Sowell Basic Economics A Citizen's Guide to the Economy
.pdfwealth to feed an entire nation. But it can barely feed itself.
It is hard even to imagine, in a free market economy, a hungry city, dependent on imports of foreign food, when there is extraordinarily fertile farmland not far away. Yet the people on that very fertile farmland were as poor as the city dwellers were hungry. The workers harvesting that land earned the equivalent of about $10 a week, with even this small amount being paid in kind-sacks of potatoes or cucumbers-because of a lack of money. As the mayor of a town in this region said:
We ought to be rich. We have wonderful soil. We have the scientific know-how. We have qualified people. But what does it add up to?
If nothing else, it adds up to a reason for understanding economics as a means of achieving an efficient allocation of scarce resources which have alternative uses. All that was lacking in Russia was a market to connect the hungry city with the products of the fertile land and a government that would allow such a market to function freely. In some places, local Russian officials forbade the movement of food across local boundary lines, in order to assure low food prices within their own jurisdictions, and therefore local political support for themselves. Again, it is necessary to emphasize that this was not a stupid policy, from the standpoint of officials trying to gain local popularity with consumers by maintaining low food prices. This protected their political careers, however disastrous such policies were for the country as a whole.
While systemic causation is in one sense impersonal, in the sense that its outcomes are not specifically predetermined by anyone, "the market" is ultimately a way by which people's individual personal desires are reconciled with one another. Too often a false contrast is made between the impersonal marketplace and the compassionate policies of various government programs. But both systems face the same scarcity of resources and both systems make choices within the constraints of that scarcity. The difference is that one system involves each individual making choices for himself or herself, while the other system involves a smaller number of people making choices for millions of others. The mechanisms of the market are impersonal but the choices made by individuals are as personal as choices made anywhere else. It may be fashionable for journalists to refer to "the whim of the marketplace," as if that were something different from the desires of people, just as it was once fashionable to refer to "production for use, rather than profit"as if profits could be made by producing things that people cannot use or do not want to use. The real contrast is between choices made by individuals for themselves and choices made for them by others who presume to define what these individuals "really" need.
SCARCITY AND COMPETITION
Scarcity means that everyone's desires cannot be satisfied completely, regardless of which particular economic system or economic policy we choose-and regardless of whether an individual or a society is poor or affluent. Therefore competition among people for these resources is inherent. It is not a question whether we like or dislike competition. Scarcity means that we do not have the option to choose whether or not to have an economy in which people compete. That is the only kind of economy that is possible-and our only choice is among the particular methods that can be used " for this competition.
Economic Institutions
One way in which competition for scarce resources might take place would be for those who hold political power to decide how resources should be allocated to different uses and shared among different people. This has happened in ancient despotisms and under modern communism. Conceivably, the people themselves might decide voluntarily how to share things, as in some tribal societies or in an Israeli kibbutz, though it is hard to imagine how that could happen in societies consisting of millions of people.
Yet another method of sharing resources among competing uses and competing individuals is by having them bid for these resources and the products resulting from them. In this system-a price-coordinated economy-those who want to use wood to produce furniture must bid against those who want to use it to produce paper, houses, or baseball bats. Those who want to use milk to produce cheese must bid against those who want to use it to produce yogurt or ice cream. Most people may be unaware that they are competing and simply see themselves as deciding how much of various things to buy at whatever prices they find, but scarcity ensures that they are competing with others, even if they are conscious only of weighing their own purchasing decisions against the amount of money they have available.
One of the incidental benefits of competing and sharing through prices is that different people are not as likely to think of themselves as rivals, nor to develop the kinds of hostility that rivalry can breed. For example, much the same labor and construction material needed to build a Protestant church could be used to build a Catholic church. But, if a Protestant congregation is raising money to build a church for themselves, they are likely to be preoccupied with how much money they can raise and how much is needed for the kind of church they want. Construction prices may cause them to scale back some of their more elaborate plans, in order to fit within the limits of what they can afford. But they are unlikely to blame Catholics, even though the competition of Catholics for the same construction materials makes their prices higher than otherwise.
If, instead, the government were in the business of building churches and presenting them to different religious groups, Protestants and Catholics would be explicit rivals for this largesse and neither would have any financial incentive to cut back on their building plans to accommodate the other. Instead, each would have an incentive to make the case, as strongly as possible, for the full extent of their desires and to resent any suggestion that they scale back their plans. The inherent scarcity of materials and labor would still limit what could be built, but that limit would now be imposed politically and would be seen by each as due to the rivalry of the other. The Constitution of the United States of course prevents the American government from building churches for religious groups, no doubt in order to prevent just such political rivalries and the bitterness, and sometimes bloodshed, to which such rivalries have led in other countries.
