Basic Economics 5th Edition by Thomas Sowell PDF

A few lines of reasoning can change the way we see the world. Steven E. Landsburg{1} Copyright © 2015 Thomas Sowell Published by Basic Books, A Member of the Perseus Books Group All rights reserved. No part of this book may be reproduced in any manner whatsoever without written permission except in the case of brief quotations embodied in critical articles and reviews. For information, address Basic Books, 250 West 57th Street, 15th Floor, New York, NY 10107. Books published by Basic Books are available at special discounts for bulk purchases in the United States by corporations, institutions, and other organizations. For more information, please contact the Special Markets Department at the Perseus Books Group, 2300 Chestnut Street, Suite 200, Philadelphia, PA 19103, or call (800) 810-4145, ext. 5000, or e-mail [email protected]. Library of Congress Control Number: 2014945836 ISBN: 978-0-465-05684-2 CONTENTS Preface Acknowledgments Chapter 1: What Is Economics? PART I: PRICES AND MARKETS Chapter 2: The Role of Prices Chapter 3: Price Controls Chapter 4: An Overview of Prices PART II: INDUSTRY AND COMMERCE Chapter 5: The Rise and Fall of Businesses Chapter 6: The Role of Proﬁts–and Losses Chapter 7: The Economics of Big Business Chapter 8: Regulation and Anti-Trust Laws Chapter 9: Market and Non-Market Economies PART III: WORK AND PAY Chapter 10: Productivity and Pay Chapter 11: Minimum Wage Laws Chapter 12: Special Problems in Labor Markets PART IV: TIME AND RISK Chapter 13: Investment Chapter 14: Stocks, Bonds and Insurance Chapter 15: Special Problems of Time and Risk PART V: THE NATIONAL ECONOMY Chapter 16: National Output Chapter 17: Money and the Banking System Chapter 18: Government Functions Chapter 19: Government Finance Chapter 20: Special Problems in the National Economy PART VI: THE INTERNATIONAL ECONOMY Chapter 21: International Trade Chapter 22: International Transfers of Wealth Chapter 23: International Disparities in Wealth PART VII: SPECIAL ECONOMIC ISSUES Chapter 24: Myths About Markets Chapter 25: “Non-Economic” Values Chapter 26: The History of Economics Chapter 27: Parting Thoughts Questions Notes PREFACE The most obvious diﬀerence between this book and other introductory economics books is that Basic Economics has no graphs or equations. It is also written in plain English, rather than in economic jargon, so that it can be readily understood by people with no previous knowledge of economics. This includes both the general public and beginning students in economics. A less obvious, but important, feature of Basic Economics is that it uses real-life examples from countries around the world to make economic principles vivid and memorable, in a way that graphs and equations might not. During the changes in its various editions, the fundamental idea behind Basic Economics has remained the same: Learning economics should be as uncomplicated as it is eye-opening. Readers’ continuing interest in these new editions at home, and a growing number of translations into foreign languages overseas,{i} suggest that there is a widespread desire for this kind of introduction to economics, when it is presented in a readable way. Just as people do, this book has put on weight with the passing years, as new chapters have been added and existing chapters updated and expanded to stay abreast of changing developments in economies around the world. Readers who have been puzzled by the large disparities in economic development, and standards of living, among the nations of the world will ﬁnd a new chapter—Chapter 23, the longest chapter in the book—devoted to exploring geographic, demographic, cultural and other reasons why such striking disparities have existed for so long. It also examines factors which are said to have been major causes of international economic disparities and ﬁnds that the facts do not always support such claims. Most of us are necessarily ignorant of many complex ﬁelds, from botany to brain surgery. As a result, we simply do not attempt to operate in, or comment on, those ﬁelds. However, every voter and every politician that they vote for aﬀects economic policies. We cannot opt out of economic issues and decisions. Our only options are to be informed, uninformed, or misinformed, when making our choices on issues and candidates. Basic Economics is intended to make it easier to be informed. The fundamental principles of economics are not hard to understand, but they are easy to forget, especially amid the heady rhetoric of politics and the media. In keeping with the nature of Basic Economics as an introduction to economics, jargon, graphs and equations have been left out. However, endnotes are included in this e-book, for those who may wish to check up on some of the surprising facts they will learn about here. For instructors who are using Basic Economics as a textbook in their courses, or for parents who are homeschooling their children, more than a hundred questions are in the back of this book, with the print book page numbers listed after each question, showing where the answer to that question can be found in the text. THOMAS SOWELL Hoover Institution Stanford University ACKNOWLEDGMENTS Like other books of mine, this one owes much to my two extraordinary research assistants, Na Liu and Elizabeth Costa. In addition to their tracking down all sorts of information for me, Ms. Costa did the copy-editing and fact-checking of the manuscript, which Ms. Liu then converted into galleys and helped to index, after which the resulting Quark ﬁle was sent to the publisher, who could have the book printed directly from her computer ﬁle. The chapter on the history of economics was read by distinguished emeritus Professor William R. Allen of UCLA, a former colleague whose insightful comments and suggestions were very much appreciated, even when I did not make full use of all of them. Needless to say, any errors or shortcomings that remain after all these people’s eﬀorts can only be my responsibility. And of course none of this would be possible without the support of the Hoover Institution and the research facilities of Stanford University. Chapter 1 WHAT IS ECONOMICS? Whether one is a conservative or a radical, a protectionist or a free trader, a cosmopolitan or a nationalist, a churchman or a heathen, it is useful to know the causes and consequences of economic phenomena. George J. Stigler{2} Economic events often make headlines in the newspapers or “breaking news” on television. Yet it is not always clear from these news stories what caused these particular events, much less what future consequences can be expected. The underlying principles involved in most economic events are usually not very complicated in themselves, but the political rhetoric and economic jargon in which they are discussed can make these events seem murky. Yet the basic economic principles that would clarify what is happening may remain unknown to most of the public and little understood by many in the media. These basic principles of economics apply around the world and have applied over thousands of years of recorded history. They apply in many very diﬀerent kinds of economies—capitalist, socialist, feudal, or whatever—and among a wide variety of peoples, cultures, and governments. Policies which led to rising price levels under Alexander the Great have led to rising price levels in America, thousands of years later. Rent control laws have led to a very similar set of consequences in Cairo, Hong Kong, Stockholm, Melbourne, and New York. So have similar agricultural policies in India and in the European Union countries. We can begin the process of understanding economics by ﬁrst being clear as to what economics means. To know what economics is, we must ﬁrst know what an economy is. Perhaps most of us think of an economy as a system for the production and distribution of the goods and services we use in everyday life. That is true as far as it goes, but it does not go far enough. The Garden of Eden was a system for the production and distribution of goods and services, but it was not an economy, because everything was available in unlimited abundance. Without scarcity, there is no need to economize—and therefore no economics. A distinguished British economist named Lionel Robbins gave a classic deﬁnition of economics: Economics is the study of the use of scarce resources which have alternative uses. SCARCITY What does “scarce” mean? It means that what everybody wants adds up to more than there is. This may seem like a simple thing, but its implications are often grossly misunderstood, even by highly educated people. For example, a feature article in the New York Times laid out the economic woes and worries of middle-class Americans— one of the most aﬄuent groups of human beings ever to inhabit this planet. Although this story included a picture of a middle-class American family in their own swimming pool, the main headline read: “The American Middle, Just Getting By.” Other headings in the article included: Wishes Deferred and Plans Unmet Goals That Remain Just Out of Sight Dogged Saving and Some Luxuries In short, middle-class Americans’ desires exceed what they can comfortably aﬀord, even though what they already have would be considered unbelievable prosperity by people in many other countries around the world—or even by earlier generations of Americans. Yet both they and the reporter regarded them as “just getting by” and a Harvard sociologist was quoted as saying “how budget-constrained these people really are.” But it is not something as man-made as a budget which constrains them: Reality constrains them. There has never been enough to satisfy everyone completely. That is the real constraint. That is what scarcity means. The New York Times reported that one of these middle-class families “got in over their heads in credit card spending” but then “got their ﬁnances in order.” “But if we make a wrong move,” Geraldine Frazier said, “the pressure we had from the bills will come back, and that is painful.”