Mankiw Chapter 1. Ten Principles of Economics, 3-18.

A number of economists have their preferred lists of key, principles, or big ideas
in economics. Mankiw outlines his top ten in Chapter 1 (3-18) of his text, Principles of
Macroeconomics. Gwartney and Stroup lay-out their ten key elements of economics in
the first section of their book, What Everyone Should Know About Economics and
Prosperity (1-29). In a recent Investors Business Daily editorial, Paul Craig Roberts
presented seven big economic ideas and three related issues. Finally, in an editorial
written by Walter E. Williams, entitled Economics 101, he identified the key
characteristic of economics. In order to set the tone for this chapter in Mankiw and all
future chapters, I can think of no better place to begin than in Williams editorial,
Economics 101:
More than anything else, economics is a way of thinking. At the heart of economics are
several simple and easily observable characteristics of humans and the world in which
we live. The first is that people prefer more of those things that give them satisfaction
and fewer of those things that give them dissatisfaction. Second, when the cost of something goes down, people tend to take or do more of it, and when the cost of something
increases, people tend to take or do less of it. Finally, having more of one thing requires
less of something else. Or, as my colleague Professor Milton Friedman puts it, Theres
no free lunch. [Economics 101, available at: www.townhall.com/columnists/
walterwilliams/ww000607, emphasis added]

It would be wise to read Williams entire editorial to discover how he applies these basic
principles to public policy issues. For more about Milton Friedman go to
www.dallasfed.org and click on Publications and Resources (top banner); then to E
(extreme upper right); and then on Economic Insights. Now, page down to Milton
Friedman Economist as Public Intellectual, Economic Insights, Vol. 7, No. 2; or you
may simply go to: www.dallasfed.org/research/ei/ei0202.
Paul Craig Roberts in his editorial has identified the seven big economic ideas of
the 20 Century (having had the most socio-political influence). He lists:
th

(i)
(ii)
(iii)
(iv)
(v)
(vi)
(vii)

communism (socialism);
Keynesianism and spending or demand-side economics;
Hayeks identification of the market system as an
information network;
monetarism la Friedmans notion demand is a
monetary phenomenon;
supply-side economics;
Coase and transaction cost analysis (laws and property
rights affect economic outcomes, i.e., socalled market failures; and
Buchanan and public choice economics (policymakers use public policy to advance their own
self-interests).

Note that there are explanatory materials devoted to Frederick Hayek, James M.
Buchanan and Ronald Coase available on the Dallas Federal Reserve website:

Hayek Social Theorist of the Century, @ www.dallasfed.org/research/ei/ei9901;

James M Buchanan The Creation of Public Choice Theory, @ www.dallasfed.org/
research/ei/ei0302; and
Ronald Coase The Nature of Firms and Their Costs, @ www.dallasfed.org/researh/
ei/ei03.03.

Additionally, an historical evaluation and comparison of John Maynard Keynes and

Frederick Hayek and their influence of politics and economics during the 20th and early
21st centuries may be found on the PBS website relating to one of their programs, The
Commanding Heights, especially:
Episode One: The Battle of Ideas @ www.pbs.org/wgbh/commandingheights/lo/story/index.

Roberts begins his editorial by stating: The two most influential communism and
Keynesian economics proved themselves to be false, but the shadows they cast kept the
five valid ideas in the shade. He proceeds by examining the seven big ideas, and
concludes by observing:
Government growth is the 20th century reflected two big ideas that proved to be wrong. If
the five valid economic ideas prove to be as influential, the future will bring a contraction
of government.

In Chapter 1, Mankiw lays out the Ten Principles of Economics that he perceives
to be most important. In many ways Mankiws principles corresponds quite closely with
the Ten Key Elements of Economics that are discussed in the first section of Gwartney
and Stroup (1-29).
Principle #1. People Face Tradeoffs The ultimate source of the need for tradeoffs is the
scarcity of (natural) resources, sometimes this is known as the Law of Scarcity.
This is reflected in what Milton Friedman has characterized as There aint no
such thing as a free lunch (TANSTAAFL). This true since to devote scarce
resources to one use, necessarily means that there are fewer resources available to
allocate to other, alternative uses. These ideas are best seen in the production
possibilities curve, see: Figure 2 (25). This principle applies to individuals
(households), as well as to society as a whole. In making a decision whether or
not to expend some portion of a households (or a nations) scarce resources
(income) [or GDP] on a particular good/service (public policy), tradeoffs should
be taken into consideration, e.g., the benefits derived and the costs imposed by
increasing taxes on households in order to provide subsidies to farmers (from
hops to tobacco, from wheat, cotton and corn to sugar and ethanol). Resource
scarcities serve as a constraint on economic production in the short-run, but over
the longer run the constraint is relaxed as prices rise. Price increases stimulate
new discoveries and older, leaner sources are made more profitable [old copper
deposits and oil wells have been made more profitable by higher prices, while
small or distant, previously uneconomic deposits, are made profitable].
Additionally, as population grows the potential labor force is expanded; new
technologies are developed [olive/animal fat lamps, candles, whale oil lamps,
kerosene lamps, electric lights] encouraged by rising prices; and substitutes are
2

found and developed [fiber glass as a substitute for steel in auto bodies and fiber
optic cable replaces copper wire in telecommunications]. This process may be
seen in Schumpeters perennial gale of creative destruction driven by the
entrepreneur, his/her quest for profit by innovating. [See: W. Michael Cox.
Schumpeter In His Own Words, Economic Insights, Vol. 6, No. 3; or online @
www.dallasfed.org/research/ei/ei0103]
The free lunch mythology is clearly addressed by Walter E. Williams in an
editorial he wrote in 2001, Theres No Free Lunch, @ www.townhall.com/
columnists/walterwilliams/ww20011003. In it Williams introduces several ideas
of the 19th Century French economist, Frdric Bastiat (1801-1850). [See: Robert
L. Formaini, Frdric Bastiat World Class Economic Educator, Economic
Insights, Vol. 3, No. 1; or online @ www.dallasfed.org/research/ei/ei9801]
Williams quotes from one of Bastiats pamphlets, What is Seen and What is Not
Seen, which illuminates the issues discussed by Gwartney and Stroup as their
10th Key Element of Economics. Bastiat wrote:
There is only one difference between a bad economist and a good one: The bad
economist confines himself to the visible effects, the good economist takes into
account both the effect that can be seen and those effects that must be foreseen.

