their time comes,as happened with the that Julian Simon and Paul Ehrlich bet on. Although the reserves of natural resources in a nati ten discussed in terms of physical quantities, economic of cost, prices, and present values must be considered i conclusions are to be reached. Sweeping statements poor country has so many billions worth of "natural w

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the form of iron ore or bauxite deposits mean very considering how much it would cost to extract and p resources. A country with $10 billion worth of som source might as well not have it if the costs of explor tion and processing add upto $11billion.

Chapter 13

Risks and Insurance

W

henever a home, a business, or any other asset in value over time, that increase is called a "capi While it is another form of income, it differs from w salaries in not being paid right after it is earned, but us after an interval of some years. A thirty-year bond, for can be cashed in only after thirty years. If you never sell your home, then whatever increas it has will be called an "unrealized capital gain." Thesa for someone who opens a grocery store that grows mor as its location becomesknown throughout the neighbor as it develops a set of customers who get into the habi ping at that particular store. Perhaps after the owner widow or children may decide to sell the store-and will the capital gain be realized. Sometimes a capital gain comes froma purely finan action, where you simply pay someone a certain am money today in order to get back a somewhat larger a money later on. This happens when you put money i ings account that pays interest, or when a pawnbro money, orwhen you buy a $10,000 U. S. Treasury bond what less than $10,000. However it is done, this is a trade-off of money money in the future. The fact that interest is paid im money today isworth more than the same amount of mo future. How much moredepends on many things, and v time to time,as well as fromcountry to country at the sa In the heyday of 19th-century British industrializa road companies could raise the huge sums of money r build miles of tracks and buy trains, by selling bonds

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about 3 percent per year. Thiswas possible only beca lic had great confidence in both the railroads and th the money. If inflation had been 4 percent a yea bought the bonds would have lost realvalue instead But the value of the British pound sterling was very liable during that era. Since those times, inflation more common, so the interest rate would now have whatever level of inflation was expected and still lea of a real gain. Leaving inflation aside, however, how much wo bond that matures a year from now be worth to Clearly it would not be worth $10,000, because fut not as valuable as the same amount of present money felt certain that you would still be alive a year from if there were no inflation expected, you would still the same amount of money right now rather than lat else, money that you have today can be put in a ban year’s interest on it. For the same reason, if you had tween buying a bond that matures a year from now bond of the same face value that matures ten years fr would not be willing to bid as much for the one th decade later. What this says is that the same nomin money has different values, depending on how lo wait to get it. At a sufficiently high interest rate, you might wait a long time to get your money back. On the oth sufficiently low interest rate, you would not be willin time at all to get your money back. Somewhere in b interest rate at which you would be indifferent betw money or keeping it. At that interest rate, the prese given amount of future money is equal to some smal present money. For example if you are indifferent then a hundred dollars today is worth $104 a year you. Any business or government agency that want from you today with a promise to pay you back a ye will have to make that repayment at least $104. If e has the same preferences that you do, then the intere economy as a whole will be4 percent.

Risks and Insurance

What if everyone does not have the same preference do? Suppose that others will lend only when they get b cent more at the end of the year? In that case, the inter the economy as a whole will be 5 percent, simply bec nesses and government cannot borrow the money the any less and they do not have to offerany more. Faced tional interest rate of 5 percent, you would have no rea cept less, even though you would take 4 percent if you this situation, let us return to the question of how m would be willing to bid for a $10,000 bond that matu from now. With an interest rate of 5 percent being available in omy as a whole, it would not pay you to bid more than for a $10,000 bond that matures a year from now. By that same amount of money somewhere else today at you could get back$10,000 in a year. Therefore,there is for you tobid more than $9,523.81 for the $10,000 bond What if the interest rate in the economy as a whole 12 percent, rather than 5 percent? Then it would not p bid more than $8,928.57 for a $10,000 bond that matu from now. Whatpeople will bid for bonds dependson h they could get forthe same money by putting it somew That is why bond prices go down when the interest rat and vice-versa. What this also says is that, when the interest rate is $9,523.81 in the year 2000 is the same as $10,000 in the This raises questions about the taxation of capital gain one buys a bond for the former price and sells it a yea the latter price, the government will of course want $476.19 difference. But is that really the same as an i value, if the two sums of money are just equivalent t other? What if there has been a one percent inflation, s $10,000 received back would not have been enough to sate for waiting, if the investor had expected inflation the real value of the bond? What if there had been a 5 percent inflation, so amount received backwas worth no more than the amo nally lent, with no reward at all forwaiting? Clearly, th

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would be worse off than if he or she had never bou How then can this ”capital gain” really be said to be These are just some of the reasons why the taxa gains is more complicated than the taxation of such income as wages and salaries. Some foreign govern tax capital gainsat all, whilethe rate at which such g in the United States remains a matter of political con

VARIABLE RETURNS VERSUS FIXED RET

Bonds differ from stocks because bonds are legal to pay fixed amounts of money on a fixed date. Stoc shares of the business that issues them, and there is that the business will makea profit in the first place have a legal right to be paid what they were prom the business is making money or losing money. In they are like the business’ employees, to whom f ments have been made as to how much they woul hour or per week or month. They are legally ent amounts, regardless of whether the business is pro profitable. Theowners of a business-whether that is vidual or millions of stockholders-are not legal anything, except whatever happens to be left over a has paid its employees, bond-holders and other cred Considering the fact that most new businesses few years, what is left over can justas easily be neg tive. In other words, people who set up businesses fail to make a profit but may even lose part or all originally invested. In short, stocks and bonds ha amounts of risk. Moreover, the mixture of stocks an by different businesses may reflect the inherent r businesses themselves. Imagine that someone is raising money to go in where (1)the chances are 50-50 that he will go bank he does survive financially, his initial investment ten-fold. Perhaps he is drilling for oil or speculati currencies. What if he wants you to contribute $5,00

Risks and Imurance

ture? If you can afford the risk, would you be better $5,000 worth of stock in this enterprise or $5,000 w company’s bonds? If you buy bonds, your chances are only 50-50 of g money back at all. And if this enterprise prospers, y entitled to whatever rate of return was specified in the outset, no matter how many millions of dollars th neur makes with your money. Buying bonds in suc does not seem likea good deal. Buying stocks,on the might make sense. If the business goes bankrupt, could be worthless, while a bond would have some v on whatever assets might remain to be sold, even pays the bondholders and other creditors pennies on On the other hand, if the business succeeds and its ass ten-fold, then the value of your stock increases ten-f If you are a venture capitalist with $50,000 to inve ventures, then you can buy $5,000 worth of stock in t terprises. If the odds are 50-50 on each, then you sh five of the ten to pay off ten-fold, while you lose $25 othersthat go bankrupt.Subtractingthat $25,000 $250,000 you get from your stock in five that succee have a phenomenal return of$225,000 on an inves $50,000. Even if you are unlucky and only two of the you still comeout ahead, with $40,000 in losses on th fail and $100,000 on the two that succeed. You get b from the $50,000 you invested. That isa 20 percent ret investment if you get your money back in a year and correspondingly less if it takes several years for the pay off. Now look at the same transaction from the standp entrepreneur who is trying to raisemoney for his vent ing that bonds would be unattractive to investors and would be reluctant to lend to him for the same reason almost certainly try to raise money by selling stocks the other end of the risk spectrum, consider a public supplies something the public always needs, such electricity. There isvery little risk involved in putting such an enterprise, so the utility can issue and sell bon

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having to pay the higher amounts that investors wo stocks. In short, risks vary among businesses and the arrangements vary accordingly. At one extreme, a comm ulator can go from profits to lossesand back again, no year to yearbut even from hour to hour on a given day there are television picturesof frantic shouting and wa modity exchanges, where prices are changing so rapi difference between making a deal right now and m minutes from now can be many thousands of dollars. A more commonpattern among those businesses is one of low income or no income at the beginning, higher earnings after the enterprise becomes establis ample, a dentist first starting out in his profession af ing from dental school and buying the costly equipm may have little or no income the first year, befor widely-enough known in the community to attract a tele. During that interim, the dentist’s secretary may more money than the dentist. Later on, of course, t will reverse and some observers may then think if un dentist makes several times the income of the secretar Even when variable sums of money add upto thes fixed sums of money, they are unlikely to be equall Would you be equally as likely to enter two occupati same average income-say, $50,000 a year-over the n one occupation paid $50,000 every year while the in other occupation might vary from $10,000 one year to next year? Chances are you would require a somewhat age incomein the occupation with variable pay, to attractive with the occupation with fixed pay. Accord usually yield a higher average rate of return than b stocks have a variable rate of return (including, some turn at all), whilebonds have a guaranteed fixed rateof does not happen because of some moral principle. It cause people will not take the risk of buying stocks un expect a higher average rateof return than they get fr The degree of risk varies not only with the kind of but also with the period of time. For a period of a yea

Risks and Insurance

likely to bemuch safer than stocks. Fora period of 20 o however, the risk of inflation threatens the value of other assets with fixed-dollar amounts, such as bank while stock pricestend to rise with inflation like reales ries, or other real assets. Being shares of real assets, s in the rising price of real assets during inflation. More in the absence of inflation, stock prices can generally b to rise overa period of decades, while bond prices and of other fixed-dollar assets do not. Therefore the relativ the two kinds of assets can bequite different in the lon in the short run. Someone planning for retirement many years in the find a suitable mixture of stocks a much safer invest someone who will need the moneyin a year or two. "L in the bank" isa popular phrase used to indicate som a very safe bet,but money in the bank is not particularl a period of decades, when inflation can steal much of its same is true of bonds. Eventually, after reachingan age remaining life expectancy isno longer decades, it may to begin transferring money out of stocks and into bond counts, and other assetswith grater short-run safety. The main point here is that safety and risk depend o period involved, as well as on the kind of asset. To t treme example,while a dollar invested in bonds in 180 worth nearly a thousand dollars by 1998, a dollar in stocks that same year would be worth more than half dollars. All this is in real terms, taking inflation int Meanwhile, a dollar invested in gold in 1801 would b worth just 78 cents. Thephrase "as good as gold" can leading as the phrase "money in the bank," when tal the long run. There have been many short-run peri bonds and gold held their value while stock prices p The relative safety of these different kinds of investm greatly with how long a time period you have in mind The relative safety and profitability of various kind ments also depends on your own knowledge. An expe pert in financial transactions may grow rich speculati while people of more modest knowledge may be lo

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However, with gold you are unlikely to be complete since gold always has a value for jewelry and indu while any given stock canend up not worth the paper on. Nor is it only novices who lose money in the st Harvard’s $13 billion endowment fell by 10 percent three months. In the past, colleges and universities k dowments in safe investments like government bonds the stock market boom of the 1990s, many went for hi return in the financial markets. As The Wall Street Jo these academic institutions ”are re-learning the less returns often are achieved bytaking high risks.” The various degrees and varieties of risk canbe d having a variety of investments-a ”portfolio,” as t that when one kind of investment is not doing well, may be flourishing, thereby reducing the over-all ris tal assets. For example,bonds may not be doing well riod when stock are very profitable, and vice versa. that includes a combination of both stocks and bo much less riskythan investing exclusively in either. These economic principles have long been und those investing their own money. Incenturies past shi ten found it more prudent to own 10 percent of ten dif rather than to own one ship outright. The dangers of ing were much greater in the days of wooden ships a in the modern era of metal, mechanicallypowered sh 10 percent shares in ten different ships increased the loss through sinking but greatly reduced how catas loss would be. These are just some of the ways in which risks ca thereby reducing the total risk. Insurance is another e

INSURANCE

Like commodity speculators, insurance compani inherent and inescapable risks. Insurance both trans duces those risks. In exchange forthe premium paid b holder, the insurance company assumes the risk of co

Risks and Insurance

for losses caused by automobile accidents, houses cat and numerous other misfortunes which befall huma There are more than 6,000 insurance companies in th States and their total assets exceed 2 trillion dollars. In addition to transferring risks, an insurance comp to reduce them. For example, it charges lower prices t vers and refuses toinsure some homesuntil brush ando mable materials neara house are removed. Ina variety segments the population and charges different prices with different risks. That way it reduces its own over-all in the process,sends a signal topeople engaging in dan havior or living in dangerous neighborhoods, conveyin the costs created by their chosen behavior or locati The most common kind of insurance-life insurance pensates for a misfortune that cannot be prevented. must die but the risk involved is in the time of death. If were known in advance to die at age 70, there would b in life insurance, because there would be no risk invol individual’s financial affairs could be arranged in advan that predictable death into account. Paying premiums surancecompanywould make no sense, becauset amount to which those premiums grew over the yea have to add upto an amount no less than the compens received by one’s surviving beneficiaries. The insura pany would, in effect, become an issuer of bonds redee fixed dates. Buying lifeinsurance at age 30 would be th buying a 40-year bond and buying life insurance at age be the same as buying a 30-year bond. What makes life insurance different from a bond i ther the individual insured nor the insurance compa when that particular individual will die. The financi others that accompany the death of a family breadwinn ness partner are transferred to the insurance company f Those risks are also reduced because the average d among millions of policy-holders is far more predictabl death of any given individual. As with other forms of risks are not simply transferred from one party to anoth duced. Where a given party has a large enough samp

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there may be no benefit from buying an insurance p car rental agency, for example, has so many autom own that its risks are sufficiently spread that it need n surance company to assume those risks. It canuse the tical methods used by insurance companies to de financial costs of its risk and incorporate that cost charges people who rent cars. There isno point trans that is not reduced in the process, becausethe insurer as much as the risk would cost the insured-plus eno pay the administrative costs of doing business and profit to the insurer. Self-insurance is thereforea viab those with a large enough sample of risks. Insurance companies do not simply save the pre receive and later pay them out when the time comes these premiums, so that they will have more mon than if they had let the money gather dust in a vaul this money has to be put into relatively safe investm ing housing developments, rather than commodity for example. Because insurance companies compete with one customers, the price of premiums is reduced by t ments, since the premiums paid in do not have to a total amount that will be paid out to the policy-hold that the money taken in over the years grows becau turns on the investments financed byinsurance comp that there can be more money at the end than was p policy-holders over the years. While it might seem that the insurance company the profit from these investments for itself, in reality forces the price of insurance down, as it forces other to a level that will cover costs and provide a rate of cient to compensate investors without attracting add petition. In an economy where investors are alway lookout for higher profits, an inflated rate of profit ance industry would tend to cause new insurance c be created, in order to share in this bonanza. This vented when there is a state regulatory agency that can and cannot be allowed to sell insurance, so that h

Risks and Insurance

are possible when such an agency protects the existing competition. The politics of insurance regulation is far more co than the basic economicsof insurance. The very proces insurance companies reduce risk is often under politica may be considered "unfair," for example, that a driv unblemished record must pay a higher premium beca neighborhood in which he or she happens to live. Th the risk to the car comes not only from its driver but other drivers, as well as from car thieves and vandal lost sight of during emotional political appeals, tho never be lost sight of by an insurance company wh money isat stake. Similar arguments are often made-and laws pass ingly-that it is "unfair" that a safe young driver is higher premium because other young drivers have h dent rates, or that young male drivers are charged mo male drivers the same age for similar reasons. Runnin such political arguments is the notion that it is wrong to be penalized for things that are not their fault. This changes the subject from risk to morality-and insuran nies exist becauseof risk. Forcingthem to charge the sa ums togroups of peoplewith different risks m premiums must rise over all,with safer groups subsidi dangerous groups. In the case of automobile insuran means that more unsafe drivers can afford to be on th that their victims pay the highest and most unnecessa all in injuries and deaths. Government programs that deal with risk are of gized to insurance, or may even be officially called "i without in fact being insurance. Federal disaster relief tims of floods, hurricanes and other natural disasters and rebuild but, unlike insurance, it does not reduce t risk. Often people rebuild homes and businesses in known paths of hurricanes and floods, often to the a the media for their "courage." But the financial risks not paid by those who create them, aswith insurance, stead paid by the taxpayers.

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In short, there is now more risk than if there wer relief available and more risk than if private insuran were charging these people premiums which cover t their risky behavior. Sometimesthe government sub ance for earthquakes or other disasters for which p ance would be "prohibitively expensive." Whatthat the government makes it less expensive for people to places-and more costly to the society as a whole, distribute themselves in more risky ways than they they had to bear the costs themselves, either in hi premiums or in financial lossesand anxieties. There is an almost politically irresistible inclin people struck by earthquakes, wildfires, tornadoes a ural disasters. The tragic pictures on television oversideration of what the situation was when they de where they did. But government-subsidized insura fect, disaster relief provided for thembeforehand, an a factor in people's choicesof where to liveand wha with other people's money. Competition among insurance companies invo price but service. When flood, hurricanes or other di an area, insurance company A cannot afford to be s surance company B in getting money to their policy ine a policy-holder whose home has been destroyed hurricane, and who is still waiting for his insurance a up, while his neighbor's insurance agent arrives within hours to advance a few thousand dollars im that the family can afford to go find shelter somewh will the customer of the tardy insurance company change companiesafterward, so will people all acro if word gets out as towho provides prompt service a their feet. For the tardy insurance company,that can losing billions of dollars worth of business. The leng some insurance companies go to avoid being later tha ing insurance companies was indicated bya New York

Prepared for the worst, some insurers had cars equi global positioning systems to help navigate neig

Risks and Insurance

downed street signs and missing landmarks, and man adjusters carried computer-produced maps identifyi cise locationof every customer.

The kind of market competition which forces such nary efforts is of course lacking in government emerg grams, which have no competitors. They may be ana insurance but do not have the same incentives.

Social Security

Another form of government program that has be gized to insurance, and is in fact called insurance in th Insurance Contributions Act," is Social Security. The premiums deducted from paychecks for Social Securi mediately spent upon their arrival in Washington-eithe pensions to existing Social Security retirees or to pay the many other government activities, fromfighting wa ing the travel expenses of members of Congress on junk The reason for the crisis atmosphere surrounding th cussions of how to "save" Social Security comes from F.I.C.A. premiums are not invested, like insurance prem are spent. Therefore, future pensions for those curren F.I.C.A. premiums will not be paid out of those prem out of juttire F.I.C.A. premiums paid by people who ar in the future-and from future general taxes, if and w F.I.C.A. premiums are insufficient. That iswhy there is such worry in Washington abo of the next generation that will have to pay the pensi current generation. So long as each successive gener larger than the previous one, Social Security operate fully like a pyramid scheme in its early phases, whe new people are joining that their payments in can prov return on the investment made by earlier members. In when the relatively small generation born during the being paid retirement pensions from the premiums rece the larger postwar "baby boom" generation, they rece far more than they paid in. However, with the prosp

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large baby boom generation themselves retiring in first century,there are no longer as high a ratio of wo paying into the system, in proportion to the retire money must be paid out. Although this problem is scribed as being due to changing demographics, the changing demographics are a problem is because So was never insurance in the first place, even though cally expedient to describeit that way. In a genuine insurance, the premiums paid by the eration are invested and the returns used to pay eit to that very same generation or to pay deathbenefits vivors. That is why insurance companies do not ha about how big the next generation is going to be, b do. Politicians do not invest the Social Security pr spend the money as fast as they get their hands on it The illusion of investment is maintained by givi Security trust fund government bonds in exchange f that is taken from it and spent on current governme But these bonds represent no tangible assets. The promises to pay money collected from future tax country as a whole is not one dime richer because were printed, so there is no analogy with private which create apartment complexes, clothing factorie bile plants, whose productions and sales will provid come needed by a retired generation whose premium things.

Chapter 14

An Overview

T

ime adds a new dimension to economics, as it do aspects of life. Future money is not the same as money, even if there has been no inflation to reduce it ing power. A bond worth $105 a year fromnow is not w ing for $100 today if the current interest rate is 6 percen Interest is the price of time and it affects not onl transactions, but even such apparently unrelated thi amount of a country’s known reserves of natural resou interest rate doubles, then the rising cost of exploring other natural resources will reduce the amount of ex which in turn means that the explorers will probably fi those who donot understand the role of interest rates i may appear that we are going to run out of these reso sooner than they thought before. But that is precisely necessary totake interest rates into account, so as not to ily stampeded by the media, politicians,and others wi interest in creating excitement oralarming the public. With time comes risk. This inherent risk must be sh tinguished from the kinds of risk that are created by s ties as gambling, mountain climbing, orplaying Russia Economic activities for dealing with inescapable risks to minimize those risks and shift them to those best ab them. A commodity speculator can reduce risks overal ing in a wider variety of risky activities than a farmer ple. A wheat farmer can be wiped out if bumper crop around the world force the price far below what wa when the crop was planted. But a similar disaster wo likely tostrike wheat, gold, cattle,and foreign currenc neously, so that someone who speculated in all th

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would be in less danger than someone who speculat of them. Whatever statistical or other expertise the specu ther reduces the risks belowwhat they would be for other producer. More fundamentally, from the stan efficient use of scarce resources, speculation reduces sociated with risks forthe economy as a whole. One tant consequences, in addition to more people being well at night because of having a guaranteed market put, is that more people find it worthwhile to produ der risky conditions than would have found it worth had to bear those risks personally. In other words, can produce more soybeans because of soybean spec if the speculators themselves know nothing about so It is especially important to understand the inte tual interests of different economic groups-the fa speculator being just one example-and, above all, the economy as a whole, because these are things of in the zest of the media for emphasizing conflicts th papers and get larger audiences for televisionnews p litical demagogues likewise benefit from portray groups as enemies of one another and themselves as the group they claim to represent. When wheat prices soar, for example, nothing i demagogue than to cry out against the injustice o where speculators sitting comfortably in their air-co fices grow rich on the sweat of farmers toiling in months under a hot sun. The years when the specula nancial beating, while the farmers lived comfortably anteed wheat prices paid by speculators, are of cours Similarly when an impending or expected short prices, much indignation is often expressedin politic dia about the higher retail prices being charged fo th sellers bought when prices were lower. What thing lier conditions is history; what the supply and deman economics. During the 1991 Persian Gulf War, for prices rose sharply around the world, in anticipation tion of Middle East oil exports becauseof military ac

A n Overview

lator then rented an oil tanker and filled it with oil pu Venezuela to beshipped to the United States. But, befo arrived, the Gulf War was over sooner than anyone ex oil prices fell, leaving the speculator unable to sell enough to recoverhis costs. Here too,what he paid in th history and what he could getnow was economics. From the standpoint of the economy as a whol chased at different times,under different sets of expec the same when they enter the market today. There is why they should be priced differently, if the goal is scarce resourcesin the most efficient way. Politics and economics differ radically in the way with time. For example,when it becomes clearthat the charged on municipal busesare too low topermit these replaced as they wear out, the logical economic conclu long run is to raisethe fares. Politically, however,a can opposes the fare increase as ”unjustified” may gain the v riders at the next election. Moreover, since the all buses ing to wear out immediately, the consequences of hol the fare will not appear all at once but will bespread out It may be some years before enough buses start break and wearing out, without adequate replacements, for t ers to noticethat there now seem to be longer waits betw and they do not arrive on schedule as often as they us By the time the municipal transit system gets s many people begin moving out of the city, taking the pay with them, so much time may have elapsed since t fare controversy that few people see any connection. M the politician who won a municipal election byassumi of champion of the bus riders may now have moved statewide office or even national office on the basis of larity. As a declining tax base causes deteriorating ci and neglected infrastructure, the erstwhile hero of the may even be able to boast that things were never this he was a city official, and blame the current problems ings of his successors. In economics, however, future consequences are ant the concept of ”present value.” If, instead of fares bein

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by municipal government, these fare were set a priv b pany operating in a free market,any neglect of financ for replacing buses as they wear out would begin im reduce the value of the bus company’s stock. In oth present value of the bus company would decline as a long-run consequences that were anticipated by in cerned about the safetyand profitability of their own If a private bus company’s management decided too low tomaintain and replace its buses as they wo cided to pay themselves higher executive salaries in ting aside funds for the maintenance of their bus fle of the public might still be unaware of this or its lon quences. But among the other one percent who woul likely to be aware would be financial institutions stock in the bus company, or were considering buyi or lending money to the bus company. Forthese inv tial investors, or lenders examining financial recor pany’s present value would be seen as reduced, lo first bus wore out. As in other situations, a market economy allo knowledge to be effective in influencing decision-m 99 percent of the population does not have that kn politics, however, the 99 percent who do not unders ate immediate political success for officialsand poli turn outin the end to be harmful to societyas a whol course be unreasonable to expect the general public nancial experts or any other kind of experts. What reasonable is to expect enough of them to see the d ting economic decisions bemade through political p Time makes foresight a crucial variable in econo the political time horizon is bounded by the next el policies are made as if the citizens subject to them a on a chessboard, to be moved here and there as the p wish. For example,when tax rates are raised 10 perc assumed that tax revenues will also rise by 10 perce more people may move out of the heavily taxed ju buy less of the heavily taxed commodity,so that the ceived may be disappointingly far below what was e

A n Overview

When traffic fines were raised steeply in California i state estimated that there would be an increase of mor lion in revenues, but the actual increase was less than h After the newand heftier fineswent into effect, more m gan challenging their ticketsin court, some chose tog stead, and otherssimply failed to pay. In San Fr two-week wait to geta date in traffic court in 1991 bec month wait in 1992. In short, people do not passively a ever government does, as too many officials and others In Third Worldcountries where confiscation of land tribution to the poor is contemplated, the long time elapse between the political campaign for redistributi and the time when it is actually done can be years, dur existing landlords neglect to maintain the property they did when they expected to reap the long-terms weeding, draining, fencing and otherwise caring for th the time the land actually reaches the poor, it may poorer land. As one development economist put it, la can be ”a bad joke on those who can least afford to la The point here isnot the wisdom or lack of wisdom ular tax, traffic, or land redistribution policies. The po people have foresight, whether they are landlords, wel ers, drivers, taxpayers or whatever. A government w ceeds as if the planned effect of its policies isthe only e finds itself surprised or shocked becausethose subject cies react in ways that benefit or protect themselves, the side effect of causing the polices toproduce very d sults from what was planned. Time produces both calculable risks and incalcula tainties. It is a calculable riskthat playing Russian roule to death about one timeout of six but there is simply to what the stock market will do next. These risksand un that are inseparable from life must be distinguished bling, which is creating a risk that would otherwise not Investors carry their own risks, in hopes of profi dends, while speculators and insurance companies c people’s risks-for a price. Like other enduring feature ket economy, speculation and insurance are not zero-s

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in which what is gainedby some comes from what is The total risk is reduced, along with the inventories of sources that must be kept idle in case there are losse insurance company does not need to have as large a fund to cover lossesas the total of the contingency fun policy-holders would need if they wereuninsured. That is becauselarge numbers make risks more ca the pooling of risks produces the large numbers nece voking the law of averages. However, when one indi ganization has sufficiently large numbers itself-su number of cars owned by Hertz-there is no benefit surance from someone else, since the same statistic can be applied directly and the costs that are calcula be included in the price of what is being sold or rente Understanding the basic economic functions of speculation, and insurance in a market economy i complicated. However,it is necessary tostop andthin only because so many unthinking people in many c periods of history have regarded these functions are contributing anything to the economy and the people in such activities as mere parasites. This was especially so at a time when most peopl hard physical laborin agriculture and were both suspi sentful of people who simply sat around handling money, while producing nothing that could be seen turies-old hostilities have been felt-and acted up groups who played such roles, whether they wereJew overseas Chinese minoritiesin Southeast Asia, or Ch native India or in Burma, East Africa, or Fiji. Often have been expelled orharassed into leaving becauseof liefs that they were just parasites. Those with such m have then been surprised to discover economic acti standard of living decliningin the wake of their depar An understanding basic economics could have many human tragedies, as well as many economic in

PART V: THE NATIONA ECONOMY

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Chapter 15

NATIONAL OUTPUT

I

n the three years following thegreat stock market cra the money supply in the United States declined by a one-third. This meant that it was now impossible to c sell as many goods and hire as many people nt the old including the old wage levels. If prices and wage rates had also declined imme one-third, then of course the reduced money supply have bought as much as before, and the same real outp ployment could have continued. There would have same amount of real things produced, just with smalle on their price tags, so that paychecks with smaller nu them could have bought just as much as before. In re ever, a complex national economy can never adjust t that perfectly, so there was a massive decline in total corresponding declines in production and employmen Thus began the Great Depression of the 1930s, durin many as one-fourth of all workers were unemployeda can corporations as a whole operated at a loss for two row. General Motors stock, which peakedat 723/4 in 19 tom at 7 5/s in 1932. U. S. Steel stockwent from 2613/4 to General Electric fell from3961/4 to 70 1/4. For the entire the 1930s, unemployment averaged more than 18 perc the greatest economic catastrophe in the history of t States. The fears, policies and institutions it generated w ident more than half a century later. What this enormous and deadly reaction to a money supply illustrates is that there are economic which apply to the national economy as a whole, as particular industries, markets, and occupations. Ho

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thinking about the national economy, the most funda lenge is to avoid what philosophers call "the fallacy tion"-the mistaken assumption that what applies applies to the whole. For example, the 1990s were dominated by storie sive reductions in employment in particular firm tries-tens of thousands being laid off by some larg and hundreds of thousands in some industries-and of unemployment in the American economy as a w lowest in years during the 1990s and the number o wide rose to recordhigh levels. Whatwas true of the tors of the economy that made news in the media w the economy as a whole. The fallacyof composition threatens confusion in of the study of the national economy as a whole, be true of an individual or evenan industry is not neces the economy. For example, any given individual wh amount of money he has will be richer, but a nation ca richer by printing twice as much money. That is bec level will rise in the economy if there is twice as mu culation and the same amount of goods. For any give more money maybe earned from otherindividuals, w respondingly less, leavingthe price level unaffected The fallacy of composition is not peculiar to ec sports stadium, any given individual can see the ga standing up but, if everybody stands up, everybod better. In a burning building, any given individua faster by running than by walking. But, if everybo stampede is likely to create bottlenecks at doors, p capes by peoplestruggling against one another to ge some of these people to lose their lives needless are fire drills, so that people will get in the habit of emergency in an orderly way, so that more lives can What is at the heart of the fallacy of compositio nores interactions among individuals, which can pre true for one of them from being true of them all. Among the common economicexamples of the fa position are attempts to "save jobs" in some indust

National Output

with higher unemployment for one reason or another. firm or industry can always be saved by a sufficiently ernment intervention, whether in the form of subsi chases of the firm’s or industry’sproducts by go agencies, or byother such means. The interaction that by those advocating such policies is that everything th ment spends is taken fromsomebody else. The 10,000 in the widget industry may be at the expense of 15,00 elsewhere in the economy by the government’s taxing resources needed to keepthese other people employed We need only imagine what would have happened ernment had decided to ’/save jobs” in the typewrite when personal computers first appeared on the scene to take away customers from the typewriter manufa laws had been passed restricting the number of comp could be sold, this would undoubtedly have saved many people who manufactured typewriters or who typewriter ribbons, carbon paper,and other accessories would have been fewer jobs created in the computer-m ing industry and in the many branches of the softwar The fallacy isnot in believing that jobs can be saved in dustries or given sectorsof the economy. The fallacy ing that these are net savings of jobs forthe economy as When dealing with the national economy, we e terms like Gross National Product and the national de as institutions like the Federal Reserve System.We also a great deal of confusion spread by politicians and m mentators with no training in economics. As in many o the facts are relatively straightforward and not difficul stand. What gets complicatedare the misconceptions th be unravelled. One of the most basicthings to understand about th economy is how much its total output adds up to. We al understand the important role of money in the national which was so painfully demonstrated in the Great De the 1930s. The government is almost always another m in the national economy, even though it may not be in industries.