The same economic principle, however, applies to groups that are not based on religion but on ethnicity, geographical regions, or age brackets. All are inherently competing for the same resources, simply because these resources are scarce. However, competing indirectly by having to keep your demands within the limits of your Own pocketbook is very different from seeing your desires for government benefits thwarted by the rival claims of some other group. Market rationing limits the amount of your claims on the output of others to what your own productivity
has created, while political rationing limits your claims by the competing claims and clout of others.
Incremental Substitution
Because economic resources are not only scarce but have alternative uses, the efficient use of these resources requires both consumers and producers to make trade-offs and substitutions. Prices provide the incentives for doing so.
When the price of oranges goes up, some consumers switch to tangerines. When bacon becomes more expensive, some consumers switch to ham.
When the cost of a vacation at the beach rises, some people decide to go on a cruise instead. Note that what is happening here is not just substitution-it is incremental substitution. Not everybody stops eating oranges when they become more pricey. Some people continue to eat the same number of oranges they always ate, some cut back a little, some cut back a lot, and others forget about oranges completely and go on to some other fruit.
When the price of oranges rises, it is very likely because the number of oranges demanded at the existing price exceeds the number of oranges actually available. Something has to give. Incremental substitution, because of Price increases, causes the loss to be minimized by being borne more by those who are relatively indifferent as between oranges and other substitutes, rather than by those who are so devoted to oranges that they will simply pay the higher prices and continue to eat the same number of oranges as before, Cutting back somewhere else in their budget to offset the additional money spent on oranges.
Incremental substitutions take place in production as well as consumption. Petroleum, for example, can be used to make heating oil or gasoline, among many other things. More petroleum is turned into heating oil during the winter, when the demand for heating oil is greatest, and more into gasoline during the summer, when many people are doing more driving to recreational areas. This is not a total substitution, since some petroleum is turned into both products (and many others) throughout the year. It is incremental substitution-somewhat more of A at the cost of somewhat less of B. Prices facilitate this kind of substitution, as they reflect incrementally changing demands, leading to incremental changes in the amount supplied.
Trade-offs and substitution can take place either intentionally or systemically. An intentional trade-off has been made by LTV, a steel manufacturer in Cleveland, whose equipment has been set up to shift automatically from oil to natural gas when the price of oil rises above a given level. Automobiles have also been adjusted intentionally by becoming more fuel-efficient. Thus, the average American car drove 2,000 miles more in 1998 than in 1973, but used about 200 gallons less gasoline than a quarter if a century earlier. This was because of high-tech equipment added to engines, obviously at a cost, but with the cost of this technology substituting incrementally for the cost of gasoline.
A systemic trade-off occurs when the economy as a whole uses less oil because the composition of its output changes. As a higher proportion of the output of the American economy has over the years come to consist of services, rather than material goods, less fuel is needed in their production. It takes less fuel to create more advanced software than to manufacture steel or automobiles. Over all, the amount of fuel used per dollar of national output
in the American economy has declined steadily since the early 1970s, when oil prices were raised dramatically by the international petroleum cartel.
As important as it is to understand the role of substitutions, it is also important to keep in mind that the efficient allocation of resources requires that these substitutions be incremental, not total. For example, one may believe that health is more important than amusements but, however reasonable that may sound as a general principle, no one really believes that having a twenty year's supply of Band-Aids in the closet is more important than having to give up all music in order to pay for it. A price-coordinated economy facilitates incremental substitution, but political decision-making tends toward categorical priorities-that is, declaring one thing absolutely more important than another and creating laws and policies accordingly.
When a political figure says that we need to "set national priorities" about one thing or another, what that amounts to is making A categorically more important than B. That is the opposite of incremental substitution, in which the value of each depends on how much of each we already have at the moment, and therefore on the changing amount of A that we are willing to give up in order to get more B.
Incremental substitution means that the relative values of each varies with how much of each we already have available. This variation can be so great as to convert something that is beneficial into something that is detrimental, and vice versa. For example, human beings cannot live without salt, fat, and cholesterol, but most Americans get so much of all three that their lifespan is reduced. Conversely, despite the many problems caused by alcohol, from fatal automobile accidents to deaths from cirrhosis of the liver, studies show that very modest amounts of alcohol have health benefits that can be lifesaving.4 It is not categorically good or bad.