Walter Williams uses the writings of Bastiat to refute the silly notions regarding
the potential economic outcomes (benefits) of 9/11 job creation associated with
public and private expenditures rebuilding the damage. He employs Bastiats
well-known, but often forgotten, idea of the broken window fallacy [a child
throws a rock through a shopkeepers window, which then has to be replaced,
creating work and income for the glazer (that which is seen)]. But this is not the
whole of it, since it fails to take into account what the shopkeeper might have
done with this money, it alternative use (that which is unseen), say the purchase of
a new jacket.] There is in fact a reorientation of spending and income earning
away from the tailor and to the glazer. Williams concludes: Property destruction
always lowers the wealth of a nation.
For other examples of the free lunch mythology, government
intervention and applications to contemporary issues, see the following:
Thomas Sowell. 2001. Electricity Shocks California, @ www.townhall. com/
columnists/thomassowell/printts20010111.
Thomas Sowell. 2001. Property Rites, @ www.townhall.com/columnists/
thomassowell/prints20010809.
Thomas Sowell. 2002. An Ancient Fallacy, @ www.townhall.com/columnists/
thomassowell/printts20020527.
Walter E. Williams. 2004. Minimum Gasoline Prices, @ www.townhall.com/
columnists/walterwilliams/printww20040331.

Sowell, in Electricity Shocks in California, points out the role of government,

through the use of price controls, in creating shortages and then seeking to shift
the blame onto the private sector. Notice what Sowell writes,
In the never-never land of California ideology, it is considered terrible if the public
should have to pay the full cost of what it wants.
In California, prices higher than you like are attributed to greed or price gouging
and the answer is either more government regulation or having the government take
over the utility company completely and run it.
But just as there is no free lunch, there is no free electricity. And the idea that the
government can run businesses at lower costs flies in the face of worldwide evidence
that whatever enterprise politicians and bureaucrats run has higher costs.
Far from lowering the cost of producing electricity, government at all levels has for
many years and in many ways been needlessly increasing that cost. (emphasis added)

He concludes with:
But if we are too squeamish to build a dam and inconvenience some fish or reptiles,
too aesthetically delicate to permit drilling for oil out in the boondocks and too
paranoid to allow nuclear power plants to be built, then we should not be surprised
if there is not enough electricity to supply our homes and support a growing economy.

Mankiw provides an interesting example of a social tradeoff that needs careful

consideration: a tradeoff between efficiency and equity. Notice Mankiws
definition of terms (found in the margin of page 5): efficiency the property of
getting the most it can from its scarce resources; and, equity the property of
distributing economic property fairly among members of society. Please note the
inherent disconnect between the two terms: efficiency is a technological
concept, while, equity refers to some moral standard. Efficiency may be
measured as an increase in some quantitative variable (output, costs, price) which
raises social welfare, while equity is a qualitative term, (defined as something
that is fair or just), a term that has as many meanings as there are people
observing whats fair to me, may be unfair to others (reducing their well-being).
Perhaps, as important in understanding these distinctions, is the decomposition of
economics and economic analysis first made by John Neville Keynes, father of
John Maynard Keynes, in his book, The Nature and Scope of Political Economy.
Keynes argued that an individuals approach to economic analysis may take one
of three approaches: (i) positive analysis; (ii) normative analysis; or (iii) the art of
practicing economic analysis. Positive economics involves the study of economic
phenomena as they are (an empirical approach), while normative economics
considers economic phenomena as they ought to be (implying some ethical
judgment, without specifically identifying whose ethical values are being used as
the standard). Further clarification may be found in Chapter 2 (28-9) where
Mankiw differentiates the tasks of the economist as: (i) scientist (implying

positive analysis); and (ii) policy formulator or political adviser (employing

normative judgments).
The issue of economist as scientist necessitates consideration of the
Baconian Scientific Method and its application to the advancement of
knowledge. For an example of the misuse and abuse of the Scientific Method in
an attempt to advance a particular political viewpoint, see: Michael Crichton,
Caltech Michelin Lecture, January 11, 2003; available at: www.crichtonofficial.com/ speeches/index. All of the other papers on the website are worth
reading. Deliberate misuse of the scientific method is a form of intellectual
dishonesty and fraud.
Principle #2: The Cost of Something Is What You [Have To] Give Up to Get It
(Emphasis added). This principle is known as an Opportunity Cost, or,
perhaps more descriptively, an Alternative Cost. A decision-maker (household,
business man, government bureaucrat), to avoid the waste of scarce resources,
should evaluate or weigh the benefits derived from the purchase or use of one
item (a sirloin steak) in comparison with the potential benefits that must be
foregone (Kentucky Fried Chicken an alternative to the steak) in order to have
the sirloin steak. In this context, the value of the fried chicken (what must be
given up in order to get the sirloin steak) is known as its alternative or opportunity
cost. Normally, if the benefits derived from the steak exceed the benefits of the
fried chicken (the steaks alternative cost), a rational consumer will purchase the
steak. Another example involves a quasi-scientific attempt to justify a
progressive tax policy (Robin Hood take from the rich, give to the poor). It is
argued that the rich value their last dollar less (expressed as marginal utility)
than the poor value their last dollar (expressed as marginal utility), so to
improve social welfare (maximize societys total utility or want satisfaction), it
makes sense to transfer income from the wealthy to the poor! The only problem is
that this argument is built on sand, since it assumes that there exists,
empirically, measurable units known as utils. (This assumption is really
scientific, just like measuring the flow of electricity through a copper wire!)
Clearly, all decision-making involves a comparison of the expected
benefits and the expected costs associated with any transaction, including the use
of tax revenues (more highway mileage or more Medicaid). Reflecting on
Bastiats example of the broken window fallacy, it is clear that the opportunity
cost associated with repairing the broken window is the foregone suit and the
income for the tailor. The production possibilities curve provides a graphic
representation of the trade-offs and their opportunity costs. One of the problems
with the Robin Hood tax policy is that it only considers that which Bastiat
described as the attribute of a bad economist that which is seen, totally
ignoring what a good economist must consider both that which is seen and
that which is unseen. Remember the quotation on page 3, above:
There is only one difference between a bad economist and a good one: The bad
economist confines himself to the visible effects, the good economist takes into

account both the effect that can be seen and those effects that must be foreseen.