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BASIC ECONOMICS

MEASURING NATIONAL OUTPUT

A country’s total wealth includes everything it the past plus everything currently being produced. put, however, is what is produced during a given y important for indicating how much is availableto a ple, for maintaining or improving their personal sta ing, or tobusiness, government and other institution out their various functions. National output during a year can be measured of ways. The most commonmeasure today is the Gr Product (GDP), which is the sum total of everythi within a nation’s borders. An older and related m Gross National Product (GNP) is the sum total of and services produced by the country’s people, whe their resources may be located. These two measure output are sufficiently similarthat people who are no need not bother about the differences. For the Unit difference between GDP and GNP is lessthan one pe The real distinction that must be made is betwe measures of national output duringa given year-a f come-versus the accumulated stock of wealth as of For example, at any given time, a country can live b rent production by using up part of its accumulated from the past. During World War11, for example, Am tion of automobiles stopped, so that factories which duced cars could insteadproduce tanks, planes and equipment. This meant that existing cars simply de did most refrigerators, apartment buildings and othe national stock of wealth. Wartime government post Use it up, Wear it out, Make it do, Or do without.

After the war was over, there was a tremendou the production of cars, refrigerators, housing, and o

National Output

the nation’s accumulated stock of wealth which ha lowed to wear down or wear out while production wa voted to urgent wartime purposes. Just as national income does not refer to money o per assets, so national wealth does not consist of thes paper either, but of the real goods and services that s can buy. Otherwise, any country could get rich immed by printing more money. Sometimes national output o wealth is added up by using the money prices of the m most serious long-run studies measure output andwe terms, taking into account price changes over time.

THE COMPOSITION OF OUTPUT

Prices are not the only things that change over tim goods and services which make up the national o change. The cars of 1950 are not the same as the cars o 2000. The older carsdid not have air-conditioning, sea lock brakes, ormany other featuresthat have beenadde years. So when we try to measure how much the produc tomobiles has increased in real terms, a mere count of cars there werein both time periods misses a huge qua ference in what we are defining as being the same thingsame istrue of housing as well. The average house at the twentieth century was much larger, had more bathroom far more likely to have air conditioningand other ame houses that existed in the middle of that century. Jus how many more houses there wereat both times does how much the production of housing had increased. While these are problems which can be left for pr economists and statisticians to try to wrestle with, it is for others to at least be aware of these problems, so a misled by politicians or media pundits who throw around for one purpose or another. Over a period of generations, the goods and serv constitute national output change so much that statis parisons become practically meaningless, because the

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paring apples and oranges. At the beginning of the tw tury, the national output didnot include any airplan sets, computers or nuclear power plants. At the en tury, national output did not include many typew rules (once essential for engineers), or a host of eq supplies once widely used in connection with hor merly provided the basic transportation of the count What then, does it mean to say that the Gross N uct was X percent larger in the year 2000 than in 1 consisted of very different things? It may mean som that output was 5 percent higher or 3 percent lowe the previous year becauseit consisted of much the sa both years. But the longer the time span involved, th statistics approach meaninglessness. The same problems which apply when compa country’s output over time can also apply when co output of two very different countries at the same Caribbean nation’s output consists largely of banan tropical crops,while some Scandinavian country’s ou more of industrial products and crops more typica mates, how is it possible tocompare totals made up o ing items? One way is to compare the total money value of tive outputs. However, this gets us into other comp ated by official exchangerates between their respecti which may or may not reflect the actual purchasi those currencies. Governments may set their offic rates anywhere they want, but that does not mean th purchasing power of the money will be whatever t Country A may have more output per capita than Co measure by official exchange rates, while it may b verse if we measure by the purchasing power of Surely we would say that Country B has the larger output if it could purchase everything produced in c still have something left over. As in other cases, the problem is not with unde basic economics involved. The problem is with conf by politicians, the media and others trying to prov

National Output

with statistics. For example, some have claimed that Ja higher per capita income than the United States, using based on official exchange rates of the dollar and the Y fact, the United States has significantly higher per capi than Japan when measured by the purchasing power o countries’ national outputs. The average American’s annual income could buy e the average Japaneseannual income buys and still have of dollars left over. Therefore the average American ha standard of living than the average Japanese. Yet statistic official exchange rates show the average Japanese earn sands of dollars morethan the average American, leavi impression that the Japanese are moreprosperous than A Another complication in comparisons of output be tions is that more of one nation’s output may have through the marketplace, while more of the other nation may have been produced by government and either gi or sold at less than its cost of production. When toomany automobiles have been produced in economy, the excess cars have to be sold for whatever bring, even if that is less than they cost to produce. value of national output is added up, these cars are co cording to what they sold for. But, in an economy wher ernment provides many free orsubsidized goods, these valued at what it cost the government to produce the ways of counting exaggerate the value of government goods and services, many of which are provided by go precisely because they would never cover their costs o tion if sold in a free market economy. Both capitalism and socialism canproduce more of things than people want, but a capitalist economy re value of the surplus goods and services, while a soci omy counts them according to what they cost, wheth those costs couldbe recovered fromthe consuming pub this tendency to overvalue the output of socialist econ tive to capitalist economies when adding up their r Gross National Products, it is all the more striking that economies still show higher per capita output.

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TRENDS OVER TIME

One of the problems with comparisons of nat over time is the arbitrary choice of the year to use ning of the time span. For example, one of the big paign issues of 1960 was the rate of growth of t economy under the existing administration. Presid date John F. Kennedy promised to ”get American m economically if he were elected, implying that the nomic growth rate had stagnated under the party nent. The validity of this charge depended entirely o you chose as the year fromwhich to begin counting. The long-term average annual rate of growth of tional Product of the United States had been about year. As of 1960, this growth rate was as low as 1.9 p 1945) or as high as 4.4 percent (since 1958). Whate ence of the existing administration on any of this, w doing a wonderful job or a terrible job depended e base yeararbitrarily selected. Many ”trends” reported in the media or proclaim depend entirely on which year has been chosen as t of the trend. Crime has been going up if you measure the present, but downif you measure from 1990 to has been claimed that automobile fatality rates ha since the federal government began imposing variou lations. This is true-but it is also true that autom rates were declining continuously for decades befo government imposed any safety regulations. Is the of a trend that existed before a given policy was be the effectiveness of that policy? National output data, like many other statistics, f time. That makes it possible tosay that the trends ar down, depending on which point in these fluctuatio as the base year fromwhich to begin counting. As i aspects of economics, the concept is relativelysimpl made complicated and confused by people with axe

Chapter 16

Money and the Banking System

M

oney is one of those things that are so commo taken for granted that we seldom bother to ask want it and what it can do. We all know that money ca important things in our own personal lives, but the mo tant question is: What does it do in the national econ whole? We need to know not only how it functions but it can malfunction, for the malfunctions of money hav economic disasters and even destroyed nations and em

THE ROLE OF MONEY

Everyone seems to want money, but there have bee lar times in particular countries when no one wanted m cause they considered it worthless. In reality, it was th no one would accept money that made i t worthless. W can’t buy anything with money, it becomes just useles paper or useless metal disks. In France during the 179 perate government passed a law prescribing the deat for anyone who refused to sell in exchange for money this suggests is that the mere fact that the governme money does not mean that it will in fact function as m therefore need to understand how money functions, avoid reaching the point where it malfunctions. Many economiesin the distant past have functione money, just by having people barter their products with one another. But these have usually been sma economies, with relatively fewthings to trade, because

BASIC ECONOMICS

ple provided themselves with food, shelter and clo trading withothers for a limited range of amenities o Barter is awkward. If you produce chairs and w ples, you certainly are not likely to trade one chair f and you may not want enough apples to add upto t chair. But if chairs and apples can both be exchang thing that can be subdivided into very small amoun trades can take place, benefitting both chair-maker growers, as well as everyone else. Allthat people ha agree on what will be used as an intermediary mean and thatmeans of exchange becomes money. Some societies have used sea shells as money, used gold or silver,and still others have used special per printed by their government. What makes allof is that people will accept them in payment for the go vices that actually constitute real wealth. Money is wealth for an individual only because other individu ply him with the real goods and services that he change for his money. But, from the standpoint of economy as a whole, money is not wealth. It isjust a fer wealth or to givepeople incentives toproduce we

INFLATION

As we havealready noted, doubling a nation’s m will not double its wealth but will more likely le prices for everything. Prices in general rise for the that prices of particular goods and services rise-n there is more demanded than supplied at a given people have more money,they tend to spend more. responding increase in the volume of output, the pric output simply rises because the quantity demanded quantity supplied. Whatever the money consists of-whether sea she paper-more of it in the national economy means h This relationship between the total amount of money eral price level has been seen for centuries. When A

Money and the Banking System

Great began spending the captured treasures of the prices rosein Greece. Similarly,when the Spaniards rem amounts of gold from their colonies in the Western He price levels rose not only in Spain, but across Eur Spaniards used much of their wealth to buy imports f European countries, sending their gold to those countr for these purchases, thereby adding to the total mone across the continent. None of this is hard to understand. Complications a sion come in when we start thinking about such things a trinsic value" of money or believethat gold somehow " our money orin some mysterious way gives it value. For much of history, gold has been used as money countries. Sometimes the gold was used directly in co large purchases) in nuggets, gold bars or other forms. E convenient for carrying around were pieces of pape printed by the government that were redeemable in go ever you wanted it. It was not only more convenien around paper money, it was also safer than carrying la of money as metal that jingled in your pockets or was ous in bags, attracting the attention of criminals. The big problem with money created by the gove that those who runthe government always face the tem create more money and spend it. Whether among anc or modern politicians, this has happened again and a the centuries, leading to inflation and many economic problems that flow from inflation. For this reason, ma tries have preferred using gold, silver,or some other ma is inherently limited in supply, as money. It isa way of governments of the power to expand the money suppl tionary levels. Gold has long been considered ideal for this purp there is a limited supply of gold in the world. When pap is convertibleinto gold whenever the individual choose then the money is said to be "backed up" by gold. Th sion is misleading only if we imagine that the value of t somehow transferred to the paper money, when in fac simply limits the amount of paper money that can be is

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The American dollar was once redeemable in mand, but that was endedback in 1933. Sincethen, ply had paper money, limited in supply only by w thought they could or couldnot get away with politi some idea of the cumulative effects of inflation, a o dollar bill in 1998would buy less than a twenty-doll in the 1960s. Among other things, this means that saved money in the 1960s had four-fifths of its v stolen from them over the next three decades. Sobering as such inflation may be in the United S alongside levels of inflation reached in some othe ”Double-digit inflation” during a given year in the creates political alarms, but various countries in L and Eastern Europe have had periods when the ann flation was in four digits. Since money is whatever we accept as money in real goods and services, there are a variety of othe function in a way very similar to money. Credit card areobvious examples. Mere promisesmay also money, when the person who makes the promise trusted. IOUs from reliable merchants were once hand to hand as money. Some banks used to issue t rency, which had no legal standing, but which was widely accepted in payment: when the particular b garded as sufficiently reliable and willing to redee rency in gold. In those times and places where bank credibility than government officials, bank notes m ferred to the official money printed by the govern times money issued by some other country is prefer issued by one’s own. Beginning in the late tenth cen money was preferred to Japanese money in Japan. century Bolivia, most of the savings accounts were 1985, during a period of runaway inflation of the Bo Gold continues to be preferred to many nationa even though gold earns no interest, whilemoney in t The fluctuating price of gold reflects not only the mands for it for making jewelry or in some indust also, and more fundamentally,the degree of worry a sibility of inflation that could erode the value of offic

Money and the Banking System

That is why a major political or military crisis can price of gold shooting up, as people dump their holdi currencies that might be affected and begin bidding ag other to buy gold, as a more reliable way to hold the wealth, even if it does not earn any interest or dividend Conversely, long periods of prosperity with price s likely to see the price of gold falling, as people are willin their wealthout of gold and into other financial assetst crease theirwealth. The greatunspoken fear behind this other transactions in the financial markets is the fear o Nor is this fear irrational, given how often governm types have resorted to inflation, as a means of getting m without having to directly confront the public with high Raising tax rate has always created political dange who hold political power, whether in a modern democ an ancient monarchy. Political careers canbe destroyed voting public turns against those who raised their ta undemocratic societies, public reaction canrange up to volts, such as those that led tothe American war of inde from Britain or to the overthrow of other governmen times and places. In addition to adverse political reactions tohigher t can be adverse economic reactions.As tax rates reach h els, particular economic activities may be abandoned who do not find the net rate of return on these activ taxes, to be enough to justify their efforts. Thus ma abandoned agriculture and moved to the cities during ing era of the Roman Empire, adding to the number needing to be taken care of by the government, at the when the food supply was declining because of those stopped farming. In order to avoid the political dangers that raising can create,governments around the world have for tho years resorted to inflation instead. If fighting a maj quires half the country’s annual output,then rather tha rates to 50 percent of everyone’s earnings in order to the government may choose instead to create more mo self and spend that money buying war materiel. Wit country’s resources being used to produce military e

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and supplies, civilian goods will become more s money becomes more plentiful. This changed ratio civilian goods will lead to inflation as more mone fewer goods and prices rise asa result. Not all inflation is caused by war, though inflat accompanied military conflicts. Even in peacetime, have found many things to spend money on, includ living by kings or dictators and numerous showy have been commonwith both democratic and undem ernments. To pay for such things, using the governm to create more money has often been considered ea ing tax rates. Put differently, inflation isin effect a h money that people have saved is robbed of part of i power, which is quietlytransferred to the governme new money. In the modern era of paper money, increasing the ply isa relatively simple matter of turning on the prin However, long before there were printing presses, were ableto create moremoney by the simple proces the amount of gold or silver in coins of a given de Thus a French francor a British pound might begin a certain amount of precious metal, but coins later French or Britishgovernment would contain less and metals, enabling these governments to issue more m given supply of gold and silver. Sincethe new coins legal value as the old, the purchasing power of them as coins becamemore abundant. More sophisticated methods of increasing the money have been used in countries with governme central banks, but the net result is still the same: An i amount of money, without acorresponding increase of real goods, means that prices rise-which is to s (Conversely, when output increased during Britain revolution in the nineteenth century, its prices decl its money supply didnot increase correspondingly. Doubling the money supply while the amount mains the same may more than double the price speed with which the money circulates increases w

Money and the Banking System

lose confidence in its retaining its value. During the cline in the value of the Russian ruble in 1998, a Mos spondent reported: ”Many are hurrying to spend thei rubles as fast as possible while the currency still has value.” Something very similar happened in Russia durin World War and in the years after the revolutions of 191 the amount of currency issued by the government wa of times greater than the currency in circulation on the war in 1913-and the price level rose tothozrsmds of ti than in 1913. When the money circulates faster, th prices is the same as if there were more money in c When both things happen on a large scale simultaneo sult is runaway inflation. Perhaps the most famous inflationof the twentieth curred in Germany during the 1920s, when 40 marks one dollar inJuly 1920 but it took more than 4 trillion worth one dollar by November1923. People discovere life savings were notenough to buy a pack of cigarette man government had, in effect, stolen virtually every owned by the simple processof keeping more than 1,7 presses running day and night, printing money. Here too, the circulation of money speeded up, c inflation to increase even more than the increase in supply. During the worst of the inflation, in October 1 rose 41percent per day. Workers were paid twice a day were allowed time off in the middle of the day to ena rush off to the stores to buy things before the pric again. In other cases, wives showed up at work at lu take their husband’s pay and rushoff to spend it befor much value. Some have blamed the economic chaosof setting the stage for the rise of Adolf Hitler and the Na

DEFLATION

While inflation has been a problem that is centu particular times and places deflation has also been d

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As noted at the beginning of chapter 15, the money s United States declined by one-third from 1929 to 193 impossible for Americans to buy as many goods and before at the old prices. Prices did come down-the Sea for 1931had many prices lower than they had been a lier -but some prices could not change because ther contracts involved. Mortgages on homes, farms, stores, and office b specified monthly mortgage payments in money t terms mighthave been quite reasonable and easy to m total amount of money in the economy was substantial now it was the same as if these payments had bee raised-as in fact they were raised in real purchasing p Many home-owners, farmersand businesses simply after the national money supply contracted-and theref places that housed them. People with leases faced problems, as it became increasingly difficultto come money topay the rent. The vastamounts of goods and chased on credit by businesses and individuals alik debts that were now harder to pay off than when the c tended in an economy with a larger money supply. Those whose wages and salaries were specified in whetherunionizedworkers or baseball players-w legally entitled to more real purchasing power than contracts were originally signed. So were governmen whose salary scales were fixed by law. But, while de fitted these particular groups if they kept theirjobs, the paying them meant that many would lose their job banks that owned the mortgages which many people gling to pay were benefitted by receiving mortgag worth more purchasing power than expected"+ the payments at all. But so many people were unable to pa that many banks began to fail-more than 900 in Other creditors likewise lost money when debtors s not pay them. Theoretically, thegovernmentcouldhave in money supply to bring the price levels backup to wh been before. However,what a government can do th

Money and the Banking System

not necessarily the same as what it is likely to do po what it understands intellectually. Both liberal and co economists looking backon this period have seen the F serve System’s monetary policies as confused or incom addition, both Republican President Herbert Hoover a mocratic successor, Franklin D. Roosevelt, thought rates should not be reduced, so this way of adjusting t was discouraged by the federal government-for bot tarian and political reasons, with the best of intention the worst consequences nevertheless. The net effect of keeping wage rates from adjus downward as the reduced money supply required workers were entitled to more real purchasing power but in fact had trouble keeping or finding jobs. In t workers were in a position similar to that of banks creditors, who were legally entitled to far more money could actually collect. One painfully revealing sign of the thinking of the that, after the election of 1932 and before FDR took off President Hoover wrote to the president-elect, asking nounce publicly ”that there will be no tampering or i the currency’’ and that the budget would be balanced, e required higher taxes. WhileFDR made no such pledg thinking at the time was very similar to Hoover’s, how taken both of them may have been in the eyes of econo Monetary policy is just one of many areas in whic enough that the government could do things to make better. What matters is what government is in fact li which can in many cases make the situation worse.

THE BANKING SYSTEM

We have already noted in Chapter 12, one of the m tant roles of a bank-serving as intermediaries to trans from some people to others who need to borrow. Not this happen across generations, as discussed there, also when money is lent to individuals and organiza

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sorts. A student just emerging from dental school enough cash on hand to buy all the equipment an needed to getstarted as a dentist. Even opening a small grocery store means buyin tory to stockthe shelves, as well as renting space, pay ties, and perhaps hiring employees. Few people h money of their own on hand to do all that, so they us ple’s money-whether loans from relatives and frien bank, or some combination. Almost no one has eno hand to buy a house and many must buy a car wit payments. Typically, the seller of a home or an aut ceives the full price immediately, not from the buy some financial intermediary whom the buyer must stallments. Modern banks, however, do more than simply tr Each individual bank may do that but the banking whole does something more. It createscredits which, to the money supply through what is called ”fracti banking.” A brief history of how this practice arose m process clearer. Goldsmiths have for centuries had to have some store the precious metal that they used to make jewel items. Once they had established a vault or other se place, other people often stored their own gold wi smith, rather than take on the cost of creating their storage facilities. Inother words, there were economi storing gold in a vault or other stronghold, so golds up storing other people’s gold, as well as their own. Naturally, the goldsmiths gave out receipts entitl ers to reclaim their gold whenever they wished to. Si ceipts were redeemable in gold, they were in effect gold” and circulated as if they were money, buying services as theywere passed on from one person to an From experience,goldsmiths learned that they se redeem all the gold that was stored with them at any If a goldsmith felt confident that he would never hav more than one-third of the gold that he held for oth any given time, then he could lend out the other tw

Money and the Banking System

earn interest on it. Since the receipts for gold and tw the gold itselfwere both in circulation at the same time smiths were, in effect, adding to the total money suppl In this way, there arose two of the major features banking-(l) holding only a fraction of the reserves cover deposits and (2) adding to the total money suppl the depositors are not going to want their money at on bank lends most of it to other people, in order to earn those loans. Some of this interest they share with the by paying interest on their bank accounts. Again,with itors writing checks on their accounts while part of the those accounts is also circulating as loans to other p banking system is in effect adding to the national mon over and above the money printed by the government. One of the reasons this system worked has worked whole banking system has never been called upon t supply cash to cover all the checks written by deposito if the Acme Bank receivesa million dollars worth of ch ten by depositors whose accounts are with the Zebr does not ask the Zebra Bank for the million dollars, bu that off against whatever checks were written by Acm positors and ended up in the hands of the Zebra Bank For example, if its own depositors had written worth of check to people who then deposited those ch Zebra Bank,then Acme Bankwould just pay the differe $200,000 to settle more than $2 million worth of check been written on accounts in the two banks. Both ba keep just a fraction of their deposits in cash becauseall would not want their money at the same time and beca checks written on all the banks required just a frac amounts on those checks to settle the differences betw rather than paying the full amounts on all the checks. This system, called ”fractional reserve banking,’’ w in normal times. But it was very vulnerable in times w depositors wanted hard cash at once. While most dep not going to ask fortheir money at the same time und conditions, there are situations where more deposito for their money than the bank can supply. Usually, this

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when the depositors fear that they will not be able money back. At one time, a bank robbery would caus to fear that the bank would have to close and th would all run to the bank at the same time, trying their money before the bank collapsed. If the bank h third as much money available as the total deposito tled to and one-half of the depositors asked for their the bank ran outof money and collapsed, with the re positors losing everything. Under this system of fractional reservebanking, a could set off a run on the banks could cause these b lapse. Not only would many depositors lose their sav tion’s total money supply could suddenly dec happened to enough banks at the same time. After a money supply consisted of credits created by the ban during the process of lending out money. When that peared, there was no longer enough money to buy that was being produced-at least not at the prices th set when the money supply waslarger. This iswhat the Great Depression of the 1930s, when literally banks in the United States collapsed in one year a money supply of the country contracted by one-third In order to prevent a repetition of this catastrophe Deposit Insurance Corporation was created, guarante government would reimburse depositors whose mon insured bank when it collapsed. Now there was no son for depositors to start a runon a bank, so very fe lapsed, and there was less likelihood of a sudden a reduction of the nation’s total money supply. While the Federal Deposit Insurance Corporatio firewall to prevent bank failures from spreading thr system, a more fine-tuned way of trying to control supply of money and credit is through the Federal R tem. The Federal Reserve aiscentral bank run by the to control allthe private banks. It has the power to t what fraction of their deposits must be kept in reserv the remainder being allowed to be lent out. It alsolen the banks, which the banks can then re-lend tothe ge

Money and the Banking System

By setting the interest rate on the money that it lends banks, the Federal Reserve Systemindirectly controls t rate that the banks will charge the general public. All the net effect of allowing the Federal Reserve to contr amount of money and credit in the economy as a who degree or another. Because of the powerful leverage of the Federal Re tem, public statements by the chairman of the Feder Board are scrutinized by bankers and investors for c whether ”the Fed” is likely to tighten the money supp up. An unguarded statement by the chairman of the F serve Board, or a statement that is misconstrued by can set off a panic in Wall Street that causes stock pric met. Or, if the Federal Reserve Board chairman soun stock prices may soar. Given such drastic repercussio can affect financial markets around the world, Feder Board chairmen over the years have learned to speak guarded and Delphic terms that leave listeners puz what they really mean. In assessing the role of the Federal Reserve, as we organs of government, a sharp distinction must be mad their stated goals and their actual performance or effe eral Reserve System was establishedin 1914 as a result such economic consequences as deflation and bank failu worst deflation and the worst bank failures in the count occurred afterthe Federal Reservewas established.

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Chapter 17

The Role of Governmen

. . . it is not enough to show thata situation is bad it is also necessary to be reasonably certnin that th problem has been properly described, fairly certni that the proposed remedy will improve it, and vir tually certain that it will Mot make it worse.

- Robert Conques

A

modern market economy cannot exist in a vacuu transactions take place within a framework of ru quire someone with the authority to enforcethose rule ment not only enforces its own rules but also enforce and other agreements among the numerous parties in omy. Sometimes government also sets standards, def is a pound, a mile, or a bushel. And to support itse ments must also collect taxes, which in turn affect decision-making. Beyond these basic functions, which virtually eve agree on, governments can play more expansive roles, up to directly owning and operating all the farms and inthenation.Controversieshaveragedaroundtheworld throughout the twentieth century, on the role that th ment should play in the economy. Formuch of that cen who favored a larger role for government were clearly cendancy. Russia, China,and others in the Communist tions were at one extreme, but democratic countries l India, and France also took overownership of various and tightly controlled the decisions made inother indu were allowed to remain privately owned. During the 1980s, however, the tide began to turn ducing the role of government, first in Britain and t

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States and then such trends spread rapidly through t tic countries and were climaxed by the collapse of co the Soviet bloc.As a 1998 study putit:

All around the globe, socialists are embracing capitali ernments are sellingoff companies they had previou alized, and countries are seeking to entice back mu corporations that they had expelled two justdecades

Experience-often bitter experience-had mor such changes than any new theory or analysis. How to understand basic economics, it is not necessary these controversies. Here we can examine the basic government that virtually everyone can agree on and these functions are important for the allocation of sca which have alternative uses. The most basic functionof government is to prov work of law and order, within which the people are f in whatever economic and other activities they choo also certain activities which generate significant cost which extendbeyond those peoplewho engage in the Here government can take account of these costs when the marketplace cannot. Finally, the individuals who work for governme capacities tend to respond to the incentives facing people do in corporations, in families, and in otherhu tions and activities. Government is neithera monolit the public interest personified.To understand what i centives and constraints must be taken into account, centives and constraints of the marketplace must be engage in market transactions.

