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Economics: Analysis and Issues

Classical Economics Reconsidered
Knowledge and Decisions
Mmxism: Philosophy and Economics
Say's Law
A Citizen’s Guide to theEcon


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, 1930-
Basic economics : a citizen’s guide to the economy/
Thomas Sowell.
p. cm.
Includes bibliographical references and index.
ISBN 0-465-08
1. Economics. I. Title.

HB171 .S73 2001



A few lines of reasoning can changethe way we see
Steven E. Lansburg
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1 What Is Economics?


2 TheRoleof Prices
3 PriceControls
4 An Overview


5 The Rise and Fall of Businesses

6 The Role of Profits-and Losses
7 Big Business and Government
8 AnOverview


9Productivity and Pay

10 ControlledLaborMarkets
11 An Overview
... Contents


12 Investment and Speculation

13 Risks and Insurance
14 AnOverview


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


19 International Trade
20 International Transfers of Wealth
21 An Overview



22 "Non-Economic" Values
23 Prices and Purchasing Power
24 Business and Labor
25 An Overview


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

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


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
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.
This Page Intentionally Left Blank
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

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

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 principlesthat 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
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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

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.


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
the of their
cream or yogurt, in order to increase output
uct to meet the risingdemand. 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

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

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
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

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.


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 all-
prefer to get the highest price that they can. But it is eq
that buyers usually wish to pay the lowest price th

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

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

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


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.

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, evenwith 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 livewith 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

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-rent-
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 Theto Times of London

Advertisements for furnished rental accommodations

Lolldon Evezzing Stnndavd plummeted dramatically in th

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

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
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

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


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.

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
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
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 theto 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

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.


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
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

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.


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

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
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 asan 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

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
complex causes. The specific facts can tell us which. A
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

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.


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

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, theor 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

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
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 necessaryto
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

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 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 chooto
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

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
changing demands, leading to incremental changes in sup
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
used about 200 gallons less gasoline. This is because of
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

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:
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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.


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

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

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

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 thosein 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

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.


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 socialist-
entirely different situation. Today’s supermarket or de
store stocks an incredible variety of goods without kno

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

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

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 Profits-
and 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 con-
tinued and which ones are abandoned . . . The cru
cial requirement for maintaining growth and
progress is that successful experiments be contin-
ued 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.


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
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
would in practice have the lower prices and greater pro
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.

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

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.


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.

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 well-
rant usually requires the presence of an owner with s

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 costsare l
each particular business is forceddoto it because their
will take customers away from them if they don’t.


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

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.
This Page Intentionally Left Blank
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.


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

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
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

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

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
I 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

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.


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

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

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.


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

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

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 anti-
has 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
This Page Intentionally Left Blank
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
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.

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 costsof 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 stayedopen 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
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.


Given the importance of the human factor and the

among people-or evenwith the samepersonat

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 is one of the scarcest of all resources.

alities abound, but specific hard facts that are releva

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

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

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.

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

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


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

nated economy with strong financial incentives to d

ers to be right and ruthless elimination of those wh
turn outto be mistaken too often.


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

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 each-
buy 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 beingbought 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

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


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:
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Chapter 9
Productivity and Pay

Do you yay your secretaries less than your engi-

neers because you Like the engineers better, or be-
cause 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
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

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
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

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


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
While someone may go into businessand work longand
no income to show for that it, will continue tohappen 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

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.


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
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.


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

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
Pay 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

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

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 low-
ple 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.


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

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

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
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.


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.

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 forward-
regard 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

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
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.
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. /
This Page Intentionally Left Blank
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.


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.


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.

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.


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

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

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
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
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

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.

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

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.

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


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

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.

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
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

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.
This Page Intentionally Left Blank
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

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

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

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.
This Page Intentionally Left Blank
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

A 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

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
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

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


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 it-
wheat 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

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 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 made a profit or not. This second reason
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

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.


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.


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

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

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

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.

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

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
I 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

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

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

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


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

having to pay the higher amounts that investors wo

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

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


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

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

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.

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 over-
sideration 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
cussions of how to "save" Social Security comes from th
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

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
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

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

by municipal government, these fare were set a priv

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

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
This Page Intentionally Left Blank
Chapter 15

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, policiesand 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

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 risein 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


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.


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 thing-
same 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

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.


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


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

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


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

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 priceof gold falling, as peopleare 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

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
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


While inflation has been a problem that is centu

particular times and places deflation has also been d

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.