{3} To all these people—from academia and journalism, as well as the middle-class people themselves—it apparently seemed strange somehow that there should be such a thing as scarcity and that this should imply a need for both productive eﬀorts on their part and personal responsibility in spending the resulting income. Yet nothing has been more pervasive in the history of the human race than scarcity and all the requirements for economizing that go with scarcity. Regardless of our policies, practices, or institutions—whether they are wise or unwise, noble or ignoble—there is simply not enough to go around to satisfy all our desires to the fullest. “Unmet needs” are inherent in these circumstances, whether we have a capitalist, socialist, feudal, or other kind of economy. These various kinds of economies are just diﬀerent institutional ways of making trade-oﬀs that are inescapable in any economy. PRODUCTIVITY Economics is not just about dealing with the existing output of goods and services as consumers. It is also, and more fundamentally, about producing that output from scarce resources in the ﬁrst place— turning inputs into output. In other words, economics studies the consequences of decisions that are made about the use of land, labor, capital and other resources that go into producing the volume of output which determines a country’s standard of living. Those decisions and their consequences can be more important than the resources themselves, for there are poor countries with rich natural resources and countries like Japan and Switzerland with relatively few natural resources but high standards of living. The values of natural resources per capita in Uruguay and Venezuela are several times what they are in Japan and Switzerland, but real income per capita in Japan and Switzerland is more than double that of Uruguay and several times that of Venezuela.{4} Not only scarcity but also “alternative uses” are at the heart of economics. If each resource had only one use, economics would be much simpler. But water can be used to produce ice or steam by itself or innumerable mixtures and compounds in combination with other things. Similarly, from petroleum comes not only gasoline and heating oil, but also plastics, asphalt and Vaseline. Iron ore can be used to produce steel products ranging from paper clips to automobiles to the frameworks of skyscrapers. How much of each resource should be allocated to each of its many uses? Every economy has to answer that question, and each one does, in one way or another, eﬃciently or ineﬃciently. Doing so eﬃciently is what economics is about. Diﬀerent kinds of economies are essentially diﬀerent ways of making decisions about the allocation of scarce resources—and those decisions have repercussions on the life of the whole society. During the days of the Soviet Union, for example, that country’s industries used more electricity than American industries used, even though Soviet industries produced a smaller amount of output than American industries produced.{5} Such ineﬃciencies in turning inputs into outputs translated into a lower standard of living, in a country richly endowed with natural resources—perhaps more richly endowed than any other country in the world. Russia is, for example, one of the few industrial nations that produces more oil than it consumes. But an abundance of resources does not automatically create an abundance of goods. Eﬃciency in production—the rate at which inputs are turned into output—is not just some technicality that economists talk about. It aﬀects the standard of living of whole societies. When visualizing this process, it helps to think about the real things—the iron ore, petroleum, wood and other inputs that go into the production process and the furniture, food and automobiles that come out the other end —rather than think of economic decisions as being simply decisions about money. Although the word “economics” suggests money to some people, for a society as a whole money is just an artiﬁcial device to get real things done. Otherwise, the government could make us all rich by simply printing more money. It is not money but the volume of goods and services which determines whether a country is poverty stricken or prosperous. THE ROLE OF ECONOMICS Among the misconceptions of economics is that it is something that tells you how to make money or run a business or predict the ups and downs of the stock market. But economics is not personal ﬁnance or business administration, and predicting the ups and downs of the stock market has yet to be reduced to a dependable formula. When economists analyze prices, wages, proﬁts, or the international balance of trade, for example, it is from the standpoint of how decisions in various parts of the economy aﬀect the allocation of scarce resources in a way that raises or lowers the material standard of living of the people as a whole. Economics is not simply a topic on which to express opinions or vent emotions. It is a systematic study of cause and eﬀect, showing what happens when you do speciﬁc things in speciﬁc ways. In economic analysis, the methods used by a Marxist economist like Oskar Lange did not diﬀer in any fundamental way from the methods used by a conservative economist like Milton Friedman.{6} It is these basic economic principles that this book is about. One of the ways of understanding the consequences of economic decisions is to look at them in terms of the incentives they create, rather than simply the goals they pursue. This means that consequences matter more than intentions—and not just the immediate consequences, but also the longer run repercussions. Nothing is easier than to have good intentions but, without an understanding of how an economy works, good intentions can lead to counterproductive, or even disastrous, consequences for a whole nation. Many, if not most, economic disasters have been a result of policies intended to be beneﬁcial—and these disasters could often have been avoided if those who originated and supported such policies had understood economics. While there are controversies in economics, as there are in science, this does not mean that the basic principles of economics are just a matter of opinion, any more than the basic principles of chemistry or physics are just a matter of opinion. Einstein’s analysis of physics, for example, was not just Einstein’s opinion, as the world discovered at Hiroshima and Nagasaki. Economic reactions may not be as spectacular or as tragic, as of a given day, but the worldwide depression of the 1930s plunged millions of people into poverty, even in the richest countries, producing malnutrition in countries with surplus food, probably causing more deaths around the world than those at Hiroshima and Nagasaki. Conversely, when India and China—historically, two of the poorest nations on earth—began in the late twentieth century to make fundamental changes in their economic policies, their economies began growing dramatically. It has been estimated that 20 million people in India rose out of destitution in a decade.