LAW AND ORDER

Where government restricts its economic role tot forcer of laws and contracts, some people say that s means "doing nothing." However, what is called no

The Role of Government

ten taken centuries to achieve-namely, a reliable fra laws, within which economic activity can flourish, an which even vast riches in natural resources may go u the people remain much poorer than they need to be. ple, oil deposits worth an estimated $4 trillion remai untapped underthe Caspian Sea because the laws and the adjoining nations of Azerbaijan and Georgia, and t uncertainties of the region, made the venture too risk that vast amount of capital investment needed to ext and establish pipelines to take it from these landlocke to seaports serving world markets. Because human beings have foresight, the mere p government economic intervention in the future can ca mediate reduction in current investment. In 1999, for military coup in Venezuela put in control a general wh ing powers and sweeping rhetoric made foreign inve of putting their money there, despite the economic as oil-rich country and despite assurances issued by the g he would respect foreign investments. So long as he cratic powers, there would be no way to hold him to h there would be in a country with reliable laws and in courts to enforcethese laws.

The Framework of L a w s

For fostering economic activitiesand the prosperit from them,laws must be reliable, above all.If the law the whims of kings or dictators, with changes in dem elected governments, or with the caprices or corrup pointed officials, then the risks surrounding investme consequently the amount of investing is likely to b purely economic considerations would produce in a m omy under a reliable framework of laws. One of the important advantages that enabled century Britain to become the first industrialized nati dependability of its laws. Not only could Britons feec investing in their country’s economy,without fear that ings would be confiscated or the contracts they made

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political reasons,so could foreigners doing business o vestments in Britain. For centuries, the reputation o for dependability and impartiality attracted merch vestments from continental Europe, as well as skilled and refugees. In short, both the physical capital and capital of foreigners contributed to the development economy from one of the more backward economie Europe to one of the most advanced, setting the stage industrial revolution that led the world into the indu In other parts of the world as well, a framewor able laws encouraged both domestic and foreign in well as attracting immigrants with skills lacking loc east Asia, for example,the imposition of European la colonial regimes of the eighteenth and nineteenth placed the powers of local rulers and tribes. Unde frameworks of laws-often uniform across wider g areas, as well as being more dependable at any giv massive immigration from Chinaand a smaller immi India brought in people whose skills and entrepren ated whole industries and transformed the econo countries throughout the region. European investors also sent capital to Southeast ing many of the giant ventures in mining and shipp often beyond the resources of the Chinese and Indian In colonial Malaya, for example, the tin mines and ru tions which provided much of the country’s export e financed by European capital and worked by laborer and India, while most local commerce and industry hands of the Chinese, leaving the indigenous Malays tators at the modern development of their own econo While impartiality is alsoa desirable quality in la criminatory laws can promote economic developme ture of the discrimination is spelled out in advance taking the form of biased, unpredictable, and corrupt judges, juries, and officials. The Chinese and Indians in the European colonial empires of Southeast Asia n same rights as Europeans there, nor the same rights a nous population. Yet whatever rights they did have

The Role of Government

lied upon and therefore served as a basis for the creat nese and Indian businesses in the region. Similarly in the Ottoman Empire, Christians and J had the same rights as Moslems. Yet, during the flour turies of that empire, the rights that Christians and Jew were sufficiently dependable to enable them to prosp merce, industry, and banking to a greater extent than t majority. Moreover, their economic activities contribu prosperity of the Ottoman Empire as a whole. Sim could be told of the Lebanese minority in colonial West dians in colonial Fiji, German immigrants in Brazil, and nority groups in other countries who prospered unde were dependable, if not impartial. Dependability isnot simply a matter of the govern treatment of people. It must also prevent some people fering with other people, so that criminals and mobs do economic life risky and thereby stifle the economic de required for prosperity. Governments differ in the ef with which they can enforce their laws in general, and ev government may be able to enforce its laws more eff some placesthan in others. For centuries, theborderlan English and Scottish kingdoms were not effectively co either country and remained lawlessand economically Mountainous regions have often been difficult to pol in the Balkans, the Appalachian region of the United S where. Such places have likewise tended to lagin econo opment and to attract few outsiders and little outsi Today, high-crime neighborhoods and neighborhoods higher than normal rates of vandalism or riots simila nomically froma lack of law and order.

Property Rights

One of the most misunderstood aspects of law and property rights. While these rights are cherished as per efits by thosefortunate enough to own substantial prop matters from the standpoint of economics is how they allocation of scarce resourceswhich have alternative u

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There are all sorts of social and economic arrange ble, with and withoutproperty rights, or with prope duced by various laws and policies to varying degre to an extent that virtually abolishes these rights or worthless. Under rent control, for example,property reduced to worthlessness or even become negative. owners of many apartment buildings in New York C ply abandoned their buildings and fled the scene, w of the legally mandated services that they are requir exceed the rents that they are allowed to collect. Sin ment of buildings is illegal, these owners go underg the value of their property right becomes negative. conditions, selling the building is out of the question become an economic liability, rather than an asset, a buyer may be impossible. Resources can be allocated without property rig been in various societies. The economic consequen or not having property rights is what matters, as fa perity of the population as a whole is concerned, as what matters to the usually relatively small numb who ownextraordinary amounts of property. A house or a hammer is the same, whether it is o owned, or owned by the government in the name o as distinct from being owned by individuals in their tive names. But, while physical things are the same, are owned or not owned, property rights matter eco cause of the incentives they create and the conseque incentives for people’s behavior. What isdifferent with and without property righ but telling example was the experience of a delegati can farmers who visited the Soviet Union. Theywer the way various agricultural produce was shippe packed and with spoiled fruit or vegetables left t spoilage to other fruits and vegetables in the same sa Coming from a country where individuals owned produce as their private property, Americanfarmers rience with such gross carelessnessand waste, which

The Role of Government

caused somebody to lose much money needlessly in States. Inthe Soviet Union, the loss was even more pa the country often had trouble feeding itself, but ther property rights to convey those losses directly to th handlers and shippers who caused it. In a country without property rights, or with the owned ”by the people,” there was nogiven individual cient incentives to ensure that this food did not spoil before it reached the consumers. Those who handled transit were paid a salary, which was fixed independen well they did or did not safeguard the food. In theory at least, closer monitoringof produce han have reduced the spoilage. But monitoring isnot free. It of the scarce resources which have alternative uses. monitoring raises the further question: Who will monit itor? The Soviets tried to deal with this problem by ha munist Party members honeycombed throughout the report on derelictions of duty and violations of law. Ho widespread corruption and inefficiency found even und totalitarianism suggests the limitations of official mon compared to automatic self-monitoring property by ow No one has to stand over an American farmer and take the rotten peaches out of a basket before they spo ers, because these peachesare his private property an about to lose money if he doesn’t have to. Property ri self-monitoring, which tends to be both more effectiv costly than third-party monitoring. The only animals threatened with extinction are a owned by anybody. Colonel Sanders is not about to le become extinct.Nor will McDonald’s stand idly by an become extinct. It things is not owned by anybody (air for example) which are polluted. In centuries past, she lowed to graze on unowned land -”the commons,” called-with the net result that land on the commo heavily grazed that it had little left but patchy groun shepherds had hungry and scrawny sheep. But privat land adjacent tothe common was usually in far better

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Legally speaking, property rights are essentially clude other people from the use of resources orthe go vices produced by those resources. Expressed in t way, property rights seem rather unattractive. But, w ple who own Yankee Stadium have a legal right to l up and keep everybody else out, they are very unlike a market economy. On the contrary, their incentives admission and to try to induce as many people a come in and pack the place full. Property rights are a legal mechanism forthe use ket prices to allocate resources. As such, these rights n sessed in terms of their economic effectson the pros population at large, not how they affect the wellbe people who ownYankee Stadium, peaches, houses or Shifting the focus tothefortunate few who amounts of property enables phrase-makers to speak rights versus human rights" or otherwise depict the i one of the wellbeing of the many versus the wellbein But it is precisely the empirical question of how the non-existence of property rights affects the economi society as a whole which provides the strongest evid social benefitsof property rights. Most Americansdo agricultural land or agricultural crops, but they ha better food availableat lower prices than incountries are no property rights in agricultural land or its prod While strict adherence to property rights would lords to evicttenants at will, the economic incentive to do just the opposite-to try to keep their apartm rented and as continuously occupied as possible, so tenants pay their rent and behave themselves. Onl control or other restrictions on their property rights are they likely to do otherwise. Under rent control rights laws, landlords have been known to try to ha into leaving, whether in New York or in Hong Kong. Under stringent rent control and tenants rights l Kong, landlords were known to sneak into their own b at night to vandalize the premises, in order to make

The Role of Government

tractive or even unlivable, so that tenants would move o empty building could then be torn down legally, to be something more lucrative as commercialindustrial or pro This of course was by no means the purpose or in those who had passed such laws in Hong Kong. But it again the importance of making a distinction between and effects-and not just as regards property rights la short, incentives matter and property rights need to be economically in terms of the incentives createdby their their modifications, or their elimination. The powerful incentives created by a profit-and-loss depend on the profits being private property. Whengov owned enterprises in the Soviet Unionmade profits, th were not their private property but belonged to ”thepeo in more mundane terms, could be taken by the gover whatever purposes higher officials chose to spend the viet economists Schmelev and Popov pointed out and the adverse effects of this on incentives:

But what justifies confiscating the larger part-someti percent-of enterprises’ profits, as is being done in man tors of the economy today? What political or econom ultimately what human right-do ministries have to do th Once again we are taking away from those who w der to keep afloat those who do nothing. How can w talk about independence, initiative, rewards for efficie ity, and technical progress?

Of course, the country’s leaders could continue to such things, but destroying the incentives which ex property rights meant that there was a reduced chance ing these goals. While government officials in the United States ca trary confiscate profits as directly as Soviet officials co can legislators can pass laws imposing costs private on e thereby causing profits to bereduced-and incenti changed. In California, for example, the state legislatur

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law requiring landlords to give elderly tenants a yea fore evicting themand to pay up to $3,000 to each te help with relocation costs. This legislation was inte with the danger of mass evictions by landlords who money under rent controland who wanted to stop ren Since this legislation went into effect on January ers of cheap hotels evicted many elderly tenants duri 1999, in order to escape these impending costs of sh their hotels. Laws are often proposed or passed be goals they seek to achieve-and without regard to actually created-which, in this case, caused many derly single men to be thrown out on the streets d Christmas season. Far more anger and indignation w at the hotel owners than atthose who hadpassed suc Yet, in the absence of attempts to confiscate profits rent control laws and laws on evictions,the ordinary property rights and a free market would have cau owners to want to keep allthe tenants they could.

Social Order

Order extends beyond laws. The honesty and rel people themselves, and their sense of responsibility tion also influence their economic prospects. Thes vary greatly between one country and another. A edgeable observerput it: ”Whileit is unimaginable in China without paying bribes, to offer one in Japa est fauxpas.” During czarist Russia’sindustrialization in the la and early twentieth centuries, one of its biggest ha the widespread corruption within the general popu dition to the corruption that was rampartwithin the ernment. Foreign firms which hired Russian work Russian executives made it a point not to hire Rus tants. This corruption continued under the Commu become an international scandal in the post-Commu By contrast, some minority groups have such st standards and social controls that they are able to

The Role of Government

ness among themselves on the basis of relying on ea verbal agreements, without recourse to contracts or to system of the larger society. Hasidic Jews in New York business, for example, often give consignments of jew another and share the sales proceeds on the basis of ver ments among themselves. The extreme social isolation sidic community from the larger society, and even f Jews, makesit very costly foranyone who grows up in munity to disgrace his family and lose his own standin as his own economic and social relationships, by chea agreement with a fellow Hasidim. It is much the same story halfway around the wor the overseas Chinese in various southeast Asian coun verbal agreements among themselves, without the sanc local legalsystem. Given the unreliability and corruptio of these post-colonial legal systems,the ability of the C nority to rely on their own social and economic stand them an economic advantage over their indigenous co who lack an equally reliable way of making transac costs of doing business are thus less for the Chinese Malay, Indonesian or other businesses in the region, Chinese competitive advantages. Honesty is more than a moral issue. It isa large eco fluence as well. While government can do little to crea in various ways it can either support or undermine the on which honest conduct is based. This it can do b teaches in its schools, by the examples set by public o by the laws that it passes. These laws can create ince ward either moral or immoral conduct. Advocates of re for example, oftenpoint to examples of villainy among to demonstrate the need for both the rent control itselfa lated tenants’ rights legislation. However, rent contro widen the difference between the value of a given a building to honest owners and dishonest owners. Where the cost of legally mandated services ishigh equal or exceed the amount of rent permitted under th value of a building to an honest landlord can be zero or ative. Yet, to a landlord willing toviolate the law and sa

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by neglecting required services, or being willing to from prospective tenants, the building may still hav Where something has different values to differ tends to move through the marketplace to its mos which is where the bids will be highest. In this ca landlords can easily bid apartment buildings away landlords, some of whom may be happy to escape rent control puts them in. Landlords willing to re may find the building most valuable of all, if they ca for commercial orindustrial use after burning the bu thereby getting rid of both tenants and rent control. As one study of housing deterioration in New ”Buildings that have no or little or declining asset v tined and often programmed for abandonment (an mate destruction) from the moment they are acqui and unscrupulous landlords have made virtually a milking a rent-controlled building by neglecting ma repairs, defaulting on mortgage payments, falling payment of taxes, and then finally letting the buildin property of the city, while they move on to repeat structive process with other rent-controlled building None of this has been peculiar to New York. A s of deliberate destruction of rent-controlled build owners was found halfway around the world in Hon ilar incentivestend to produce similar results,even ent societies. Without rent control, the incentives facing land rectly the opposite-that is, to maintain the quality erty, in order to attract tenants, and to safeguard it ag other sources of dangers to the survival of the build complaints against landlords’ behavior by rent con can bevalid, even though few of these advocates se tion between rent control and adeclining moral qua who become landlords. When honest landlords s money under rent control, while dishonest landlo make a profit, it isvirtually inevitable that the prop from the former to the latter.

The Role of Government

KNOWLEDGE

In some respects, governments are able to asse amounts of knowledge, but the kind of knowledge inv ten in the form of statistical generalities or verbal g known as "expertise," while many economic decisio crucially on highly specific knowledge of particular th Agriculture is especially difficult to plan beca amount of highly specific knowledge required. The q the soil can vary significantly on a single acre, much whole farm or on all the farms spread out across a nat one sitting in a distant capital city cannot know where farm it would be better to grow carrots and where wh better suit the soil itself orthe way the land slopes and off it after a rain. Without having such a minutely detai the country-which would itself probably cover seve miles-they would have little chance of deciding w would have land best suited for which crops. Moreover, the products of agriculture are more than the products of industry. Central planners may look at official documents that tell them how many to kind of steel exist in which warehouses, but strawber have spoiled before any such national data could be c all of them. Specific knowledge is one of the scarce sources, regardless of how many people there may b talk in glib generalities. The net result of all this is that even countries w long been food exporters often begin to have difficu themselves after the government takes control of a This has happened over the centuries and in many among people of every race, and under governmen from democracies tototalitarian dictatorships. Even th planned economies of the Soviet Union and the Sov Eastern Europe ended up having to allow a larger ro vidual farming decisions, made by farmers guided by sales, than they would permit in industry. Nevertheles not permit a fully free market in agriculture and so en

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peatedly being forced to import large amounts of their populations. Ironically, many of these countries bloc, including Russia and the Ukraine, had been la of food forcenturies before the Communists took pow control of agriculture. In the last peacetime year o regime, 1913, Russia exported more than 9 million to Nothing illustrates the role of prices in a free mar matically than the consequences of their absence-or increases in agricultural output when markets and pri permitted to operate freely, asin China under Deng X are such economic consequences confined to Com The output of cocoa in Ghana likewise increased afte ment there loosenedits price controlson cocoa. One of the classic disasters of government plann the British government's attempts to grow peanut Rhodesia after World War 11. Although this scheme t be a costly failure, ordinary farmers around the wo deciding for generations where and how to grow p on his own particular land, whose individual charac known directly from personal experience. Why was ment plan to grow peanuts such an economic di poorly educated or even illiterate farmers have bee what highly educated experts were not able to do? had highly specific knowledge, which is often far mo than general "expertise." While centralplanning has an unimpressive reco as well, the fact that its agricultural failures are usua and more often catastrophic, suggests the crucial ro edge. Industrial products and industrial production pr a far greater degreeof uniformity than is found in ag ders from Moscowon how to make steelin Vladivosto chances of achieving their goalthan orders from Mo to grow carrots or strawberries in Vladivostok. One of the most dangerous powers of any govern cratic or despotic, is the power to foreclose knowle fecting decisions. Given that most specific knowled scattered in fragments among vast numbers of huma cisions made by any manageably small number of

The Role of Government

planners is likely tobe based on far lessknowledge tha able in the society as a whole. Yet, once the governme sions have been turned into laws and policies, it matters whether the beliefs on which they were based false. Power trumps truth. The economic history of Union isa monument to counterproductive policies beh spread poverty in one of the most richly endowed co the face of the earth. For example, the richness of the soil in vast regions ropean portion of the Soviet Union was so widely kn Hitler had plans to have trainloads of that soil transport many for the benefit of German agriculture, after he c the U.S.S.R. But his own foreclosure of knowledge from tary officers in the field on the Russian front prevente tory that might have permitted that scheme to be tried. the fact that a country with soil of such renowned qual in the Soviet Union should have had to import food own people is one measure of the importance of econ ciency and inefficiency in the allocation of scarce resou

EXTERNAL COSTS AND BENEFITS

Economic decisionsmade through the marketplace ways better than decisions that governments can make pends on whether those market transactions accurat both the costs and the benefits which result. Under so tions, they do not. When someone buys a table or a tractor, the ques whether it is worth whatit cost is answered by the acti purchaser who made the decision to buy it. However electric utility company buys coal to burn to generate el significant part of the costs of this operation is paid who breathe the smoke that results from the burning o and whose homes and cars are dirtied by the soot. Cle painting and medical costs paid by these people are into account in the marketplace, becausethese people d ticipate in the transactions between the coal produce

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utility company. Their costs are called "external co mists because such costs falloutside the parties to th which creates the costs. External costsare therefore n account in the marketplace, even when these are ve costs, which extend beyond monetary losses toinclu and premature death. While there are many decisions that can be ma ciently through the marketplacethan by governmen those decisions that can be made more efficiently by than by the marketplace. Clean airlaws can reduce h sions by legislation and regulations. Clean water la against disposing of toxic wastes can likewise force made in ways that take into account the external co otherwise be ignored by those transacting in the mark By the same token, theremay be transactionsthat eficid to people who are not party to the decision whose interestsare therefore not taken into account. mud flaps on cars and trucks may beapparent to an ever driven in a rainstorm behind a car or truckthat so much water or mud on his windshield as to dan scure vision. Evenif everyone agreesthat the benefits greatly exceed their costs, there is no feasible way of benefits in a free market, since you receive no bene mud flaps that you buy and put on your own car, b mud flaps that other people buy and put on their car These are "external benefits." Here again, itis p collectively through government what cannot be ob ually through the marketplace, simply by having la quiring all carsand trucks to havemud flaps on them Some benefitsare indivisible. Either everybody fits or nobody gets them. Military defense is one e tary defense had to bepurchasedindividuallythro marketplace, then those who felt threatened by fo could pay for guns, troops, cannon and all the other m tary deterrence and self-defense, while thosewho sa could refuse to spend their money on such things. H level of military securitywould be the same for both

The Role of Government

ers and non-supporters of military forces are intermix same societyand exposed tothe same dangers from ene Given the indivisibility of the benefits, even som who fully appreciate the military dangers, and who co costs of meeting it to be fully justified bythe benefits, w have no reason to spend their own money for military since their individual contribution would have no seri on their own individual security, which would depend on how much others contributed. In such a situation, it possible to end up with inadequate miliary defense everyone understands the cost of effective defense and the benefits worth it. By collectivizing this decision and having it made b ment, an endresult can be achieved that is more in kee what most people want than if those people were allow cide individually what to do. Even the strongest defend free market do not suggest that each individual should tary defense in the marketplace. In short, there are th government can do more efficiently than individuals be ternal costs orexternal benefits make individual decisio on individual interests, a less effectiveway of weighing benefits to the whole society. Setting standards is another government function w into this category. For centuries governments have set of measurement or prescribed certain measurements, su width of rails on railroads. The inch,the yard, and the m government-prescribedunits of measurement,asarep quarts, and gallons. If individuals had each set up their of measurement, transactions and contracts would b mare of complications, as would the legal enforcemen When railroads first began, each company was free to d itself how wide apart its rails would be set. The net r that rail widths differed from one railroad to anoth meant that the space between train wheels also differe trains from one rail line could not run on another. To tie together with railroads would be vastly more costly from San Francisco could reach Chicago only if there hap

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be railsof the same width covering that entire distan when rails were of different widths would have requ railroads to be built, many with tracks running par of different widths, to reach the same places. Gover posed standards for the distance between rails el vastly expensive problem.

INCENTIVES AND CONSTRAINTS

Government is of course inseparable from polit in a democratic country, so a distinction must mad mind between what a government can do to make than they would be in a free market and what it is i do under the influence of political incentivesand co distinction between what the government can do likely to do can be lostwhen we think of the gover ply an agent of society or even as one integral perfo ity, themanyindividualsand agencies withi government have their own separate interests and which they may respond far more often than they ther the public interest or tothe policies set by polit In the Soviet Union, for example, industrial ente ferent ministries avoided relying on each other for resources, if at all possible. Thus an enterprise loc vostok might order equipment or natural resources from another enterprise under the same ministry in sands of miles away, rather than depend on gettin needed from another enterprise located nearby in that was underthe control of a different ministry. T might be shipped thousands of miles eastward on dened Soviet railroads while the same kinds of m also being shipped westward on the same railroad enterprise in another ministry. Such economically needless cross-hauling was inefficient allocationsof scarce resourcesdue to the ity that government is not a monolith, even in a tot ety. In democratic societies, where innumerable in

The Role of Government

are free toorganize and influence differentbranches and of government, there is even less reason to expect tha ernment will follow one coherent policy, much less a p would be followed byan ideal government representin lic interest. Under popularly elected government, the political are to do what is popular, even if the consequence are w the consequences of doing nothing, or doing somethi less popular. As an example of what virtually every agrees was a mistaken policy, the Nixon administratio created the first peacetimewage controls and price con history of the United States. Among those at the meet this fateful decision was made was internationally re economist Arthur F. Burns, who argued strenuously a policy being considered-and was over-ruled. Nor other people present economically illiterate. The presi self was a conservative who had long resisted the ide and price controls. Indeed, he had publicly rejected the eleven days before doing an about-face and accepting flation had created mounting pressures from the publi media to ”do something.’’ With a presidential election due the following yea ernment could not afford to beseen as doing nothing w tion raged out of control. However,even aside from suc concerns, the participants in this meeting were “exhilar the great decisions they had made” that day, accordin who were present. Looking back, they later recalled ” time was spent discussing the timing of the presiden than how the economic program would work.” There w ular concern that, if his speech were broadcast in prim would cause cancellation of the very popular television Bonanza, leading to public resentments. Here is what ha

Nixon’s speech-despite the preemption ofBonsma-wa great hit. The public felt that the government was c defense against the price gougers. . . During the next e newscasts, 90 percent of the coverage was devoted to N new policy. The coverage was favorable. And the Do

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dustrial Average registered a 32.9 point gain-the larg day increaseup to then.

In short, the controls were a complete success p for their economic consequences:

Ranchers stopped shipping their cattle to the mark drowned their chickens, and consumers emptied th supermarkets.

Price controls produced essentially the same resu Nixon administration as they had produced in the R under Diocletian, in the Soviet Union under the Co Ghana under Nkhrumah, and in numerous other tim where such policies had been tried before. Nor was t policy unique politically in how it was conceived an Veteran economic adviser Herbert Stein observed, 2 the Nixon administration meeting at which he had ”failure to lookahead is extremely commonin gover making.” Another way of saying the same thing is time horizons tend to be much shorter than econom zons. Before the full economic consequences of th price control policies became widely apparent, Nix re-elected with a landslide victory at the polls. The constraintswithin which government policy ates are as important as the incentives. Important and a framework of rules of law may be, what that also many matters must be dealt with categorically, rath mentally. A Protestant president cannot stop people Catholic churches or viceversa. No one can be exec being convictedof a crime. The applicationof such ca prevents the enormous powers of government from at the discretion or whim or officials. However, th things which require discretionary incremental ad noted in Chapter 4, and for these things categorical la ficult toapply or canproduce counterproductive resu For example, while prevention of air pollution an lution are widely recognized as legitimate function

The Role of Government

ment, which can achieve more economically efficient re those of the free market, doing so through categorical create majorproblems. Despite the political appeal of c phrases like "clean water" and "clean air," there are i such things, never have been, and perhaps never will over, there are diminishing returns in removing impur water or air. Reducing truly dangerous amounts of im from water or air can be done at costs that most peop agree were quite reasonable. But, as higher and higher of purity are prescribed by government, in order to ever more minute traces of ever more remote or more able dangers, the costs escalateout of proportion. But t of categorical phrases like "clean water" may be as polit tent when the water is already 99.99 percent pure as wh dangerously polluted. Depending on what the particular impurity is, min may or may not pose a serious danger. But there are con raging over the presence of some impurities in water ready 99.999999 percent pure. These controversiesare u be settled at the scientific level when political passion whipped up in the name of non-existent "clean water."N how pure the water becomes, someone can always de removal of more impurities. And, unless the public und the logical and economic implications of what is being demand can become politically irresistible, since no pub wants to be known as being opposed to clean water. The same principle applies in many other contex minute traces of impurities can produce major political battles-and consume millions of tax dollars with little effect on the health or safety of the public. One legal ba for a decade over the impurities in a New Hampshire to site, where these wastes were so diluted that children c eaten some of the dirt there for 70 days a year without a icant harm-if there had been any children playing the there were not. As a result of spending more than $9 m level of impurities was reduced to the point where child have eaten the dirt there 245 days a year. Moreover,wit thing being done at all, both parties to the litigation ag

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more than half the volatile impurities would have e the year 2000. Yet hypothetical dangers to hypothe kept the issue going. With environmental safety, as with other kinds o forms of safety in one respect creates dangers in o California, for example,required a certain additive all gasoline sold in that state, in order to reduce the from automobile exhaust fumes. However, this n tended to leak from filling station storage tanks an gas tanks, polluting the ground water in the first ca to more automobile fires in the second. Similarly, mandated air bags in automobiles, introduced to sa crashes, have themselves killedsmall children. These are all matters of incremental trade-offs to mal amount and kind of safetF in a world where b cally safe is as impossible as achieving 100 percen clean water. Incremental trade-offs are made all the vidual market transactions, but it can be politicallys pose demands for more clean air, clean water o safety. Thereforesaying that the government can imp results of individual transactions in a free market is as saying that it will in fact do so. Among the gre costs imposed in a society canbe those imposed poli islators and officials who pay nocosts whatever, w billions of dollars in costs on others, in order to resp cal pressures from advocates of particular interests o By the same token, while external costs are not taken into account in the marketplace, this is not to may not be some imaginative ways in which they Britain, for example, ponds or lakes are often priv and these owners have every incentive to keep them ing polluted, since a clean body of water is more attr ermen or boaters who pay for its use. Similarly w malls: Although maintaining clean, attractive malls restrooms and security personnel costs money that ers do not collect from the shoppers, a mall with su tracts more customers, and so the rents charged t

The Role of Government

storeowners can be higher because a location in suc more valuable than in a mall without such amenities. In short, while externalities are a serious considera termining the role of government, they do not simply magic word which automatically allows economics to b and politically attractive goals to be pursued without fu Both the incentives of the market and the incentives must be weighed when choosing between them on any issue. Just as we must keep in mind a sharp distinction be goals of a particular policy and the actual consequen policy, so we must keep in mind a sharp distinction be purpose for which a particular power is created and the for which that power can be used. President Frankli sevelt took the United States off the gold standard in 1 presidential powers created during the First World W vent trading with enemy nations. Though that war had for morethan a dozen years and we no longer had any tions, the power was still there to be used for wholly purposes.