Whenever there are two things that each have some value, one cannot be categorically more valuable than another: Enough pennies will be worth more than any diamond. That is why incremental trade-offs tend to produce better results than categorical priorities.
Subsidies and Taxes
Ideally, prices allow alternative users to compete for scarce resources in the marketplace. However, this competition is distorted to the extent that special taxes are put on some products or resources but not on others, or when some products or resources are subsidized by the government but others are not. Prices charged to the consumers of such specially taxed or specially subsidized goods and services do not convey the real costs of producing them and therefore do not produce the same trade-offs as if they did. Yet there is always a political temptation to subsidize "good" things and tax "bad" things.
-. 'Men who drank either nothing alcoholic or just one drink per week had a reduction in cardiovascular disease when they increased their alcohol intake by from one to six drinks per week. However, among men who already averaged seven or more alcoholic drinks per week, an increase in their drinking led to more cardiovascular disease, according to the Journal of the American Medical Association, September 25, 2000 issue. The medical publication The Lancet reported that "light-to-moderate alcohol consumption is associated with a reduced risk of dementia in individuals 55 years or older" in its January 26,2002 issue.
However, when neither good things nor bad things are good or bad categorically, this
prevents our finding out just how good or how bad any of these things is by letting people choose freely, uninfluenced by politically changed prices.
One of the factors in California's periodic water crises, for example, is that California farmers' use of water is subsidized so heavily that its price to farmers is less than one percent of what the same amount of water costs people living in Los Angeles or San Francisco. The net result is that agriculture, which accounts for about 3 percent of the state's output, consumes more than four-fifths of its water. Another consequence of subsidized water is that farmers grow crops requiring great amounts of water, such as rice and cotton, in California's semi-desert climate, where such crops would never be grown if farmers had to pay the real costs of the water they use. Inspiring as it may be to some that California's arid lands have been enabled to produce vast amounts of fruits and vegetables with the aid of subsidized water, those same fruits and vegetables could be produced more cheaply elsewhere with water supplied free of charge from the clouds.
The way to tell whether the California produce is worth what it costs to grow is to allow all those costs to be paid by California farmers who compete with farmers in other states that have higher rainfall levels. There is no need for government officials to decide arbitrarily-and categoricallywhether it is a good thing or a bad thing for particular crops to be grown in California with water artificially supplied from federal irrigation projects. Such questions can be decided incrementally through price competition in a free market.
California is, unfortunately, not unique in this respect. In fact, this is not a peculiarly American problem. Halfway around the world, the government of India provides "almost free electricity and water" to farmers, according to The Economist, encouraging farmers to plant too much "water-guzzling rice," with the result that water tables in the Punjab "are dropping fast." Making anything artificially cheap usually means that it will be wasted, whatever that thing might be and wherever it might be located.
From standpoint of the allocation of resources, government should either not tax resources, goods, and services or else tax them all equally, so as to minimize the distortions of choices made by consumers and producers. For similar reasons, particular resources, goods, and services should not be subsidized, even if particular people are subsidized out of humanitarian concern over their being the victims of natural disasters, birth defects, or other misfortunes beyond their control.
From a political standpoint, however, politicians win votes by doing special favors for special interests or putting special taxes on whoever or whatever might be unpopular at the moment.
The Meaning of Costs"
In light of the role of trade-offs and substitutions, it is easier to understand the real meaning of costs as the foregone opportunities to use the same resources elsewhere. Because an economy deals with scarce resources which have alternative uses, every benefit has a cost in the alternative uses that could have been made of the same resources that created a particular benefit. We do not simply "put" a price on things. Things have inherent costs and our political choice is only between trying to suppress the conveying of those costs to the users in prices or allowing these
inherent costs to be expressed in the marketplace.
Free-market prices are not mere arbitrary obstacles to getting what people want. Prices are symptoms of an underlying reality that is not nearly as susceptible to political manipulation as the prices are. Prices are like thermometer readings-and a patient with a fever is not going to be helped by plunging the thermometer into ice water to lower the reading. On the contrary, if we were to take the new readings seriously and imagine that the patient's fever was over, the dangers would be even greater, now that the underlying reality was being ignored.