Also, consider: Gwartney and Stroups last principle, drawn from Henry Hazlitts,
Economics in One Lesson -- 10. Ignoring Secondary Effects and Long-term
Consequences is the Most Common Source of Error in Economics. (See syllabus,
page 12) There Gwarney and Stroup are quoted as having written: Hazlitts one
lesson was, that when analyzing an economic proposal, one:
must trace not merely the immediate results but the results in the long run, not
merely the primary consequences but the secondary consequences, and not
merely the effects on some special group but the effects on everyone.(27,
emphasis in the original)

It would be helpful to read: Robert L. Formaini. Henry Hazlitt Journalist

Advocate of Free Enterprise, Economic Insights, Vol. 6, No. 1; available @
www.dallasfed.org/research/ei/ei0101.
Comparison of the benefits and the costs are essential if the decision maker
wishes to avoid waste (inefficient choices). This principle applies to individuals,
households, larger groups, as well as government bureaucrats. All too often,
bureaucrats believe that they have superior wisdom and, therefore have the right
to impose their decisions on others. In order to accomplish their rights to
governance, bureaucrats and bureaucracies create a justifying mythology.
Typically, this mythology is advanced and perpetuated by the self-anointed
intelligencia [] the taste makers, the cultural pace setters. For
examples of the myths that have been created, see: Walter E. Williams. 2005.
Greedy or Ignorant, available @ www.townhall.com/columnists/walter
williams/ww20050112. The myths must be scrapped before the true
relationships-- the real costs and the real benefits may be revealed.
Principle #3: Rational People Think at the Margin This represents the basis of what is
known as marginal analysis, the weighing of the relative merits (benefits vs.
costs) of the last unit(s) of a given transaction, e.g., one more hour at a weekend
party, compared with one more hour studying for the economics test scheduled for
Tuesday [benefits = momentary fun vs. cost = lower grade). For an alternative
view see Gwartney and Stroup, page 46:
If an investment program is going to enhance the wealth of a nation, the value of
the additional output derived from the investment must exceed the cost of the
investment.

If my weekly allowance is $100 and I want to buy some DVDs ($ 25 each) and go
out with the love of my life this week end. I can: (i) ignore the love of my life
and buy four DVDs; (ii) buy three DVDs and take the love of my life out for
dinner at McDonalds; (iii) buy two DVDs and take the love of my life to an
afternoon Matinee and dinner at Burger King; (iv) buy one DVD and take the
love of my life to dinner at Wendys; (v) take the love of my life to dinner at
Chris Steakhouse and walk in the moonlight along the Riverwalk. Each
6

alternative involve a tradeoff or the sacrifice of something desirable to the

individual. The critical point is: in order to get something of value, one must giveup, or sacrifice, something else of value.
Principle # 4: People Respond to Incentives (or Disincentives) [Emphasis added] Keep
in mind Gwartney and Stroups first element of economics Incentives Matter.
They specifically note that incentives affect human behaviors, e.g., if you want
more of a certain behavior, provide incentives (tax breaks), but if you want less of
a behavior, impose disincentives (taxes). Please pay particular attention to the
second paragraph of page 4 the responses of buyers and sellers to the higher
gasoline prices of the 1970s (the so-called energy crises of 1973/4). [For an
analysis of the current oil crisis, see: Thomas Sowell, An Oil Crisis? @
www.townhall.com/columnists/thomassowell/printts20050823;
and
Thomas
Sowell, An Oil Crisis? Part II, @ www.townhall.com/columnists/thomas
sowell/ printts20050824.] Sowell points to the obvious reasons for the high prices:
excess demand or inadequate supply. No mystery there. What should
governments response be? According to Sowell the best response would be to do
nothing! He notes that unfortunately there are Congressional elections coming up
in 1906 and Presidential elections in 08. The solutions likely to emerge are:
price controls, arbitrary new higher gas mileage standards for vehicles,
alternative energy sourcesall of which have substantial costs, e.g., price
controls = SHORTAGES; higher gas standards = higher priced cars or lighter
(unsafe vehicles); and alternative sources = more expensive energy (largely
funded through government subsidies [consider ethanol]. For more on the
effects of government subsidies, see: Alan Greenspans comments in his article
Antitrust, discussed in Principle 7, below. Alan Reynolds, in a brief article, cut
to the heart of the current energy situation [Oil Prices: Cause and Effect,
available @ www.townhall.com/columnists/alanreynolds20050623. He explains
oil prices simply in terms of, surprise, surprise: Supply and Demand pointing
out that only 45% of each barrel of oil is converted into gasoline! Notice that
in1997/98 the price of a barrel of oil was cut in half (a disincentive for oil
exploration). Also note that between:
1978 and 2004 oil consumption rose 28.6 percent in the world but only 8.9 percent in the United States. That difference was exemplified by a 344 percent
increase in South Koreas oil demand.
60 percent of incremental oil demand [is] not coming from China and the
United States.

Especially interesting, or should I say alarming, are Reynolds conclusions concerning potential proposed actions by members of Congress:
Meanwhile, some clueless senators are oddly eager to push the Chinese currency
up, which would make oil cheaper for Chinese industry and more expensive at
home. The White House seems oddly eager to enact more tax-financed subsidies
for those who buy Japanese hybrid cars, German diesels and ethanol made from
corn or sugar. It is difficult to imagine a more irrelevant energy policy. (emphasis

added)
The only policy that might actually shrink the fear premium in oil (estimated at
$10 to $ 20) is to use the strategic petroleum reserve strategically to quell panic
during hurricanes, strikes, wars and the like. But the United States has instead
imported oil to add to the reserve whenever oil prices were unnaturally high (1981
to 1985 and now) and sold when the price was low (1997).
When it comes to causes and effects of high oil prices, nobody in Washington shows
much interest in logic or facts. It might be sad if it wasnt so pathologically pathetic.