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Chapter 18

An Overview

0

ne of the most dangerous ways of reasoning abo tional economy is by analogy to the circumstanc viduals or by anecdotal observations about what h individual situations. That way lies the fallacy of co Yet politicians, the media and others who seek to ov often use such analogies, whether innocently or in ord others in their direction. The fallacyin the fallacy of composition comes fro the interactions which prevent what is true of a part f true of the whole. Because a national economy invo complex interaction9 among millions of individuals, and other organizatiAns, what is true for some of them be true for the economy as a whole. For example, sav the steel industry by restricting imports of steel fromo tries does not mean that the economy as a whole will jobs.WhenAmeric made steel becomes more expe imported steel, tha ditional cost translates into m sive American-made automobiles, refrigerators and o uctsmadewith steel-all of whichhave to com imported products made with less expensive steel ove aside from international competition, more expensive ucts mean fewer sales of these products than there w been at lower prices, and that in turn means lower p and employment in all those industries. The jobs lo other industries can easily exceed the jobs saved in th dustry, quite aside from needlessly lowering the pu power of American consumers because of artificia prices forproducts made with steel.

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Although the fallacy of composition shows up pects of economics-and of life-it is especially like in questions involving the national economy as a w cians love to come to the rescue of particular indus sions, classes, or racial or ethnic groups-and to r benefits tothese groups as net benefits to the country nalists likewise loveto feature the fortunes or misfor ticular individuals,groups,organizations, or reg country. They tootend to present these stories as if th ical or indicative of what is happening over all. Not only may the fates of particular parts of the e fer fromthe fate of the economy as a whole, to some e evitable that parts of the economy suffer fromthe pr whole. Where are the new technologies, the new in the new ways of distributing products to get the re need, except by taking capital, labor and other res from other parts of the economy? Automobiles, tru tors necessarily displaced horses from their historica in transportation and farming, thereby freeing up all required to feed and maintain vast numbers of hor were also displaced from agriculture as farming met more efficient. One of the key factors in the growth output has been the ever-growing availability of w placed from agriculture. How else could America have gotten all the millions of workers needed to fi ries, except bytaking them from the farms? Those who lament the passing of the family farm connection between that andthe greater outpouring services from industry that created a rising standard millions of Americans. Nothing is easier for the m politicians than to present ”human interest” stories one whose family has been farming for generations now been forced out of the kind of life they knew a the impersonal economic forces of the marketplace. gotten is that these impersonal forces represent ben sumers who are just as much persons as the produce been arbitrarily selected as the focus of the discussio tation is always there to try to “solve” the problem of

An Overview

plight has been singled out for attention, without reg effects elsewhere. Because the national economy isso large and comp ten described in gross statistics which may or may not nomic realities.We have noted how an arbitrary choic year for beginning to follow trends over time can be c misleading as regards economic growth. It can also be m in many other ways. For example, real wage rates salaries were often at unprecedented highs at the de Great Depression of the 1930s, because the reduced m ply increased the purchasing power of any given inc lions of people were unemployed or employed part-tim sporadically employed, but the statistics on real pay time forthose employed nevertheless represented unus purchasing power. In later years, many representatives of salaried go employees, such as civil servants or school teachers, year during the Great Depressionas their baseperiod f to measure how their pay had failed to keepup with i had lagged behind the pay of people in other occupation viously intended as arguments for raising their incom or not their pay should have been raised on other gro particular statistical exercise compares apples and oran People who kept theirjobs-as most teachersand civ did during the Great Depression-were of course bette their fixed money incomes could buy more goods an during a deflationary period. And of course a return ployment meantthat others who had suffered much mo ically during the Great Depression were now impro economic position relative to that of teachers and civ during that unusual period of deflation and depressio no need to freeze the economic relationship of thes groups to oneanother where they werein 1932-or any The tragicbungling of economic policy bypreside political parties, as well as by officialsof the Federal R tem, during the Great Depressionof the 1930s has sobe cations for those who regard government as a force t economy fromthe imperfections of the marketplace. M

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indeed imperfect, as everything human is imperfect. failure'' is not a magic phrase that automatically just ment intervention, because the government can alsof make things worse. When a home run slugger strikes out (as most of t some frequency), he is not automatically taken out and a pinch hitter sent in. After all, pinch-hitters ca out, and they may not be as likely to hit a home run. was fashionable at one time to represent the Roosev tration as having rescued the country from the Great all previous depressions had come and gone withou government action-and prosperity had returned m quickly in earlier times. Presidents Hoover and Ro tried to use the powers of the federal government t economy. However good their intentions, economis scholars who have studied that era in depth have concluded that they made matters worse. Because a national economy includes such a hug ever-changing goodsand services, merelymeasuring t flation ismuch more chancythan confident discussio on the subject might indicate. As already noted, cars have changed dramatically over the years. If the aver costs X percent morethan it used to, doesthat mean t that most of that change has been X percent inflation or higher pricespaid for higherquality? No one callsit in someone who has been buying Chevrolets begins tob and pays more money. Whythen call it inflation when begins to have features that were once reserved for C its costs rise to levels once charged for Cadillacs? Another source of inaccuracy in measuring infla things that are included and not included in the stati create an index of inflation, such as the Consumer Everything cannot be included in an index, both be enormous time and moneythiswouldrequire a "everything" itself changes over time with the crea products and the disappearance of old ones.Instead, a collection of commonly purchased items are follow years, measuring how much those particular prices r

An Overview

The problem with this is that what is commonly pends on prices. Withinliving memory, televisionsets w pensivethat only rich peoplecould afford them. air-conditioned cars and portable computers. At that tim would have dreamed of including such rare luxuries in dex to measure the cost of living of the average Amer after their prices fell toa fraction of what they once we items become commonplace possessions. What this me the price indexes missed all the jillirzg prices of such thi years before they becamewidely used, while counting ilzg prices of other things that were already widely used these indexeswere biased upward in their estimates of Because government policies and private contracts based on the cost of living, as measured by these inde sums of money changed hands across the country, as exaggerated estimates of inflation. Social Security recip example, received billions of dollars in cost-of-living in their pension checks because of an inflation that was in tistical artifact, rather than a real increase in the prices what they had always bought. This was a factor in creati cial panel of distinguished scholars to revise the index matter how distinguished the individuals, or how co~~ they worked, the task they were attempting could nev precision, evenif it could bemade more realisticthan it The national economyis such a large and complex it cannot be covered comprehensively here. This sect meant to answer all questions. Ithas succeeded to the e you knowwhat kinds of questions to ask when people st ing statistics around and claiming to have "proved" th

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PART VI: THE INTERNATIONA ECONOMY

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Chapter 19

International Trade

hen the historic North American Free Trade Ag 1993 (NAFTA) was approaching its controversi in Congress, the New York Times said:

Abundant evidence is emerging that jobs are shifting borders too rapidly to declare the United States a job a job loser from the trade agreement.

Posing the issue in these terms committed the cen in many discussions of international trade-assuming country must be a ”loser” if the other country is a ”w ternational trade is not a zero-sum game. Otherwise would not continuously engage in it. Both must gain o make no sense. As for jobs, there were dire predictions of ”a gian sound” as jobs would be suckedout of the United States and other countries with lower wage rates after the agreement went into effect. In reality, thenumber of Am increased after the agreement and the unemployment United States fell to the lowest levels seen in decad NAFTA was passed, Congressman David Bonior of warned: ”If the agreement withMexico receives congre proval, Michigan’sauto industry will eventually vanis actually happened was that employment in the autom try increasedby more than 100,000 jobs over the next Such results clearly surprised many people. But it s have surprised anyone who understood economics. Let’s go back to square one. What happens when country, in isolation, becomes more prosperous? It ten

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more because it has more to buy with. And what hap buys more? There are more jobs created making th goods and services that are now in greater demand. Make that two countries and the principle rema There is nofixednumber of jobs that the two countri over. If they both become moreprosperous, they are create more jobs. Theonly question is whether intern tends to make both countries more prosperous. As with any other exchange, the only reason i trade takes place in the first place is because both par benefit. If either side discovers that it is worse off, trading. The facts about international trade are not diffic stand. What is difficultto untangle are all the miscon jargon which so often clutter up the discussion.

THE BASIS FOR INTERNATIONAL TRA

While international trade takes place for the sam other trades take place-because both sides gain-it to understand just why both countries gain, especia are so many politicians and journalists who mudd with claims tothe contrary. The reasons why countries gain from internatio usually grouped together by economists under thre solute advantage, comparative advantage,and econom

Absolute Advantage

It is obvious why Americans buy bananas gro Caribbean. It ismuch cheaper to grow bananas in the in places where greenhouses and other artificial me taining warmth would be necessary. In tropical coun provides free the warmth that people have to prov means in cooler climates. This isjust one example of what economists call vantage"-one country, for any of a number of reas

International Trade

duce some things cheaper than another. These reaso due to climate, geography or the mixture of skills in th tive populations. Whatever the reason may be in each case, one country can simply produce a given prod cheaply than another. There is another more subtle, but at least equally reason forinternational trade. This iswhat economists parative advantage.”

Comparative Advantage

To illustrate what is meant by comparative advan pose that one country is so efficient that it is capable of anything more cheaply than another country. Shoul countries trade? Yes. Why? Because, even in an extreme case where on can produce anything more cheaply than another coun do so to varying degrees. For example,it may be twice at producing chairs but ten times as efficient at produc sion sets. In this case, the total number of chairs and sets produced in the two countries combined would be one country produced all the chairs and the other pro the television sets. Then they could trade with one an each end up with more chairs and more television s they each produced both products for themselves. As economists would say, country A has an ”absol tage” in producing both products but country B has a tive advantage” in producing chairs while A has a ”co advantage’’ in producing television sets. Let’s look at this on a small, human scale. Imagin are an eye surgeon and that you paid your way throu by washing cars. Now that you have a car of your ow you wash it yourself or should you hire someone els it-even if your previous experience allows you to more efficientlythan the person you hire? Obviously, it makes no sense to you financially, o in terms of over-all wellbeing, foryou to be spending

BASIC ECONOMICS

ing down a car instead of being in an operating someone’s eyesight. In other words, even though ”absolute advantage” in both activities, your compa tage in treating eye diseases is far greater. The key to understanding both individual exam amples from international trade is the basic econom scarcity. The surgeon has only 24 hours in the day, else. Timethat he isspending doing one thing canno ing something else. The same is true of countries, w have an unlimited amount of labor, time, or other r so must do one thing at the cost of not doing someth Although country A may be capable, in the abs ducing anything more cheaply than country B, it can produce ezwytlzirzg more cheaply because the time i ducing one thing comes at the expense of the time th been spent producing other things. As we saw in C real cost of producing anything is the loss of othe could have been produced with the same time, e sources. If country B is very inexperiencedin produc sets, it will take an inordinate amount of time to ma that could have been better spent producing chair them to Country A to get television sets. Conversely, while Country A can produce either efficiently, the time it spends producing chairs w much bigger in producing television sets, some of trade for chairs from Country B, ending up with products than if it produced both for itself. Each country’s economic well-being-and the nomic well-being-will be greatest if it devotes i sources to producing those things in which it ha ”comparative advantage’’ and trades with another c the restof what it wants. A numerical example may make the point clear bers in the table below illustrate what is meant by advantage.” Imagine that the United States and Canada b shirts and shoes and that the United States produce ucts with less labor and other resources than is

International Trade

Canada. For the sake of simplicity, let us let labor stand resources used. Assume for the sake of argument that States can produce 75 shirts per man-hour, while Ca duces only 30 and that the United States produces 25 man-hour, while Canada produces only 20. Here is the they eachproduce both products:

AMERICAN AMERICAN CANADIAN CANA PRODUCTS MAN-HOURS OUTPUT MAN-HOURS O

Shoes

200

5,000 4,000

200

With both countries producing both products, their output would come to a grand total of 31,500 shirts shoes from a grand total of 1,000 man-hours of work. In this hypothetical example, the United States h solute advantage” in producing both products but Ca ”comparative advantage” in producing shoes. Even one-sided differences as those assumed and shown on it would still pay for the United States toproduce only to buy its shoes from Canada. Similarly, it would pay produce only shoes and buy its shirts from the Uni With the very same output per man-hour in both coun could produce a larger grand total of the two products. If they engagein international trade, with each coun izing in producing the product in which it has a comp vantage, the table below illustrates the outputund conditions and with the sameindividual productivity a

AMERICAN AMERICAN CANADIAN CA PRODUCTS MAN-HOURS OUTPUT MAN-HOURS O Shirts

500

37,500

0

Shoes

0

0

500

-

Even though output per man-hour remains the sa country as before, now their combined total of 1,000

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produces 37,500 shirts and 10,000 shoes, instead of and 9,000 shoes as before. By utilizing their compa tages, the two countries can produce 6,000 more shi more shoes than before, with no more resources tha with no technological change. That gain comes from concentrating on producing those things for which parative advantage. In other words, Americans c shoes by producing shirts and trading them with C shoes, instead of producing their own shoes at the e bor and other resources that could have gone into something where their advantage is not as great. Canadians can get more shirts by producing shoes them for American-made shirts. Only if the United States produced everything ciently than Canada by the same pevcentagefov each p there be no gain from trade because there would the parative advantage. This is virtually impossible to fi world. Comparative advantage is very important no ory but in practice. It has been more than a century Britain produced enough food to feed itself. Briton able to eat only because the country has concentrated producing those things in which it has hada compa tage, such as manufacturing, shipping, and financi and using the proceeds to buy food fromother count British consumers end up better fed and with m tured goods than if the country grew enough of its feed itself. Sincethe real cost of anything that is prod other things that could have been produced with the it would cost the British too much industry to put en into agriculture to become self-sufficient in food. Th off getting food from some other country whose com vantage is in agriculture, even if that other country’ not as efficient as British farmers.

Economies of Scale

While absolute advantage and comparative adva key reasons for benefits frominternational trade, the

International Trade

only reasons. Sometimesa particular product requires investment in machinery and in developing a skilled l that the resulting output can be sold at a low enough p competitive only when some enormous amount of out duced, because of what economists call ”economies of s If General Motors produced only a hundred Chev cost per car would be astronomical, since all the expe chinery and all the engineering research and develop went into creating the automobile would have to be from the sale of just 100 vehicles. However, by spread fixed overhead costs over hundreds of thousands of C the cost per car shrinks to a fraction of what it would wise, and thus it can be sold at a price that enables it t in the marketplace. It has been estimated that the mini put of automobiles needed to achieve an efficient cost somewhere between 200,000 to 400,000 automobiles per Producing in such huge quantities is not a serious p country of the size and wealth of the United States.But, try with a much smaller population-Australia, for e there isno way to sellenough cars within the country to develop and produce automobiles from scratch to at se would compete with automobiles produced in much lar ties overseas. The largest number of cars of a given ma Australia in 1996 was 112,000 Fords, well below the needed to reap all the cost benefits of economies of scale The Australian government’s program to gradual tariffs on imported cars has been bitterly opposed by th tic automobile manufacturers, who would have to com automobiles produced more cheaply overseas. Such co has been estimated to cost thousands of jobs in Aus some analysts say that it would probably force all four A automobile producers out of business. Even the cars been manufactured in Australia have been develope countries-Ford and General Motors cars fromthe Un and Toyotas and Mitsubishis from Japan. They are e Australian-built American and Japanese cars, but the economies of scale that are possible in the much larger m the United States and Japan.

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Exports enable some countries to achieve econo that would not be possible from domestic sales alon panies make most of their sales outside their respect borders. For example, the Dutch retailer Royal Ah than two-thirds of its sales outside of the Netherl Swedish retailer Hennes & Mauritz has more than its sales outside of Sweden. While the American reta has larger overseas sales than either of these two com than four-fifths of Wal-Mart’s sales are in the huge A ket, where it can realizegreat economies of scale dom small countries like South Korea and Taiwan depen tional trade to be able to produce on a scale far ex can be sold domestically. In short, international trade is necessary formany achieve economiesof scale that will enable them to s itive prices. For some products requiring huge invest chinery and research, only a very few large and countries could reach the levels of output needed these costs from domestic sales alone. International greater efficiency by allowing more economiesof sca by taking advantage of each country’s absolute or advantages. Over time, even the comparative advantk5es cha international production centers to shift from count For example, when the computer was a new and ex much of its early development and production took United States. But, after much of the technological w that turned it into a widely used product that many how to produce, the United States retained its com vantage in the development of computer technology design, but the machines themselves could now eas bled in poorer countries overseas-and were. Those who think of American production movin a loss of jobs in the United States have been proved facts, as the number of American jobs increased an ment rates fell while all these jobs were being ”lo opaque facts are not enough. What also needs to be u wlzy things happened this way, when so many po

International Trade

journalists painted an entirely different picture when their dire predictions. Labor is one of innumerable scarce resources which ternative uses. The computer software industry in th States could not have expanded so much and so success American computer engineers were tied down with the tion of machines that could have been just as easily pro some other country. Since the same American labor can two places at one time, it can move towhere its compa vantage is greatest only if the country ”loses jobs”where comparative advantage. That iswhy the United States co unprecedented levels of prosperity and rapidly growing ment at the very times when media headlines were regu nouncing lay-offs bythe tens of thousands in some indus by the hundreds of thousands in others. Desperate attempts to salvage their wrong predicti led some to assert that the new jobs were only low-w ”flipping hamburgers’’ and the like. But if Americans i were losing higher-paid jobs and being forced to take lo jobs, how then could the American standard of living h tinued to rise, as all data show? In reality, when the s low-skill jobs to other countries enables an American co become more profitable, it can then afford to hire Ame higher-skill jobs. It isnot a zero-sum game when there total resources available afterthe shift. While it is undoubtedly true that some particular ind or even many employees of some particular firms or in may have lost ground during the transition, we canno ”the fallacy of composition’’ and assume that what is some is true in general. The risein the general level of re in the United States means that the gains have clearly ou the losses. But, where those who lose jobs are organiz complaints carry more politicalweight. When the number of jobs in the American steel indu cut from 340,000 to 125,000 during the decade of the 1 had a devastating impact and was big economic and news. It also led toa variety of laws and regulations de reduce the amount of steel imported into the country to

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ECONOMICS

BASIC

with domestically produced steel. Of course, this supply led to higher steel prices within the Unite therefore higher costs for all American industries p jects made of steel, ranging from automobiles to American manufacturers paying more than a hu more per ton of steel, and having to recover such i from increased prices charged the consumers, all t were at a disadvantage in competing with similar products, both within the United States and in markets. The steel products manufacturers’ choices wer or toshift production of their products overseas-wit a loss of jobs in the United States. It has been estim gain in domestic American steel production due to tions led to a net loss in the production of dome steel products as a whole. In other words, American whole was worse off, on net balance, as a result of strictions. While such steel import restrictions made nomically, it made sense politically to thosein responsible for creating these restrictions. From a p point, what matters is not what works outbest fo over all. Whatmatters is how vocal and how much cle one sector has relative toanother. Such economically short-sighted and nationall ductive policies are by no means confined to the ste a million new and well-paying jobs are created in co tered all across the country, that carries less weig than if half a million jobs are lost in one industr unions and employer associations are able to raisea the million new jobs represent a few dozen here and merable businesses scattered from coast to coast enough concentration of economic interest and po one place to make it worthwhile to mount a coun Therefore laws are often passed by Congress restr tional trade for the benefit of some concentrated a stituency, even though these restrictions may cau losses of jobs nationwide.

International Trade

INTERNATIONAL TRADE RESTRICTION

While there are many advantages to international the world as a whole and for individual countries as a w all forms of economic efficiency, at home or abroad, it less efficientways of doing things. Just as the advent of mobile inflicted losses on the horse-and-buggy industr spread of giant supermarket chains drove many small hood stores out of business, so imports of things in wh countries have a comparative advantage create losses and jobs in the corresponding domestic industry. Despite offsetting economicgains that typically far the losses, politicallyit is almost inevitable that there w calls for governmentprotection from foreign co through various restrictions against imports. Many of long-lived fallacies in economics have grown out of at justify these international trade restrictions. Althou Smith destroyed most of these fallacies more than two ago, as far as economists are concerned, these fallacies r litically potent today. Some people argue, for example, that we cannot with countries whose wages are much lower than ou countries, on the other hand, may say that they must pr ”infant industries” from competition with more deve dustrial nations until the local industries acquire the e and know-how to compete on even terms. In all count are complaints that other nations are not being ”fair” in regarding imports and exports. A frequently heard complaint of unfairness, for ex that some countries ”dump” their goods on the inter market at artificially low prices, losingmoney in the sh order to gain a larger market share that they will later raising prices afterthey achieve a monopolistic position In the complexities of real life, seldom is any argum 100 percent of the time orwrong 100 percent of the tim comes to arguments for international restrictions, how of the arguments are fallacious most of the time. Let u them one at a time, beginning with the high-wage fallac

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BASIC ECONOMICS

The High- Wage Fallacy

In a prosperous country such as the United Sta that sounds very plausible is that American goods Pete with goods produced by low-wage workers in tries. But, plausibleasthismaysound,bothhistory economics refute it. Historically, high-wage countri exporting to low-wage countries for centuries. Br world’s greatest exporter in the nineteenth century rates were much higher than the wage rates in many of the countries to which it sold. Economically, the key flaw in the high-wage arg it confuses wage rates with labor costs-and labor co costs. When workers in a prosperous country receive t rate as workers in a poorer country and produce th output per man-hour, then it is the high-wage coun the lower labor costs. That is,it is cheaper to get a g of work done in the more prosperous country simp takes less labor, even though individual workers a The higher-paid workers may be more efficiently o managed, or have far more or better machinery t There are, after all,reasons why one country is mor than another and often that reason is that they are m at producing output. Higher wage rates per unit of time are not the sa costs per unit of output. It may not even mean high per unit of output-and labor costs are not the only The costof capital and management are a consid the cost of the product. In some cases, capital costs cost, especiallyin industries with high fixed costs,su utilities and telephone companies. A prosperous co has a greater abundance of capital and, because of su mand, capital tends to be cheaper than in poorer co capital is more scarceand earns a correspondingly h return. When Russia began a large-scale industrializ 1890s, foreign investors could earn 17.5 percent per y

Trade

International

many invested in Russia that the rate of return fell bel cent by1900. Poorercountries with high capital costs wo difficulty competing with richer countries with lowe costs, even if they had areal advantage in labor costs,w often do not. Against this background, it may be easier to unders dire predictions of a "giant sucking sound" as Amer would go to Mexico in the wake of the North Amer Trade Agreementof 1993 turned outto be completely w number of American jobs increasedand the unemploy in the United States fell to record lows. Thisdid not co expense of Mexico, however. Bothcountries gained for reasons that countries have gained from international centuries-absolute advantage and comparative advant At any given time,it is undoubtedly true thatsome i will be adversely affected by foreign imports, just as adversely affected by every other source of cheaper p These other sources of greater efficiency are at work all forcing industries to modernize, downsize or go out of Yet, when this happens because of foreigners, it can be politically as a case of our country versus Japan or Mex in fact it is the old story of domestic special interes consumers. During periods of unemployment, politicians are e likely to beunder great pressure to come tothe rescue o lar industries by restricting imports that compete with t of the most tragic examples of such restrictions occurre the worldwide depression of the 1930s, when tariff bar other restriction went up around the world. Just as freet vides economic benefits to all countries simultaneously restrictions reduce the efficiency of all countries simult lowering standards of living, without producing the employment that was hoped for. At any given time, a protective tariff or other impo tion may provide immediate relief to a particular indu thus gain the financial and political support of corpora labor unions in that industry. But, like many political b comes at the expense of others who may not be as orga

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BASIC ECONOMICS

visible, or as vocal. Economists have long blamed tional trade restrictions around the world for needle ing the worldwide depression of the 1930s. Econom do not have many votes. Nor do many of the voter economics.

Chapter 20

International Transfers of Wealth

0

ne of the things that keeps people thinking of int trade as some kind of contest between nations, wit and losers, isthe practice of regarding ”deficits” and ” in the international balance of trade as if they represent problem or benefit. The trade itself can be very bene means of adding to the total supply of goods and serv able to the countries which engage in it, but these bene depend on whether a given country has more export ports or vice-versa. The great Supreme Court Justice Oliver WendellHo ”Think things, not words.” Nowhere is that more impo when discussing international trade, where there are misleading and emotional words used to describe an things that are not difficult to understand in themselve minology used to describean export surplus as a ”favo ance of trade and an import surplus as an ”unfavorabl of trade goes back forcenturies. At one time, it was widely believed that an impo impoverished a nation because the difference betwee and exports had to be paidin gold, and the loss of gold as a loss of national wealth. However, as early as 17 Smith’s classic The Wealth of Nations argued that the r of a nation consists of its goods and services, not its go Too many people have yet to grasp this, even at the be the twenty-first century. If the goods and services av the American people are greater as a result of internatio

“ p

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BASIC ECONOMICS

then Americans are wealthier, not poorer, regardles there is a “deficit” or a “surplus” in the internati of trade. If Americans buy more Japanese goods than the American goods, then Japan gets American dollars difference. SinceJapan is not just going to collect th souvenirs, it usually turns around andinvests them can economy. In most cases, the money never leave States. The Japanese simply buy investment goodsCenter, for example-rather than consumer goods. A lars are worthless to the Japanese if they do not sp something. In gross terms, international trade has t order to make any economic sense. But it so happens ventions of international accounting count imports a the ”balance of trade,” but not things which don’t m Rockefeller Center. In some years, the best-selling car in America Honda or a Toyota, but no automobile made in De been the best-selling car in Japan. The net result is automakers receive many millions of dollars in Ame and Japanhas a net surplus in its trade withthe Unit what do the makers of Hondas and Toyotas do w American money? One of the things they do is buil the United States, employing thousands of America manufacture their cars closer to their customers, so and Toyota do not have to pay the cost of shipping c Pacific Ocean. Their American employees have bee ciently high wages that they have repeatedly voted ing labor unions in secret ballot elections. Looking at things, rather than words, there is lit alarmed about. What alarms people are the words counting rules which produce numbers to fit tho country’s total output consists of both goods and houses and haircuts, sausage and surgery-but the trade balance consists only of physical goods that American economy produces more services than g not surprising that we import more goods than we export more services than weimport.

International Transfers

of Wealth

American know-how and American technology ar other countries around the world and these countries pay us for these services. For example, most of the com the world run on operating systems created by Micr their payments to Microsoft and other American com their services are not counted in the international b trade, since trade includes only goods. This is just an a convention.Yet the American "balanceof trade" is repo media as if this partial picture were the whole pictur emotionally explosiveword "deficit" sets off alarms. When you count all the money and resources mov out of a country for allsorts of reasons, then you are talk the international "balance of payments"-regardless o the payments were made for goods or services. While as misleading as the balance of trade, it is still far from whole story, and it has no necessary connectionwith th the economy. Ironically,one of the rare balance of paym pluses for the United States in recent years was follow 1992 recession. According to the accounting rules, when people countries invest in the United States, that makes us a " those people, because we owe them the money that they since it was not sent as a gift. When people in many around the world feel more secure in putting their American banks or investing in American corporatio than relying on their own banks and corporations, then of money fromoverseas find their way to the United St Foreigners invested $12 billion in American bus 1980 and this rose over the years until they were inves than $200 billion annually by 1998. Looked at in terms there isnothing wrong with this. It creates more jobs workers and creates moregoods for American consum at in terms of words, however, this is a growing debt to Incidentally, contrary to popular fears that Japan was b America, the largest share of foreign direct investm United States in 1998 was Great Britain's 19 percent,co Japan's 16 percent. Britainwas also the largest recipien

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can direct investment abroad, receiving 18 percento ments, with Canada being next at 11percent. The more prosperous and secure the American the more foreigners are likely to want to send thei and the higher our annualbalance of payments ”def cumulated international ”debt” rises. Henceit is not ing that the long prosperity of the U. S. economy in accompanied by record levels of international defic The United States was where the action was and th many foreigners wanted their money to be, in orde the action. Thisincluded foreign businesses merging can businesses or buying them. As an official publ Commerce Department put it:

Total acquisition activity by foreign direct investors levels . . .A general factor behind the surge in acq desire to reduce costs through economiesof scale in r heightened global competition.In addition, the desir investors to gain access to the advanced and grow of a cal capabilityof the United States led to a number of telecommunication and information-related busi

International mergers and acquisitions have be large scale that, in 1995, 32 percent of all American to foreign companies affiliated with American comp percent of imports to the United States came from nies affiliated with American companies. The late distinguished economist Herbert Stein economist co-author put it best: ”If all transactions a for, there can be no deficit in the balanceof payments. not disappear into thin air, nor do foreign recipient dollars let the money sit idle-and they know that the put American dollars is in the United States. Howe counting conventions count some kinds of cash flow ers, there can be ”deficits” and ”surpluses.” For ex flows of foreign investmentsinto the United States then the United States canhave a deficit and run up cording to accounting conventions. Such capital inf

International Transfers

of Wealth

between 1988 and 1998. The ”debts” generated by such are more like what happens when you deposit money rather than like what happens when you simply charge credit card. Every time you deposit a hundred dollars that bank goes a hundred dollars deeper in debt, becau your moneyand they oweit to you. Some people might become alarmed if they were tol bank in which they keep their life’s savings was goin and deeper into debt every year. Butsuch worries woul pletely uncalled for, since the bank’s growing debt m that many other people are also depositing money in bank. Alarmists are unlikely to try to scare people by sa American banks are going deeper into debt, because themselves would correct the misconception and dis alarmists. But when similar fears are stirred up be United States isin debt to foreigncountries, such misco are less likely to be dispelled, because there is less lik someone on hand with a vested interest in correcting t and sufficient credibility todo so. For most of its history, the United Stateshas been a d tion-and has likewise had the highest standard of liv world. One of the things that helped develop the Ameri omy and changed the United States froma small agricu tion to an industrial giant was an inflow of capital from Europe in general and from Britain in particular. Thes sources enabled the United States to build canals, fact transcontinental railroads to tiethe country together eco As of the 1890s, for example, foreign investors own one-fifth of the stock of the Baltimore & Ohio Railroad, one-third of the stock of the New York Central, more tha stock of the Pennsylvania Railroad and nearly two-thi stock of the Illinois Central. Obviously, foreign investo never have sent their money here unless they expecte back with interest and dividends. Equally obviously, entrepreneurs would never have agreed to pay this in these dividends to them unless they expected these inv to produce big enough returns to cover these payment leave a profit forthe American enterprises.