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

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
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

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.
This Page Intentionally Left Blank
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
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
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

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 whichgenerate 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.


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

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

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

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 commercialindustrialor 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

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

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


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

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


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

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 isno 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

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.


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

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

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 categoricalla
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

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
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
This Page Intentionally Left Blank
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.

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

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
been X percent inflation or that most of that change has
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
This Page Intentionally Left Blank
This Page Intentionally Left Blank
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

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,
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.


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?
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

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
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:



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
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


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

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.

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
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

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
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


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

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
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
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
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

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
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


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 goods-
Center, 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.
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

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
cal capabilityof the United States led to a numberof a
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 beno 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
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.

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
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.


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.

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

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

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
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

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

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.


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
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


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
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


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

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,
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:
This Page Intentionally Left Blank
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


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
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


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
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 very language in which many issues are discu

the way to confusing economicswith some materialist

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.


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?
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
however itis done, there will still be morem e t needs
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.

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 politician-
even 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.


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.

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

”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
This Page Intentionally Left Blank
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.


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

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 UPStwo-
actually 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

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
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

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 multi-
corporation. 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
and Prices

into your tank that messes up your engine or-worse yet-

eat 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

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
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


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.

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
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


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

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


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

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
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

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
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.” Anysuggestions 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.

1When I taught economics, I used to offer togive an A to any studentw

a favorable reference tobusinessmen in The W e d f hofNutions. None ever did

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

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.


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

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

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.


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

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.

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
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

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

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
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
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 proclaimsits 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

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
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.

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


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.


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
Marx himself makes similar comments in the text, though n
language as that used by Engels. Information on Ghana
Coast is from book
a by W. L. Alpine and James Picket, Agricu
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
Upstate,” by Jerry Zremski in the Autumn 1999 issue of City
lished by the Manhattan Institute, a think tank in New
348 Sources


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 Intersectionof 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

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.

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


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
Walton. The declining circulation of New York City newspape
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
Robert Heilbroner titled ”Socialism” in The Fortune Encyclop
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.


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 fromThe 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.


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 pages380
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.

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
from his bookThe State and Revolution, written on the eve of
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


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
Soviet Union is from page 11of The TurningPoint by Nikolai S
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
tal equipmentin the Soviet Union and in the United State
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.


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
and employment are from Motov Vehicle Facts & Figures: 1
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


Data on employees’ share in national income are
Illusfvated Guide to the American Economy, third edition, w

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


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.


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


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.


Data on the unemployment rate during the Great
1930s is from page196 of an article titled ”Great Depres
J. Samuelson, published in the Fortzlne Elzcyclopedia of Eco
the fall in pricesof various corporate stocks from 1929 to
page 76 of Since Yesterday: The 1930s i~zAmerica by Frederi
published in1986 in the Perennial Library edition by


The fact that a hundred-dollar bill in the 1990s had l
power than a twenty-dollar bill in the 1960s is from pag
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
twice a day during this period is from pages 450-451
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
Old Days’.’’ Data on the 1921 inflation in the Soviet Un
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.


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
Herbert Stein in theWall Street Journal of August 25,1996, p
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


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
in Paul Johnson’sA History of the American People, pages 737
Out of Work by RichardK. Vedder and Lowell E. Gallaway


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
Joel Millman titled ”Job Shift to Mexico Lets U.S. Firm
appeared in the November 15,1999, page A 28.


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
sity Press. Information on Americans producing on tha
all the manufactured goods in the worldin 1913 is from p
same book. Page 68 of Myron Weiner’s 1995 book, The Mig
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.


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



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


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
mate that airline fares were up to 50 percent higher under g
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,”
This Page Intentionally Left Blank