Despite how obvious all this might seem, there are never-ending streams of political schemes designed to escape the realities being conveyed by prices-whether through direct price controls or by making this or that "affordable" with subsidies or by having the government itself supply various goods and services free, as a "right." There are probably more ill-conceived economic policies based on treating prices as just nuisances to get around than on any other single fallacy. What all these schemes have in common is that they exempt some things from the process of weighing costs and benefits against one another.
Sometimes the rationale for removing particular things from the process if weighing costs against benefits is expressed in some such question as:
Bow can you put a price on art?"-or education, health, music, etc. The fundamental fallacy underlying this question is the belief that prices are simply "put" on things. So long as art, education, health, music, and thousands of other things all require time, effort, and material resources, the costs of these inputs are the prices that are inherent. These costs do not go away because a law prevents them from being conveyed through prices in the marketplace. Ultimately, to society as a whole, costs are the other things that could have been produced with the same resources. Money flows and price movements are symptoms of that fact-and suppressing these symptoms will not change the underlying fact.
PART II:
INDUSTRY AND COMMERCE
Chapter 5
The Rise and Fall of Businesses
Failure is part of the natural cycle of business. Companies are born, companies die, capitalism moves forward.
-FORTUNE MAGAZINE
Ordinarily, we tend to think of businesses as simply money-making enterprises, but that can be very misleading, in at least two ways. First of all, most businesses go out of business within a very few years after getting started, so it is likely that at least as many businesses are losing money as are making money. More important, from the standpoint of economics, is not what money the business owner hopes to make or whether he succeeds, but how all this affects the use of scarce resources which have alternative uses and therefore how it affects the economic well-being of millions of other people in the society at large.
ADJUSTING TO CHANGES
The businesses we hear about, in the media and elsewhere, are usually those which have succeeded, and especially those which have succeeded on a grand scale-Microsoft, Sony, General Motors, Lloyd's of London, Credit Suisse.
In an earlier era, Americans would have heard about the A & P grocery chain, once the largest retail chain in any field, anywhere in the world. Its 15,000 stores in 1929 were more than any other retailer ever had in America, before or since. The fact that A & P has shrunk to a minute fraction of its former size, and is now virtually unknown, suggests that industry and commerce are not static things, but dynamic processes, in which individual companies and whole industries rise and fall, as a result of relentless competition under changing conditions.
Half the companies on the" Fortune 500" list of the largest American businesses in 1980 were no longer on that list a decade later. In just one year between 2001 and 2002-38 businesses dropped off the list, including Enron, which had been the fifth largest company in America the previous year. Nor are such falls from the financial peaks confined to the United States. At one time, the largest bank in the world, Japan's Mizuho, had a $20 billion loss in its fiscal year ending in 2003 and the value of its stock fell by 93 percent. The amount by which its total stock value fell was greater than the Gross Domestic Product of New Zealand.
At the heart of all of this is the role of profit-and of losses. Each is equally important from the standpoint of forcing companies and industries to use scarce resources efficiently. Industry and commerce are not just a matter of routine management, with profits rolling in more or less automatically.
Masses of ever-changing details, within an ever-changing surrounding economic and social
environment, mean that the threat of losses hangs over even the biggest and most successful businesses. There is a reason why business executives usually work far longer hours than their employees, and why so many businesses fail within a few years after getting started. Only from the outside does it look easy.
Just as companies rise and fall over time, so do profit rates-even more quickly. When compact disks began rapidly replacing long-playing records in the late 1980s, Japanese manufacturers of CD players "thrived" according to the Far Eastern Economic Review. But "within a few years, CD-players only offered manufacturers razor-thin margins." This has been a common experience with many products in many industries. The companies which first introduce a product that consumers like may make large profits, but those very profits attract more investments into existing companies and encourage new companies to form, both of which add to output, driving down prices and profit margins through supply and demand. Sometimes profits then turn to losses, forcing some firms into bankruptcy until the industry's supply and demand balance at levels that are sustainable.
Even the largest corporations can see profit turn to losses and vice versa.
Sony lost $354 million in a six-month period and then, about a year later, had profits that topped one billion dollars. General Motors lost $30 billion during a three-year period in the early 1990s but rebounded under new management to earn nearly $4 billion in profits in 2002.
Companies superbly adapted to a given set of conditions can be left behind when those conditions change suddenly and their competitors are quicker to respond. During the 1920s, for example, the A & P grocery chain in the United States was making a phenomenal rate of profit on its investment-never less than 20 percent per year, about double the national average-and it continued to prosper on through the decades of the 1930s and 1940s. But all this began to change drastically in the 1950s, when A & P lost more than $50 million in one 52-week period. A few years later, it lost $175 million over the same span of time. Its decline had begun.
