Sowell Basic Economics A Citizen's Guide to the Economy
.pdfCook, Butler, and Steward, for example. But, however emotionally powerful the role of labor may be, it is still part of the general economic pattern of the allocation of scarce resources which have alternative uses.
ALLOCATION AND INEQUALITIES
In an economy that never changed, it would be possible to establish some permanent allocation of labor to its various uses and to establish some payment system-whether based on equal pay or some other principle-that would also be permanent. But no such permanent arrangements are possible in an economy that is growing in size and developing technologically. Unpredictable advances in organization and technology occur in different parts of the economy at different times, requiring shifts in labor and other resources from one industry or sector to another, if the new potentialities are to lead to greater output and the higher standards of living which depend on greater output.
The allocation of human resources-with the inequalities this often entails-is inextricably bound up with the economic development on which the prosperity of all depends. Unless workers are to be ordered to move from one industry, region, or occupation to another, as under totalitarianism, economic incentives and constraints must accomplish these transfers in a market economy. Higher pay may attract workers to the newer and more productive sectors or unemployment may force them out of sectors whose products or technologies are becoming obsolete.
Simple and obvious as this may seem, it is often misunderstood by those who are shocked to see some sectors of the economy prospering at the same time when others are being "left behind" or are even suffering losses of business and jobs. Too often there is no sense that these are all part of the same process, rather than separate happen-stances that are good for some and bad for others.
There were, for example, many laments in nineteenth century England for the plight of the handloom weavers, increasingly displaced by power looms that produced cloth more cheaply and thereby made clothing more affordable to millions. Today, in an affluent age, when physically adequate clothing is so widely available that only issues of style and brand name concern most people in modern industrial societies, it is difficult to imagine the hardships endured by many people in centuries past who were unable to afford enough clothing to provide adequate protection against the elements I-or what a blessing it was to them to have the prices of clothes brought down to a level where they could finally afford them, because of advances in the mechanization of production. Their good fortune and the misfortunes of the handloom weavers were inseparably part of the same process.
In the late twentieth century, China's robust economic growth rate in the wake of opening up more of the economy to free markets after the death of Mao in 1978 led to rising real incomes in those regions of the country where free markets were first allowed. Nationally, this meant a growing income inequality, since the state-run industries and sectors remained inefficient and poor. Here was the situation before the reforms took effect, as described by The Economist magazine:
When the economic reform era began in the late 1970s, urban residents enjoyed guaranteed
jobs for life, free housing and health care. Unemployment was virtually non-existent and rural residents were banned from moving into urban areas. There was no private enterprise. Most people's lives were spartan.
--(1) At one time, centuries ago, hospitals in parts of Europe had to take precautions to see that clothing was not stolen from the bodies of people who had died, when there were so many people desperate for adequate clothing.
This government-guaranteed subsidence for all at a poverty level was referred to as "the iron rice bowl" and it was egalitarian. When the new leader, Deng Xiaoping, announced a new policy of seeking to raise the economic level of the country as a whole, he said: "Let some people get rich first" by allowing the kinds of incentives that exist in prosperous capitalist countries.
This policy led to rapid growth rates for China's economy, with spectacular results for particular regions, sectors and individuals. The reasons for growing inequalities, were not just that those left out of these experimental reforms did not experience the same prosperity, but also that to some extent enterprises in the state-owned and state-run sector suffered from competition with more efficient private enterprises.
While about 9 percent of the people in China's cities lived below the official poverty level of 1,800 yuan in annual income-$217 in American money-the percentage was much higher in particular cities. For example, the poverty rate was 30 percent in the city of Xian, with 2.7 million people and was even more widespread "in some northeastern cities that are home to many of the worst-performing state-owned industries," according to The Economist. Here 60 percent of the 1.8 million people in the city of Shuangyashan lived below the official poverty level. In short, the rising prosperity of China was accompanied by growing internal inequalities, as has happened in other countries at various times in history.