A & P grocery chain,60,61-62,63, American Express,336

76’78-79,93,99,101,102-103, The American Medical
107,110,111,116,123,320,323 335
Absolute advantage(See also Amherst, xi
Comparative Advantage), Annheuser-Busch, 79
270-271 Antitrust laws,92-93,94
Advanced MicroDevices, 75 323-325
”Affordability,” 24,28,44,46,48,54, Australia, 25,26,275
343,345 Authors, 84,114
Africa, 13,46,48,112,291 Automobiles, 8,20,46,5
Age, 133-134,135,136,137-138, 76, 79,80,84,86,107
141-142,183,184,199,341 120,144,146,152,16
Agents, 114115,254 177,184,185-186,20
Agriculture, 33-36,4849,112,113, 206,212,218,219,22
117,130,143,144,150,177,178, 261,262,264,265,26
179,180,181,182,186,207,208, 275,278,279,284,29
212,227,230,242-243,249-250, 339
251,262,274,287,294,298,328, Avery, Sewell, 66,110
Ahold, Royal, 276 Balance of Payments (Se
Airlines, 62,81,98,120,315,321,331 International Trad
Airplanes, 67,220 Payments)
Alcoa, 76,89,101-102 Balance of Trade (See Int
Alexander the Great,224225,290 Trade and Paymen
Allen, William R., xi Baltimore & Ohio Railro
Allocation of resources, 1,2-3,9-10, Bankruptcy, 14,15,17,1
11,12-13,14,17,28,39,45,49, 62,98,105,107, 182
50,59,63,69,70,84,9,0,91, 299,315,323,324,33
118,123,160,162,167,170,171, Banks, 138-139,184,185
180,182,183,185,209,238,241, 223-235,241,285,28
244,251,254,299,301,306,336, Barter, 223,224
342,344 Baseball, 129,160,244
Allstate, 119 Bauer, P. T., 156,294,342, 181 Beer, 79
American CancerSociety, 335 Berkeley, 26

360 Index

Bloomingdale’s, 66,32,46 204-205,275,276

Bombing, 45 320,321,324,331
Borzmm, 255 Complexity, 36,4243
Bonds, 131,193-197,197-198,200,201 Computers, 4,102,12
Bonior, David, 269 217,220,265,276
Brand Names,318-321 Constraints (See Incen
Budget, Government Constraints)
Burger King, 320,321 Consumers, 9-10,14,
Burma, 13,212 52,63,66, 74, 79
Burns, Arthur F., 255 96,99,106,117,1
Business and Industry, 46,57-123, 127,151,152,160
182-183,186,195,196-198,203, 221,243,258-259
218,230,237,238,240,241, 281,285,297,299
246-247,261,262,278,287-288, ”Control” of markets
291,299-300,327,328,329-333 Costs, 8,9-15,54-55,6
Buses, 143-144,209-210 74,79-83,85,90,9
Cameras, 62,120,121,297-298, 203-204,245-246
316-317,319 254,257,258,270
Capital, 143-147,240,262, 280,287, 307,31O,317,32O
299,337,339 338
Capital Gains, 193,195-196,241 Credit andCreditors
Capitalism, 4,11,67,85,86,111,119, 138,178,185,196
120,122,221,338 234,235,288
Carnegie, Andrew, 168,322 Crime, 40,108,225,2
Cartel, 33,92-93 Cyrix, 75
Carter administration, 72,191
Caspian Sea, 239 Debtor Nation (See In
Causation, 39-44,49 Debt)
Central Planning,4,15,69,70,71,87, Deflation, 229-231,26
112-114,122,190,249,250 Demand (See Supply
Cheese, 9,lO Dentists, 198
China, 13,237,240,246, 250,290 Department Stores, 6
Chinese, 185,212,226,240,241,247, 106,107,120
290 Depressions, 33,107,1
Civil Aeronautics Board (CAB),97-98 262,264,281,282
Clothing, 171,206 Discount Stores, 316-
Consumer Price Index, 264 Discrimination, 100-1
Coal, 162-153,187,191,251 Distribution of Incom
Collective Bargaining,149,159-165 Dividends (see Stock
The Commons,243 Dow Jones Industri
Communism and Communists, 45, 255-256
243,250,256,308 Economics, 14, 14,2
Comparative advantage,271-274 43,45,49,91,118
Competition, 50-55,59,63,65,83,90, 182,203,208,20
91,92,93,96,96,97,99,100,102, 259,262,269,279
109,116,122,158,179,202, 299,305,306,30