{7} In China, the number of people living on a dollar a day or less fell from 374 million—one third of the country’s population in 1990—to 128 million by 2004,{8} now just 10 percent of a growing population. In other words, nearly a quarter of a billion Chinese were now better oﬀ as a result of a change in economic policy. Things like this are what make the study of economics important —and not just a matter of opinions or emotions. Economics is a tool of cause and eﬀect analysis, a body of tested knowledge—and principles derived from that knowledge. Money doesn’t even have to be involved to make a decision be economic. When a military medical team arrives on a battleﬁeld where soldiers have a variety of wounds, they are confronted with the classic economic problem of allocating scarce resources which have alternative uses. Almost never are there enough doctors, nurses, or paramedics to go around, nor enough medications. Some of the wounded are near death and have little chance of being saved, while others have a ﬁghting chance if they get immediate care, and still others are only slightly wounded and will probably recover whether they get immediate attention or not. If the medical team does not allocate its time and medications eﬃciently, some wounded soldiers will die needlessly, while time is being spent attending to others not as urgently in need of care or still others whose wounds are so devastating that they will probably die in spite of anything that can be done for them. It is an economic problem, though not a dime changes hands. Most of us hate even to think of having to make such choices. Indeed, as we have already seen, some middle-class Americans are distressed at having to make much milder choices and trade-oﬀs. But life does not ask us what we want. It presents us with options. Economics is one of the ways of trying to make the most of those options. PART I: PRICES AND MARKETS Chapter 2 THE ROLE OF PRICES The wonder of markets is that they reconcile the choices of myriad individuals. William Easterly{9} Since we know that the key task facing any economy is the allocation of scarce resources which have alternative uses, the next question is: How does an economy do that? Diﬀerent kinds of economies obviously do it diﬀerently. In a feudal economy, the lord of the manor simply told the people under him what to do and where he wanted resources put: Grow less barley and more wheat, put fertilizer here, more hay there, drain the swamps. It was much the same story in twentieth century Communist societies, such as the Soviet Union, which organized a far more complex modern economy in much the same way, with the government issuing orders for a hydroelectric dam to be built on the Volga River, for so many tons of steel to be produced in Siberia, so much wheat to be grown in the Ukraine. By contrast, in a market economy coordinated by prices, there is no one at the top to issue orders to control or coordinate activities throughout the economy. How an incredibly complex, high-tech economy can operate without any central direction is baﬄing to many. The last President of the Soviet Union, Mikhail Gorbachev, is said to have asked British Prime Minister Margaret Thatcher: “How do you see to it that people get food?” The answer was that she didn’t. Prices did that. Moreover, the British people were better fed than people in the Soviet Union, even though the British have not produced enough food to feed themselves in more than a century. Prices bring them food from other countries. Without the role of prices, imagine what a monumental bureaucracy it would take to see to it that the city of London alone is supplied with the tons of food, of every variety, which it consumes every day. Yet such an army of bureaucrats can be dispensed with— and the people that would be needed in such a bureaucracy can do productive work elsewhere in the economy—because the simple mechanism of prices does the same job faster, cheaper and better. This is also true in China, where the Communists still run the government but, by the early twenty-ﬁrst century, were allowing free markets to operate in much of that country’s economy. Although China has one-ﬁfth of the total population of the world, it has only 10 percent of the world’s arable land, so feeding its people could continue to be the critical problem that it once was, back in the days when recurring famines took millions of lives each in China. Today prices attract food to China from other countries: China’s food supplement is coming from abroad—from South America, the U.S. and Australia. This means prosperity for agricultural traders and processors like Archer Daniels Midland. They’re moving into China in all of the ways you’d expect in a $100 billion national market for processed food that’s growing more than 10% annually. It means a windfall for farmers in the American Midwest, who are enjoying soybean prices that have risen about two-thirds from what they were a year ago. It means a better diet for the Chinese, who have raised their caloric intake by a third in the past quarter-century.{10} Given the attractive power of prices, the American fried-chicken company KFC was by the early twenty-ﬁrst century making more sales in China than in the United States.{11} China’s per capita consumption of dairy products nearly doubled in just ﬁve years.{12} A study estimated that one-fourth of the adults in China were overweight{13}—not a good thing in itself, but a heartening development in a country once aﬄicted with recurring famines. ECONOMIC DECISION-MAKING The fact that no given individual or set of individuals controls or coordinates all the innumerable economic activities in a market economy does not mean that these things just happen randomly or chaotically. Each consumer, producer, retailer, landlord, or worker makes individual transactions with other individuals on whatever terms they can mutually agree on. Prices convey those terms, not just to the particular individuals immediately involved but throughout the whole economic system—and indeed, throughout the world. If someone else somewhere else has a better product or a lower price for the same product or service, that fact gets conveyed and acted upon through prices, without any elected oﬃcial or planning commission having to issue orders to consumers or producers—indeed, faster than any planners could assemble the information on which to base their orders. If someone in Fiji ﬁgures out how to manufacture better shoes at lower costs, it will not be long before you are likely to see those shoes on sale at attractive prices in the United States or in India, or anywhere in between. After the Second World War ended, Americans could begin buying cameras from Japan, whether or not oﬃcials in Washington were even aware at that time that the Japanese made cameras. Given that any modern economy has millions of products, it is too much to expect the leaders of any country to even know what all those products are, much less know how much of each resource should be allocated to the production of each of those millions of products. Prices play a crucial role in determining how much of each resource gets used where and how the resulting products get transferred to millions of people. Yet this role is seldom understood by the public and it is often disregarded entirely by politicians. Prime Minister Margaret Thatcher in her memoirs said that Mikhail Gorbachev “had little understanding of economics,”{14} even though he was at that time the leader of the largest nation on earth. Unfortunately, he was not unique in that regard. The same could be said of many other national leaders around the world, in countries large and small, democratic or undemocratic. In countries where prices coordinate economic activities automatically, that lack of knowledge of economics does not matter nearly as much as in countries where political leaders try to direct and coordinate economic activities. Many people see prices as simply obstacles to their getting the things they want. Those who would like to live in a beach-front home, for example, may abandon such plans when they discover how extremely expensive beach-front property can be. But high prices are not the reason we cannot all live in beach-front houses. On the contrary, the inherent reality is that there are not nearly enough beach- front homes to go around, and prices simply convey that underlying reality. When many people bid for a relatively few homes, those homes become very expensive because of supply and demand. But it is not the prices that cause the scarcity. There would be the same scarcity under feudalism or socialism or in a tribal society. If the government today were to come up with a “plan” for “universal access” to beach-front homes and put “caps” on the prices that could be charged for such property, that would not change the underlying reality of the extremely high ratio of people to beach-front land. With a given population and a given amount of beach-front property, rationing without prices would have to take place by bureaucratic ﬁat, political favoritism or random chance—but the rationing would still have to take place. Even if the government were to decree that beach-front homes were a “basic right” of all members of society, that would still not change the underlying scarcity in the slightest. Prices are like messengers conveying news—sometimes bad news, in the case of beach-front property desired by far more people than can possibly live at the beach, but often also good news. For example, computers have been getting both cheaper and better at a very rapid rate, as a result of technological advances. Yet the vast majority of beneﬁciaries of those high-tech advances have not the foggiest idea of just what speciﬁcally those technological