A & P's fate, both when it prospered and when it lost out to rival grocery chains, illustrates the dynamic nature of a price-coordinated economy and the role of profits and losses. When A & P was prospering up through the 1940s, it did so by charging lower prices than competing grocery stores. It could do this because its efficiency kept its costs lower than those of competing grocery stores and chains, and the resulting lower prices attracted vast numbers of customers. When A & P began to lose customers to other grocery chains, this was because these other chains could now sell for lower prices than A & P. Changing conditions in the surrounding society brought this about-together with differences in the speed with which different companies spotted these changes and realized their implications.
What were these changes? In the years following the end of World War II, suburbanization and the American public's rising prosperity gave huge supermarkets in shopping malls with vast parking lots decisive advantages over neighborhood stores located along the streets in the central cities. As the ownership of automobiles, refrigerators and freezers became far more widespread, this completely changed the economics of the grocery industry.
The automobile, which made suburbanization possible, also made possible greater economies of scale for both customers and supermarkets. Shoppers could now buy far more groceries at one time than they could have carried home in their arms from an urban neighborhood store before the war. That was the crucial role of the automobile. Moreover, refrigerators and freezers now made it possible to stock up on perishable items like meat and dairy products. This led to fewer trips to the grocery store, with larger purchases each time.
What this meant to the supermarket itself was a larger volume of sales at a given location,
which could now draw customers with automobiles from miles around, whereas a neighborhood store in the central city was unlikely to draw customers on foot from ten blocks away. High volume meant savings in delivery costs from the wholesale warehouses to the supermarket, as compared to delivering the same total amount of groceries in smaller individual lots to many neighborhood stores, whose total sales would add up to what one supermarket sold.
This also meant savings in the cost of selling within the supermarket itself, because it did not take as long to check out one customer buying $50 worth of groceries at a supermarket as it did to check out ten customers buying $5 worth of groceries each at a neighborhood store. Because of these and other differences in the costs of doing business, supermarkets could be very profitable while charging prices lower than those in neighborhood stores that were struggling to survive.
All this not only lowered the costs of delivering groceries to the consumer, it changed the relative economic advantages and disadvantages of different locations for stores. Some supermarket chains, such as Safeway, responded to these radically new conditions faster and better than A & P did. The A & P stores lingered in the central cities longer and also did not follow the shifts of population to California and other sunbelt regions.
A & P was also reluctant to sign long leases or pay high prices for new locations where the customers and their money were now moving. As a result, after years of being the lowest-price major grocery chain, A & P suddenly found itself being undersold by rivals with even lower costs of doing business.
Lower costs reflected in lower prices is what made A & P the world's leading retail chain in the first half of the twentieth century. Similarly, lower costs reflected in lower prices is what enabled other supermarket chains to take A & P's customers away in the second half of the twentieth century.
While A & P succeeded in one era and failed in another, what is far more important is that the economy as a whole succeeded in both eras in getting its groceries at the lowest prices possible at the time-from whichever company happened to have the lowest prices. By the early twenty-first century, general merchandiser Wal-Mart had moved to the top of the grocery industry, with nearly double the number of stores selling groceries as Safeway.
Many other corporations that once dominated their fields have likewise fallen behind in the face of changes or have even gone bankrupt. For decades, the Graflex Corporation produced most of the cameras used by press photographers. Movies and newsreels of the 1930s and 1940s almost invariably showed news photographers using a big, bulky camera with a bellows called a Speed Graphic, produced by Graflex. Then, in the early 1950s, outstanding photographs of the Korean war were made with a 35mm Leica camera, using lenses produced by a Japanese manufacturer that also made a new camera called the Nikon.
Advances in lens design and films now made it possible for newspaper and magazine photographers to take pictures with smaller cameras that had enough sharpness and detail for their pictures to compete with pictures taken by much bulkier cameras. Within a decade, smaller cameras rapidly replaced Speed Graphics and other large cameras made by the Graflex Corporation. The last Speed Graphic was produced in 1973 and the Graflex Corporation itself became extinct, after decades of dominating its field.
Similar stories could be told in industry after industry. Pan American Airlines, which pioneered in commercial flights across the Atlantic and the Pacific, went out of business in the wake of the deregulation of the American airline industry in the 1970s. Famous newspapers like the New York Herald Tribune, with a pedigree going back more than a century, stopped