Economies of scale, 80,81,89, Feudalism, 4,11,15,145

99-100,274278,286 Food, 20,21,34,37,46,47
The Economist, 180-181 129,150,177,180,18
Economists, ix, x,4,11,24,29,100, 223-224,227,243,24
113,154,156,162-163,168, 251,274
189-190,218,219,231,245,252, Foreign Aid,290,293-294
255,256,264,270,271,282,283, Foreign Investments(see
286,294,296,297,305,308,311, International Trade
325,341 Payments)
Education, ix, x, 117,141,149,175, Franchises, 82,108,115-11
263 Friedman, Milton,4,73
Efficiency, 34,9,11,14,15,20,28, Futures contracts, 179,18
61,63,65,70, 71, 74, 75,81,84,
85,91,92,95,97- 98,99,106, Gambling, 179,207,211
117,118,119,122,123,133-134, Gasoline, 21,31-32,414
143,145,146,150,151,160,161, 70-72,84-85,113-114
170,182,190,191,208,209,212, 318
243,245,251,271,279,299,301, Germany, 13,27,154,229
311,330,331 291,292,341,346
Ehrlich, Paul, 189-190,191 Gold, 17,181,199-200,20
Elites, 29,65-66,67 226-227,228,232,25
Empirical Evidence,39,4445 295-296
Energy (see also Petroleum), 189 Government, 49,51.55,7
Engels, Friedrich, 15 119,122,143,149,15
Exploitation, 40,133,292,337,340 155,162,164-165,17
Exports (see International Trade and 203-204,210-211,216
Payments) 221,225,230-231,235
External Costsand Benefits (see 264,300,328,330
Social Costsand Social regulation: 71,91,93-94
Benefits) 202-203,208-209,222
taxing and spending:7
Fairness and Unfairness, 100,133, Graflex Corporation, 62
135,160,163,171,198,203,279, Great Depressionof the 1
298,331,345 34,107,108,215,217
Fallacy of Composition, 216-217, 264,295,297,298,32
261,262,277,327 Greed, 17,18,20,29,40,41
Famine, 20,37 306,315,321-322,336
Federal Communications Groceries, 59,60,61,62,6
Commission, 94 109,110,123,317-318
Federal Deposit Insurance Gross Domestic Produc
Corporation, 234 Gross National Product
Federal Emergency Management 218,221,222
Agency (FEMA), 119 Growth Rates, 13,14,71,2
Federal Express,317
Federal Insurance Contributions Act Hamburgers, 107-109,116
(FICA), 205 318,319
Federal Reserve System, 217,231, Harvard, 2,200,333
236235,263,327 Hertz, 202,212
362 Index

Higgins, James, xi Inflation, 194,199,20

Hippocratic Oath, 41 264,345
Hitler, Adolf, 229,251,346 Insurance, 40,119,18
Holmes, Oliver Wendell, 283 212
Homeless People, 28,30,31 Intentions, 27,3940,
Honesty, 246-247,247-248 245
Hoover, Herbert, 231,264,327 328 Interest rates, 17,40,
Horses, 20,220,262,279 193-195,207,22
Hotels, 18-19,319 International Compa
Housing, 18, 19,21,22-31,44,47, 167, International Debt, 2
184,186,200-201,203,206,218, 343
219,230,241,244-245,245-246, International Trade a
264,345 171,225,261,26
Human Capital, 240,341-342 balance of paymen
Ice Cream, 9,lO balance of trade: 2
Immigration, 240,289-290 foreign investmen
Imperialism, 290-293 280-281,285,286
Imports (see International Trade and 292-293,294,29
Payments) remittances: 289-2
Incentives and Constraints, ix, 2,25, transfers of wealth
27,31,39,43,44-50,74,76,77, 339
85,86,93,94,114,118,152,172, Interstate Commerc
205,224,238,242,243,244,245, (ICC), 94,96,97
246,247,254-259,320,337,344, Inventory 78,97,177
345 212,232
Income, 36,125-172,198 Investment, 67,75,7
family income: 134-135 175-178,180,18
forms of payment: 130-132 205,206,210,21
household income: 134-135,136 299,325
income "distribution": 132-139, Iron Ore, 8
individual income: 134,167 Japan, 3,36, 70,72,16
national income: 167 246,275,281,28
per capita income: 134-135,221 339,341
the poor: 13,27,29,30,35-36, J. C. Penney, 60,65-6
40,49,133,137,138,139,146, Jews, 185,212,241
167,168,169,170,211,343 Job Security, 149-152
real income: 2,137 Jobs, 18,67,75,82,83
the rich: 136-137,138,146, 130,131,134,13
168-169,170,322-323,343 142,143,149-16
"unearned" income: 184-185, 216,217,230,23
337,339 270,271,275,27
wages andsalaries: 17,21, 281,285,298,29
127-139,280 344
Incremental versus categorical Johnson, Howard, 82
Decisions (see alsoPriorities),
210,52-53,54,256,258,310-311 Kennedy, John F., 222