changes are. But prices convey to them the end results—which are all that matter for their own decision-making and their own enhanced productivity and general well-being from using computers. Similarly, if vast new rich iron ore deposits were suddenly discovered somewhere, perhaps no more than one percent of the population would be likely to be aware of it, but everyone would discover that things made of steel were becoming cheaper. People thinking of buying desks, for example, would discover that steel desks had become more of a bargain compared to wooden desks and some would undoubtedly change their minds as to which kind of desk to purchase because of that. The same would be true when comparing various other products made of steel to competing products made of aluminum, copper, plastic, wood, or other materials. In short, price changes would enable a whole society—indeed, consumers around the world—to adjust automatically to a greater abundance of known iron ore deposits, even if 99 percent of those consumers were wholly unaware of the new discovery. Prices are not just ways of transferring money. Their primary role is to provide ﬁnancial incentives to aﬀect behavior in the use of resources and their resulting products. Prices not only guide consumers, they guide producers as well. When all is said and done, producers cannot possibly know what millions of diﬀerent consumers want. All that automobile manufacturers, for example, know is that when they produce cars with a certain combination of features they can sell those cars for a price that covers their production costs and leaves them a proﬁt, but when they manufacture cars with a diﬀerent combination of features, these don’t sell as well. In order to get rid of the unsold cars, the sellers must cut the prices to whatever level is necessary to get them oﬀ the dealers’ lots, even if that means taking a loss. The alternative would be to take a bigger loss by not selling them at all. Although a free market economic system is sometimes called a proﬁt system, it is in reality a proﬁt-and-loss system—and the losses are equally important for the eﬃciency of the economy, because losses tell producers what to stop doing—what to stop producing, where to stop putting resources, what to stop investing in. Losses force the producers to stop producing what consumers don’t want. Without really knowing why consumers like one set of features rather than another, producers automatically produce more of what earns a proﬁt and less of what is losing money. That amounts to producing what the consumers want and stopping the production of what they don’t want. Although the producers are only looking out for themselves and their companies’ bottom line, nevertheless from the standpoint of the economy as a whole the society is using its scarce resources more eﬃciently because decisions are guided by prices. Prices formed a worldwide web of communication long before there was an Internet. Prices connect you with anyone, anywhere in the world where markets are allowed to operate freely, so that places with the lowest prices for particular goods can sell those goods around the world. As a result, you can end up wearing shirts made in Malaysia, shoes produced in Italy, and slacks made in Canada, while driving a car manufactured in Japan, rolling on tires produced in France. Price-coordinated markets enable people to signal to other people how much they want and how much they are willing to oﬀer for it, while other people signal what they are willing to supply in exchange for what compensation. Prices responding to supply and demand cause natural resources to move from places where they are abundant, like Australia, to places where they are almost non-existent, like Japan. The Japanese are willing to pay higher prices than Australians pay for those resources. These higher prices will cover shipping costs and still leave a larger proﬁt than selling the same resources within Australia, where their abundance makes their prices lower. A discovery of large bauxite deposits in India would reduce the cost of aluminum baseball bats in America. A disastrous failure of the wheat crop in Argentina would raise the incomes of farmers in Ukraine, who would now ﬁnd more demand for their wheat in the world market, and therefore higher prices. When more of some item is supplied than demanded, competition among sellers trying to get rid of the excess will force the price down, discouraging future production, with the resources used for that item being set free for use in producing something else that is in greater demand. Conversely, when the demand for a particular item exceeds the existing supply, rising prices due to competition among consumers encourage more production, drawing resources away from other parts of the economy to accomplish that. The signiﬁcance of free market prices in the allocation of resources can be seen more clearly by looking at situations where prices are not allowed to perform this function. During the era of the government-directed economy of the Soviet Union, for example, prices were not set by supply and demand but by central planners who sent resources to their various uses by direct commands, supplemented by prices that the planners raised or lowered as they saw ﬁt. Two Soviet economists, Nikolai Shmelev and Vladimir Popov, described a situation in which their government raised the price it would pay for moleskins, leading hunters to get and sell more of them: State purchases increased, and now all the distribution centers are ﬁlled with these pelts. Industry is unable to use them all, and they often rot in warehouses before they can be processed. The Ministry of Light Industry has already requested Goskomtsen twice to lower purchasing prices, but the “question has not been decided” yet. And this is not surprising. Its members are too busy to decide. They have no time: besides setting prices on these pelts, they have to keep track of another 24 million prices. {15} However overwhelming it might be for a government agency to try to keep track of 24 million prices, a country with more than a hundred million people can far more easily keep track of those prices individually, because no given individual or enterprise has to keep track of more than the relatively few prices that are relevant to their own decision-making. The over-all coordination of these innumerable isolated decisions takes place through the eﬀect of supply and demand on prices and the eﬀect of prices on the behavior of consumers and producers. Money talks—and people listen. Their reactions are usually faster than central planners could get their reports together. While telling people what to do might seem to be a more rational or orderly way of coordinating an economy, it has turned out repeatedly to be far less eﬀective in practice. The situation as regards pelts was common for many other goods during the days of the Soviet Union’s centrally planned economy, where a chronic problem was a piling up of unsold goods in warehouses at the very time when there were painful shortages of other things that could have been produced with the same resources. In a market economy, the prices of surplus goods would fall automatically by supply and demand, while the prices of goods in short supply would rise automatically for the same reason —the net result being a shifting of resources from the former to the latter, again automatically, as producers seek to gain proﬁts and avoid losses. The problem was not that particular planners made particular mistakes in the Soviet Union or in other planned economies. Whatever the mistakes made by central planners, there are mistakes made in all kinds of economic systems—capitalist, socialist, or whatever. The more fundamental problem with central planning has been that the task taken on has repeatedly proven to be too much for human beings, in whatever country that task has been taken on. As Soviet economists Shmelev and Popov put it: No matter how much we wish to organize everything rationally, without waste, no matter how passionately we wish to lay all the bricks of the economic structure tightly, with no chinks in the mortar, it is not yet within our power.{16} PRICES AND COSTS Prices in a market economy are not simply numbers plucked out of the air or arbitrarily set by sellers. While you may put whatever price you wish on the goods or services you provide, those prices will become economic realities only if others are willing to pay them—and that depends not on whatever prices you have chosen but on how much consumers want what you oﬀer and on what prices other producers charge for the same goods and services. Even if you produce something that would be worth $100 to a customer and oﬀer it for sale at $80, that customer will still not buy it from you if another producer oﬀers the same thing for $70. Obvious as all this may seem, its implications are not at all obvious to some people —those who blame high prices on “greed,” for example, for that implies that a seller can set prices at will and make sales at those arbitrary prices. For example, a front-page newspaper story in The Arizona Republic began: Greed drove metropolitan Phoenix’s home prices and sales to new records in 2005. Fear is driving the market this year.