Sowell identifies organized nature cults, read: environmental groups (a special

interest group), that impede drilling (increasing the domestic supply and lower
prices). He debunks the idea that we are running-out of petroleum (or any other
minerals, for that matter) See the bet between Julian Simon (an economist) and
Paul Ehrlich (a botanist), a paper Julian Simons Bet with Paul Ehrlich, is
available @ www.overpopulation.com/faq/People/julian_simon.html. [This
particular paper is a must read for those who have been duped into believing
extreme environmental rhetoric. After losing the bet Ehrlich reverted to his old
ways ignoring his failed predictions in general and declaring that the bet
didnt mean anything. (Now thats adhering to the scientific method!)] Higher
prices means that oil producers will seek out and attempt to discover and produce
more! Remember: INCENTIVES MATTER and higher prices are incentives for oil
producers.
Incentives (money, power, prestige, approval, love) normally lead to more
of a given behavior, while negative incentives (disincentives) typically discourage
given behaviors. Mankiw rightly emphasizes the critical role that price plays in
the free market in allocating (channel or direct) resources to their highest and
best (most valued) uses. This is an issue of economic efficiency and deviations
from the allocation of scarce resources to their highest and most valued uses
represent economic waste and a reduction is social welfare. For an example, see:
Thomas Sowell. 2001. The Mail Monopoly, available @ www.townhall.com/
columnists/thomassowell/printts20010705. Sowell discusses how the Postal
Service is a protected entity and does not have to worry about competition, and
therefore does not have to cater to its customers. His point is:
When the post offices copier takes business away from a local copier shop, it
also takes taxes away from the local government. More important, the economys
resources do not flow to the most efficient user but to the operation with the most
privileges.
Monopoly means inefficiency and a money-losing monopoly means even more
inefficiency.

It is rare that a change in one economic variable does not affect the behaviors of
market participants. Mankiw uses an example of an increase in the price of apples
resulting in an increase in purchases of other alternative fruit (pears) to make this
point. Also, note Mankiws example of seat belts.people feel safer.so they

speed more, resulting in even more accidents, but fewer deaths. More accidents
are the unintended consequences of government imposed mandatory seat belt
laws!!
Principle # 5: Trade Can Make Everyone Better Off It makes sense to substitute the
broader term, exchange for trade in Mankiws statement. Such a substitution
permits a fuller understanding of the concept by introducing the ideas of two
Classical economists: Adam Smith and David Ricardo. When considering Adam
Smiths contributions it is essential to note two major ideas: (i) the division of
labor and (ii) the invisible hand that is the free market. First, consider the
origin of the division of labor:
This division of work is not however the effect of any human policy, but is the
necessary consequence of a natural disposition altogether particular to man, viz
[Latin, videlicet that is to say, namely] the disposition to truck, barter, and
exchange; and as this disposition is peculiar to man, so is the consequences
of it, the division of work betwixt different persons acting in concert.Man
continually standing in need of the assistance of others, must fall upon some
means to procure their help. This he does not merely by coaxing and courting;
he does not expect it unless he can turn it to your advantage or make it appear
to be so. Mere love is not sufficient for it, till he applies in some way to your selflove. A bargain does this in the easiest manner. When you apply to a brewer or
butcher for beer or beef, you do not explain to him your interest to allow you to
have them for a certain price. You do not address his humanity, but his selflove.
This disposition to truck, barter, and exchange does not only give occasion to the
diversity of employment, but also makes it useful. [Smith, Lectures on
Jurisprudence, 347-8, as quoted by Robert L. Formaini in Adam Smith
Capitalisms Prophet, Economic Insights, Vol. 7, No. 1; available @
www.dallasfed.org/research/ei/ei0201. Emphasis added.

Smiths famous remark about the invisible hand guiding the market may also be
usefully considered here:
By pursuing his own interest he frequently promotes that of society more
effectually than when he really intends to promote it. I have never known
much good done by those who affected to trade for the public good. It is an
affectation, indeed, not very common among merchants, and very few words
need be employed in dissuading them from it. (1981. The Wealth of Nations,
I, 456, emphasis added)

For more, see: Robert L. Formaini. Adam Smith Capitalisms Prophet,

Economic Insights, Vol. 7, No. 1; available @ www.dallasfed.org/ research/ei/ei
0201. The voluntary (free) exchange between individuals and between nations
makes at least one party better off, without making the other party any worse off,
or the voluntary exchange would not take place. Ricardo argues that individuals
and nations should focus their productive efforts (land, labor, capital and
entrepreneurial talents) on doing the things they do best (in which they have a
comparative advantage.) For more, see: Robert L. Formaini. David Ricardo
Theory of Free International Trade, Economic Insights, Vol. 9, No. 2; available
@ www.dallasfed.org/research/ei/ei04012. If the exchanges are truly voluntary,

the mere existence of exchange indicates that the individual parties and, by
extension, society is better off. Additional insights are to be found in Dwight R.
Lee. Economic Protectionism, Economic Insights, Vol. 6, No. 2; @ www.
dallasfed.org/research/ei/ei04012. This paper is a must read for anyone who want
to understand the basic principles of economics and wants to be inoculated against
the pathogenic views of politicians and mainstream journalists. Perhaps one of the
most telling ideas is the conflict between production and consumption, between
the interests of producers and the interests of consumers. Lee writes:
To some degree, a strong emphasis on productions is justified.Few things are
more destructive than concentrating on grandiose redistribution [Robin Hood
economics] schemes with no thought to their negative effect on incentives to
produce [that which is seen and that which is unseen]. The supply-side movement focuses attention on the distorting impact of high marginal tax rates have
on production decisions. Lower marginal tax rates reduce the difference between
what consumers pay and what producers receive and make producers more responsive to consumer demands.
Unfortunately, political decisions aimed at promoting production typically make
producers less responsive to consumers. Instead of seeing production as the means
of serving consumer interests, producers interests are treated as ends in themselves. The result is a reduction in the value of what is produced, which is, since
we are all consumers, a sure prescription for making most people worse off.
[emphasis added]

Principle # 6: Markets Are Usually a Good Way to Organize Economic Activity This
calls attention to the three main ways that societies have organized themselves to
produce goods and services efficiently. First, is subsistence economies usually
characteristic of pre-industrial societies, where one eats what one produces and
there is little division of labor, save along gender lines. In such societies, per
capita output is low as is the standards of living. The benefits and costs of such
social arrangements have been discussed in James M. Buchanans small book:
Market as a Guarantor of Liberty, The Shaftesbury Papers. Hants, England:
Edward Elgar, 1993. The second form is capitalism, a system in which private
property, well enforced property rights and specialization of task are welldeveloped. Under such a social system surplus production accompanies the
division of labor permitting a higher level of per capita output and level of
earnings, as well as a higher standard of living. [The role of specialization of task
and increased levels of worker productivity is to be seen in Adam Smiths
justifiably famous pin factory example, according to Rima, Smith
calculates that division of labor makes it possible for ten workers to
produce 48,000 pins per day, so that each worker produces the equivalent
of 4,800. Without division of labor, a worker might not even make one pin
in a day, and certainly not 20. (I.H. Rima. 1971. Development of Economic
Analysis. Haywood, IL: Richard D. Irwin, Inc, 68.)]