It would be a mistake to regard a given level of inequality at a particular time in this on-going process as a permanent inequality. That is not necessarily so for a nation any more than it is for individuals or families. As market reforms spread through China, more regions, sectors, and populations in China began to share in the resulting prosperity by becoming more productive in response to changing incentives. In India, differing levels of economic development in different regions likewise led to differences in income in general and different levels of poverty in particular. At the end of the twentieth century, the percentage of the population of India that lived below that country's official poverty level was 47 percent in the state of Orissa but only 6 percent in the Punjab.
The alternative to uneven economic development, and the income inequalities this entails, can be egalitarian stagnation in poverty. In an ever changing economy with new and more productive technologies emerging unpredictably and more efficient methods of organization being devised, to keep workers employed where they are already working is to force society to forgo the economic benefits of such new developments.
Even within a given occupation, technology affects people of different abilities differently. Local entertainers of modest abilities could earn a modest living more easily before motion pictures, television, and compact disks enabled the most talented entertainers in the world to become available to audiences around the world. People thousands of miles away could hear Pavarotti sing or watch Andre Agassi play tennis or Tiger Woods play golf Just as the televising of major league baseball made minor league baseball less attractive, so the availability of superstars in many fields led to what one economist called "a 'winner-take-all' effect, where only the best do well, and those lucky few command enormous incomes." Focusing on such growing
internal inequalities in a given occupation overlooks the vastly larger numbers of other people who benefit from hearing Pavarotti or seeing a wider array of highly talented people in a variety of fields. Moreover, it is by no means clear that most people are as preoccupied with income differences as intellectuals in academia and the media seem to be. One classic study, Equality by R. H. Tawney, lamented that the public seemed less resentful of the rich than fascinated by their goings-on.
Occupational Pay Differentials
Pay differentials are typically reflections of productivity differences and are part of the process of allocating scarce labor resources which have alternative uses. Again, a fairly obvious economic fact can become very confused when intertwined with very different moral questions about whether one group of people merit so much more than others. Productivity and merit are wholly different things. Someone born and raised in highly favorable circumstances may find it easier to become a brain surgeon than someone born and raised I in highly unfavorable circumstances may find it to become a carpenter. But that is very different from saying that brain surgeons are paid "too much" or carpenters "too little." In policy terms, making it easier for people born in less fortunate circumstances to acquire the knowledge and skills to become brain surgeons is very , different from simply decreeing that pay differentials between brain surgeons and carpenters be reduced or eliminated. The latter policy affects the allocation of resources, affecting not only how hard existing brain surgeons will work or how early they will retire, but also how many replacements they will ' have, as young people decide whether or not it is worth all the years and effort it takes to become a brain surgeon.
Those who have the biggest stake in all this are people suffering from medical conditions that require brain surgery. Despite a tendency in some quarters to see economic choices as a zero-sum activity involving a trade-off between the interests of two competing groups, very often the third parties who are ignored are affected most of all. Moreover, seeing economic issues as simply issues about how to divide up money ignores the larger role of financial incentives in allocating resources. From the standpoint of society as a whole, money is just an artifact used to get real things done. How well those real things are done is what determines the material well-being of the people in that society.
Unmerited misfortunes and windfall gains leave many people uneasy, especially when these undeserved happenstances have large effects on someone's whole way of life. The desire to help the less fortunate may be especially strong, but whether a particular policy will in fact have that effect is not an easy question to answer-except for those who simply want to "do something" to express their sympathy or solidarity, without regard to the actual consequences.
Income Distribution
So-called "income distribution" issues often include concern about the rich and the disproportionate share of the national income that they receive.
Where the term "rich" simply refers to the top 10 percent or 20 percent of income earners as of a given time, then these are more likely to be people who have simply reached their peak earnings years-usually in their forties or fifties-rather than people who are genuinely rich in the sense of having enough wealth to live on without continuing to work. However, even considering the genuinely rich, how much do they cost the rest of society? Their total wealth is not subtracted from the total output of the country, but only what they actually consume, which is typically a tiny fraction of what they own, as well as a fraction of the wealth that they have created for others in the process of earning their fortunes.