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This all worked out largely as planned, for ge end. But this meant that the United States was offic nation for generations on end. Only as a result of le to European governments during the First World United States become a creditor nation. Since then both, at one time or another. But these have been a tails, not determinants of American prosperity or pr Neither the domestic economy nor the internati is a zero-sum game, where some must lose wha Everyone can win when investments create a grow There is a bigger pie, from which everyone can get The massiveinfusion of foreign capital contributed United States the leading industrial nation by 1913 duced more than one-third of all the manufactured world. The situation is very different in some less fortu today, even when the words used in accounting are these poorer countries, when exports will not cover ports and there is no high-tech know-how to expor ment must borrow money from some other country international agency, in order to cover the differen genuine debts and causes for genuine concern. But of a tradedeficit does not by itself create a crisis in the United States, though political and journalistic turn it into something to alarm the public. In general, international deficits and surpluses tually no correlation with the performance of m economies. Germany and France have had intern surpluses while their unemployment rates were in Japan’s postwar rise to economic prominence on th included years when it ran deficits, as well as year surpluses. The United States was the biggest debtor world during its rise toindustrial supremacy, becam a result of lending money to its European allies du World War, and has been both a debtor and a credi times since.Through it all, the Americanstandard of mained the highest in the world, unaffected by wh creditor or a debtor nation.

International Transfers of Wealth

Deficits and debts are accounting concepts. Whatm nomically is what is done with the resources involved biggest and richest corporations have debts, since they as well as stocks. Prosperous countries likewise attra ments from other countries. When these investment they make both the creditor and the debtor wealthier th This is wholly different from a poor country whi ceived loans from foreigngovernments or internationa precisely because its economic prospects cannot attra ments through the marketplace. As far as accountin cerned, these debts are all the same. But that is why e differs from accounting-and why the facts often diff from what is said in politics and the media.

KINDS OF TRANSFERS

International transfers of wealth take a variety of fo people working abroad send money back to their f home. Companies send investments to other countries if things work out as hoped, they receive profits back f countries. Nations have conquered other nations and t the wealth of the conquered people to the conqueror's c more recent times, some of the wealthier countries hav foreign aid to some of the poorer countries. As with other aspects of economics, the basic prin volved in international movements of wealth are no cated. However, much confusion has been spread ab international transactions as a result of economic illite tics and journalistic hype.

Remittances

Emigrants working in foreign countries often s money to their families to support them. During the n and early twentieth centuries, Italian emigrant men we larly noted for living in terrible conditions and even sk food, in order to send money back totheir families in I

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of the people fleeing the famine in Ireland during th eled across the Atlantic with their fares paid by mem families already living in the United States. In the late twentieth century, there were so ma working in so many countries abroad, and sending that their remittances exceeded all the foreign aid government agencies in the world combined. Most international trade deficit was covered by remittanc istanis working abroad and Jordan received more Jordanians living overseas than it did from allits exp At one time, overseas Chinese living in Malays and other Southeast Asian nations were noted for se back to their families in China. Politicians and jou whipped up hostility against the overseas Chinese that such remittances were impoverishing their cou benefit of China. In reality, the Chinese created many prises -and sometimes whole industries-in the countries. What they were sending back to China wa the wealth they had created and addedto the wealth tries where they were now living. Similar charges were made against the Leba Africa, the Indians and Pakistanis in East Africa,and around the world. The underlying fallacy in each ca ignoring the wealth created by these groups, so that to which they immigrated had more wealth-not less of their being there. Sometimes the hostility gene these groups has led to their leaving these countrie pelled, leading to economic declines after their depa

Imperialism

Genuine plunder of one nation or people by ano all too common throughout human history. Alexan looted the treasures of the conquered Persians. Sp and silver by the ton from the conquered indigeno the Western Hemisphere and forced some of them dig up more. Julius Caesar was one of many Roman c

International Transfers

of Wealth

march in triumph through the eternal city, displaying and slaves he was bringing back fromhis victories abro Although imperialism is one of the ways in which w be transferred from one country to another, there are economic reasons forimperialism which have caused it sisted in, even when it was costing the conquering money on net balance. Militaryleaders may want strate such as the British base at Gibraltar or the America Guantanamo Bay in Cuba. Nineteenth century mi urged the British government toward acquiring contr ous countries in Africa where there was much mission going on-such urgings often being opposed by chan the exchequer, who realized that they would never g money out of these poor countries to repay the costs of ing and maintaining a colonial regimethere. Some private individuals like Cecil Rhodes might Africa, but the costs to the British taxpayers excee Rhodes’ fabulous fortune. In other countries as well, individual or corporate special interests might make conquered lands where the government lost money. even the business interests often lost money in the colo ing the era before the First World War, when Germ colonies in Africa, only 4 of its 22 enterprises with coc tions there paid dividends, as did only 8 of 58 rubber p and only 3 out of 49 diamond mining companies. Most major industrial nations sent only trivial perc their exports or investments to their conquered colon Third Worldand received imports that were similarly tr pared to what these industrial nations produced them purchased as imports from other industrial countrie height of the British Empire in the early twentieth ce British invested more in the United States than in all of Africa put together. Quite simply, there was more we made from rich countries than from poor countries. F reasons, throughout most of the twentieth century th States invested more in Canada than in Asia and Afri gether. Onlythe rise of prosperous Asian industrial nati

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latter part of the twentieth century attracted more vestors to that partof the world. Perhaps the strongest evidence against the econ cance of colonies in the modern world is that Germa lost all their colonies and conquered lands as a resu feat in the Second World War-and both countries precedented levels of prosperity thereafter. A need was a particularly effective political talking poin Japan, which had very few natural resources of its o its dreams of military glory ended with its defeat, bought whatever natural resources it needed from th that hadthem. Imperialism has often caused much suffering am quered peoples. But, in the modern industrial worl perialismhasseldombeen a major source of transfers of wealth. While investors have tended to invest in more p tions, making both themselves and these nations we people have depicted investments in poor countries making the latter even poorer. The Marxian conce tion” was applied internationally in Lenin’s book where investments by industrial nations in non-ind tries were treated as being economically equivalent done by imperialist conquerors. Tragically, howeve cisely those less developed countries where little or vestment has taken place that poverty is at its worst Wealthy individuals in poor countries often in countries, where their money is safer from politic u confiscations. Ironically, poorer countries thus are hel dustrial nations to become still richer. Meanwhile, nomic imperialism depict international investments equivalent of imperialist looting. Underthe influence ries, orin response topopular belief in such theories in poorer countries have often pursued policies whic investments from being made there by foreign inv By the late twentieth century, however, the pain consequences of such policies had become sufficient many people in the Third World that some governme

International Transfers of Wealth

America and India, for example-began moving away policies, in order to gain some of the benefits receive countries whichhad risen frompoverty to prosperity w of foreign investments. Economic realities had fina through ideological beliefs, though generations suffer deprivations before basic economics was finally accep

Foreign Aid

What is called ”foreign aid” are transfers of wealt eign governmental organizations to the government countries. The term “aid” assumes a priori that such tra in fact aid the poorer countries’ economies to develo cases it does, but in other cases foreignaid simply ena isting politicians in power to enrich themselves throug to dispense largess strategically to others who help to in power. Becauseit is a transfer of wealth to governme tinguished from investments in the private sector, for encouraged many countries to set up government prises that have failed. Perhaps the most famous foreign aid program wa shall Plan, which transferred wealth from the Unite various countries in Western Europe after the end of 11. It was far more successful than later attempts to im sending foreign aid to Third World countries. Wester economic distress was caused by the devastations Once the people were fed and the infrastructure rebui Europe simply resumed the industrial way of life whic achieved-indeed, pioneered-before. That was whol from trying to create all the industrial skills that were poorer, non-industrial nations. Even massive and highly visible failures and coun tive results from foreign aid have not stopped its co and expansion. The vast sums of money dispensed by agencies such as the International Monetary Fund and Bank give the officials of these agencies enormous in the governments of poorer countries, regardless of the failure of the programs they suggest or impose as pre

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for receivingthe money. In short, there is no economi to determine which actions, policies, organizations or could survive the weeding out process that takes pl competition in the marketplace. In addition to the ”foreign aid’’ dispensed by i agencies, thereare also direct government-to-govern money, shipments of free food,and loans which are ma on terms more lenientthan those availablein the finan and which are periodically ”forgiven” or allowed tod American governmentloans to the government of Indi government loans to a number of Third World gover been simply cancelled, converting these loans into gift Sometimes a richer country takes overa whole po heavily subsidizes it, as the United States did in M much American aidpoured in that many Micronesian economic activities on which they had supported the fore, such as fishing and farming. If and when the A cide to end such aid, it is not at all certain that th experience that Micronesians once had will remain widespread to allow them to become self-sufficien Beneficial results of foreign aid are more likely cized by the national or international agencies wh these ventures, while failures are more likely to be p critics, so the net effect is not immediately obvious leading development economists of his time, Pro Bauer of the London School of Economics, has argued whole, ”official aid is more likely to retard developm promote it.” Whether that controversial conclusion i rejected, what is more fundamental is that terms like ” not be allowed to insinuate a result which may or m out to be substantiated by factsand analysis.

THE INTERNATIONAL MONETARY SYST

Wealth may be transferred from country to co form of goods and services, but by far the greatest made in the form of money. Just as a stable monetar

International Transfers

of Wealth

tates economic activity within a country, so internat nomic activity is facilitated when there are stable rel between one country's currency and another's. It is no question of the ease or difficultyof translating dollars i francs. It isa far more important question of knowing w investment made in the United States, Japan, or France be repaid a decade or more from now in money of value-whether measured in purchasing power or i rency originallyinvested. Where currencies fluctuate relative to one anothe who engages in any international transactions become lator. Even a tourist who buys souvenirs in Mexic Caribbean cruise willhave to wait until the credit card to discover how much the item they paid 30 pesos fo them in U.S. dollars. It canturn outto be either more o they thought. Where millionsof dollars are invested ov stability of the various currencies is urgently importan portant not simply to those whose money is directly in is important in maintaining the flows of trade and in which affect the material wellbeing of the general pu countries concerned. During the era of the gold standard, which bega down during the First World War and ended during Depression of the 1930s, various nations made their na rencies equivalent to a given amount of gold. An Ame lar, for example,could always be exchanged fora fixed gold from the U. S. government. Both Americans and could exchange their dollars for a given amount of go fore any foreign investor putting his money into the economy knew in advance what he could count on gett his investment worked out. No doubt that had much the vast amount of capital that poured into the United S Europe and helped develop it into the leading indust of the world. Other nations which made their currency redeemab amounts of gold likewise made their economies safer both domestic and foreign investors. Moreover, their were also automatically fixed relativeto the dollar and

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rencies from other countries that used the gold stan bel Prizewinning monetary economist Robert Mu "currencies were just different names for particula gold." During that era, financier J. P. Morgan could s gold, and nothing else." Various attemptsatstabilizinginternational against one another have followed the disappearanc standard. Some nations have made their currencies a fixed number of dollars, for example. VariousEuro have created their own international currency the E Japanese yen has been another stable currency widel international financial transactions. With the spread of electronic transfers of money any national currency's change in reliability can be stantaneous. Any government that is tempted tow knows that money can flee from their economy liter ment. The discipline this imposes is different from posed by a gold standard, but whether it is equally only be known when future economic pressures pu tional monetary system to a real test.

Chapter 21

An Overview

A

lthough the basic economicsof international econo actions is not rocket science, it does take a li thought than some other economic principles. How alone is not enough to explain allthe confusion that rei subject. Peoplewith special interests to protect, or ide sions to which they are committed, find international international wealth movements a fertile field forbam public that has few reasons to pay much attention to in economics. Most Americans' livesare not likely to be changed vious and fundamental way by international trade o tional financial activities. While therearemanyimpo products in the American economy, these are typicall that Americans also make today or have made in th could makein the future, if there were no international There are, however,some important consequences tional economic events that may not be obvious. A noted, the severe tariff restrictions put in place early in Depression of the 1930s have been regarded by many e as needlessly worsening and extending the worldwid sion. The last thing needed when the national incom down is a policy that makes it go down faster, by de sumers the benefits of being able to buy what they w lowest price available. Even in normal times, the losses associated with many goods domestically at higher costs would add u of real purchasing power and the standard of living on it. Virtually all high-quality cameras in America with interchangeable lenses, for example-are impor

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has been decades since such cameras were manufa United States. Many cars, computers, television se products sold in the United States-including some can brand names-are imported. In short, while i trade does not play as large a role in the economy o States as in some other economies, its effects are larger than may be apparent to the general public. Just as trade restrictions such as the Hawley-Sm the 1930s damaged the already ailing economy of t pression, the North American Free Trade Agreem helped enhance the prosperity of the 1990s, creatin and reducing unemployment to record low levels cries of protectionists that NAFTA would lead to a m of jobs from America to low-wage countries elsewh international economic activitiesmatter to American to the same extent as to the peoples of other countr ternational trade is a much larger percentage of their nomic activity. Britain, for example, has not fed itself agriculture in more than a century, so it is heavily d international trade just to have something to eat,qui the many other benefits it receives. Whatever the complications of international eco ties, the fundamental fact in international markets is that in domestic markets: Exchanges continue to tak to the extent that both parties benefit. Opponents of to depict it as harmful and to appeal to a sense of ”them,” as if other countries are in some way makin worse off by selling them things that they want to bu Sometimes this approach is buttressed by claim that foreign country is being ”unfair” in its restriction from the United States. But the sad fact is that all c pose ”unfair” restrictions on imports, usually in resp internal special interests. However, here as elsewher make our choices among alternatives actually ava countries’ restrictions deprive both them and us of benefits of international trade. If we do the same in will deprive both of us of still more benefits. If we away with it,” this will minimize the losses on both s

An Overview

International trade is not a favor we bestow on othe despite laws about giving or withholding "most favore treatment to this or that country in its trade with th States. International trade is not a contest, despite talk a "wins" or "loses"in this trade. Anybody who loses stop The real losses occur when the public allows this kind o to lead them astray from the basic fundamentals of eco International trade is likeanything else that allows g services to be produced more cheaply or better. It be consumers while harming profits and employment am who produce more costly or more obsolete products. the less efficient producer makes no more sense inter than it does domestically. Whatever jobs are saved In e do not represent net savings for the economy as a whole the saving of some jobs by sacrificingothers, along wit ing the consumer. When particular jobs and businesses to more efficientcompetition, whether domestic or inte resources which have alternative uses can go to those a uses and add to the national output. It isnot a zero-sum The transfer of wealth internationally through mar actions allocatesthe resources of the world in much the that such transfers allocate resources domestically. Inb it is like water seeking its own level. If investments wi degree of risk are paying off at a higher rate in Taiwa Sweden, then American or British orGerman capital w Taiwan and not to Sweden,thereby raising the level of p ity in the world as a whole and raising standards of liv nationally. Money and the resources it represents bec were, citizensof the world. Such economic benefits are often not welcome p however. While comparative advantage and free trade nations to share in the world prosperity promoted by f ments of resources, not all industries in all nations pros sectors of particular economies that are unable to match petition in efficiency stand to lose moneyand jobs, and be threatened with bankruptcy. Seldom will they go qu resentatives of industries and regions that stand to los and jobs because of international competition are alm

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to seek restrictionsonimportedgoods or reso threaten their particular wellbeing, however benefic national transactions may be to the population as a w International movements of goods and investm strict the range of options available to particular gov noted in Chapter 16, governments have for centuri wealth from the people to themselves by the simple suing inflationary amounts of money and spendi created money for whatever the government wante With free international movements of wealth-at i speeds with computerized banking-money and they represent tend to be transferred out of countrie ernments are conducting such clandestine confisc economically counterproductive policies tend like domestic wealth to flow out of a country and fore stop coming in. Political leaders have far more control when wea their countries in the form of "foreign aid"-that is, t national or international agencies to governments. T of receiving wealth from abroad via the marketpla quire satisfying foreign investors that a project was ceed and that the local legal and political system could relyon when time came totake their earnings their whole investment out if they wished. Showy projects with only a political pay-off fo ment-a sports stadium, a glitzy plaza, or a nation country without enough passengers to enable it to p can all be financed byforeign aid but are unlikely t by international investors. Moreover, government o more generous with themselves and their followers when it comes to appropriating foreign aid money use, including putting it in Swiss banks. In short, countries with inefficient economies governments are far more likelyto receive foreign a ceive investments from people who are risking thei Put differently, the availability of foreign aid reduces for a country to restrict its investments to econom projects or toreduce its level of corruption. Far mor

An Overview

be available internationally for the economic develop poor country and yet that country’s government may p ceive a smaller amount through foreign aid, since gove ficials themselves benefit more from this smaller am from a larger amount of wealth that would have pre which negatively affect these officials’ wellbeing, even enhance the economic wellbeingof their country as aw An intermediary form of wealth transfer is an in from private sources that is guaranteed by their ow ment, which stands ready to reimburse them with money should their overseas investment prove unpro the profits uncollectible. Thus when the Mexican go was on the verge of defaulting on its loans from Amer in 1986, the American government lent them the money these banks and other investors. Obviously ,if these been forced to take huge losses, they would have bec wary of risky investments in the future and in other co we have seen in other contexts, lossesplay as importan the economy as profits, though they are not nearly as po tificially preventing losses is reducing incentives to a sources efficiently.

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Part VII: POPULAR ECONOMIC FALLACIES

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Chapter 22

“Non-Economic” Value

N

ow that you know some of the basics of econom be much easier to see through some popular no sound good but will not stand up under scrutiny. Th chapters contain just a sampling of such notions. One of the last refuges of someone whose pet proj ory has been exposedas economic nonsense is to say: is all very well, but there are also non-economic valu sider.” Presumably, these are supposed to be higher a concerns that soar above the level of crass materialism. Of course there are non-economic values. In fact, only non-economic values. Economics is not a value in self. It is onlya way of weighing one value against ano nomics does not say that you should make the most possible. Many professors of economics could themsel more money in private industry. Anyone with a kno firearms could probably make moremoney working as for organized crime. But economics does not urge yo such choices. Adam Smith, the father of laissez-faire economics,g substantial sums of his own money to less fortuna though he did so with such discretion that this fact w ered only after his death, when his personal records w ined. Henry Thornton, one of the great monetary eco the nineteenth century, regularly gave away more tha annual income before he married and had a family t though he continued to give large donations to hum causes afterwards. What lofty talk about ”non-economic values” usu down to is that some people do not want their own

.S

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values weighed against anything. If they are for s Lake or preserving some historic building, then they that weighed against the cost-which is tosay, ultim all the other things that might be done instead with sources. For such people, there is no point considering Third World children could be vaccinated against f with the money that is spent saving Mono Lake or historic building. We should vaccinate those child Mono Lake and preserve the historic building-as we innumerable other good things, according to this w at the world. To people who think (or rather, react economics is at best a nuisance that stands in the w what they have their hearts set on doing. At worst, seen as a needlessly narrow,if not morally warped, ing at the world. Such condemnations of economics are due to the fact that economics is the study of the useof scarce re have alternative uses. We might all be happier in a there wereno such constraints to force us into choicesa that we would rather not face. Butthat is not theworl beings live in-r have ever lived in,during thousan recorded history. In the world that people live in, and live in for centuries to come, trade-offs are inescapa refuse to make a choice, circumstances will make ch we run out of many important things that we could only we had taken the trouble to weigh alternativ Lofty talk about ”non-economic values” too ofte very selfish attempts to impose one’s own values, wi to weigh them against other people’s values. Taxin other people have earned, in order to finance one’s o ventures, is often depicted as a humanitarian endea lowing others the same freedom and dignity as on they can make their own choices with their own ear sidered to be pandering to ”greed.” Greed for pow dangerous than greed for money, and has shed far m the process. Political authorities have often had ”n values’’ that were devastating to the general populat

“Non-Economic” Values SAVING LIVES

Perhaps the strongest arguments for ”non-econom are those involving human lives. Many highly costly cies, or devicesdesigned to safeguard the public from ards are defended on grounds that ”if it saves just o life” it is worth whatever it costs. Powerful as the mora tional appeal of such pronouncements may be, theyca stand scrutiny in a world where scarce resourceshave uses. One of those alternative uses is saving other hum other ways. Few things have saved as many lives as growth of wealth. An earthquake powerful enough dozen people in California will kill hundreds of peop less affluent country and thousands in a Third Wo Greater wealth enables California buildings, bridges, structures to bebuilt to withstand far greaterstresses th structures can withstand in poorer countries. Those in earthquake in California can berushed more quickly elaborately equipped hospitals with larger numbers highly trained medical personnel. This is just one of innumerable ways in which we lives. Therehave been various calculations of how mu in national income saves how many lives. Whatever figure-X million dollars to save one life-anything tha national income fromrising that much has, in effect, c some particular safety law, policy, or device costs 5X m lars, either directly orin its inhibiting effect on econom then it can no longer be said to be worthit “if it saves ju man life” because it does so at the cost of 5 other hu There is no escaping trade-offs, so long as resources and have alternative uses.

THE MARKET

The very language in which many issues are discu the way to confusing economicswith some materialist

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pation that violates human considerations. Many ec others speak of ”the market” as a shorthand way of r set of conditions in which individuals make their ow light of their own respective values. But this languag who hear it to imagine that ”the market” is some im amoral idol, on whose altar we are sacrificing moral concerns. In reality, the market i s merely a mechan which millions of human beings express their own and values, rather than have some elite with politic pose that elite’s preferencesand values on all. Once we realize that scarcity and trade-offs are the only questions remaining are who is to make tho and through what mechanisms. Individual freedom, and prices add up to what is loosely called “the mar market is not a thing located at a place. Marketsin th simple-minded sense have existed even inCommun What distinguishes ”the market” as economists use (1)individual free choiceand ( 2 ) the guidance provid which result from millionsof people interacting with as they exercise that free choice. To say ”the marke only tosay that these millionsof people decide,inste others’ decisionsimposed on them. Like economics, not some separate entity with its own values. It is p their own choices.

”UNMET NEEDS”

One of the most common-and certainly one of t found-misconceptions of economics involves ”un Politicians, journalists, and academicians are almost pointing out unmet needs in our society that should by some program or other. Mostof these arethings th wish our society had more of. What is wrong with that? Let us go back to squar nomics is the study of the use of scarce resources w ternative uses, then it follows that there will alwa

“Non-Economic” Values

needs. Some particular desires can be singled out an percent, but that only means that other desires will be unfulfilled than they are now. Anyone who has driven in most big cities will un feel that there is an unmet need for more parking sp while it is both economically and technologically p build cities in such a way as tohave a parking space av anyone who wants one, anywhere in the city at any h day or night, does it follow that we should do it? The cost of building vast new underground parkin or of tearing down existing buildings to create parkin above ground, or of designing new cities with fewer and more parking lots, would all be astronomical. W things are we prepared to give up, in order to have thi tive heaven? Fewer hospitals? Less police protection? departments? Are we prepared to put up with even more unme these areas? Maybe some would give up public libraries have more places to park. But, whatever choices are m e t needs however itis done, there will still be more as a result of meeting an m e t need for moreparking sp We may differ among ourselves as to what is wort ing in order to have more of something else. The poi more fundamental: Merely demonstrating an unmet n sufficient to say that it should be met-not when reso scarce and have alternative uses. What might appear to be cheaper, when measure government expenditures, would be to restrict or forb of private automobiles in cities, adjusting the number the number of parking spaces, instead of vice-versa. Bu ing in government expenditures would have to be against the vast private expenditures currently devo purchase, maintenance, and parking of automobiles in viously these expenditures would not have been unde the first place if those who paythese prices (as well as t personal aggravation that go with driving in a city) di the benefits tobe worth it to them.

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To go back to square one again, costs are foregone not government expenditures. Forcing thousands forego opportunities for which they have willingl amounts is a cost that may outweigh the savings fro to build more parking spaces or do the other things accommodate carsin cities. None of this says that we more or fewer parking spaces in cities. What it sa way this issue-and many others-is presented ma in a world of scarce resources which have alternative a world of trade-offs, not solutions-and whatever tr cided upon will still leave unmet needs. So long as we respond gullibly to political rhet met needs, we will arbitrarily choose to shift resou ever the featured unmet need of the day happensto from other things. Then, when another politicianeven the same politician at a later time-discovers Peter to pay Paul has left Paul worse off, and want meet his unmet needs, we will start shifting resourc direction. In short, we will be like a dog chasing his ting no closer, no matter how fast he runs. This is not to say that we have the ideal trade-off should leave them alone. Rather, it says that whate we make should be seen from theoutset as trade-off ing unmet needs. The very word "needs" arbitrarily puts some higher plane than others, as categorically more im however urgent it may be to have some food and wat sustain life itself, nevertheless-beyond some poi come not only unnecessary but even counterproduc gerous. Widespread obesity among Americans sho has already reached that point and anyone who has ravages of flood (evenif it is onlya flooded basemen water can reach that point as well. Inshort, even the needs remain needs only within a given range. W half an hour withoutoxygen but even oxygen beyo centration level can promote the growth of cancer known to make newborn babies blind for life. Ther why hospitals do not use oxygentanks willy-nilly.

“‘Non-Economic” Values

In short, nothing is a ”need” categorically, regardle urgent it may beto have at particular times and places a ticular amounts. Unfortunately, most laws and governm cies apply categorically, if only because of the dangers every official to becomea petty despotin interpreting w laws and policies meanand when they should apply. In text, calling something a ”need” categorically is playing Many complaints that some basically good governme has been applied stupidly may fail to address the u problem of categorical laws in an incremental world. T not have been any intelligent way to apply categoricall designed to meet desires whose benefits vary incremen ultimately cease to be benefits. By its very nature, as a study of the use of scarce which have alternative uses, economics is about inc trade-offs-not about ”needs” or ”solutions.” That ma economistshaveneverbeen as popular aspoliticia promise to solve our problems and meet our needs.

WHAT IS “WASTE”?

Although efficiency is what economics is all about, many falsenotions as to what constitutes ”efficiency.” S that it can be reduced to output per man-hour or to m per gallon or larger crops per acre. Itcannot. Efficiency is inescapably bound up with whatpeop and at whatcost. Even an apparently scientific questio efficiency of an automobile engine rests ultimately on want the car to do. Otherwise, all automobile engines ar cent efficient, in the sense that all the energy they get fr used, whether in moving the car forward, overcomin friction in the engine, shaking the car body randomly, g heat that is radiated out intothe air, etc. Itis only after y what you want as moving the car forward that the eff different engines can be compared in terms of what perc their power is used for that particular purpose.