The third mode of economic organization is communism (or socialism). Under

such a system private property rights do not exist, or are strictly limited to
personal effects. The factors of production are all directly under the control of the
10

government and are allocated to the uses decided upon by government decisionmakers (or bureaucrats), including production and consumption. The
collectivization of the factors of production by the state eliminates the incentives
for individuals to produce and to excel.
The issue of modern capitalism and its benefits have been addressed in a
series of articles (extracted from a book, Investors Business Daily Guide to the
Markets) published several years ago The Hallmarks of Modern Capitalism,
America, And the Entrepreneur, Ascendant, and Capitalisms Miracle Period
After WW II.) The author(s) point out the obvious:
If capitalism has many forms, what makes the modern variety different?
For one thing, property rights are now a bedrock of our existence. In no other
system are the rights of the individual so carefully guarded.
Such a system presumes the individual will use his role as property owner to
beneficial ends, [remember Adam Smiths comments on self-interest and a
public good?] that in pursuing his own self-interest through profit, the
greater interest of society will be served. [emphasis added]
Contrary to what critics of capitalism say, the placement of property in private
hands requires the owner to be a good steward, not a despoiler.
Its no coincidence, for example, that the worst ecological crisis wrought
during the industrial age came in the former nations of the East Bloc and in
the Third World, where property rights are weakest. [emphasis added]
Markets, ultimately, are a kind of democracy. One person sells, another buys
at a mutually agreed-upon price. Markets rarely discriminate efficient markets
never do except on price. When two parties strike a deal, it tangibly demonstrates that both are better off, or neither would have wasted the time or effort.
[emphasis added]

Somewhat later, the author(s) add:

In todays world, the most advanced capitalist nations are also the wealthiest.
These countries have had the most success not only in creating wealth, but also
in getting that wealth into the most hands. [emphasis added]

More importantly, they quote Angus Maddisons book, Dynamic Forces in

Capitalist Development:
Since 1820, the total product of the advanced capitalist group [Britain, the
United States, Australia, Austria, Belgium, Canada, Denmark, Finland,
France, Germany, Italy, Japan, the Netherlands, Norway, Sweden and Switzerland] has increased 70-fold, population nearly 5-fold, and per capita product
14-fold. Annual working hours have been cut in half and life expectancy has
doubled.
These 17 decades constitute the capitalist epoch, for the pace of advance in
peacetime has virtually always been a huge multiple of that in earlier centuries.

11

The output of the average worker today increases more during the short span of
a career than during the entire 1,000 years of the Middle Ages.
The basic reason for this productivity miracle is investment. [emphasis in
original]

Investments are made for improving ones lot-in-life (betterment, selfinterest) which may be accomplished through the quest for profits. Many of those
who invested in the growth of this country (the Goulds, Vanderbilts, Rockefellers,
Morgans, and Carnegies) and increased the nations output have been vilified as
Robber Barons, implying that the succeeded by stealing wealth, not creating it.
In fact, they were responsible for building the nations industrial infrastructure,
partly with foreign money (investment). The second installment of the IBDs
series (America, And The Entrepreneur, Ascendant) reports:
From 1890 to 1913, Americas capital stock grew at an average rate of 5.4% a
year about 60% higher than the average for other major capitalist
countries.
Relatively less was invested in the following decades.
The United States also seemed to be the home of an unusual number of
geniuses people like Thomas Edison and Alexander Graham Bell, who
found ready markets in the U.S. for their ideas.
The vast economies of scale that Americas markets provided were not lost
on U.S. corporations
The primary reason for U.S. dominance, however, can be summed up in one,
Ironically foreign, word: entrepreneur. Derived from the French for undertake,
it refers to the individual who drives the economy by organizing and managing
business ventures, and assumes risks for the sake of profit. [emphasis added]

Remember the first key element formulated by Gwartney and Stroup: Incentives
Matter? Well, profits is not a dirty word, in fact, profits provide incentives for
entrepreneurs to drive the economy and to bear risk!
It was not a French, but an Austrian economist who first gave the entrepreneur
his due. Previous commentators on capitalism had focused on the accumulation
of capital, laissez-faire trade policies or technological change as the reasons for
capitalisms success.
Joseph Schumpeter was different. He saw capitalism as a dynamic system beset
by periodic crises he termed waves of creative destruction. A crisis, he believed,
led to new opportunities as much as it destroyed something old. [emphasis
added]
The entrepreneur, he asserted, is the rarest of commodities: an able risk taker.

12

For a more comprehensive view of Schumpeter and his contributions to

economics, see: W. Michael Cox. Schumpeter In His Own Words, Economic
Insights, Vol. 6, No. 3; available @ www.dallasfed.org/research/ei/ei0103.
Principle # 7: Governments Can Sometimes [?] Improve Market Outcomes [emphasis
added] Provides economic justifications for the public provision of certain
essential goods and services (police). The primary explanation is that at times
markets fail [Adam Smiths invisible hand doesnt seem to work in certain
situations] due to the nature of the production processes (need for very large-scale
production units to attain both economic and technological efficiencies); so-called
externalities (pollution, health risks); or fairness in the distribution of either
income or wealth (the fruits of the production process).
A good place to find some answers to the issue of so-called market
failure is in the works of James M. Buchanan it would be helpful to read:
Robert L. Formaini. James M. Buchanan The Creation of Public Choice
Theory,
Economic
Insights,
Vol.
8,
No.
2;
available
@
www.dallasfed.orf/research/ei/ei0302. Formaini has noted:
At first glance, public choice theory seems to be nothing more than common sense:
Governments are collections of individuals whose interaction is determined by the
same self-interest that motivates people in the private sector.
As many economists came to doubt the efficiency of large, state-funded programs,
they saw public choice theory as a way to examine what has come to be known
as government failure. For decades following Arthur Cecil Pigous famous book
The Economics of Welfare, economists saw government as a disinterested agency
that could correct for market failure. Buchanan and other public choice theorists
altered the debate by proposing that government may not really correct problems
in the marketplace because of the wealth trading, or rent seeking, that occurs
during the legislative process.