Often there is a sense of amazement, or even resentment in some quarters, when the rich spend huge sums of money on such things as rare stamps or antique furniture. But often these are items of little or no use or interest to most people, even though their prices may be bid up to astronomical levels by a few rich people bidding against one another. The loss to the society .IS typically trivial. For example, a rare camera used by the Japanese navy 111 World War II was put on sale for $40,000, but better photographs can be taken with cameras on sale today for less than one percent of that. In such cases, the rich are paying for the distinction of having something rare, while others suffer no real loss in their standard of living.
, It is not only in buying expensive things from the past that the rich may seek the distinction of ownership. They can also acquire distinction by buying new products that are too expensive for most other people to buy. When the first television sets were sold around 1940, they were so expensive that only truly wealthy people could afford them. Sales to the rich is what enabled television manufacturers to survive and to have the time to continually improve their product over the years, meanwhile improving their production methods as well, so that by 1980 even poor people could afford television sets far superior to what the rich had paid much higher prices for in earlier years.
Nor was television unique. Many products taken for granted today were able to develop to the point of being within the budgets of millions of people only because their high initial costs were paid by the wealthy. An American popular song of the 1920s had lyrics that said: "We won't have it known, dear, that we own a telephone, dear."2 Two generations later, such lyrics would make no sense, because virtually every American had a telephone.
Those who look only at a static picture of events as they appear at a given moment often want to heavily tax things that are "luxuries of the rich," without considering that it may be only a matter of time when those very same things will be part of the standard of living of ordinary people. As late as the middle of the twentieth century, college was largely a luxury of the affluent and the wealthy. Had it been heavily taxed, instead of being heavily subsidized, it might well have continued to be a luxury confined to the rich.
By 1994, most American households living below the official poverty line had a microwave oven and a video cassette recorder, things that less than one percent of all American households had in 1971. For the population at large, homes were much bigger, automobiles were much better, and more Americans were connected to the Internet at the end of the twentieth century than Were connected to a water supply at the beginning of that century. This was clearly not a zero-sum activity, in which what was gained by some was lost , by others. Other countries have shown similar patterns. In New Zealand, for example, most people whose incomes were in the lowest quarter owned a video cassette recorder, a freezer, a washing machine, and a vehicle.
'The song was "Tea for Two."
Media and even academic preoccupation with instant snapshot statistics create major distortions of economic reality. "The rich" and "the poor" have become staples of income
discussions, even though most people in the top and bottom income categories may be the same people at different stages of their lives, at least in Western countries, rather than fixed classes of people who remain at the top and bottom throughout their lives. Even among American millionaires, studies show that four-fifths of them did not inherit their fortune but earned it during their own lifetimes. The great historic American fortunes-Carnegie, Ford, Vanderbilt, etc.-were often created by people who began in modest or even humble circumstances. Richard Warren Sears, Aaron Montgomery Ward, and James Cash Penney all began working to support themselves in lowly jobs as teenagers, too young to be allowed to work under today's child labor laws, though each eventually rose to become fabulously wealthy as creators of the retail store chains that bore their respective names.
Similar stories could be told of teenage Henry Ford, who became fed up with farm work and walked eight miles to Detroit to look for a job. David Sarnoff, who went on in later life to create the NBC broadcasting network, likewise began working to support himself as a teenager by selling newspapers on the streets. Another teenager who supported himself was an immigrant lumberyard worker named Frederick Weyerhauser, who went on to establish a wood products empire. The list goes on and on.