{17} This implies that lower prices meant less greed, rather than changed circumstances that reduce the sellers’ ability to charge the same prices as before and still make sales. The changed circumstances in this case included the fact that homes for sale in Phoenix remained on the market longer before being sold than during the year before, and the fact that home builders were “struggling to sell even deeply discounted new homes.”{18} There was not the slightest indication that sellers were any less interested in getting as much money as they could for the houses they sold—that is, that they were any less “greedy.” Competition in the market is what limits how much anyone can charge and still make sales, so what is at issue is not anyone’s disposition, whether greedy or not, but what the circumstances of the market cause to happen. A seller’s feelings—whether “greedy” or not —tell us nothing about what the buyer will be willing to pay. Resource Allocation by Prices We now need to look more closely at the process by which prices allocate scarce resources that have alternative uses. The situation where the consumers want product A and don’t want product B is the simplest example of how prices lead to eﬃciency in the use of scarce resources. But prices are equally important in more common and more complex situations, where consumers want both A and B, as well as many other things, some of which require the same ingredients in their production. For example, consumers not only want cheese, they also want ice cream and yogurt, as well as other products made from milk. How do prices help the economy to determine how much milk should go to each of these products? In paying for cheese, ice cream, and yogurt, consumers are in eﬀect also bidding indirectly for the milk from which these products are produced. In other words, money that comes in from the sales of these products is what enables the producers to again buy milk to use to continue making their respective products. When the demand for cheese goes up, cheese-makers use their additional revenue to bid away some of the milk that before went into making ice cream or yogurt, in order to increase the output of their own product to meet the rising demand. When the cheese-makers demand more milk, this increased demand forces up the price of milk—to everyone, including the producers of ice cream and yogurt. As the producers of these other products raise the prices of ice cream and yogurt to cover the higher cost of the milk that goes into them, consumers are likely to buy less of these other dairy products at these higher prices. How will each producer know just how much milk to buy? Obviously they will buy only as much milk as will repay its higher costs from the higher prices of these dairy products. If consumers who buy ice cream are not as discouraged by rising prices as consumers of yogurt are, then very little of the additional milk that goes into making more cheese will come from a reduced production of ice cream and more will come from a reduced production of yogurt. What this all means as a general principle is that the price which one producer is willing to pay for any given ingredient becomes the price that other producers are forced to pay for that same ingredient. This applies whether we are talking about the milk that goes into making cheese, ice cream, and yogurt or we are talking about the wood that goes into making baseball bats, furniture, and paper. If the amount of paper demanded doubles, this means that the demand for wood pulp to make paper goes up. As the price of wood rises in response to this increased demand, that in turn means that the prices of baseball bats and furniture will have to go up, in order to cover the higher costs of the wood from which they are made. The repercussions go further. As the price of milk rises, dairies have incentives to produce more milk, which can mean buying more cows, which in turn can mean that more cows will be allowed to grow to maturity, instead of being slaughtered for meat as calves. Nor do the repercussions stop there. As fewer cows are slaughtered, there is less cowhide available, and the prices of baseball gloves can rise because of supply and demand. Such repercussions spread throughout the economy, much as waves spread across a pond when a stone drops into the water. No one is at the top coordinating all of this, mainly because no one would be capable of following all these repercussions in all directions. Such a task has proven to be too much for central planners in country after country. Incremental Substitution Since scarce resources have alternative uses, the value placed on one of these uses by one individual or company sets the cost that has to be paid by others who want to bid some of these resources away for their own use. From the standpoint of the economy as a whole, this means that resources tend to ﬂow to their most valued uses when there is price competition in the marketplace. This does not mean that one use categorically precludes all other uses. On the contrary, adjustments are incremental. Only that amount of milk which is as valuable to ice cream consumers or consumers of yogurt as it is to cheese purchasers will be used to make ice cream or yogurt. Only that amount of wood which is as valuable to the makers of baseball bats or furniture as it is to the producers of paper will be used to make bats and furniture. Now look at the demand from the consumers’ standpoint: Whether considering consumers of cheese, ice cream, or yogurt, some will be anxious to have a certain amount, less anxious to have additional amounts, and ﬁnally—beyond some point—indiﬀerent to having any more, or even unwilling to consume any more after becoming satiated. The same principle applies when more wood pulp is used to make paper and the producers and consumers of furniture and baseball bats have to make their incremental adjustments accordingly. In short, prices coordinate the use of resources, so that only that amount is used for one thing which is equal in value to what it is worth to others in other uses. That way, a price-coordinated economy does not ﬂood people with cheese to the point where they are sick of it, while others are crying out in vain for more ice cream or yogurt. Absurd as such a situation would be, it has happened many times in economies where prices are not used to allocate scarce resources. Pelts were not the only unsalable goods that were piling up in Soviet warehouses while people were waiting in long lines trying to get other things that were in short supply.{ii} The eﬃcient allocation of scarce resources which have alternative uses is not just some abstract notion of economists. It determines how well or how badly millions of people live. Again, as in the example of beach-front property, prices convey an underlying reality: From the standpoint of society as a whole, the “cost” of anything is the value that it has in alternative uses. That cost is reﬂected in the market when the price that one individual is willing to pay becomes a cost that others are forced to pay, in order to get a share of the same scarce resource or the products made from it. But, no matter whether a particular society has a capitalist price system or a socialist economy or a feudal or other system, the real cost of anything is still its value in alternative uses. The real cost of building a bridge is whatever else could have been built with that same labor and material. This is also true at the level of a given individual, even when no money is involved. The cost of watching a television sitcom or soap opera is the value of the other things that could have been done with that same time. Economic Systems Diﬀerent economic systems deal with this underlying reality in diﬀerent ways and with diﬀerent degrees of eﬃciency, but the underlying reality exists independently of whatever particular kind of economic system happens to exist in a given society. Once we recognize that, we can then compare how economic systems which use prices to force people to share scarce resources among themselves diﬀer in eﬃciency from economic systems which determine such things by having kings, politicians, or bureaucrats issue orders saying who can get how much of what. During a brief era of greater openness in the last years of the Soviet Union, when people became more free to speak their minds, the two Soviet economists already mentioned wrote a book giving a very candid account of how their economy worked, and this book was later translated into English.