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ECONOMICS

BASIC

When a third party defines efficiency forother pe ten conflicts with what those other people prefer in dividually differing circumstances. For example, th many laments about Americans using gasoline i ways during the 1980s and 1990s, as contrasted wi "fuel-efficient" behavior in the 1970s.But the re change was that the real price of gasoline was lowe and 1990s, reflectinglarge increases in both the imm and the known reserves of petroleum in the world were responding to the changing realities convey rather than to the fashionable but unproven alarms words in the media and in politics. During the 1970s, an international oil cartel-the tion of Petroleum Exporting Countries (OPEC)-deli back on petroleum production, disrupting economi world. In the United States, government price cont minor adjustment into a major shortage. By the 19 coveries of petroleum deposits and the weakening cartel had the world awash in oil, with the real pric hitting all-time lows. It is not wasteful to increase one's use of resour become more abundant. That is precisely what is happen in a price-coordinated economy because tha efficient behavior, with efficiency defined as the m way of satisfying people's desires. Waste is no more objectively definable than its o ciency. The arbitrary assumption that it is serves on parties impose their definitions on other people, w would not be doing the things that observers define they themselvesdid not see matters differently. Some consider it a "waste" not to recycle alum newspapers, but studieshave shown that recycling resources than it saves. About 10 percent of the entir Earth consists of aluminum, and the trees that new made from automatically recycled themselves for years before human being figured out how to plant s were a genuine threat of running outof aluminum, i would reflect that future scarcity through the me

““Non-Economic”Values

”present value” discussed in Chapter 12, and people wo matically find it financially worthwhile to recycle a cans. The factthat it is not financially worthwhile refle derlying reality that is very different from the fashiona ria behind public exhortations and politically-imposed

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Chapter 23

Prices and Purchasing Power

T

here seem to bealmost as many fallacies about pric are prices. For example, it is common to hear that thing is sold at very different prices by different sell this can happen, usually this involves defining thing “the same” when they are not. Other fallacies include that ”greedy” sellers are responsible for rising pric ”predatory” businesses destroy competition by selling b and bankrupting their rivals, so that they can then rais monopolistic levels afterward. While these are only a s ple, lookingat them closely may illustrate how easy it i a plausible-sounding fallacy and get it accepted by ma wise intelligent people, who simply do not bother to the logic orthe evidence.

DIFFERENT PRICES FOR THE “SAME” THIN

Physically identical things are often sold for differ usually because of accompanying conditions that are qu ent. As noted in Chapter 6, two airline passengers sitti side in the same plane may have paid very different far one bought a guaranteed reservation, while the othe standby who got on board when there happened to available. What they really bought were two very diffe abilities of getting on board that plane. Only in retro they end up with the same thing-but people do not ac spect. As of the time they acted, they bought very

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things. Similarly, someone who wins an automobi lottery ticket can end up with the same car for wh else paid $20,000. But one bought a low probability car and the other bought a virtual certainty. The ca up with may be the same but whatthey bought was The Post Office has run a massive advertisin claiming that its two-day delivery service, Priorit much less than the competing two-day delivery ser eral Express or United Parcel Service. Theonly prob claim is that almost all Federal Express or UPStwoactually get delivered in two days, while little mo third of the long-distance Priority Mail arrives in other words, the more expensive service is more re was why it is more expensive. The Post Officeads w ing apples and oranges. It is also possible to be comparing apples and o the products themselves are in fact physically ide times different brands of the same goods or service to differ only by brand name and brands in gen thought to serve no useful purpose. Both these spec deserve closer attention.

"identical Products I’

Discount stores often sell the same camera for than a camera store charges. But the people in a cam usually more knowledgeableabout photography tha work in discount stores, and more knowledgeable p have higher salaries that have to be paid out of higher era storesusually also have a larger inventory of diff and accessories, and larger inventories of merchandis just as a larger inventory of knowledge has a cost. The value of these higher-cost features varies wit lar customer and that customer’s own knowledge This becomespainfully apparent whensomeone wh a new camera has trouble operating it and goes bac to get advice on how to use it. If the clerk in a discou not know enough to solve the customer’s problem

Purchasing and Prices

Power

camera may turn out tobe no bargain, after all. Moreo discount-house customer then goes toa camera store sa seek advice, he may find the salesman less than wholl thetic tosome other store’s customer. Another way in which the accompanying knowledg tegral part of the value of the physical product is in m initial choice of camera. If a camera store sells a particu and model of camera for $300 and the discount house $280, it may still pay to go to the camera store wher make and model of camera is available for $250 that d you want to do just as well or better. The more expensi may have features that mean nothing to you but is no b perhaps not as good, for the kinds of pictures you want the camera store’slarger selection and more knowledge staff enables you to buy only what meets your own ne may be financialsavings there, as well as better advice o ing the camera, even if the discount house charges a lo for each particular camera that both stores carry. On the other hand, if the customer happens to be ve edgeable about photography, then it may be unnecessa sult the sales staff at either store, whether in making a se in knowing how to use the camera. In that case, buying count house can mean real savings. Similarly, if the cam bought is so simple that anybody can figure it out, the no need to pay for expertise that is not needed. Appare people do not feel the need to buy cameras from a cam More than half buy them from discount houses and a percent buy them from mailorder houses. The point here is not to claimthat it is generally bett erally worse to buy cameras at a camera store or at a house. Instead, the point is that what is being sold in places is not the same, even when the cameras thems physically identical. The stores are charging different cause they are supplying different things which have costs tothe seller, as well as to the buyer. Other products in other stores may also be physica cal and yet sell for different prices reflecting differe ing circumstances. Groceries are likely to cost more in

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community, hundred of miles from the supplier’s w in a high-crime neighborhood, where the cost of i armed guards, as well as higher rates of shopliftin ism, have to be recovered fromthe prices charged th Goods sold in attractively decorated stores with sophisticated sales staffs,as well as easy return polic to cost more than the physically identical products s warehouse store with a no-refund policy. Christma bought for much lower prices on December 26th th ber 16th, even though the cards are physically iden they were when they were in great demand before C Mistakes or miscalculations may sometimes ca thing to be sold for different prices under compara temporarily, but competition usually makes this a nomenon. When customers go where prices are whose prices are higher have little choice but to low if they are not offering some offsetting advantages a same physical product. Where there are permane prices for things that are truly the same, the highe usually ends up going out of business.

Brand Names

Brand names are another way of economizi knowledge. When you drive into a town you have n fore and want to get some gasoline for your car o burger, youhave no direct way of knowing what is i that some stranger at the filling station is putting int what is in the hamburger that another stranger is co to eat at a roadside stand that you have never seen the filling station’s sign says Chevron and the res says McDonald’s, then you don’t worry about it. something terrible happens, you can sue a multicorporation. You know it, the corporation knows it, dealer knows it. That is what reduces the likeliho thing terrible will happen. On the other hand, imagine if you pull into a no station in some little town and the stranger there pu

Power Purchasing and Prices

into your tank that messes up your engine or-worse yeteat a no-name hamburger that sends you to the hosp chance of suing the local dealer business owner success haps before a jury of his friends and neighbors) may be ably less. Moreover, even if you should win, the c collecting enough money to compensate you for all you have been through is more remote. Brand names are not guarantees. But they do r range of uncertainty. If a hotel sign says Hyatt Regenc are you will not have to worry about whether the bed your room were changed since the last person slept th camera you buy is a Leica, it is unlikely to jam up the you wind the film. Evenif you stop at a dingy and run tle store in a strange town, you are not afraid to drink a sell you, if it is a bottle or canof Coca Cola or Seven-U however, if the owner of this unsavory little place mi soda at his own soda fountain. Would you have the sa dence in drinking it? Like everything else in the economy, brand names benefits and costs. A hotel with a Hyatt Regency sign o likely to charge you more for the same size and quality and accompanying service, than you would pay for things in some locally-run independent hotel if you kne look. Someone who regularly stops in this town on bus might well find a locally-run hotel that is a better deal. rational for you to look for a brand name when passin for the first time as it is for the regular traveller to go knows he can getthe same things for less. Since brand names are a substitute for specific kn how valuable they are depends on how much knowled ready have about the particular product or service. So is very knowledgeableabout photography might be ab bargain on an off-brand camera or lens, or even a sec camera or lens. But that same person might be well a stick to wellknown brands of new stereo equipment, if h edge in that field falls farshort of his expertise in photog Many critics of brand names argue that the main br all alike.’’ Even when that is so, the brand names still

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valuable function. All the brands may be better tha have to be if the product were sold under anonymo labels. Both Kodak and Fuji film have to be bette would have to be if boxes simply said ”Film,” witho ence to the manufacturer. But, when film is sold names on the boxes, Kodakknows that it will lose lars in sales if it falls behind Fuji in quality and Fuji will lose millionsif it falls behind Kodak. Even when the various brands of a product are same formula by law, as with aspirin, quality contro when each producer of each bottle of aspirin is id when the producer is anonymous. Moreover, the brand has the most to lose if some impurity gets in during production and causes anyone injury ordeath cially important with foods and medicines. McDon has to meet thestandards set by the government,it h standards set by the competition of Wendy’s and B Campbell’s soup were identified on the label only ”Tomato Soup,” ”Clam Chowder,” etc), the pressures soup producers to maintainboth safety and quality w One of the A & P grocery chain’s big advantag heyday was that it produced many items itself and s der its own brand name. This not only saved A amounts of advertising money usually needed to product known and accepted by the public, it saved the costs associated with the use of one of its mo sources, knowledge. Consumers were able to rely and unknownproduct simply because it had anA & For example, A & P itself baked much of the bre stores-half a billion loaves a year. Whilethis bread on faith by the public, if A & P had taken advantage o sell low-quality bread made with cheaper ingredie not only have lost sales of bread after the public di its trust was misplaced, the value of A & P’s brand n products would also have been tarnished-and man dollars lost as a result. Most consumers have no k what it takes to make a good loaf of bread, but A & brand name gave it an incentive to use its knowle

Purchasing Power and Prices

Thus the knowledge of the few served the interest of th a result of brand names and a competitive market eco countries where there are no brand names, or where th producer created orauthorized by the government, the the product or service tends to be notoriously low. D days of the Soviet Union, the country’s only airline, A came the epitome of bad service and rudeness to passe ter the dissolution of the Soviet Union, a new privately airline began to have great success, in part because its p appreciated being treated like human beings for a ch management of the new airline declared that its employ icy was that it would not hire anyone who had ever w Aeroflot. Similarly,one of the reasons for the great succ Donald’s in Moscow-the largest McDonald’s in the w lines of people waiting to get into it-is that it was b pared to the previous bad quality of service in Soviet re not to Wendy’s or Burger King. Competition in the marketplace affects not only quality. Brandnames make the competitors responsible

VOLITIONAL PRICING

High prices are often blamed on the ”greed” of se they can set prices by an act of will. In some trivial s can. Any of us can set the price of his own labor at a m lars a year, but that will not make us millionaires. Ob doesn’t matter what we charge, unless others to agree That is not likely to happen in a world ruled by suppl mand, except forindividuals whose rare talents cause t in huge demand andin very short supply. ”Greed” is seldom even defined. Virtually everyo prefer to geta higher price for what he sells and paya lo for what he buys. Would you pay a dollar for a newsp was available for fiftycents? Or offer towork for half o employer was willing to pay you? Would adding a strin to prices or salaries change the principle or the def greed? It ishard to see why it should.

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But, if everybody is greedy, then the word is vi ingless. If it refers to people who desire far more mon others would aspire to, then the history of most gr fortunes-Ford, Rockefeller, Carnegie, etc.-sugge way to amass vast amounts of wealth is tofigure ou provide goods and services at lower prices, not highe Richard Sears was ferociously determined to ov gomery Ward and worked tirelessly for incredible that end,taking risks that bordered on the reckless. H every way of cutting costs, so that he could unde prices, and every way of attracting customers away f vals. He did all this, not because he did not have en to live on, but because he wanted more. If that is ou ”greed,” then he was greedy. More important, in t many others, it was precisely greed that led to lowe was how Sears overtook Montgomery Ward and rep leading retailer in the country at the beginning of century. In later years, that is how Wal-Mart overtoo When prices go up, it is far more likely to be d and demand than to greed. In most cases, the onl which a business can move and maintain its price will is down-and they can do this only if they hav bring their costs done to a level that enables them to at these lower prices. To force prices up by an act o low rivals to undersell you and take away your cust If it is greed to want vast amounts of money, th tive is far more readily reached through low price market. Today, Wal-Mart makes far more millions profits than stores that cater to the rich. There is p snooty upscale restaurant anywhere that makes money that McDonald’s brings in every year fro 25,000 outlets around the world. Each individual rich person, by definition, has than average, but they are so overwhelmingly out people who are not rich that more money is usually a mass market. There is a reason why advertisers money to run their commercials during broadca Bowls than during broadcasts of operas or ballets. A

Power Purchasing and Prices

opera or ballet may average higher incomes than foo but the big money is to be made selling to football fa because thereare so many of them. As noted in chapter 4, no company would ever go b it could simply raise its prices to cover whatever to be.In reality, far more businessesgo belly up than su should be the decisive evidence against volitional pri

”PREDATORY” PRICING

One of the popular fallacies that has become part of tion of anti-trust law is ”predatory pricing.’’ Accord theory, a big company that is out to eliminate its smalle tors and take overtheir share of the market will loweri a level that dooms the competitor to unsustainable l forces it out of business. Then, having acquired a mo position, it will raiseits prices-not just to the previous to new and higher levels in keeping with its new mo position. Thus, it recoups its losses and enjoys abo profits thereafter, at the expense of the consumers. One of the most remarkable things about this the those who advocate it seldom provide concrete examp it actually happened. Perhaps even more remarkable, not had to do so, even in courts of law, in anti-trust cas Both the A & P grocery chain in the 1940s and the Corporation in the 1990s have been accused of pursu practice in anti-trust cases, but without a single exam process having gone to completion. Instead, their cu prices (in the case of A & P) and the inclusion of a fre browser in Windows software (in the case of Micro been interpreted as directed toward that end-though actually having achieved it. Since it is impossible topro tive, the accused company cannot disprove that it is such a goal, and the issue simply becomes a question o those who hear the charge choose to believe it. At one time, it was claimed that the Standard Oil gained its dominant position in the petroleum industr

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Later scholarly research, however, discredited even ample. Yet the theory has continued to be advocate crete examples being neither asked nor given. But than just a theory without evidence. It isa fallacy in no economic sense. A company that sustains losses by selling below out a competitor is following a very risky strategy. it can be sure of is losing money initially. Whether it cover enough extra profits to make the gamble pay o run is problematical. Whether it can do so and esc trust laws is even more problematical-and these law millions of dollars in fines and/or the dismembe company. But, even if our would-be predator manag to overcomethese problems, it is by no means clear t ing existing competitors will mean eliminating comp Even when a rival firm has been forced into ba physical equipment and the skills of the people who viable do not vanish into thin air. A new entreprene along and acquire both-perhaps at low distress sa abling the new competitor to have lower costs than hence bea more dangerous rival. As an illustration of what can happen, back in 19 ilzgton Post went bankrupt, though not because of pr ing. However, thisbankruptcydidnotcausetheprinti equipment, the building, or the reporters to disapp acquired by publisher Eugene Meyer,at a price that one-fifth of what he hadbid unsuccessfully forthe s per just four years earlier. In the decades that foll new ownership and management, The Washington become the largest newspaper in the nation’s capita vals disappeared one by one, until it was the only m per in town in 1978. Bankruptcy can eliminate particular owners an but it does not eliminate competition in the form of who may either take over an existing bankrupt enter their own new business from scratch in the same i fallacy of ”predatory pricing’’ includes another fall ing existing competitors with competition. Competi

Prices and Purchasing Power

dition in the market in which there is no way to keep who wish to enter an industry. Even elimination of competitors will not destroy competition, if the result profits of the surviving monopoly attract new competi

PURCHASING POWER

Some of the oldest fallacies in economics-refuted b mists more than two centuries ago-revolve around there will not be enough ”purchasing power” to buy a and growing array of things being produced. And, if it ble to sell everything that it being produced, it will l impossible to keepthe workers fully employed. Government social programs or even the building bases are often proclaimed by politicians to be add country’s purchasing power, when in fact they are sim fervilzg purchasing power from taxpayers, with no net i the economy as a whole. Sometimes it is even claime government money spent ”multiplies” its economic ef ing spent and re-spent again and again as it circulates t community. But if that same money had not been take taxpayers, it would have been spent and re-spent s else. Similarly, if private businesses had used that sa for investment, it would have been re-spent bythose f the investors bought machinery or desks or whateve might buy. At various times it has been thought that people wh depriving the economy of purchasing power and thus ing other people’s jobs.But money that is saved does into thin air. It is lent out by banks and other financ tions, being spent by different people for different pur still remaining just as much a part of purchasing pow had never been saved. Some have argued that workers do not receive eno ”buy back” what they have produced, while the weal do not spend all of their income, leavinga gap betwee of total output and the purchasing power available to b

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as already noted, moneythat is saved and invested is purchasing power as money that is spent for consum this was argued out in the early nineteenth century, in over what became known as Say’s Law-that supp own demand. Yet the idea that purchasing power is d capitalism has never completely died out, despite b both theoretically and empirically by economists ce In the crudest form of the purchasing power falla mous increase in output resulting fromthe industrial r many in the eighteenth and nineteenth centuries to the economy could possibly absorb such unprecede and growing production. What would happen when of human beings had been met, as seemed imminent t time, and the machines and workers kept producing m As history unfolded, this proved to be one of man lems with which imaginative members of the intelli managed to torture themselves, and alarm others, o turies. (Declining IQs,exhaustion of natural resource lation, and global warming are others) The satin desires, which some feared in the early nineteenth seems remote today, even though we have an abund things as refrigerators, computers, and television se not even dreamed of then. More is involved herethan the simple fact that th was feared never materialized. Ingenious alarmists gue that the disaster they foretold has merely been ”p good fortune that cannot last forever.In short, the em ment against a failure of purchasing power is not en must be understood is why such a theory is invalid What a group of French economists known as showed in the late eighteenth century was that the p goods and services automatically generates the purch needed to buy those goods and services. When the e ates another hundred million dollars worth of outpu another hundred million dollars worth of wealth tha to buy this or other output. Production is ultimately other production, using money as a convenience to transactions.

Prices and Purchasing Power

At any given moment, there may be too many belt to sell at prices that will cover the costs of making th producers will lose money and therefore be forced t production, hiring fewer workers as a result. But, a Chapter 15, it is a fallacy to assume that what is true f the national economy is necessarilytrue for the whole. resources are scarce and have alternative uses, the fac are being wasted in one sector only means that there sectors that could put those same resources tobetter us Business lossesand unemployment in the sectors th ducing output that is worth less than its cost of prod precisely what causes these resources to be transferre sectors. It is the assumption that the overproduction particular sectors can also be found in the economy that is the fallacy of composition. One of the things that has lent an appearance of pla theories of "overproduction" or a deficiency of purchas has been a recurrence of periods of economic downtu as recessions or depressions. During the Great Depres 1930s, for example, there was a massive increase of u ment, along with business losses forthe economy as a greatly reduced money supply of 1932 was incapable the amount of output that hadbeen produced during years that ended in 1929. More precisely,the 1932 mon was incapable of buying the 1929 level of output at 2 Prices began declining as a result of unsold goods, but not fall fast enough or far enough to restore immediat production needed to createfull employment. Major malfunctions of the monetary system, incl massive bank failures and counterproductive policies eral Reserve Board, as well as restrictive tariffsthat di ternational trade, and amateurish tinkering with the e both the Hoover and Roosevelt administrations, turn lem into a catastrophe. In this situation, Keynesian emerged to re-introducetheories of insufficient p power, though in a more sophisticated form. John Maynard Keynes argued that government could put more money back into circulation and restor

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omy to full employment faster than by waiting for into balance with the reduced amount of money in But Keynes never claimed that the economy had ju too much. Nor isthere any reason to believe that he been surprised to see several times ashigh a level of put selling with no problemsin later years. Whatever the merits or demerits of Keynesian which once reignedsupreme but wasfading fast byt twentieth century, discussions of purchasing powe and in the media have been far cruder than anyth Keynes himself. For example,President Herbert Hoo Franklin D. Roosevelt both tried to keep wage rates as a means of maintaining the purchasing power of well as for humanitarian reasons. But there was no employing the same number of workers as before, wage rates as before, when the money supply was smaller. Similar government attempts to keep part up, both in agriculture and in industry, ignored the fa had to comedown in the economy asa whole if every be purchased with a smaller money supply. Scary as it may seem, neither president understoo basic economics. Moreover, itdid not just seem scar because the livelihoods of millions of Americans we many suffered disastrously. Although some have tr FDR as the man whogot us out of the Great Depress ous depressions had endedmuch sooner, without an ernment intervention. This was in fact the first de which the federal government intervened so much Hoover and then even moreso under Roosevelt. Some economists,including Nobel Prize winner M man, have argued that it was precisely government kept the economy from recovering as quickly as it when left alone.

Chapter 24

Business and Labor

T

hose who favor government intervention in the ec ten depict those who prefer free competition as pr apologists. This has been profoundly wrong for at lea turies. Adam Smith, the eighteenth-century father of fr economics, was so scathingly critical of businessm would be impossible to find a single favorable referen in his 900-page classic, The Wealth of Nations.1 Inste warned against ”the clamour and sophistry of merc manufacturers,” whom he characterized as people ”w meet together,even for merriment and diversion, but t sation ends in a conspiracy against the public, or in trivance to raise prices.” Any suggestions about laws a coming from such people, he said, ought to be ”caref ined, not only with the most scrupulous, but withthe m cious attention.” In the nineteenth century,the next great classical e the free-markettradition, David Ricardo, spoke of busin ”notoriously ignorant of the most obvious principles”o ics. Knowinghow to run a business is not the same as u ing the larger and very different issues involvedin und how the economy as a whole affects the population a Skepticism about the business communityhas remained tradition of free-market economiststhroughout the twe tury as well, with Milton Friedman’s views being very those of Adam Smithon this point.

a

1When I taught economics, I used to offer togive an A to any studentw favorable reference tobusinessmen in The W e d f hofNutions. None ever did

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Free market competition has often been opposed ness community, from Adam Smith’s time to our business interests which promoted the pervasive po ernment intervention known as ”mercantilism” in before Smith and others made the case for ending s tion and establishing free markets. After free market principles gained wider acce nineteenth and twentieth centuries, business leade course prepared to invoke those principles for poli whenever it suited their particular purposes of the business leaders and organizations have proven eq to seek government intervention to keep out foreign bail out failing corporations and banks, and receiv dollars in agricultural subsidies, ostensibly for the s family farms, but in reality going disproportionately rations. When President Richard Nixon imposed th time wage and price controls in 1971, he was public the chairman of General Motors,and cooperation wi cies was urged by the National Association of Manu the U. S. Chamber of Commerce. Businesses them pushed for laws making it harder for outside inve over a corporation and replace its management. Bus are not wedded to a free market philosophy or any o phy. They promote their own self-interest any way t like other special interest groups. Economists and ot in fact supporters of the free market have known th far backas Adam Smith. As noted in earlier chapters, the efficient uses sources by the economy as a whole depends on a sys tures both profits and losses. Businessesare intereste profit half. If they can avoid losses by getting gover dies, tariffs and restrictions against imports, or dome stifle competition in various agricultural products, so. Losses, however, are essential to the process t sources to those who are providing what consumer lowest prices-and away from those who are not. The American computer industry is a classic exa period of more than a decade, the prices of compu

Business and Labor

clined byan average of more than 30 percent nnnually. M the advances in computer chip design have led ato30 nual increase in the power to process millionsof pieces tion per second. Yet, during this incredible era of prog computer companies have operated at huge losses, w have profited greatly. Data General lost$59 million do year, UNISYS lost $436 million and IBM lost $18 bill years. Resources were shifting toother firms that were more of what the consumers wanted at lower prices. S these changes isthat Microsoft’s Bill Gates, once just as tor toIBM, became the richestman in America whileIB ing billionsof dollars and laying off more than 100,000 e It was all part of the same process. Much the same story could be told of the airline in tween the last yearof federal regulationin 1977 and tw later in 1997, the average air fare dropped by 40 percent erage percentageof seats filledon planes rose from 56 pe percent, while more passengers than ever were carried than ever. Meanwhile, whole airlines went bankrupt. Th cost of greater efficiency. It has been estimated that,dur of federal regulation, government interventionin the m caused costs and fares to be up to 50 percent higher would have been in a free market. When the protectio regulation was removed, those airlines which could n with lower faresand rising fuel costswent out of busine Even people who understand the need for compe for both profits and losses, nevertheless often insist tha be ”fair” competition. But this is a slippery word that almost anything. For many years, there were federal “ laws designed to prevent chain stores from selling m below list price and thus driving smaller sellers out o With international trade likewise, there are those wh they are for freetrade, provided that it is ”fair” trade. H means artificiallykeeping prices higher than they woul absence of government intervention, so that compa higher costs of doing business can survive. Like disc fairness in other contexts besides economics, this kind ing ignores the costs imposed on third parties-in th

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consumers whospay needlessly high prices to keep businesses using scarce resourceswhich have alterna Businesses are often praised for what they do w nounced for what they do best. The greatest contrib business makes to the economy and the society is i the most goods with the least resources,including lab ing will get a corporation denounced more widely th workers. On the other hand, nothing gets more publi business’ giving away the stockholders’ money to causes, many of which undermine the free market an ciety on which business itself depends. Some people consider it a valid criticism of corp they are ”just in business to makeprofits.” By this kin ing, workers are just working to earn their pay. In however, they produce all the things that give their fe cans the highest standard of living in the world. Wh not the motivation but the results. In the case of busin question is: Whatare the preconditions for earning a p One precondition is that profit-seeking corpora squander scarce resourcesthe way Soviet enterprises rations operating in a market economy have to pay fo puts-whether labor, raw materials, or electricity-and to pay as much as others are willing to bid for them have to selltheir own end product-at a price as low petitors are charging. If they fail to do this, they fa profit. And if they keep on failing to makea profit, eit agement will be replaced or the whole business will by some competitor who is more efficient. Sometimes the charge is made that profits are sho with the implication that they come at the expense of considerations. But future values are reflected in the p of a business’ assets. A factory that runs full blast tom today, while neglecting the maintenance and repair o ery will immediately see a decline in the value of its p of its stockholders’ stock. It is in the absence of a pr economy that there are few incentives to maintain productivity of an industrial enterprise or a collectiv the Soviet Union. What happens to the enterprise afte

Business and Labor

management’s tenure is over isof little concern in a sys there are no profits and no present values to influence The case fora free market is not that it benefits bu that it benefits consumers. It is a sad commentary on when that case is not debated on its own merits, but i motives of those who make that case are impugned an presumed to be agents or apologists for business int are in fact oftenopposed to freemarkets.