While such stories have long been part of what has been called the American Dream, dramatic social mobility has not been confined to the United States. Despite India's reputation as a rigid, caste-ridden society, it has likewise had its rags-to riches stories, especially as more free markets emerged toward the end of the twentieth century. Dhiruhai Ambani, for example, was born in poverty and was able to go as far as high school only because he was admitted as a "free student"-and he was too poor to continue on to college. His first job was pumping gas at a filling station, his second job was as a shipping clerk. But from there on he rose, step by step, eventually establishing his own business, making synthetic yarn. From there he branched out into petrochemicals and eventually created India's largest company and the world's largest multi feed refinery. By 1995, his company had 2.4 million stockholders and their annual meetings had to be held in a football stadium.
Such stories have often been seen as just examples of individual good fortune for exceptional people. But the more fundamental point is the great advantage for any society that can tap the talents of people from all across the social spectrum to develop its economy and thereby raise the living standards of its population as a whole. That is what Carnegie, Ford, Sears, and Penney did in America and what people from modest or even poverty backgrounds have begun to do in India after it moved in the direction of freer markets at the end of the twentieth century.
Info sys was started by six Indian computer engineers with a total capital of $600 among them, and it grew until the company was worth $15 billion. Its Chief Executive Officer received his education at one of the local engineering colleges because, although he had been admitted to the more prestigious Indian Institute of Technology, his father could not afford to pay the $20 a month required for a place for him to live away from home.
Another Indian entrepreneur who rose from poverty was Sam Pitroda, born in a village where there was no electricity, no telephones, and no running water. His early education was in a one-room school where most of the children had neither books nor shoes. He somehow made his way to the United States, where he rose to become a millionaire in telecommunications.
Then he returned to India and proceeded to revolutionize their antiquated and bureaucratically dominated telephone system. From a country with only 12,000 telephones for 700 million people, India had by 1990 become a country with 5 million telephones. Before the
end of the decade India had nearly 20 million phones and the years-long waiting lists of the past had virtually disappeared. That Pitroda became wealthy during this process is a footnote to history. It is what he did for millions of people in India that was historic.
Neither poverty nor caste has died out in India. While most of India's managers and professionals come from upper-caste backgrounds, the modern sectors of the Indian economy have fewer caste barriers. With vast sums of money being able to be made by supplying what people want through a freer marketplace, the cost of discrimination by caste becomes enormous when there are educated and talented individuals who can make a company hugely profitable. The bottleneck has been producing such individuals in an educational system where, as a leading Indian entrepreneur put it, "our schools and colleges were only creating an army of unemployables." Yet the new Indian entrepreneurs also set about creating private education in practical skills in the computer industry. In short, the more market-oriented economy of late twentieth-century India opened new avenues of social mobility for those at the bottom, in contrast to the previous decades of socialist emphasis on helping "the poor" while they remained poor.
Individuals and groups have often been accused of reducing the wealth of nations, when in fact they have contributed to its increase. Many highly productive immigrant groups in many parts of the world-the overseas Chinese in Southeast Asia, the Lebanese in West Africa, and the Indians in Fiji, among others-have been accused of draining away the wealth of the countries in which they settled because they have sent money back to members of their families still living in the countries from which they came. But these earnings are almost invariably due to providing goods and services which their customers and clients obviously valued more than the money they paid.
On net balance, these productive groups have drained nothing but have added to the wealth of both the countries in which they settled and the countries from which they came. It has not been a zero-sum process. As in many other cases, the economic facts are fairly straightforward and uncomplicated. It is the myths and misconceptions which become complicated, especially those revolving around "income distribution. Fights over which individuals and groups get how big a slice of the pie create the kind of emotions and controversy on which the media, politicians, and intellectuals thrive. But the economic reality is that the main reason most Americans have prospered is that the pie itself has gotten much bigger, not because this group or that group changed a few percentage points in its share. For example, American families in the bottom quintile in income earned 4 percent of the income of all U.S. families in 1967 and this fell to 3.6 percent by the year 2000. Over that same span, however, the median real income of families in the bottom quintile rose by more than $4,000. That is not even counting the fact that most American families in the bottom quintile do not stay there permanently-and, indeed, most are also in the top quintile at some point over the years.