Kentucky Fried Chicken, 121 McDonald’s, 107-109,11

Keynes, John Maynard, 327-328 169,243,318,320,32
Knowledge, 8-9,14,17,43,46,63, Media, 59,96,167,169,18
65,66-72,80,82,84,90,95, 208,216,217,219,220
111-116,134,177-178,179,180, 255,261,262,270,27
182,187,190,199,201,208,210, 289,290,308,312,34
243,249-251,316,317,318-321, Medical services, 34,21,1
340 198,307,310,335
Kodak, 60,320 Merit, 171
Microsoft, 60,285,323,33
Labor, xi, 15,17,123,125-172,262, Middlemen, 84,85
273,277,337-342 Milk, 9-10,79,134
Labor Unions, 97,142,149,154,155, Minimum Wage Laws, 2
159,160,161,162-165,169,278, 152-159
281-282,282 Mining, 43
Land, 243,251 Mohawk Indians, 140
Land Reform, 211 Money 3,4,11,55,67,68,
Landlords, 29,30,44,211,242, 118,143,145,165,17
244-245 182-183,184,185,1
Lange, Oskar, 4 194,197,202,203,20
Law and order, 32,100-101,238-248, 215,216,217,219,22
256 279,284,285,286,29
Lewis, John L. 162,163 305,306,320,326,32
Long Run versusShort Run, 199, 345
209-210,220,279,332 Monopoly, 80,86,89-92,9
Losses (see Profits and Losses) 101,119,129,279
Montgomery Ward, 60,6
Mail, 316 103,106,107,110,11
Mail Order Houses, 64,65,66,119, Morality, 39,44,160-161,
120 248,306,307,308
Management, 60,65,69-70,71,84, Mortgages, 108,230
103n, 104,105,106,109-111, Movies, 62,102,129
337,338 National Debt, 217
Mantle, Mickey, 129 Natural Disasters, 18, 19
Maris, Roger, 129 204,307
Market Economies, x, 4,7,8,11,12, Natural gas, 190-191
13,22,4546,47,49,59,65-66, Natural resources, 3,8,12
67,69,71,72,73,77,103,106, 187-192,207,238,25
113,117-122,123,133,142,149, 343
161,186,190,210,211-212,221, ”Needs,” 16,50,308-311,
232,237,238,239,244,246,248, New York City, 25-26,28
250,251,252,253,254,256-257, 66,70,96,175,242,2
258,262,263-264,294,300, The New York Times, 1,2,
307-308,329,330,331,332,333 Newspapers, 62,84,134,
Marshall Plan, 293 Nikon, 62,102
Marx, Karl, 15,74, 76,337,340 Nixon administration,48
Maximum Wage Laws, 153 255,256,300
364 Index

Non-Profit Organizations, 333-337 179,180,182-18

Ottoman Empire, 241 332,333,337,344
losses: 8-9,14,15,2
Pan American Airline, 62,101 66,67,105,122,2
Pay (see Income) monopoly profit: 9
Peanuts, 250 profits on sales: 76
Penney, James Cash, 66,169 profits on investm
Persian Gulf War, 208,342 77-78,101,280-28
Petroleum, 52-53,71-72,76,84,175, Property Rights, 241-
180-181,186,187,188,189,196, Protestants, 51
207,208-209,239,278,312,343 Purchasing Power, 32
Pianos, 78
Politics, 7, 11, 13,21,24,29,36-38,43, Quality, 29,30,31-32,
46,50,53,63,65, 72,95,97,118, 97,106,120,121-
122,123,138,164,167,169-170, 245,248,264,321
208,209,210,217,219,220- 221, Race and Ethnicity 1
222,225,226,227,230-231,254, 141-143,154,155
255,256,257,258,259,262,263, Railroads, 94,96,97,1
270,276-277,278,279,288,289, 193-194,253-254
290,293,300,308,310,311,312, Rationality and Irrati
313,330,340,343,345 49,70,345
Pollution, 243,256-257,258 Rationing, 7,18-19,46
The Poor (see Income) "Real" value, 17, 18,
"Predatory" behavior, 315,323-325 Redistribution, 211
Preferences, 9,10,14,15,308 Refrigerators, 61,86-
Present value, 186-190,191,194, Regulatory commissi
209-210,312-313,332 Rent control, 22-31,14
Price control, 7,19,21-38,42,47-49, 246,247-248,343
70,72,89,90-91,120,190,250, Residual claimants,7
255,312 Retailing, 59,63-64,6
"ceiling" prices: 21,22-32 116,117,150
"floor" prices: 21,32-36 Restaurants, 25,81-82
Prices, x, 4,5-55,35,54,60,62,65,69, 115,120,321
70,71,76,84,89-94,99,101,103, The Rich (see Income
106,113,116,118,133,138,151, Risk, 131,173-212,23
188, 191,215,219,224,228,230, Roman Empire, 48,22
234,250,261,265,279,308, Roosevelt, Franklin D
315-328,331,343 327,334
Priorities, 53-54 Russia, 4 8 4 9
Producers, 8-9,10,11-12,17,46,52,
53,85,93,117,262,299 Safety, 183,188,199-1
Productivity, 127-147,157,168,171, 203,210,222,257
299,332,339 Safeway, 61,103n, 10
Profits and Losses (see also Non- Sales volume, 61,64,
Profit Organizations), 8-9,40, 116,117
46,59,60,63, 71-87,95,105,106, San Francisco, 20,316
114,117,118,119,121,123,151, Sanders, Colonel, 121