NON-PROFIT ORGANIZATIONS

We have seen that the role of profit-seeking busine ter understood when they are recognized as profit-and nesses, with all thepressures and incentives createdby potentialities. By the same token, what are called ”non ganizations” can bebetter understood when they are se profit a d non-loss institutions-that is, institutions whi free of the constraints of a bottom line. This does not mean that they have unlimited mon mean that, with whatever money they do have, non-p nizations are under very little pressure to achieve th tional goals tothe maximum extent possible with the r their disposal. Those who supply those resources in general public, who cannot closelymonitor what happ donations, and those whose money provided the endo $13 billion at Harvard, for example-that help finance institutions. Much or mostof these endowments were ple now dead, who cannot monitor at all. Non-profit organizations have additional sources including fees from those who use their services, such to museums and audiences for symphony orchestras. are in fact the main source of the more than half a trill in revenue received annually by non-profit organiz America. However, these feesdo not cover the full co operation -which is to say, the recipients are receiv and services that cost more than these recipients are p some are receiving them free. Such subsidized benefic

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not impose the same kind of economic discipline as th of a profit-and-loss business who are paying the full c thing they get. Under these conditions, the goals of those ind charge of a non-profit institution can be substituted tution's ostensible goals or the goals of their donors It has been said, for example,that Henry Ford and Jo feller would turn over in their graves if they knew w things are being financed today by the foundations their names. While that is ultimately unknowable, it i Henry Ford I1 resigned from the board of the Ford F protest against what the foundation was doing with left by his grandfather. More generally, it is now w nized how difficult it is to establish a foundation to s purpose andexpect it to stick tothat purpose after th been contributed and the donors are dead. Academic institutions, hospitals and foundations non-profit organizations in the United States, althoug institutions cover a wide range and can also engage normally engaged in by profit-seekingenterprises, su Sun Kist oranges or publishing Nation's Business mag In whatever activities they engage, non-profit o are not under the same pressures to get "the most buck" as are enterprises in which profit and loss det survival. This effects efficiency, not only in the narr sense, but also in the broader sense of achieving a poses. Collegesand universities, for example, can inators of particular ideological views that happen to ("political correctness") and restrictors of alternative though the goals of education would be better served students to contrasting and contending ideas. Two centuries ago, Adam Smith pointed out how running colleges and universities financed by endo run them in self-serving ways, being ""very indulge other," so that each academic would "consent that h may neglect his duty, provided he himself is allowe his own." Widespread complaints today that profes teaching in favor of research, and sometimes neglect b

Business and Labor

of leisure or other activities, suggest that the underlying has not changed much in more than two hundred yea guaranteeing lifetime appointments are common in colleges and universities, but are practically unknow nesses that must meet the competition of the marketpla This is only oneof the ways in which the employm of non-profit organizations have more latitude than thos prises that operate in the hope of profit and under th losses. Before World War 11, hospitals were among mo discriminatory of American employers,even though the purposes would have been better served byhiring the fied doctors, even when those doctors happened to b Jewish. Non-profitfoundations were also among the m discriminatory institutions at that time. The same was academic world, where the first black professor was no major university until1940, not long after the first Jew received tenureat Columbia University. Itwas only in th era, with racial attitudes beginning to change in the w horrors of the Nazi Holocaust, that either group bega more general access to positions in non-profit organizat None of this should suggest that non-profit organi oblivious to money. It is just that the purposes for money is spent may be quite different from the pur which it was donated. Non-profit organizations can be to get more money, and some even skirt the boundari missions and the law to do so. In 1999, for example,non ganizations took in about $500 million from sellersof c products who were allowed to say or suggest in their ments that some foundation or other non-profit org were favorable toward these products. Commercia ments by these tax-exempt organizations are illegal, b that these commercial tie-ins were endorsements ha kept law enforcement officials at bay. The American Medical Association, for example $600,000 for allowing its logo to be displayed in adve for a pharmaceutical drug. Another non-profit organiz American Cancer Society, pulled in more than a milli the same year for allowing the use of its name and log

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BASIC ECONOMICS

tisements for commercial products, even though it c does not endorse anything. Looked at from the other can Express has paid hundreds of millions of dollar of non-profit organizations for advertising tie-ins. The fact that some organizations’ income is calle other organizations’ income isnot does not change a nomically, however much it may suggest to the unw institution is greedy and the other is not. Many h profit organizations receive farmore money in salary erage owner of a store or a restaurant receives. What changes incentives and constraints is the money received by a profit-and-loss business comes those who use its goods and services, while the mo by a non-profit organization comes primarily from beneficiaries, from donors and-indirectly-from t who pay the additional taxes made necessary by th tions of non-profit organizations. The factthat a non-profit organization can provid free or below cost virtually assures a market for its o out being forced toproduce that output at the lowest the very nature of the output itself can be changed preferences of the non-profit officials, among other that are possible with money donated by people who to monitor performance as closely as stockholders who specialize in corporate takeovers. These illustrations of the financial circumstance non-profit organizationsare not the whole story. Bec manitarian and socially responsible goals of many no tutions, theymay attract many people whose idealis conscientious, evenwhen the incentivesand pressures they are in a profit-and-loss enterprise. To what exte the common human temptation to self-indulgence i question. It should not be forgotten, however, that self-indulgence arenot mutually exclusive, and self-in easily take the formof promoting one’s own ideology serving the ostensible purposes of the institution. Here, as elsewhere, we are concerned with the scarce resources which have alternative uses. Non-p

Business and Labor

zations are therefore examined here interms of how t incentives and constraints of such institutions affect nomic effectiveness. People tend to respond to incen constraints, no matter what kind of organization they derstanding the behavior of these organizations requi standing the differing incentives and constraints tha different kinds of institutions.

THE MYSTIQUE OF “LABOR”

In various forms, the idea has persisted for centur bor is what ”really” creates the output that we all live joy. In this view, it is the farmers who feed us and t workers who clothe us and provide us with furniture sion sets, while a variety of other workers build the live in. Karl Marx took this vision to its logical conclu picting capitalists, landlords andinvestors as people w way or another, were enabled bythe institutions of ca take away much of what labor had created-that is, to labor. Echoes of this vision can still be found today among a relative handful of Marxists but also among n ists or even anti-Marxists, who use such terms as ”un come” to describe profits, interest, rent and dividends This view that there was something special about source of output and of the value of individual comm isted before Marx was born-and not only among ra even among such orthodox economists as Adam Smith of laissez-faire economics. The first sentence of Smith’s Wealth of Nations says: ”The annual labour of every na fund which originallysupplies it with all the necessar veniences of life which it annually consumes, and wh always either in the immediate produce of that labour, is purchased with that produce from othernations.” By the late nineteenth century, however, econo given up the notion that it is primarily labor which d the value of goods, since capital, management and sources all contribute to output and must be paid fo

338

BASIC ECONOMICS

price of that output. More fundamentally, labor, l sources of production costs, was no longer seen as value. On the contrary, it was the value of the good sumers which made it worthwhile to produce those vided that the consumer was willing topay enough t production costs. Thisnew understanding marked a the development of economics. It is also a sobering how long it can take for even highly intelligent a misconception whose fallacy then seems obvious in In one sense, everything we consume is produce labor, especially if we broaden the term to include those who. plan, manage and coordinate the activi who directly lay theirhands on the things that are be tured or built. Usually, however, the term "labor" or reserved for those who are employed by others. Th who works 35 or 40 hours a week is called a worker, one who works 50 or 60 hours a week managing the not. Clearly, the amount of work you do is not what worker or not, as that term is generallyused. If labor were in fact the crucial source of output ity then we should expect to see countries where gre people toil long hours richer than countries where work shorter hours, in a more leisurely fashion, and pleasant conditions, often including air-conditionin ple. In reality, we find justthe opposite. Third World toil away under a hot sun and in difficult conditio once common in Western nations which have long soft and prosperous under industrial capitalism. Put differently, the growth and development of bor inputs as science, engineering and sophisticated and managementpolicies, as well as the institutional price-coordinated economy, have made the differenc hundreds of millions of people higher standards of l this is not something that is difficult to grasp-once ceptions have been gotten rid of. Those misconceptions tend to linger on wherev find refuge, even after theyhave been formallybanis

Business and Labor

and evidence. Official government statistics are still ca terms as ”unearned income” and “productivity” is d output divided by the labor that went into it. Internati is still discussed as if high-wage countries cannot com cessfully with low-wage countries, as if labor were the of production. In reality,high-wage countries have bee ing successfully with low-wage countries for centuries because of advantages in capital, technologyand organ India was for years forced toban imports of automo the United States and Japan, in order to protect its own cally produced cars, made by workers who were paid than American orJapanese workers. Consumers in Indi years forced to pay far higher prices for automobiles-an on waiting lists to buy them-because the products of wage workers could not compete with automobiles shi thousands of miles fromhigh-wage Countries? Misconceptions have practical consequences, s needlessly holding down the standard of living of po Antipathy toward ”unearned incomes” has led to at control orsuppress profits in various countries at variou of history, with the result of discouraging the investme tal that those countries have desperately needed to rais dard of living of their people. In some cases, the more p classes in these poor countries invest their capital abr richer industrial nations that do not tax or restrict much-leading to international transfers of wealth from is most needed to where it is least needed, as a result mestic politics of envy and resentment, compounded nomic confusion. What can be seen physically is always more vivid cannot be. Those who watch a factory in operation c

2Nor were automobiles the only products for which this was so. Tou have been scrutinized to make sure they were not bringing in computers a tronic devices to sell while they were there, since such devices were cheap when produced in many more industrial nations with higher wage rates. Th irony in these bans on imports of computer products, since Indians in the Un prominent as engineers and entrepreneurs in California’s silicon valley.

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BASIC ECONOMICS

workers creating a product before their eyes. Theyc investment that made that factory possiblein the firs less the thinking that went into assessing whether t the product was sufficient to justify the expense, or and trial-and-error experience that made possible th with which the workers are working or the massiv knowledge required to deal with ever-changing m ever-changing economy and society. Many have taken the special roleof labor in the Karl Marx took it, leading to the emotionally p vaguely defined, concept of ”exploitation.” When d prosperity and wealth are attributed to exploitat among individuals or among nations, this serves s tant political purposes, however counterproductive i nomically. First of all, it converts misfortune into making others responsible, guilty and fair game fo Far from feeling inferior, the less fortunate can feel rior-and entitled to recompense. These are almostideal conditions for political m der political and quasi-political leaders,whose own is promoted, whether or not the advancement of thos them is helped or hindered. Even thoseon the sidelin intelligentsia, can gain great ideological satisfac of a vanguard of those seeking to redress historic This general pattern has appeared in country a even when the particulars of these countries have v ”Dependency theory” held sway in Latin America while ”post-colonialism” theories were in the ascend Africa and other variations on the exploitation them American racial politicsand played a role in the exp dians and Pakistanis from East Africa and the drivi ”boat people’’ fromSoutheast Asia. Under the influence of ”dependency theory,” American nations restricted their economic trans wealthier industrial nations of North America and We lest these capitalists exploit them. Only after ma economic failures in trying to produce internally the could have been bought more cheaply in the worl

Business and Labor

Latin America’sgovernments abandon dependency theo self-destructive economic policies based on it, Perhaps remarkable, this theory eventually lost ground even am American intellectuals.Yet what a pricewas paid in the by those Latin American peoples whose standards of l needlessly kept lower than they could have been. Mi are more than mere intellectual problems. Even among those who are conventionally called w laborers, muchof what they contribute to the econom but capital-”human capital,” as economists call it. I much physical exertion as job skills which constitute th tion of a machinist, tailor, photographer, chef, pilot, w ian, or entertainer. Most American workers do today not merely work but skills, which is why their incomes inc stantially over their lifetimes. If it were their physica which matter, their capabilities would be greatest in t and so would their incomes. But, whereit is human cap being rewarded, then this is far more consistent with the rising with age. As their human capital grows, the pro ceive on that capital grows, even though it is called wa A failure tounderstand the importance of human c tributed to the defeat of Germany and Japan in World W rienced and battle-hardened fighter pilots represented investment of human capital. Yet the Germans and th did not systematically take their experienced pilotsout missions to safeguard theirhuman capital and have the instructors who could spread some of their human cap and inexperienced pilots being trained for combat. Bo policies described by the Germans as ”fly tillyou die.” The net result was that, while German and Japan pilots were very formidable opponents to the British a can pilots who fought against them early in the war, t of skills swung in favor of the British and American pil the war, aftermuch of the German and Japanese human the air was lost when their top fighter pilots were even down and replaced by inexperienced pilots who ha everything the hard way in aerial combat, where sma can be fatal. Economic concepts apply even when n

342

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changing hands. German and Japanese air forces w cient at allocating scarce resources which had alterna Uneasy as some people may be with the idea of human beings as capital, this is not a denigration but ment of the value of human life. In addition to the in of life to each individual, that individual’s value to o lighted by the concept of human capital. The old mi of going to great effortsto save cannonin combat, wh diers as if they were expendable, has since given w very expensive high-tech weapons, asin the Gulf Wa order to minimize casualties among one’s own mil nel, who represent very valuable human capital. In civilian life as well, human capital is crucial. T uals who can contribute only their labor have incre ties finding jobs in a high-tech world, where skills rewarded and there are few jobs left where ”a stron weak mind” are sufficient. Machines have increasin strong backs, even in traditionally arduous occupat mining. This economic de-emphasis of physical st time has also had the side-effect of reducing or elimin vantage of male workers over femaleworkers. As is so often the case, the economic realities complicated, but there is nevertheless a great difficul ing ourselves from tangled myths and misconception pecially so when it comes to labor, for people’s wo sufficiently central to their lives tohelp define who th flected in the great number of family names which occupations-Smith, Shepherd, Weaver, Taylor, Dyer, Wright, Miller, Brewer, Cook, Butler, and Steward, not to mention such foreign names as Kaufman (m Bauer (farmer). But, however, emotionallypowerful t bor may be, is it still part of the general economicpatt location of scarce resources which have alternative us

Chapter 25

An Overview

I

n addition to whatever you may have learned in the this book about particular things such as prices, spec international trade, you should also have learned a mo skepticism about many of the glittering words and fuzz that are massproduced by the media, by politicians, and By this time, you may no longer be as ready to bel who talk about things selling ”below their real value” how terrible it is for the United States to be’Ia debtor n the course of reading this book, you may have acquired skepticism about government programs to make this o fordable.” Statements and statistics about ”the rich” poor” may not be unthinkingly accepted any more. N you find it mysterious that so many places with rent co also have housing shortages. However, no listing of economic fallacies canbe com cause the fertility of the human imagination is virtua ited. New fallacies are being conceived, or misconceiv the old ones are being exposed. The mostthat can be ho to expose some of the more common fallacies and prom skepticism and ananalytical approach that goes beyond tional appeals which sustain so many damaging and gerous fallacies in politics and in the media. The importance of economic principlesextendsb things that most people think of as economics. For exam who worry about the exhaustion of petroleum, iron ore natural resources often assume that they are discussing amount of physical stuff in the earth, but that assum changes radically when you realize that statistics on ” serves” of these resources may tell us more about the in

3.14

BASIC ECONOMICS

and the costs of exploration than about how much of remains underground. This is one of a whole range and issues which, on the surface, may not seem li matters, but which nevertheless look very different standing basic economicprinciples. Those economic principles are easier to unders keep in mind in the midst of slogans and controve the emotions. For example, nothing is simpler or m with common sense than the economic principle tha to buy less at a higher price and more at a lower price vious-and equally important-is the tendency of p ply more at a higher price than at a lower price. Y implications of these two simple principles are of when discussing such things as rent control or min laws. These implications are also forgotten when p quantify individual or national "needs," disregardin the amount people will use varies with the price. It is likewise not difficult to understand that ec study of the allocation of scarce resourceswhich hav uses. But that too is easyto lose sight of when the me cians focus on the plight of particular industries th money and jobs, and call for rescuing these industri misfortunes. Those who proclaim that some particu or regions of the country are not sharing in the gen ity-that they are being "left out" or "left behind"-s acknowledge the possibility that the general prosper part a consequence of transferring resources from w less productive to where they are more productive. R bottom line and lay-off notices are among the mecha transfers. If you are prepared to sacrifice prosperity for th bility, so be it. All economics cando is make you awa sequences of your choices. It cannot tell youw philosophy or your priorities should be, though it c consistencies between goals. Perhaps more than anything else, an understan economics canenable us to consider policy issues in incentives they create and the consequences that f

An Overview

than simply the goals they proclaimand how wonderfu be to achieve such goals. Bothwithin government and vate sector, individuals and organizations tend to resp particular incentives facing them by trying to promote wellbeing. When this adversely affects others, it need not be d reaucratic bungling" within government or to "greed" vate sector. Perfectlyrational and decent people tend to the incentives confronting them. Those incentivesma consideration more than the individuals need denounc While critics of various programs often point ou tended consequences" that did more harm than good these consequences were predictable from the outset if

looked at the incentivescreated, rather than thegoals proclai

Very often either history or economics could ha what to expect,but neither was consulted. It does not m a law or policy proclaims its goal tobe "affordable hou trade" or "a living wage." What matters is what ince created by the specifics of these laws and how peop such incentives. Theseare dry empirical questions whi dom as exciting as political crusades or moral pronou But they are questions which must be asked, if we are t ested in the wellbeing of others, rather than in excite sense of moral superiority for ourselves. As historian son has said:

The study of history is a powerful antidote to conte rogance. It is humbling to discover how many of our sumptions, which seem to us novel and plausible, h tested before, not once but many times and in innum guises; and discovered to be, at great human cost,

We have seen some of those great human costs-peop hungry in Russia, despite some of the richest farmla continent of Europe, people sleeping on cold sidewalks nights in Manhattan, despite far more boarded-up hou than it would take to shelter them all. A desperate gov eighteenth-century France decreed the death penalty f

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BASIC ECONOMICS

who refused to accept the money that the revolutio had issued, in ignorance or disregard of economics. tronomical inflation in Germany in the 1920s had de lions of families’ life savings, many who w disappointedwiththeirtraditionalleadersandinstituti turned eventually toward someone who hadbeen ju natic before: Adolf Hitler. No complex or esoteric economic principles wou required to avoid these and other human tragedies world. But it would have required people stop to and t of being swept along by emotions, rhetoric or the of the moment. For those who are willing to stop and economics provides the tools for evaluating policiea in termsof logical implicationsand empirical evidenc If this book has contributed to that end, then it ha in its mission.

SOURCES

I t is neither possible nor necessary to document the source of ment made in this book. However, there are some key facts which may want to check out or to explore further. Rather than clutter footnotes, in a book intended for the general public, the citationsa i n an informal way thatshould nevertheless make it possible tojind sources. CHAPTER 1: WHAT IS ECONOMICS?

The article about middle-class Americans began o Section 3 of the New York Times of August 1, 1999 and wa Louis Uchitelle. The statement that Marxist economist not differ fundamentally from Milton Friedman on cer sitions and procedures can be verified by reading Oskar Scope and Method of Economics,” in the Review of Econo (1945-1946), pages 19-32, and comparing that with Milton Fri essay ”The Methodology of Positive Economics” in his bo Positive Economics. CHAPTER 2: THE ROLE OF PRICES

The quoted statistics and analysis about the Soviet a book titledThe TurningPoint: Revitcrlizing the Soviet Economy viet economists, Nikolai Shmelev and Vladimir Popov, es 128, 130-131, 141. The quote from Friedrich Engels is from hi the first German edition of The Povertyof Philosophy by Karl in the text, though n Marx himself makes similar comments language as that used by Engels. Information on Ghana by W. L. Alpine and James Picket, Agricu Coast is from book a alisation and Economic Growth in Ghana and C6te D’Ivoire:1968 lished in Paris in 1996 by the Organisation for Economic C and Development. The sales of beef suspected of ”mad cow reported in the Financial Times of March 30, 1996. The rela tween housing prices and population changes in upstate New cussed was described on page 70 of an article titled ”Do in the Autumn 1999 issue of City Upstate,” by Jerry Zremski lished by the Manhattan Institute, a think tank in New

348

Sources CHAPTER 3 : PRICE CONTROLS

The fact that the housing shortage in the United St when there was no change in the ratioof housing to pe book titled Roofs or Ceilings? by two economists later de Nobel Prizes, Milton Friedman and George J. Stigler. The long been outof print, but excerpts from it were incl of writings titled Rent Control: Costs a d Consequemes, edi Albon and published in 1980 by an Australian think Independent Studies, located in Sydney. This particular curs on page 16. The data on housing in San Francisc earthquake are on pages 5 and 6. The facts about are from a different article in the same book, "The of 'Swedish Rent Control'' by Sven Rydeenfelt. The lack of Melbourne under Australian rent control is mentioned o another article. The effectsof rent control in Paris are fr Bertrand de Jouvenal titled "No Vacancies" in a book A Popular Paradox, published in 1975 by a Canadian th Fraser Institute. Facts about the effects on rent contro Germany, and the Netherlands are from Relzt Control in and Four Ezlropean Countries by JoelF. Brenner and Herbe published by Mercury Press), pages 4,9, and 69. of Mat rent control and homelessness in the United States a Americans by William Tucker (especially pages 19, 162,2 19, which discusses various elite celebrities living in re apartments). The comment from theNew York Times is fr an article by John Tierney in their Sunday magazine sec 1997, titled "At the Intersection of Supply and Demand." higher rents in rent-controlled cities is from another st Tucker, "How Rent Control Drives Out Affordable Hous Analysis paper number 274, published by the Cat0 Ins in Washington. The declineof the housing stock under r Washington is cited inan article by Thomas Hazlett in solving the Housing Crisis, published in 1982 by a San F tank, the Pacific Institute for Public Policy Research. T official of the Communist government of Vietnam is from The Fortune Encyclopedia ofEconomics, edited by DavidR. H published in 1993 by WarnerBooks. Data on the numbe taken over by the city government in New York can of The Homeless by Christopher Jencks, published by H Press in 1994. The fact that building resumed in variou communities after the state banned local rent control in Rude Azuakenings by Richard W. White, Jr., published in Press in San Francisco. The passage describing the caus price controls during a seventeenth-century local food is from page 381 of The Formation of National States in W

Sources

edited by Charles Tilly and published by the Princeton Univ in 1975. Discussion of the eighteenth-century and nineteenth cal foodshortages in India is fromForty Centuries of Wage nn trols by Robert L. Schuettinger and Eamonn F. Butler, publis Heritage Foundation, a Washingtonthink tank, in 1979.

CHAPTER 4: AN OVERVIEW

Comparisons of bombing and rent control as means of housing appear on pages 422 and 425 of an article by Walter ”Rent Control”in The Fortulze Encyclopedin of Ecommics, edite Henderson. The economic problems of the rich ”black earth” Russia are discussed in Frank Viviano, ”Russian Farmlan Vine: Politics, Mind-set Keep Nation on a Dietof Imports,” S Chronicle, October 19, 1998, p. A1 and in Andrew Higgins, ”F Wall Street Journal, October 1998,pp. A1 ff. Thesteel manufac equipment automatically shfted from oil to natural gas was Steve Liesmanand Jacob M. Schlesinger, ”Blunted Spike: Th Has Doubled This Year; So Where’s the Recession?” Wall St December 13, 1999, where other fuel economy measuresare See pages A1 ff. Former food-exporting countries which bec to feed themselvesare mentioned in innumerable places, incl ern Times by Paul Johnson, pages 724-727 of the 1992 edition. ports of wheat underthe czarare shown onpage 62 of The T bySoviet economists Nikolai Shmelev and Vladimir Po painfully enlightening examination of the media’s inability basic economic principles during the gasoline crises of the their resulting susceptibility to irrational explanationsof wha pening, see Thomas W. Hazlett, T V Coverage of the Oil Crise Was the Public Serviced? (Washington: The Media Institute,19

CHAPTER 5 : THE RISE A N D FALL OF BUSINES

The historical sketches of various businesses are based o tion from a variety of sources, including innumerable new magazine articles,as well as books such as New and Improved: Mass Marketingin America written by RichardS. Tedlow and p 1996 bythe Harvard Business School Press,Forbes Greatest Bus ofAI2 Timeby Daniel Grossand the editors of Forbes magazine Enterprise by H. W. Brands, Empire Builders by Burton W. Fols First Hundred Years are tke Toughest:What W e Can Learn for th Competition Between Sears and Wards by Cecil C. Hoge, Sr.A b Adelman, Tke Riseand Decline of the Great Atlantic b Pacifi’c TeaC former A & P executive William L. Walsh and Made in Amer of New York City newspape Walton. The declining circulation

350

Sources

story on pageE5of The NewYork Times of November 18, 1 Prial and titled, ”Suburban Sprawl Also Applies to th Newspapers.” The quote about the Soviet economy is in The Fortune Encyclop Robert Heilbroner titled ”Socialism” ics, p. 164. On the misallocationof gasoline, see Stephen Gas Lines of ’79,” The Public Interest, Summer 1980, p.47; ”Gas Crisis: Experts Find Mixture of Causes,” New York Ti 1979, p. A1ff; Pranay B. Gupte, U. S. to Allow Shiftof Som Urban Sections,” New York Times, June 30, 1979, pp, A 1 f pages of regulations and subsequent ”clarifications,” s tner listed above. On the lackof gasoline shortages in th during the 1967 Arab oil embargo, see Thomas W. Hazlett the OilCrises, pp. 14-15. The dire predictions that ending oil would cause skyrocketing gasoline prices are quo ”Snake Oil Salesman,”Policy Review, Summer 1986,pp. 74 gasoline prices reaching an all-time low, see “Gas is Rising,” Consumer Research, August 1994, pp. 28-29. The gomery Ward executives who urged expansion into sub mentioned on page 153 The of NewYork TilnesCentury ofbu Floyd Norris and Christine Blaclunan and publishedin th McGraw-Hill. The big New York department stores’ initi credit cards is mentioned on page o 204 f the same book. CHAPTER 6: THE ROLE OF PROFITS-AND

L

Data on corporate profit rates in the American ec pages 46 and 49of The Illustrated Guide to the American E bert Stein and Murray Foss, third edition, published i Press for the American Enterprise Institute, a Washingt The statistic that the largest manufacturerof automobile States in 1896 produced just six cars is from The American by Robert Genat, page 7. The story of the microchip, in risking its corporate survival for the sakeof research, i pages 247-248,254,259-262 of Forbes Greatest Business Sto edited by Daniel Gross, et a1 and published in 1996 by Data on economies and diseconomies of scale in the a beer industries are from pages76, 77, 131 and 145 of T American Industry,9th edition, by Walter Adams and J lished by Prentice-Hall. Data and comments on the eff enterprises is from The Turning Point by Soviet econom Shmelev and Vladimir Popov. Howard Johnson’s pione rant franchising is discussed on page of Fast 51 Food: Roads in the Automobile Ageby John A Jakle& Keither A. Scul Johns Hopkins University Press in 1999.

Sources

CHAPTER 7: BIG BUSINESS AND GOVERNME

Data on the trucking industry are from pages 435 cle by ThomasG. Moore titled “Trucking Deregulation” in Encyclopedia of Economics. Data on airlines are from pages 380 an article in the same book by Alfred E. Kahn titled ” tion.” Soviet enterprises’ tendency to make things for than get them from specialized producers, is discussed on pag 160-161 of The Red Executive by David Granick. CHAPTER 8: A N OVERVIEW

The historical information about Athe & P grocery chai Rise and Decline of the Great Atlantic G, Pacific Tea Company b Walsh. Lenin’s estimate of how easy it was to run an en of from his bookThe State and Revolution, written on the eve vik revolution. His later changeof mind is from ”The Fli come the Fuel Crisis,” ”The Role and Functions of Trade U the New Economic Policy,” ”Five Years of the Russian R ”The Ninth Congress of the Russian Communist Party (B quoted from the 1951 editionof Selected Works by V. I. Lenin in Moscow by the Foreign Languages Publishing House. T tion on the McDonald’s restaurant chain is fromFast Food Jakle and Keith Sculle, pages 58 and 146-147, and Mast from prise: From John Jacob Astor and J. P. Morgan to Bill Gates and Op by H.W. Brands, published in 1999 by The Free Press CHAPTER 9: PRODUCTIVITY AND PAY

The misleading claim that income quintiles divide the five equal parts was made on page 48of Economics Explaine Heilbroner and Lester Thurow. Data on household inco S. Bureau of the Census serial publication, Current Popuht P-23-196, with its individual title being Changes in Median H come: 2969 to 1996. The misguided remark from the Washin from page 34of The Washilzgton Post Weekly Edition, Septembe an article titled ”The Rich Get Richer, andSo Do the Old,” Vobejda. No doubt it was reprinted from a recent issueof daily Washington Post. Data on people’s changing incomes and 1991 are from pages 8 and 22 of the 1995Annual Rqovt of Reserve Bank of Dallas. Earlier studies indicating similar Years of Poverty, Years of Plenty by Greg Duncan et al, pub University of Michigan Press. The number of Americans wo 11of The TurningPoint by Nikolai S Soviet Union is from page Vladimir Popov. The fact that women who worked contin

352

Sources

slightly more than men who did the same is from page nomic Role of Women,” The Economic Report of the Presiden ington, D.C.: US. Government Printing Office, 1973). The between the earningsof women with and without chld 15 of a valuable compendiumof data on women in the Wonzelz’s Figures, 1999 edition, written by Diana Furchtgo Christine Stolba and published by the American Enterp Washington think tank. Data on male predominance in w deaths are from the same source, page 33. Data on in the United State tal equipmentin the Soviet Union and 145-146 of The Turning Point by Nikolai Shmelev and V internally contradictory claim that people are ”living be has been madein remarkably numerous, including a boo the Harvard University Press in 1981,America’s Struggle A 1900-1980 by James T. Patterson, page 42.