Interestingly, Pigous ideas figure strongly in the formulation of Ronald Coases

transaction cost approach to economic analysis. [See: Robert L. Formaini and
Thomas F. Siems. Ronald Coase The Nature of Firms and Their Costs,
Economic Insights, Vol. 8, No. 3; available at: www.dallasfed.org/research/ei/
ei0303.html.] Coases arguments against the Pigouvian position are best
developed in: Ronald H. Coase. 1960. The Problem of Social Cost, Journal of
Law and Economics; earlier intimations are to be found in his 1937 article, The
Nature of the Firm, Economica, Vol. 4 (November), 386-405.
It is well to consider the observations of Alan Greenspan in a paper he
presented at the National Association of Bureau of Economics in 1961, entitled,
Antitrust, and has been re-printed in Ayn Rand. 1967. Capitalism: The
Unknown Ideal. New York: Signet, 63-71. The discussion provides insights into
the consequences of governmental policies (things unseen to use Bastiats
terms). Greenspan observed:
The world of antitrust is reminiscent of Alices Wonderland; everything seemingly

13

is, yet apparently isnt simultaneously. It is a world in which competition is lauded

as the basic axiom and guiding principle, yet too much competition is condemned
as cutthroat. It is a world in which actions designed to limit competition are
branded as criminal when taken by businessmen, yet praised as enlightened when
initiated by the government. It is a world in which the law is so vague that businessmen have no way of knowing whether specific actions will be declared illegal until
they hear the judges verdict after the fact. [63, emphasis added]

The implications of the contrast is unnerving bureaucrats are omniscient,

dedicated public servants while businessmen (with their own money at risk) are
not only short-sighted, but greedy (self-interested) and behave illegally. But,
please keep James M. Buchanans ideas in mind: bureaucrats behave in their own
self-interest and frequently respond to the rent-seeking behaviors of special
interest (aka political pressure) groups, often placing these interests above the
interests of the rest of society. Greenspan then reviews the origins of the
Interstate Commerce Act (1887) and the Sherman Act (1890). The history is
illuminating
The railroads developed in the East, prior to the Civil War, in stiff competition
with one another as well as with the older forms of transportation barges, riverboats, and wagons. By the 1860s there arose a political clamor demanding that
the railroads move west and tie California to the nation: national prestige was held
to be at stake. But the traffic volume outside the populous East was insufficient to
draw commercial transportation westward. [Read: demand was inadequate to
assure that revenues would cover costs of construction and operation of the
proposed railroad expansion.] The potential profit did not warrant the heavy cost
of investment in transportation facilities. In the name of public policy it was,
therefore, decided to subsidize the railroads in their move West. [Read: at all taxpayers expense for the benefit of those living on the West coast] [Emphasis
added; materials added] (Greenspan, 1967, 64)

Far from railroads lobbying for subsidies, politicians, especially those on the West
coast and those in states along the right-of-way lobbied [political clamor] for the
construction of the railroads! The U.S. Government provided land, from the
public domain as inducements to railroad companies to lay track. Greenspan
reports:
Between 1863 and 1867, close to one hundred million acres of public lands were
granted to the railroads. Since these grants were made to individual roads, no
competing railroads could vie for traffic in the same area in the West. [Remember
the stiff competition railroads faced with one another in the East?] Meanwhile,
the alternative forms of competition (wagons, riverboats, etc.) could not afford to
challenge the railroads in the West. Thus, with the aid of the federal government, a
segment of the railroad industry was able to break free from the competitive
bounds which had prevailed in the East. (emphasis added, material added)
As might be expected, the subsidies attracted the kind of promoters who always exist
on the fringe of the business community and who are constantly seeking an easy deal.
[Note that this statement does not apply only to the business community, there are
those on the fringe of society who who are constantly seeking an easy dealthieves,
swindlers, looters, and gangsters of all types.] Many of the new western railroads were
shabbily built: they were not constructed to carry traffic, but to acquire land grants.
[material added] (Greenspan, 64)

14

The western rail roads were true monopolies in the textbook sense of the word. They
could, and did, behave with an aura of arbitrary power. But that power was not derived
from a free market. It stemmed from governmental subsidies and government
restrictions. (65)
When, ultimately, western traffic increased to levels which could support other profitmaking transportation carriers, the railroads monopolistic power was soon undercut.
In spite of the initial privileges, they were unable to withstand the pressure of free
competition.
In the meantime, however, an ominous turning point had taken place in out economic
history: the Interstate Commerce Act of 1887.
This Act was not necessitated by the evils of the free market. Like subsequent
legislation controlling business, the Act was an attempt to remedy the economic
distortions which prior government interventions had created, but which were blamed
on the free market. [emphasis added]

As in Alice in Wonderland, things just keep getting curiouser and curiouser.

All of this should encourage skepticism regarding Mankiws idea that: Markets
Are Usually a Good Way to Organize Economic Activity [Principle # 6]. Perhaps
free-markets are a better way of getting things done, since they harness
individual self-interest in serving the needs and wants of others through the
provision of positive incentives (rents, wages and salaries, interest and dividends,
AND profits.
For a brief comparison of the issue of provision of goods and services by the free market and by
the government, see: Hugh Macaulay. 1999. Can Government Deliver the Goods? The
Freeman: Ideas in Liberty (January); available @: www.fee.org/vnews.php?nid=4220.

Principle # 8: A Countrys Standard of Living Depends on Its Ability to Produce Goods

and Services Identifies the nexus between/among production, wealth
creation and a regions standard of living. Perhaps one of the most illuminating
sources for a deeper understanding of these issues, particularly in Africa and
Southeast Asia, as well as regions of developed countries, may be found in the
writings of Sir Peter Bauer (1915-2002), especially a brief article in a hard to
find German economics journal: The Vicious Circle of Poverty. Much of the
material from the article may be found in chapters with the same title in several of
his books. On his death in 2002, Thomas Sowell wrote a tribute to Bauer, it is
worth a quick read, just to discover his key ideas. [www.townhall.
vcom/columnists/thomassowell/20020510] Other tributes to Sir Peter are: Paul
Craig Roberts, Peter Bauer: A Dissenter on Development, www.vdare.com/
roberts/bauer; Peter Brimelow, In Memoriam: Peter, Lord Bauer, wwwvdare.
com/pb/bauer_memorium; and Razeen Sally, Aid, Trade, Development: The
Bauer Legacy, www.lse.ac.uk/collections/globalDimensions/research/aid....
Several of Sowells comments are:

15

The dominant orthodoxy in developmental economics was that Third World

countries were trapped in a vicious cycle of poverty that could be broken only
by massive foreign aid from the more prosperous industrial nations of the
world [emphasis added]
Peter Bauer never bought any part of this vision. He had too much respect for
people in the Third World, where he had lived for years, to think of them as
helpless. Before 1886, he pointed out, there was not one cocoa tree in British
West Africa. By the 1930s there were millions of acres under cocoa there, all
owned and operated by Africans.
Developmental economics hostility to the market and contempt for ordinary
people were to Bauer only two sides of the same coin. [emphasis added]
If poverty was a trap from which there was no escape, Bauer declared, we would
all still be living in the Stone Age, since all countries were once as poor as Third
World nations are today.
Peter Bauer considered it arbitrary and self-serving to call international transfers
of money [wealth] to Third World governments foreign aid. Whether it was aid
or a hindrance was an empirical question. Sometimes it could turn out to be simply
transferring money from poor people in rich countries to rich people in poor
countries.[emphasis added]
Bauer likewise rejected overpopulation as a cause of Third World poverty, even
though that was also one of the key dogmas of developmental economics. [emphasis
added]

Finally,
The later research of Hernando de Soto, published in his book The Mystery
of Capital, added still more evidence that supported Peter Bauers thesis that
Third World people were capable of creating wealth, even if their governments
followed economically counterproductive policies that held them back.
For decades on end, Peter Bauer stood virtually alone in opposing the prevailing
dogmas of developmental economics.

Perhaps a most telling observation about Sir Peter Bauer has been made by Paul
Craig Roberts. He has written:
One of the chilling facts about the 20th century West is how poorly champions
of individual liberty have fared in free societies. They seldom receive state
honors. Rarely are they celebrated in academia or the media.
One of the 20th centurys great economists, Ludwig von Mises, a refugee from
Hitler, could not get a university appointment in America. Mises said that
government was the problem, not the solution, and outraged progressives, who
were committed to the welfare state, ostracized him. F.A. Hayek was disparaged
for many years for his warnings against big government, as was Milton
Friedman.
There have been no prizes for those whose work advanced liberty. Neither are
there Ford, Rockefeller, or Carnegie Foundation grants nor Mac Arthur
Foundation genius grants. Progressive prejudice has been such that no one

16

who advances liberty could possibly be seen as a genius. The liberal-socialist

establishment has worked to shut such people up.
For decades Lord Bauer stood alone in opposition to the view that only planning
and foreign aid could produce economic development in poor third world
countries.
He watched marketing boards destroy a flourishing peasant agriculture keyed to
exports, forcing the peasants back into subsistence farming.
Bauers dissent on development was based on his realization of the importance of
traders in moving an economy from subsistence to exchange. This critical activity
of traders was curtailed by the regulations imposed by development planning.

Ironically, according to Bauers research:

With planning and aid came poverty and war. Foreign aid, Bauer noted, made
control of the government a life-and-death matter, causing genocidal warfare
between tribes. [emphasis added]

Even more telling are the observations of Peter Brimelow:

, Bauer had two problems as an economist. Firstly, in the mysterious
way that these things happen, he chose to get interested in free market
economics at a time when it was utterly and completely out of fashion
portrait of Cambridge (U.K.) in the early 1950s, with economics
discourse controlled by the self-styled secret seminar orchestrated by
left-wing Keynesians led by Richard Kahn and Joan Robinson.
Bauers second problem in some ways even more serious, it may have
cost him the Nobel Prize was that he preferred words to numbers and
arguments to equations.

Most economists since Adam Smith and David Ricardo have understood the
connection between production, exchange, wealth creation and rising standards of
living (individual and national) are attained by serving the needs of others, while
pursuing your own self-interest. Please remember Adam Smiths comment on the
pursuit of self-interest:
By pursuing his own interest he frequently promotes that of the society
more effectually than when he really intends to promote it. I have never
known much good done by those who affected to trade for the public
good

Few have put it better, none more succinctly.

Principle # 9: Prices Rise When the Government Prints Too Much Money Such actions
by the government are meant to have a(n) ameliorative effect(s) on certain
economic variables, but all too often, there are unintended consequences (read
inflation). Inflation has been described as Too many dollars chasing to few
goods, resulting rising price levels. To understand one of the effects of too much
money, inflation, and contemporary issues, see: Walter E. Williams. 2005.
17

Gasoline Prices, @ www.townhall.com/columnists/walterwilliams/ww2005

0831. Most economists recognize the harmful effects of inflation, many recall the
good-ol-days of the late 1970s (President Jimmy Carter) and the days of the
first Reagan administration when inflation rates were high . To verify this
statement, go to:

www.bls.gov

in the left hand corner, click on:

Inflation $ Consumer Spending

CPI and Inflation Calculator

Tables Created by BLS

[First Table]
Table Containing History of CPI
In this table, look at the last column on the right, per cent change year on year and
read down to the period 1970 to 1990. Note that in 1971 the annual CPI rate
(inflation rate) was 3.3%. After 1973 [the first, so-called energy crisis began in
October of that year] the rate rose to 12.3% in 1974 and remained higher that the
average for the previous decade. The second, so-called energy crisis began in
1979 when the CPI reached 13.3% and in 1980 was still high at 12.5%, only
falling to 8.9% in 1981. It then fell to 3.8% in 1982 and has continued low to the
present day.
Despite the acknowledgement that inflation is a monetary phenomenon, myths
about inflation abound. In an essay, Ten Great Economic Myths, in Murry N.
Rotherbards book, Making Economic Myths, Auburn, AL: Ludwig von Mises
Institute, 1995, 18-29. Rothbards first myth is:
Myth 1: Deficits are the cause of inflation; deficits have nothing to do with inflation.
In recent decades we always have had federal deficits. The invariable response
of the party out of power, whichever it may be, is to denounce those deficits as
being the cause of perpetual inflation. And the invariable response of whatever
party is in power has been to claim that deficits have nothing to do with inflation.
Both opposing statements are myths.
Deficits mean that the federal government is spending more than it is taking in in
taxes. Those deficits can be financed in two ways. If they are financed by selling
Treasury bonds to the public, then the deficits are not inflationary. No new money
is created; people and institutions simply draw down their bank deposits to pay for
the bonds, and the Treasury spends that money. Money has simply been transferred
from the public to the Treasury, and then the money is spent on other members of
the public.
On the other hand, the deficit may be financed by selling bonds to the banking