{iii} As Shmelev and Popov put it, production enterprises in the Soviet Union “always ask for more than they need” from the government in the way of raw materials, equipment, and other resources used in production. “They take everything they can get, regardless of how much they actually need, and they don’t worry about economizing on materials,” according to these economists. “After all, nobody ‘at the top’ knows exactly what the real requirements are,” so “squandering” made sense{19}—from the standpoint of the manager of a Soviet enterprise. Among the resources that were squandered were workers. These economists estimated that “from 5 to 15 percent of the workers in the majority of enterprises are surplus and are kept ‘just in case.’”{20} The consequence was that far more resources were used to produce a given amount of output in the Soviet economy as compared to a price- coordinated economic system, such as that in Japan, Germany and other market economies. Citing oﬃcial statistics, Shmelev and Popov lamented: To make one ton of copper we use about 1,000 kilowatt hours of electrical energy, as against 300 in West Germany. To produce one ton of cement we use twice the amount of energy that Japan does.{21} The Soviet Union did not lack for resources, but was in fact one of the most richly endowed nations on earth—if not the most richly endowed in natural resources. Nor was it lacking in highly educated and well-trained people. What it lacked was an economic system that made eﬃcient use of its resources. Because Soviet enterprises were not under the same ﬁnancial constraints as capitalist enterprises, they acquired more machines than they needed, “which then gather dust in warehouses or rust out of doors,”{22} as the Soviet economists put it. In short, Soviet enterprises were not forced to economize—that is, to treat their resources as both scarce and valuable in alternative uses, for the alternative users were not bidding for those resources, as they would in a market economy. While such waste cost individual Soviet enterprises little or nothing, they cost the Soviet people dearly, in the form of a lower standard of living than their resources and technology were capable of producing. Such a waste of inputs as these economists described could not of course continue in the kind of economy where these inputs would have to be purchased in competition with alternative users, and where the enterprise itself could survive only by keeping its costs lower than its sales receipts. In such a price-coordinated capitalist system, the amount of inputs ordered would be based on the enterprise’s most accurate estimate of what was really required, not on how much its managers could persuade higher government oﬃcials to let them have. These higher oﬃcials could not possibly be experts on all the wide range of industries and products under their control, so those with the power in the central planning agencies were to some extent dependent on those with the knowledge of their own particular industries and enterprises. This separation of power and knowledge was at the heart of the problem. Central planners could be skeptical of what the enterprise managers told them but skepticism is not knowledge. If resources were denied, production could suﬀer—and heads could roll in the central planning agencies. The net result was the excessive use of resources described by the Soviet economists. The contrast between the Soviet economy and the economies of Japan and Germany is just one of many that can be made between economic systems which use prices to allocate resources and those which have relied on political or bureaucratic control. In other regions of the world as well, and in other political systems, there have been similar contrasts between places that used prices to ration goods and allocate resources versus places that have relied on hereditary rulers, elected oﬃcials or appointed planning commissions. When many African colonies achieved national independence in the 1960s, a famous bet was made between the president of Ghana and the president of the neighboring Ivory Coast as to which country would be more prosperous in the years ahead. At that time, Ghana was not only more prosperous than the Ivory Coast, it had more natural resources, so the bet might have seemed reckless on the part of the president of the Ivory Coast. However, he knew that Ghana was committed to a government-run economy and the Ivory Coast to a freer market. By 1982, the Ivory Coast had so surpassed Ghana economically that the poorest 20 percent of its people had a higher real income per capita than most of the people in Ghana.{23} This could not be attributed to any superiority of the country or its people. In fact, in later years, when the government of the Ivory Coast eventually succumbed to the temptation to control more of their country’s economy, while Ghana ﬁnally learned from its mistakes and began to loosen government controls on the market, these two countries’ roles reversed—and now Ghana’s economy began to grow, while that of the Ivory Coast declined.{24} Similar comparisons could be made between Burma and Thailand, the former having had the higher standard of living before instituting socialism, and the latter a much higher standard of living afterwards. Other countries—India, Germany, China, New Zealand, South Korea, Sri Lanka—have experienced sharp upturns in their economies when they freed those economies from many government controls and relied more on prices to allocate resources. As of 1960, India and South Korea were at comparable economic levels but, by the late 1980s, South Korea’s per capita income was ten times that in India.{25} India remained committed to a government-controlled economy for many years after achieving independence in 1947. However, in the 1990s, India “jettisoned four decades of economic isolation and planning, and freed the country’s entrepreneurs for the ﬁrst time since independence,” in the words of the distinguished London magazine The Economist. There followed a new growth rate of 6 percent a year, making it “one of the world’s fastest-growing big economies.”{26} From 1950 to 1990, India’s average growth rate had been 2 percent.{27} The cumulative eﬀect of growing three times as fast as before was that millions of Indians rose out of poverty. In China, the transition to a market economy began earlier, in the 1980s. Government controls were at ﬁrst relaxed on an experimental basis in particular economic sectors and in particular geographic regions earlier than in others. This led to stunning economic contrasts within the same country, as well as rapid economic growth overall. Back in 1978, less than 10 percent of China’s agricultural output was sold in open markets, instead of being turned over to the government for distribution. But, by 1990, 80 percent was sold directly in the market.{28} The net result was more food and a greater variety of food available to city dwellers in China, and a rise in farmers’ income by more than 50 percent within a few years.{29} In contrast to China’s severe economic problems when there was heavy-handed government control under Mao, who died in 1976, the subsequent freeing up of prices in the marketplace led to an astonishing economic growth rate of 9 percent per year between 1978 and 1995. While history can tell us that such things happened, economics helps explain why they happened—what there is about prices that allows them to accomplish what political control of an economy can seldom match. There is more to economics than prices, but understanding how prices function is the foundation for understanding much of the rest of economics. A rationally planned economy sounds more plausible than an economy coordinated only by prices linking millions of separate decisions by individuals and organizations. Yet Soviet economists who saw the actual consequences of a centrally planned economy reached very diﬀerent conclusions—namely, “there are far too many economic relationships, and it is impossible to take them all into account and coordinate them sensibly.”