The changing allocation of scarce resources which makes continuing prosperity possible may change these percentages back and forth over time, as changing pay and employment prospects direct individuals to where their productivity would be higher and away from where it is lower. But it is changes in productivity and allocation which are crucial to the economic well-being of the population as a whole, not the few percentage point changes in relative shares which attract so much media, political, and other attention.
PART IV:
TIME AND RISK
Chapter 12
Investment and Speculation
A tourist in New Yorks Greenwich Village decided to have his portrait sketched by a sidewalk artist. He received a very fine sketch, for which he was charged $100.
"Thats expensive," he said to the artist, "but I'll pay it, because it is a great sketch. But, really, it took you only five minutes.
"Twenty years and five minutes, " the artist said.
Artistic ability is only one of many things which are accumulated over time for use later on. If the earlier sacrifices and risks are ignored, then the reward for what was done within the present time period may often seen exorbitant. Oil wells can repay their costs many times over-but they must also cover the costs of all the dry holes that were drilled in the ground while searching in vain for petroleum deposits before finally striking oil.
Add to this the cost of keeping people alive while waiting for their artistic talent to develop, their oil exploration to payoff, or their academic credits to finally add up to enough to earn their degree, and there may be a considerable investment to be repaid. The repaying of the investment is not a matter . of morality, but of economics. If the return on the investment is not enough to make it worthwhile, fewer people will make that particular investment in the future, and consumers will therefore be denied the use of the goods and services that would otherwise have been Produced. No one is under any obligation to make all investments payoff, but how many need to payoff, and to what extent, is determined by how many consumers value the benefits of other people's investments.
Where the consumers do not value what is being produced, the investment should not payoff. When people insist on specializing in a field for which there is little demand, their investment has been a waste of scarce resources that could have produced something else that others wanted. The low pay and sparse employment opportunities in that field are a compelling signal to them-and to others coming after them-to stop making such investments.
The principles of investment are involved in activities that do not pass through the marketplace; and are not normally thought of as economic.
Putting things away after you use them is an investment of time in the present to reduce the time required to find them in the future. Explaining yourself to others can be a time-consuming, and even unpleasant, activity but it is engaged in as an investment to prevent greater unhappiness in the future from misunderstandings.
Investments take many forms, whether the investment is in human beings, steel mills, or transmission lines for electricity. Risk is an inseparable part of these investments and others.
Among the ways of dealing with risk are speculation, insurance and the issuance of stocks and bonds. Among the kinds of investments to be considered here are investments in human beings, as well as investments in machinery, farm crops and hydroelectric dams.
While human capital can take many forms, there is a tendency of some to equate it with formal education. However, not only may many other valuable forms of human capital be overlooked this way, the value of formal schooling may be exaggerated and its counterproductive consequences in some cases not understood.
The industrial revolution was not created by highly educated people but by people with practical industrial experience. The airplane was invented by a couple of bicycle mechanics who had never gone to college. Electricity and many inventions run by electricity became central parts of the modern world because of a man with only three months of formal schooling, Thomas Edison.
Education has of course also made major contributions to economic development. But this is not to say that all kinds of education have. From an economic standpoint, some education has great value, some has no value and some can even have a negative value. While it is easy to understand the great value of specific skills in medical science or engineering, for example, or the more general foundation for a number of professions provided by mathematics or a command of the English language, other subjects such as literature make no pretense of producing marketable skills but are available for whatever they may contribute in other ways. In a country where education or higher levels of education are new, those who have obtained diplomas or degrees may feel that many kinds of work are now beneath them. In such societies, even engineers may prefer the desk to standing in the mud in hip boots at a construction site. Depending on what they have studied, the newly educated may have higher levels of expectations than they have higher levels of ability to create the wealth from which their expectations can be redeemed. In the Third World especially, those who are the first members of their respective families to reach higher education typically do not study difficult and demanding subjects like science, medicine, or engineering, but instead tend toward easier and fuzzier subjects which provide them with little in the way of marketable skills, which is to say, skills that can create prosperity for themselves or their country.