Saving, 136,176,177,178,185,325, Subsidies, 36,54,217,294

326 Subsistence, 133
Sears, 60,64,65,66,76,86,93,103, Substitution, 53,101-102
106,107,110,116,119,120,150, Suburbs, 60,61,66,107,
230,322 Supermarkets, 60-62,67,
Sears, fichard Warren, 110,169,322 107,109,138
Selling Short and Long, 181 Supply andDemand, 7,
Sex, 140-141,203,342 18-19,20,21,29,32,
Sharing, 19,25,50,51,145,190 97,98n, 128,129-13
Shaw, George Bernard, 74,76 150,153,159,163,18
Shopping Malls, 41,60-61,66,107, 280,321
108,258-259 Surplus, 15,21,22,24,33-
Shortages, 15,16,22,23,24,30, 142,153,155,158,1
31-32,33,35,4142,4445,47, Sweden, 23,24,28,276,2
69,157,185,188,208,343 Switzerland, 3,70,153,1
Simon, Julian, 189-190,191
Slavery, 127 Takeovers, 105,330,336
Smith, Adam, 279,283,305.329-330, Tariffs, 281-282,297,298
334,337 Taxes, 196,205,209,210,
Smith-Corona, 63,101,123 231,306,336
Social Costs and Social Benefits, Television, 62,115,220,2
251-254 Tenants, 23,24,25,26,29
Social Justice, 44 245-246,247-248
Social Security, 134,205-206,265 Third World, 155,156,15
Socialism and Socialists, 4,11,13,15, 292-293,294,306,33
45,67,74-75,77,85,87,118, Time, 173-212,256
119,120,122,145,169,221,238 Trade-offs, 4,53,163,171
"Society," 134,135 307,308,310
Soviet Union, x, 10,ll-12,4344, Trees, 187,312
69-70,71,74-75,81,85-86,111, Trends, 64,219-220,222,
113,120,140,146,147,242-243, Trucking, 96-97,146,164
245,249,254,256,321,332 Typewriters, 63,123,217
Soybeans, 17,181,182,186,208
Speculation, 178-182,196,198,200, Unemployment, 130,150
207-208,208-209,211,212,295, 153-155,156,157,15
343 262,269,281,288,29
Standard of Living, 1-2,3,4,13,15, Unfairness (see Fairness
25,46,60,63,64,65,70,74,76, Unfairness)
106,108,122,123,127,167,168, Unions (seeLabor Union
170,171,212,218,219,241,244, Urbanization, 64,106
Standards, 253 Venezuela, 209,239
Steel, 82,164,261,277-278
Stigler, George, 155 Wages and salaries (see
Stocks, 105,106,110,131,151,176, Wal-Mart, 66,76,116,150
177,181,183,184-185,196, War, 208,227-228
197-198,200,215,287 Washington Post, 135,32
Stupidity (seeRationality and Waste, 14,15,70,146,176
Irrationality) 257,311-313
366 Index

Wealth, 136,137-138,168,218,219, World War 11,22,26,3

224,227,283-296,290,291,292, 107,112,139,155
307 293,335,341
Wendy’s, 121,320,321 Writers, 84,114
White Castle, 108,109,116
Yankee Stadium, 244
Williams, Ted, 129
Yogurt, 9,lO
Williams, Walter E., xi
World War I, 26,229,259,288,291, Zero-sum games,98,1
295 211-212,269,277