{30} Knowledge is one of the most scarce of all resources, and a pricing system economizes on its use by forcing those with the most knowledge of their own particular situation to make bids for goods and resources based on that knowledge, rather than on their ability to inﬂuence other people in planning commissions, legislatures, or royal palaces. However much articulation may be valued by intellectuals, it is not nearly as eﬃcient a way of conveying accurate information as confronting people with a need to “put your money where your mouth is.” That forces them to summon up their most accurate information, rather than their most plausible words. Human beings are going to make mistakes in any kind of economic system. The key question is: What kinds of incentives and constraints will force them to correct their own mistakes? In a price- coordinated economy, any producer who uses ingredients which are more valuable elsewhere in the economy is likely to discover that the costs of those ingredients cannot be repaid from what the consumers are willing to pay for the product. After all, the producer has had to bid those resources away from alternative users, paying more than the resources are worth to some of those alternative users. If it turns out that these resources are not more valuable in the uses to which this producer puts them, then he is going to lose money. There will be no choice but to discontinue making that product with those ingredients. For those producers who are too blind or too stubborn to change, continuing losses will force their businesses into bankruptcy, so that the waste of the resources available to the society will be stopped that way. That is why losses are just as important as proﬁts, from the standpoint of the economy, even though losses are not nearly as popular with businesses. In a price-coordinated economy, employees and creditors insist on being paid, regardless of whether the managers and owners have made mistakes. This means that capitalist businesses can make only so many mistakes for so long before they have to either stop or get stopped—whether by an inability to get the labor and supplies they need or by bankruptcy. In a feudal economy or a socialist economy, leaders can continue to make the same mistakes indeﬁnitely. The consequences are paid by others in the form of a standard of living lower than it would be if there were greater eﬃciency in the use of scarce resources. In the absence of compelling price signals and the threat of ﬁnancial losses to the producers that they convey, ineﬃciency and waste in the Soviet Union could continue until such time as each particular instance of waste reached proportions big enough and blatant enough to attract the attention of central planners in Moscow, who were preoccupied with thousands of other decisions. Ironically, the problems caused by trying to run an economy by direct orders or by arbitrarily-imposed prices created by government ﬁat were foreseen in the nineteenth century by Karl Marx and Friedrich Engels, whose ideas the Soviet Union claimed to be following. Engels pointed out that price ﬂuctuations have “forcibly brought home to the individual commodity producers what things and what quantity of them society requires or does not require.” Without such a mechanism, he demanded to know “what guarantee we have that necessary quantity and not more of each product will be produced, that we shall not go hungry in regard to corn and meat while we are choked in beet sugar and drowned in potato spirit, that we shall not lack trousers to cover our nakedness while trouser buttons ﬂood us in millions.”{31} Marx and Engels apparently understood economics much better than their latter-day followers. Or perhaps Marx and Engels were more concerned with economic eﬃciency than with maintaining political control from the top. There were also Soviet economists who understood the role of price ﬂuctuations in coordinating any economy. Near the end of the Soviet Union, two of these economists, Shmelev and Popov, whom we have already quoted, said: “Everything is interconnected in the world of prices, so that the smallest change in one element is passed along the chain to millions of others.”{32} These Soviet economists were especially aware of the role of prices from having seen what happened when prices were not allowed to perform that role. But economists were not in charge of the Soviet economy. Political leaders were. Under Stalin, a number of economists were shot for saying things he did not want to hear. SUPPLY AND DEMAND There is perhaps no more basic or more obvious principle of economics than the fact that people tend to buy more at a lower price and less at a higher price. By the same token, people who produce goods or supply services tend to supply more at a higher price and less at a lower price. Yet the implications of these two simple principles, singly or in combination, cover a remarkable range of economic activities and issues—and contradict an equally remarkable range of misconceptions and fallacies. Demand versus “Need” When people try to quantify a country’s “need” for this or that product or service, they are ignoring the fact that there is no ﬁxed or objective “need.” Seldom, if ever, is there a ﬁxed quantity demanded. For example, communal living in an Israeli kibbutz was based on its members’ collectively producing and supplying each other with goods and services, without resort to money or prices. However, supplying electricity and food without charging prices led to a situation where people often did not bother to turn oﬀ electric lights during the day and members would bring friends from outside the kibbutz to join them for meals. But, after the kibbutz began to charge prices for electricity and food, there was a sharp drop in the consumption of both.{33} In short, there was no ﬁxed quantity of “need” or demand for food or electricity, despite how indispensable both might be. Likewise, there is no ﬁxed supply. Statistics on the amount of petroleum, iron ore, or other natural resources seem to indicate that this is just a simple matter of how much physical stuﬀ there is in the ground. In reality, the costs of discovery, extraction and processing of natural resources vary greatly from one place to another. There is some oil that can be extracted and processed from some places for $20 a barrel and other oil elsewhere that cannot repay all its production costs at $40 a barrel, but which can at $60 a barrel. With goods in general, the quantity supplied varies directly with the price, just as the quantity demanded varies inversely with the price. When the price of oil falls below a certain point, low-yield oil wells are shut down because the cost of extracting and processing the oil from those particular wells would exceed the price that the oil would sell for in the market. If the price later rises—or if the cost of extraction or processing is lowered by some new technology—then such oil wells will be put back into operation again. Certain sands containing oil in Venezuela and in Canada had such low yields that they were not even counted in the world’s oil reserves until oil prices hit new highs in the early twenty-ﬁrst century. That changed things, as the Wall Street Journal reported: These deposits were once dismissed as “unconventional” oil that couldn’t be recovered economically. But now, thanks to rising global oil prices and improved technology, most oil-industry experts count oil sands as recoverable reserves. That recalculation has vaulted Venezuela and Canada to ﬁrst and third in global reserves rankings...{34} The Economist magazine likewise reported: Canada’s oil sands, or tar sands, as the goo is known, are outsized in every way. They contain 174 billion barrels of oil that can be recovered proﬁtably, and another 141 billion that might be worth exploiting if the oil price rises or the costs of extraction decrease—enough to give Canada bigger oil reserves than Saudi Arabia.{35} In short, there is no ﬁxed supply of oil—or of most other things. In some ultimate sense, the earth has a ﬁnite amount of each resource but, even when that amount may be enough to last for centuries or millennia, at any given time the amount that is economically feasible to extract and process varies directly with the price for which it can be sold. Many false predictions over the past century or more that we were “running out” of various natural resources in a few years were based on confusing the economically available current supply at current prices with the ultimate physical supply in the earth, which is often vastly greater. Natural resources are not the only things that will be supplied in greater quantities when their prices rise. That is true of many commodities and even workers. When people project that there will be a shortage of engineers or teachers or food in the years ahead, they usually either ignore prices or implicitly assume that there will be a shortage at today’s prices. But shortages are precisely what cause prices to rise. At higher prices, it may be no harder to ﬁll vacancies for engineers or teachers than today and no harder to ﬁnd food, as rising prices cause more crops to be grown and more livestock to be raised. In short, a larger quantity is usually supplied at higher prices than at lower prices, whether what is being sold is oil or apples, lobsters or labor. “Real” Value The producer whose product turns out to have the combination of features that are closest to what the consumers really want may be no wiser than his competitors. Yet he can grow rich while his competitors who guessed wrong go bankrupt. But the larger result is that society as a whole gets more beneﬁts from its limited resources by having them directed toward where those resources produce the kind of output that millions of people want, instead of producing things that they don’t want. Simple as all this may seem, it contradicts many widely held ideas. For example, not only are high prices often blamed on “greed,” people