CHAPTER 10: CONTROLLED LABOR MARK

The effect of minimum wages in reducing the em ers in general in various countries, and the employm o less skilled workers in particular, is discussed on pa What Fzltzlrefor New Zenland’s M i n i m z m Wcrge Lnzu, based o by ACIL Economics and Policy, Pty. Ltd., and published Zealand Business Roundtable. Similar conclusions for t are found in Youth and Minority Unemployment, written Williams and published in1977 by the Hoover Institutio fect of informal minimum wages in West Africa are dis 18 and 19 of West Afiican Trnde, written by Professor P. T London School of Economics and publishedin 1954 by C versity Press. The use of minimum wage laws to promo ination is discussed on page14 of Youth and Minority Une Walter Williams and on page50 of The Japanese Canadians Young and Helen R. Y. Reid. Data on American automo Motov Vehicle Facts & Figures: 1 and employment are from by the American Automobile Manufacturers Associat 19 and 20 of an article by Christopher J. Singleton title Jobs in the 1980s: A Decade of Transition,” which appeare Department of Labor’s Monthly Labor Review for February the declineof unionization is available from many so article by Richard A. Ryan titled ”Labors Gains Underc Problems,” which appeared The in Detroit News of July 26 CHAPTER 11: A N OVERVIEW

Data on employees’ share in national income are

Illusfvated Guide to the American Economy, third edition, w

Sources

bert Stein and Murray Foss, and published in 1999 by the Data on the movement of individuals from one income bra other over time are from pages 8 and 14 of the 1995Annual R Federal Reserve Bankof Dallas. Dataon the income levels th beginning of various quintiles were downloaded from the U of the Census web site. Data on the hours worked by peopl one percent of the income distribution is from page 31 of A P Affluent in America Today published in 1998 bythe U. S. Trust

CHAPTER 12: INVESTMENT AND SPECULATI

The disastrous speculation in silver by the Huntbrothers on pages 249-250 of The New York Times Century of Business Floyd Norris and Christine Bockelmann and published in th by McGraw-Hill. Thebuying up of future payments due to a tims in installments by paying a lump sumis discussed in a ginning on the front page of the Wall Street Journal of Februa titled ”Thriving Industry Buys Insurance Settlements fro Plaintiffs.’’ Twentieth century energy consumption and the know reserves of various metals are discussed on pages 40 a article by WilliamJ. Baumol and Sue Anne Blackman titled ” sources” in The Fortune Encyclopedia of Econonzics. See also Table 1of the Basic Petroleum Data Book, vol. XX, No. 2 (July s lished by the American Petroleum Institute. CHAPTER 13: RISKS AND INSURANCE

Information on the current value of a dollar invested in g and bonds in 1801is from an article titled”Now What?” in the 21,1998 Forbes Global Business t3 Finance, pages 20-21. The c academic institutions losing money in the stock market is fro Street Journal of October 13,1998,page Cl. Information on the insurance companies in the United Statesand their assets is of a 1994 publication of the Insurance Institute of America tit surmzce Works, written by Barry D. Smith and Eric A. Wienin global positioning systems by insurance companies looking f icy-holders in the wake of natural disaster is from the New Y January 18,1999, section, C,page 8. The titleof the story is ’M heart, GiveMe a Reboot” and it was written by Dylan Loeb CHAPTER 14: AN OVERVIEW

California motorists’ reactions to heavier fines for traffi were reported in a story beginning on thefront page of the S Chrolzick of July 23,1992. Thestory is titled ”Revolt Against S

354

Sources

Fines” and was written T. byChristian Miller. The com tive effects of anticipations of land reform is from Devel Aid by MelvynB. Krauss. CHAPTER 15: NATIONAL OUTPUT

Data on the unemployment rate during the Great

1930s is from page196 of an article titled ”Great Depres

Fortzlne Elzcyclopedia of Eco J. Samuelson, published in the 1929 to the fall in pricesof various corporate stocks from page 76 of Since Yesterday: The 1930s i~zAmerica by Frederi published in1986 in the Perennial Library edition by

CHAPTER 16: MONEY AND THE BANKING S

The fact that a hundred-dollar bill in the 1990s had l 1960s is from pag power than a twenty-dollar bill in the titled ”Going Underground,” written by Peter Brimelow in the September21,1998 issue of Forbes Global Business an fact that Chinese money was once preferred to Jap is from page 150 of a book titledMoney by Jonathan W that most savings accounts in Bolivia were in dollars d try’s runaway inflation is from page 210 of an article titl tion,” written by Michael K.Salemi and published in Encyclopedia of Ecorzonzics, where the German hyperinfla is also discussed on page 208. The fact that German wo 450-451 twice a day during this period is from pages 1866-1945 by Gordon A. Craig. The haste of Russians rubles during that country’s inflation is in a news sto page of the Christian Science Monitor of August 31, 1999 was Judith Matloff and the titleof the story was ”Russia 1921 inflation in the Soviet Un Old Days’.’’ Data on the of The Tl4rning Point by Nikolai Shmelev and Vladimir P markable agreement of both liberal and conservative ec confused and counterproductive monetary policiesof th serve during the Great Depression of the 1930s can be fo ing the accounts inThe Great Crash by John Kenneth Gal Monetary History of the United States by Milton Friedma Schwartz, where this point is discussed on pages 407-4 Herbert Hoover’s admonition to President-elect Fran quoted on page 16 of The Great Depression by John A. Ga lapse of hundreds of American banks during the Grea mentioned on page11 of A Monetary History of the United man and Schwartz.

Sources

CHAPTER 17: THE ROLE OF G O V E R N M E N

The comment on the changing role of government in around the world is from pageof10 a 1990 book that goe ject at length-The Commanding Heights, written by Danie Joseph Stanislaw and published by Simon & Schuster. C about the confiscation of the profitsof Soviet enterprises b ment of the U.S.S.R. are from page 261of The Turning Poin Shmelev and Vladimir Popov. The comment on bribes in Japan is from by Angelo Codevilla. The storyof how unscrupulous landlords exploit and controlled apartment buildings is toldThe in Ecology of Hous tion by Peter D. Salins. The particular comment quoted i of that book. The story of the genesis and consequences Nixon’s wage and price controls is from page of The C Heights by Daniel Yergin and Joseph Stanislaw and from Wall Street Journal of August 25,1996, p Herbert Stein in the amples of private market waysof taking externalities into found in an article titled ”Public Goods and Externalities Cowen inThe FortuneEncyclopedia of Economics, edited by D derson. Franklin D. Roosevelt’s use of presidential powers ing the First World War to take the United States off t mentioned on page 86of The Nezu York Times Centuryof Busi CHAPTER 18: A N O V E R V I E W

The argument that government policy worsened, r ated, the Great Depression can be found inA Monetary H United Statesby Milton Friedman and AnnaJ. Schwartz, p A History of the American People, pages 737 in Paul Johnson’s Out of Work by RichardK. Vedder and Lowell E. Gallaway 137-146. CHAPTER 19: INTERNATIONAL TRADE

The comment from the New York Times about whether States was a ”job winner” or a ”job loser’’ from free ticle by Louis Uchitelle titled ”Nafta and Jobs,” which ap November 14,1993 issue, on the first page of section 4. Cong nior’s warning and the facts to the contrary are both fro study titledTrade Liberalization: The North AmericanFree Trade Economic Impact on Michigan, published in December 1999 inac Center, athink tank in Michigan. The Estimate of econ in automobile production are from page 76 of The Structure dustry, ninth edition, by Walter Adams and James Brock,

356

Sources

1995 by Prentice-Hall. Pages 97 and 104of the same book losses in the American steel industry and the job losses omy as a whole from trying to protect jobs in the stee tion on automobile production in Australia is from Automotive Yearbook, 59th edition, published in 1997 by W cations in Southfield, Michigan. Reports on the Dutch a national retailers is from ”Shopping All Over the W of June 19,1999, page 60. An example of how job shifts a duction changes domestically can be seen in a Street Jo Wall Joel Millman titled ”Job Shift to Mexico Lets U.S. Firm A 28. appeared in the November 15,1999, page CHAPTER 20: INTERNATIONAL TRANSFERS OF

Data on imports and exports between affiliates of the s are from page 272 of The Illustrated Guide to the American E edition, by Herbert Stein and Murray FOSS, which als data on pages 274 and 275. Statistics on foreign investm States are from the an official Commerce Department pu ofcurrent Business, Volume 79, Number4 (June 1999), p. 16. balance of payments surplus preceded the 1992 recessio z v y of Clrrrent Business, Vol. 79, No. 2. (December 1999), pa on foreign ownershipof American railroads in the ninete from page 195 of The History of Foreign Investment in the U 1924, Data on foreign ownership of American railroadsin t century are from page 195 of The History ofForeign Investm States to 1914, written by Mira Wilkins and published b tha sity Press. Information on Americans producing on more all the manufactured goods in the worldin 1913 is from p The Mig same book. Page 68 of Myron Weiner’s 1995 book, the sourceof the statement that remittances from citiz ceed all the foreign aid from all the government agencies Professor P. T. Bauer’s comment on foreign aid is from p book Equality, the Third World and Econonzic Delusion, publ vard University Press. J. P. Morgan’s comment on gold wa page 41 ofTke Nezu York Times Centuy of Business.

CHAPTER 22: “NON-ECONOMIC” VALUE

The counterproductive effects of recycling have be many studies. See, for example, John Tierney, ”Recycli New York Times Magazilze,June 30,1996, beginning on pa

.

Sources

CHAPTER 23: PRICES AND PURCHASING POW

Comparisonsof delivery times the Post Office, on th Federal Express and United Parcel Service, on the othe Co cle titled ”Special Delivery’’ in the December 1998 ofissu ports, page 15. Data on how many people buy cameras from The 1997-1998 P M houses, rather than camera stores, is from Trends Report published in Jackson, Michigan, by the Phot Association International. CHAPTER 24: BUSINESS AND LABOR

The quotes from Adam Smith are from the Modern of The Wealth of Nations, page 128 and 250. The quote from cardo is from page 123 of Volume I11 of The Works and Corres David Ricardo, edited by Piero Sraffa and published by Ca versity Press. The fact that the bulk of agricultural subsidie corporations, rather than to family farmers, can be verifi sources, including The Structure of American Industry by Wa and James Brock, 9th edition, page 29. The same book a losses in the computer industry on pages 166-167. Busine President Nixon’s wage and price controls is mentioned o The Suicidal Corporation by Paul Weaver. Data on air fares of plane capacity after airline deregulation are froman artic Phillips titIed ’20 Days, 18 Flights,” which appeared on p Washington Post National Weekly Editionof July 5,1999-and w ably appeared shortly before that in the regular daily edi 50 percent higher under g mate that airline fares were up to regulation than they would have been in a free market of the Adams and Brock book mentioned above. For an old federal ”fair trade” laws in action, see Thomas O’D Banford, ”Jack Daniels, Meet Adam Smith” in the Nov sue of Forbes magazine, page 163. Information on fees cha profit organizations is from an interview with Peter Dru published in the March/April1999 issue of Philanthropy on p controversial practiceof non-profit organizations selling t their logos to commercial businesses is discussed in aNezu story beginning on pageA1 of their May 3,1999 issue und ”Sales Pitches Tied to Charities Draw States’ Scrutiny,” Abelson.

This Page Intentionally Left Blank

INDEX

A & P grocery chain,60,61-62,63, 76’78-79,93,99,101,102-103, 107,110,111,116,123,320,323 Absolute advantage(See also Comparative Advantage), 270-271 Advanced MicroDevices, 75 ”Affordability,” 24,28,44,46,48,54, 343,345 Africa, 13,46,48,112,291 Age, 133-134,135,136,137-138, 141-142,183,184,199,341 Agents, 114115,254 Agriculture, 33-36,4849,112,113, 117,130,143,144,150,177,178, 179,180,181,182,186,207,208, 212,227,230,242-243,249-250, 251,262,274,287,294,298,328, 330,337,345 Ahold, Royal, 276 Airlines, 62,81,98,120,315,321,331 Airplanes, 67,220 Alcoa, 76,89,101-102 Alexander the Great,224225,290 Allen, William R., xi Allocation of resources, 1,2-3,9-10, 11,12-13,14,17,28,39,45,49, 50,59,63,69,70,84,9,0,91, 118,123,160,162,167,170,171, 180,182,183,185,209,238,241, 244,251,254,299,301,306,336, 342,344 Allstate, 119 Amazon.com, 181 American CancerSociety, 335

American Express,336 The American Medical 335 Amherst, xi Annheuser-Busch, 79 Antitrust laws,92-93,94 323-325 Australia, 25,26,275 Authors, 84,114 Automobiles, 8,20,46,5 76, 79,80,84,86,107 120,144,146,152,16 177,184,185-186,20 206,212,218,219,22 261,262,264,265,26 275,278,279,284,29 339 Avery, Sewell, 66,110

Balance of Payments (Se International Trad Payments) Balance of Trade (See Int Trade and Paymen Baltimore & Ohio Railro Bankruptcy, 14,15,17,1 62,98,105,107, 182 299,315,323,324,33 Banks, 138-139,184,185 223-235,241,285,28 Barter, 223,224 Baseball, 129,160,244 Bauer, P. T., 156,294,342 Beer, 79 Berkeley, 26

359

360

Index Bloomingdale’s, 66,32,46 Bombing, 45 Borzmm, 255 Bonds, 131,193-197,197-198,200,201 Bonior, David, 269 Brand Names,318-321 Budget, Government Burger King, 320,321 Burma, 13,212 Burns, Arthur F., 255 Business and Industry, 46,57-123, 182-183,186,195,196-198,203, 218,230,237,238,240,241, 246-247,261,262,278,287-288, 291,299-300,327,328,329-333 Buses, 143-144,209-210 Cameras, 62,120,121,297-298, 316-317,319 Capital, 143-147,240,262, 280,287, 299,337,339 Capital Gains, 193,195-196,241 Capitalism, 4,11,67,85,86,111,119, 120,122,221,338 Carnegie, Andrew, 168,322 Cartel, 33,92-93 Carter administration, 72,191 Caspian Sea, 239 Causation, 39-44,49 Central Planning,4,15,69,70,71,87, 112-114,122,190,249,250 Cheese, 9,lO China, 13,237,240,246, 250,290 Chinese, 185,212,226,240,241,247, 290 Civil Aeronautics Board (CAB),97-98 Clothing, 171,206 Consumer Price Index, 264 Coal, 162-153,187,191,251 Collective Bargaining,149,159-165 The Commons,243 Communism and Communists, 45, 50,65,111,118,122,169,238, 243,250,256,308 Comparative advantage,271-274 Competition, 50-55,59,63,65,83,90, 91,92,93,96,96,97,99,100,102, 109,116,122,158,179,202,

204-205,275,276 320,321,324,331 Complexity, 36,4243 Computers, 4,102,12 217,220,265,276 Constraints (See Incen Constraints) Consumers, 9-10,14, 52,63,66, 74, 79 96,99,106,117,1 127,151,152,160 221,243,258-259 281,285,297,299 ”Control” of markets Costs, 8,9-15,54-55,6 74,79-83,85,90,9 109,116-117,138 203-204,245-246 254,257,258,270 307,31O,317,32O 338 Credit andCreditors 138,178,185,196 234,235,288 Crime, 40,108,225,2 Cyrix, 75

Debtor Nation (See In Debt) Deflation, 229-231,26 Demand (See Supply Dentists, 198 Department Stores, 6 106,107,120 Depressions, 33,107,1 262,264,281,282 Discount Stores, 316Discrimination, 100-1 Distribution of Incom Dividends (see Stock Dow Jones Industri 255-256

Economics, 14, 14,2 43,45,49,91,118 182,203,208,20 259,262,269,279 299,305,306,30

Index Economies of scale, 80,81,89, 99-100,274278,286 The Economist, 180-181 Economists, ix, x,4,11,24,29,100, 113,154,156,162-163,168, 189-190,218,219,231,245,252, 255,256,264,270,271,282,283, 286,294,296,297,305,308,311, 325,341 Education, ix, x, 117,141,149,175, 263 Efficiency, 34,9,11,14,15,20,28, 61,63,65,70, 71, 74, 75,81,84, 85,91,92,95,97- 98,99,106, 117,118,119,122,123,133-134, 143,145,146,150,151,160,161, 170,182,190,191,208,209,212, 243,245,251,271,279,299,301, 311,330,331 Ehrlich, Paul, 189-190,191 Elites, 29,65-66,67 Empirical Evidence,39,4445 Energy (see also Petroleum), 189 Engels, Friedrich, 15 Exploitation, 40,133,292,337,340 Exports (see International Trade and Payments) External Costsand Benefits (see Social Costsand Social Benefits) Fairness and Unfairness, 100,133, 135,160,163,171,198,203,279, 298,331,345 Fallacy of Composition, 216-217, 261,262,277,327 Famine, 20,37 Federal Communications Commission, 94 Federal Deposit Insurance Corporation, 234 Federal Emergency Management Agency (FEMA), 119 Federal Express,317 Federal Insurance Contributions Act (FICA), 205 Federal Reserve System, 217,231, 236235,263,327

Feudalism, 4,11,15,145 Food, 20,21,34,37,46,47 129,150,177,180,18 223-224,227,243,24 251,274 Foreign Aid,290,293-294 Foreign Investments(see International Trade Payments) Franchises, 82,108,115-11 Friedman, Milton,4,73 Futures contracts, 179,18

Gambling, 179,207,211 Gasoline, 21,31-32,414 70-72,84-85,113-114 318 Germany, 13,27,154,229 291,292,341,346 Gold, 17,181,199-200,20 226-227,228,232,25 295-296 Government, 49,51.55,7 119,122,143,149,15 155,162,164-165,17 203-204,210-211,216 221,225,230-231,235 264,300,328,330 regulation: 71,91,93-94 202-203,208-209,222 taxing and spending:7 Graflex Corporation, 62 Great Depressionof the 1 34,107,108,215,217 264,295,297,298,32 Greed, 17,18,20,29,40,41 306,315,321-322,336 Groceries, 59,60,61,62,6 109,110,123,317-318 Gross Domestic Produc Gross National Product 218,221,222 Growth Rates, 13,14,71,2

Hamburgers, 107-109,116 318,319 Harvard, 2,200,333 Hertz, 202,212

Index

362

Higgins, James, xi Hippocratic Oath, 41 Hitler, Adolf, 229,251,346 Holmes, Oliver Wendell, 283 Homeless People, 28,30,31 Honesty, 246-247,247-248 Hoover, Herbert, 231,264,327 328 Horses, 20,220,262,279 Hotels, 18-19,319 Housing, 18, 19,21,22-31,44,47, 167, 184,186,200-201,203,206,218, 219,230,241,244-245,245-246, 264,345 Human Capital, 240,341-342 Ice Cream, 9,lO Immigration, 240,289-290 Imperialism, 290-293 Imports (see International Trade and Payments) Incentives and Constraints, ix, 2,25, 27,31,39,43,44-50,74,76,77, 85,86,93,94,114,118,152,172, 205,224,238,242,243,244,245, 246,247,254-259,320,337,344, 345 Income, 36,125-172,198 family income: 134-135 forms of payment: 130-132 household income: 134-135,136 income "distribution": 132-139, 167,168 individual income: 134,167 national income: 167 per capita income: 134-135,221 the poor: 13,27,29,30,35-36, 40,49,133,137,138,139,146, 167,168,169,170,211,343 real income: 2,137 the rich: 136-137,138,146, 168-169,170,322-323,343 "unearned" income: 184-185, 337,339 wages andsalaries: 17,21, 127-139,280 Incremental versus categorical Decisions (see alsoPriorities), 210,52-53,54,256,258,310-311

Inflation, 194,199,20 264,345 Insurance, 40,119,18 212 Intentions, 27,3940, 245 Interest rates, 17,40, 193-195,207,22 International Compa International Debt, 2 343 International Trade a 171,225,261,26 balance of paymen 286 balance of trade: 2 foreign investmen 280-281,285,286 292-293,294,29 remittances: 289-2 transfers of wealth 339 Interstate Commerc (ICC), 94,96,97 Inventory 78,97,177 212,232 Investment, 67,75,7 175-178,180,18 205,206,210,21 299,325 Iron Ore, 8

Japan, 3,36, 70,72,16 246,275,281,28 339,341 J. C. Penney, 60,65-6 Jews, 185,212,241 Job Security, 149-152 Jobs, 18,67,75,82,83 130,131,134,13 142,143,149-16 216,217,230,23 270,271,275,27 281,285,298,29 344 Johnson, Howard, 82

Kennedy, John F., 222

Index Kentucky Fried Chicken, 121 Keynes, John Maynard, 327-328 Knowledge, 8-9,14,17,43,46,63, 65,66-72,80,82,84,90,95, 111-116,134,177-178,179,180, 182,187,190,199,201,208,210, 243,249-251,316,317,318-321, 340 Kodak, 60,320 Labor, xi, 15,17,123,125-172,262, 273,277,337-342 Labor Unions, 97,142,149,154,155, 159,160,161,162-165,169,278, 281-282,282 Land, 243,251 Land Reform, 211 Landlords, 29,30,44,211,242, 244-245 Lange, Oskar, 4 Law and order, 32,100-101,238-248, 256 Lewis, John L. 162,163 Long Run versusShort Run, 199, 209-210,220,279,332 Losses (see Profits and Losses) Mail, 316 Mail Order Houses, 64,65,66,119, 120 Management, 60,65,69-70,71,84, 103n, 104,105,106,109-111, 113,116,129,210,280,324,332, 337,338 Mantle, Mickey, 129 Maris, Roger, 129 Market Economies, x, 4,7,8,11,12, 13,22,4546,47,49,59,65-66, 67,69,71,72,73,77,103,106, 113,117-122,123,133,142,149, 161,186,190,210,211-212,221, 232,237,238,239,244,246,248, 250,251,252,253,254,256-257, 258,262,263-264,294,300, 307-308,329,330,331,332,333 Marshall Plan, 293 Marx, Karl, 15,74, 76,337,340 Maximum Wage Laws, 153

McDonald’s, 107-109,11 169,243,318,320,32 Media, 59,96,167,169,18 208,216,217,219,220 255,261,262,270,27 289,290,308,312,34 Medical services, 34,21,1 198,307,310,335 Merit, 171 Microsoft, 60,285,323,33 Middlemen, 84,85 Milk, 9-10,79,134 Minimum Wage Laws, 2 152-159 Mining, 43 Mohawk Indians, 140 Money 3,4,11,55,67,68, 118,143,145,165,17 182-183,184,185,1 194,197,202,203,20 215,216,217,219,22 279,284,285,286,29 305,306,320,326,32 345 Monopoly, 80,86,89-92,9 101,119,129,279 Montgomery Ward, 60,6 103,106,107,110,11 Morality, 39,44,160-161, 248,306,307,308 Mortgages, 108,230 Movies, 62,102,129

National Debt, 217 Natural Disasters, 18, 19 204,307 Natural gas, 190-191 Natural resources, 3,8,12 187-192,207,238,25 343 ”Needs,” 16,50,308-311, New York City, 25-26,28 66,70,96,175,242,2 The New York Times, 1,2, Newspapers, 62,84,134, Nikon, 62,102 Nixon administration,48 255,256,300

364

Index Non-Profit Organizations, 333-337 Ottoman Empire, 241 Pan American Airline, 62,101 Pay (see Income) Peanuts, 250 Penney, James Cash, 66,169 Persian Gulf War, 208,342 Petroleum, 52-53,71-72,76,84,175, 180-181,186,187,188,189,196, 207,208-209,239,278,312,343 Pianos, 78 Politics, 7, 11, 13,21,24,29,36-38,43, 46,50,53,63,65, 72,95,97,118, 122,123,138,164,167,169-170, 186,189,190,191,203,206,207, 208,209,210,217,219,220- 221, 222,225,226,227,230-231,254, 255,256,257,258,259,262,263, 270,276-277,278,279,288,289, 290,293,300,308,310,311,312, 313,330,340,343,345 Pollution, 243,256-257,258 The Poor (see Income) "Predatory" behavior, 315,323-325 Preferences, 9,10,14,15,308 Present value, 186-190,191,194, 209-210,312-313,332 Price control, 7,19,21-38,42,47-49, 70,72,89,90-91,120,190,250, 255,312 "ceiling" prices: 21,22-32 "floor" prices: 21,32-36 Prices, x, 4,5-55,35,54,60,62,65,69, 70,71,76,84,89-94,99,101,103, 106,113,116,118,133,138,151, 188, 191,215,219,224,228,230, 234,250,261,265,279,308, 315-328,331,343 Priorities, 53-54 Producers, 8-9,10,11-12,17,46,52, 53,85,93,117,262,299 Productivity, 127-147,157,168,171, 299,332,339 Profits and Losses (see also NonProfit Organizations), 8-9,40, 46,59,60,63, 71-87,95,105,106, 114,117,118,119,121,123,151,

179,180,182-18 210,245,287-288 332,333,337,344 losses: 8-9,14,15,2 66,67,105,122,2 monopoly profit: 9 profits on sales: 76 profits on investm 77-78,101,280-28 Property Rights, 241Protestants, 51 Purchasing Power, 32

Quality, 29,30,31-32, 97,106,120,121245,248,264,321

Race and Ethnicity 1 141-143,154,155 Railroads, 94,96,97,1 193-194,253-254 Rationality and Irrati 49,70,345 Rationing, 7,18-19,46 "Real" value, 17, 18, Redistribution, 211 Refrigerators, 61,86Regulatory commissi Rent control, 22-31,14 246,247-248,343 Residual claimants,7 Retailing, 59,63-64,6 116,117,150 Restaurants, 25,81-82 115,120,321 The Rich (see Income Risk, 131,173-212,23 Roman Empire, 48,22 Roosevelt, Franklin D 327,334 Russia, 4 8 4 9

Safety, 183,188,199-1 203,210,222,257 Safeway, 61,103n, 10 Sales volume, 61,64, 116,117 San Francisco, 20,316 Sanders, Colonel, 121

Index Saving, 136,176,177,178,185,325, 326 Sears, 60,64,65,66,76,86,93,103, 106,107,110,116,119,120,150, 230,322 Sears, fichard Warren, 110,169,322 Selling Short and Long, 181 Sex, 140-141,203,342 Sharing, 19,25,50,51,145,190 Shaw, George Bernard, 74,76 Shopping Malls, 41,60-61,66,107, 108,258-259 Shortages, 15,16,22,23,24,30, 31-32,33,35,4142,4445,47, 69,157,185,188,208,343 Simon, Julian, 189-190,191 Slavery, 127 Smith, Adam, 279,283,305.329-330, 334,337 Smith-Corona, 63,101,123 Social Costs and Social Benefits, 251-254 Social Justice, 44 Social Security, 134,205-206,265 Socialism and Socialists, 4,11,13,15, 45,67,74-75,77,85,87,118, 119,120,122,145,169,221,238 "Society," 134,135 Soviet Union, x, 10,ll-12,4344, 69-70,71,74-75,81,85-86,111, 113,120,140,146,147,242-243, 245,249,254,256,321,332 Soybeans, 17,181,182,186,208 Speculation, 178-182,196,198,200, 207-208,208-209,211,212,295, 343 Standard of Living, 1-2,3,4,13,15, 25,46,60,63,64,65,70,74,76, 106,108,122,123,127,167,168, 170,171,212,218,219,241,244, 262,269,287,327,339,341 Standards, 253 Steel, 82,164,261,277-278 Stigler, George, 155 Stocks, 105,106,110,131,151,176, 177,181,183,184-185,196, 197-198,200,215,287 Stupidity (seeRationality and Irrationality)

Subsidies, 36,54,217,294 Subsistence, 133 Substitution, 53,101-102 Suburbs, 60,61,66,107, Supermarkets, 60-62,67, 107,109,138 Supply andDemand, 7, 18-19,20,21,29,32, 97,98n, 128,129-13 150,153,159,163,18 280,321 Surplus, 15,21,22,24,33142,153,155,158,1 Sweden, 23,24,28,276,2 Switzerland, 3,70,153,1

Takeovers, 105,330,336 Tariffs, 281-282,297,298 Taxes, 196,205,209,210, 231,306,336 Television, 62,115,220,2 Tenants, 23,24,25,26,29 245-246,247-248 Third World, 155,156,15 292-293,294,306,33 Time, 173-212,256 Trade-offs, 4,53,163,171 307,308,310 Trees, 187,312 Trends, 64,219-220,222, Trucking, 96-97,146,164 Typewriters, 63,123,217

Unemployment, 130,150 153-155,156,157,15 262,269,281,288,29 Unfairness (see Fairness Unfairness) Unions (seeLabor Union Urbanization, 64,106 Venezuela, 209,239

Wages and salaries (see Wal-Mart, 66,76,116,150 War, 208,227-228 Washington Post, 135,32 Waste, 14,15,70,146,176 257,311-313

Index

366 Wealth, 136,137-138,168,218,219, 224,227,283-296,290,291,292, 307 Wendy’s, 121,320,321 White Castle, 108,109,116 Williams, Ted, 129 Williams, Walter E., xi World War I, 26,229,259,288,291, 295

World War 11,22,26,3 107,112,139,155 293,335,341 Writers, 84,114 Yankee Stadium, 244 Yogurt, 9,lO

Zero-sum games,98,1 211-212,269,277