Large numbers of young people with schooling, but without economically meaningful skills, have produced much unemployment in Third World nations. Since the marketplace has little to offer such people that would be commensurate with their expectations, governments have created swollen bureaucracies to hire them, in order to neutralize their potential for political disaffection, civil unrest or insurrection. In turn, these bureaucracies and the voluminous and time-consuming red tape they generate can become obstacles to others who do have the skills and entrepreneur ship needed to contribute to the country's economic advancement. In India, for example, two of its leading entrepreneurial families, the Tatas and the Birlas, were repeatedly frustrated in their efforts to obtain the necessary government permission to expand their enterprises:
The Tatas made 119 proposals between 1960 and 1989 to start new businesses or expand old ones, and all of them ended up in the wastebaskets of bureaucrats. Aditya Birla, the young and dynamic inheritor of the Birla empire, who had trained at MIT, was so disillusioned with Indian policy that he decided to expand Birla enterprises outside India, and eventually set up dynamic companies in Thailand, Malaysia, Indonesia, and the Philippines, away from the hostile atmosphere of his home.
, The vast array of government rules micro-managing businesses "ensured :. that every
businessman would break some law or other every month," according to an India executive. Large businesses in India set up their own bureaucracies in Delhi, parallel to those of the government, in order to try to keep track of the progress of their applications for the innumerable government permissions required to do things that businesses did on their own in free market economies, and to pay bribes as necessary to secure these permissions. The consequences of suffocating bureaucratic controls in India have been shown not only by such experiences while they were in full force but also by the country's dramatic economic improvements after many of these controls were relaxed or eliminated. The economy's growth rate increased dramatically after reforms in 1991 freed many of its entrepreneurs from some of the worst controls, and foreign investment in India rose from $150 million to $3 billion.
Hostility to entrepreneurial minorities like the Chinese in Southeast Asia or the Lebanese in West Africa has been especially fierce among the newly educated indigenous people, who see their own diplomas and degrees bringing them much less economic reward than the earnings of minority business owners who may have less formal schooling than themselves.
In short, more schooling is not automatically more human capital. It can in some cases reduce a country's ability to use the human capital that it already possesses.
SPECULATION
Most market transactions involve buying things that exist, based on whatever value they have to the buyer and whatever price is charged by the seller.
Some transactions, however, involve buying things that do not yet exist or whose value has yet to be determined-or both. For example, the price of stock in the Internet company Amazon.com rose for years before the company made its first dollar of profits. People were obviously speculating that the company would eventually make profits or that others would keep bidding the price up, so that the initial stockholder could sell the stock for a profit, whether or not Amazon.com itself ever made a profit. After years of operating at a loss, Amazon.com finally made its first profit in 2001.
Exploring for oil is a costly speculation, since millions of dollars may be spent before discovering whether there is in fact any oil at all where the exploration is taking place, much less whether it is enough oil to repay the money spent. Many other things are bought in hopes of future earnings which mayor may not materialize-scripts for movies that may never be made, pictures painted by artists who mayor may not become famous some day, and foreign currencies that may go up in value over time, but which could just as easily go down. Speculation as an economic activity may be engaged in by people in all walks of life but there are also professional speculators for whom this is their career. One of the professional speculator's main roles is in relieving other people from having to speculate as part of their regular economic activity.
When an American wheat farmer in Idaho or Nebraska is getting ready to plant his crop, he has no way of knowing what the price of wheat will be when the crop is harvested. That depends on innumerable other wheat farmers, not only in the United States but as far away as Russia or Argentina. If the wheat crop fails in Russia or Argentina, the world price of wheat will shoot up, causing American wheat farmers to get very high prices for their crop. But if there are bumper crops of wheat in Russia or Argentina, there may be more wheat on the world market than