18

system If that occurs, the banks create new money by creating new bank deposits
and using them to buy the bonds. The new money, in the form of bank deposits,
is then spent by the Treasury , and thereby enters permanently into the spending
stream of the economy raising prices and causing inflation. By a complex process
the Federal Reserve enables the banks to create the new money by generating bank
reserves.In short, the government and the banking system it controls in effect
print new money to pay for the federal deficit. (19, emphasis in the original)
Thus, deficits are inflationary to the extent that they are financed by the banking
system; they are not inflationary to the extent they are underwritten by the public.
General price changes are determined by two factors: the supply of, and the demand
for, money.(19-20)

Some economists have argued that inflation is a form of tax on peoples wealth
(savings and investments), eroding the value of their assets over time. This is a
cruel joke to play on people saving for their retirement. A wonderful example of
this view may be found in a brief article by Llewelln H. Rockwell, Jr., 2005.
Bushs Ten Worst Economic Errors, The Free Market, Vol. 23, No. 6 (June), 36. In this article, Rockwell considers the single worst economic mistake that
President Bush has made to date, has been Ben S. Bernanke as the head of the
Council of Economic Advisors, replacing the author of your text, Greg Mankiw.
Rockwell wrote:
Number One: The Appointment of Ben S. Bernanke, formerly of the Fed, to be
chairman of the Council of Economic Advisors. Please listen to his words from
a speech given in the context of trying to settle down peoples fears of the
economic future.
The US government has a technology, called a printing press (or, today its
electronic equivalent), that allows it to produce as many US dollars as it wishes
at essentially no cost. By increasing the number of US dollars in circulation, or
even by credibly threatening to do so, the US government can also reduce the
value of goods and services, which is equivalent to raising the prices in dollars
of those goods and services. We conclude that, under a paper-money system, a
determined government can always generate higher spending and hence positive
inflation.

Having caught his breathe, Rockwell continues, sarcastically:

Well, these comments certainly do calm fears that deflation is in our future. But
what he seems incredibly sanguine about is the effects of inflation. Already,
inflation amounts to a daily robbery of the American consumer. Even in these
supposedly low inflation times, price indexes have doubled since 1980. What
this means is that one dollar in 1980 purchases only 50 cents worth of goods and
services today. There are no long lines at gas stations and we arent panicked for
our future, but we are still being robbed, only more slowly and more subtly than
in the past.
The Bernanke appointment is the most egregious decision that the Bush administration has made.

19

An inflationist Keynesian and an aggressive advocate of printing-press economics,

Bernanke is the sort of crank who becomes famous in history for having destroyed
whole countries. He is utterly and completely dedicated to the idea that paper money
will save the world, with no downside. I shudder for our future if he becomes head of
the Fed. Yet this appointment is probably a pathway to Greenspans job, as it was for
Greenspan himself. (6, emphasis in the original)

Principle # 10: Society Faces a Short-Run Tradeoff between Inflation and Unemployment
Its important to note upfront that government has a monopoly on money
creation, but has no power to create jobs, that is a function of the private
sector. While some economists believe in this relationship, known as the socalled Phillips curve, many economists have called it into question. Murray
Rothbard, for example, considers it to be one of the Ten Great Economic
Myths, having written:
Myth 6: There is a tradeoff between unemployment and inflation.
Every time someone calls for the government to abandon its inflationary policies,
establishment economists and politicians warn that the result can only be severe
unemployment. We are trapped, therefore, into playing off inflation against high
unemployment, and become persuaded that we must therefore accept some of both.
The doctrine is the fallback position for Keynesians. Originally, the Keynesians
promised us that by manipulating and fine-tuning deficits and government spending,
they could and would bring us permanent prosperity and full employment
without inflation. Then, when inflation became chronic and ever-greater, they
changed their tune to warn of the alleged tradeoff, so as to weaken any possible
pressure upon the government to stop its inflationary creation of new money. (24)
The tradeoff doctrine is based on the alleged Phillips curve, a curve invented
many years ago by the British economist A.W. Phillips. Phillips correlated [In
statistics it has been long know that correlation is not causation.] wage
rate increases with unemployment, and claimed that the two move inversely: the
higher the increases in wage rates, the lower the unemployment. On its face, this
is a peculiar doctrine, since it flies in the face of logical, commonsense theory.
Theory tells us that the higher the wage rates, the greater the unemployment,
and vice versa. If everyone went to their employer tomorrow and insisted on
double or triple the wage rate, many of us would be promptly out of a job.
Yet this bizarre finding was accepted as gospel by the Keynesian economic
establishment. (24-5, emphasis in original, material in brackets added)
By now, it should be clear that this statistical finding violates the facts as well
as logical theory. For during the 1959s, inflation was only about one to two
percent per year, and unemployment hovered around three or four percent, whereas
later unemployment ranged between eight and 11%, and inflation between five and
13%. In the last two or three decades, in short, both inflation and unemployment
have increased sharply and severely. If anything, we have had a reverse Phillips
curve. There has been anything but an inflation-unemployment tradeoff.
But ideologues seldom give way to the facts, even as they continuously claim to
test their theories by Facts. To save the concept, they have simply concluded
that the Phillips curve still remains as an inflation-unemployment tradeoff, except
that the curve has unaccountably shifted to a new set of alleged tradeoffs. On
this sort of mind-set, of course, no one could ever refute any theory.

20

In fact, current inflation, even if it reduces unemployment in the short-run by

inducing prices to spurt ahead of wage rates (thereby reducing real wage rates),
will only create more unemployment in the long run. Eventually, wage rates catch
up with inflation, and inflation brings recession and unemployment inevitably in
its wake. After more than two decades of inflation, we are now living in that
long run.

There are several major points to consider in Murray Rothbards critic of the
Keynesian adherence to the so-called Phillips curve: (i) an unwillingness on the
part of Phillips curve advocates to adhere to the standards of the Baconian
Scientific Method [subject their theory to the rigors of empirical testing]; and (ii)
once the theory has been demonstrated to be defective to reject it and seek a new
theory. [Remember the points made by Michael Crichton in his Michelin Speech,
Aliens Cause Global Warming?]

21