often speak of something being sold for more than its “real” value, or of workers being paid less than they are “really” worth—or of corporate executives, athletes, and entertainers being paid more than they are “really” worth. The fact that prices ﬂuctuate over time, and occasionally have a sharp rise or a steep drop, misleads some people into concluding that prices are deviating from their “real” values. But their usual level under usual conditions is no more real or valid than their much higher or much lower levels under diﬀerent conditions. When a large employer goes bankrupt in a small community, or simply moves away to another region or country, many of the business’ former employees may decide to move away themselves from a place that now has fewer jobs—and when their numerous homes go on sale in the same small area at the same time, the prices of those houses are likely to be driven down by competition. But this does not mean that people are selling their homes for less than their “real” value. The value of living in that particular community has simply declined with the decline of job opportunities, and housing prices reﬂect this underlying fact. The most fundamental reason why there is no such thing as an objective or “real” value is that there would be no rational basis for economic transactions if there were. When you pay a dollar for a newspaper, obviously the only reason you do so is that the newspaper is more valuable to you than the dollar is. At the same time, the only reason people are willing to sell the newspaper is that a dollar is more valuable to them than the newspaper is. If there were any such thing as a “real” or objective value of a newspaper—or anything else—neither the buyer nor the seller would beneﬁt from making a transaction at a price equal to that objective value, since what would be acquired would be of no greater value than what was given up. In that case, why bother to make the transaction in the ﬁrst place? On the other hand, if either the buyer or the seller was getting more than the objective value from the transaction, then the other person must be getting less—in which case, why would the other party continue making such transactions while being continually cheated? Continuing transactions between buyer and seller make sense only if value is subjective, each getting what is worth more subjectively. Economic transactions are not a zero-sum process, where one person loses whatever the other person gains. Competition Competition is the crucial factor in explaining why prices usually cannot be maintained at arbitrarily set levels. Competition is the key to the operation of a price-coordinated economy. It not only forces prices toward equality, it likewise causes capital, labor, and other resources to ﬂow toward where their rates of return are highest—that is, where the unsatisﬁed demand is greatest—until the returns are evened out through competition, much like water seeking its own level. However, the fact that water seeks its own level does not mean that the ocean has a glassy smooth surface. Waves and tides are among the ways in which water seeks its own level, without being frozen indeﬁnitely at a given level. Similarly, in an economy, the fact that prices and rates of return on investments tend to equalize means only that their ﬂuctuations, relative to one another, are what move resources from places where their earnings are lower to where their earnings are higher—that is, from where the quantity supplied is greatest, relative to the quantity demanded, to where there is the most unsatisﬁed demand. It does not mean that prices remain the same over time or that some ideal pattern of allocation of resources remains the same indeﬁnitely. Prices and Supplies Prices not only ration existing supplies, they also act as powerful incentives to cause supplies to rise or fall in response to changing demand. When a crop failure in a given region creates a sudden increase in demand for imports of food into that region, food suppliers elsewhere rush to be the ﬁrst to get there, in order to capitalize on the high prices that will prevail until more supplies arrive and drive food prices back down again through competition. What this means, from the standpoint of the hungry people in that region, is that food is being rushed to them at maximum speed by “greedy” suppliers, probably much faster than if the same food were being transported to them by salaried government employees sent on a humanitarian mission. Those spurred on by a desire to earn top dollar for the food they sell may well drive throughout the night or take short cuts over rough terrain, while those operating “in the public interest” are more likely to proceed at a less hectic pace and by safer or more comfortable routes. In short, people tend to do more for their own beneﬁt than for the beneﬁt of others. Freely ﬂuctuating prices can make that turn out to be beneﬁcial to others. In the case of food supplies, earlier arrival can be the diﬀerence between temporary hunger and death by starvation or by diseases to which people are more susceptible when they are undernourished. Where there are local famines in Third World countries, it is not at all uncommon for food supplied by international agencies to the national government to sit spoiling on the docks while people are dying of hunger inland.{iv} However unattractive greed may be, it is likely to move food much faster, saving more lives. In other situations, the consumers may not want more, but less. Prices also convey this. When automobiles began to displace horses and buggies in the early twentieth century, the demand for saddles, horseshoes, carriages and other such paraphernalia declined. As the manufacturers of such products faced losses instead of proﬁts, many began to abandon their businesses or were forced to shut down by bankruptcy. In a sense, it is unfair when some people are unable to earn as much as others with similar levels of skills and diligence, because of innovations which were as unforeseen by most of the producers who beneﬁtted as by most of the producers who were made worse oﬀ. Yet this unfairness to particular individuals and businesses is what makes the economy as a whole operate more eﬃciently for the beneﬁt of vastly larger numbers of others. Would creating more fairness among producers, at the cost of reduced eﬃciency and a resulting lower standard of living, be fair to consumers? The gains and losses are not isolated or independent events. The crucial role of prices is in tying together a vast network of economic activities among people too widely scattered to all know each other. However much we may think of ourselves as independent individuals, we are all dependent on other people for our very lives, as well as being dependent on innumerable strangers who produce the amenities of life. Few of us could grow the food we need to live, much less build a place to live in, or produce such things as computers or automobiles. Other people have to be induced to create all these things for us, and economic incentives are crucial for that purpose. As Will Rogers once said, “We couldn’t live a day without depending on everybody.”{36} Prices make that dependence viable by linking their interests with ours. “UNMET NEEDS” One of the most common—and certainly one of the most profound—misconceptions of economics involves “unmet needs.” Politicians, journalists, and academicians are almost continuously pointing out unmet needs in our society that should be supplied by some government program or other. Most of these are things that most of us wish our society had more of. What is wrong with that? Let us go back to square one. If economics is the study of the use of scarce resources which have alternative uses, then it follows that there will always be unmet needs. Some particular desires can be singled out and met 100 percent, but that only means that other desires will be even more unfulﬁlled than they are now. Anyone who has driven in most big cities will undoubtedly feel that there is an unmet need for more parking spaces. But, while it is both economically and technologically possible to build cities in such a way as to have a parking space available for anyone who wants one, anywhere in the city, at any hour of the day or night, does it follow that we should do it? The cost of building vast new underground parking garages, or of tearing down existing buildings to create parking garages above ground, or of designing new cities with fewer buildings and more parking lots, would all be astronomically costly. What other things are we prepared to give up, in order to have this automotive Utopia? Fewer hospitals? Less police protection? Fewer ﬁre departments? Are we prepared to put up with even more unmet needs in these areas? Maybe some would give up public libraries in order to have more places to park. But, whatever choices are made and however it is done, there will still be more unmet needs elsewhere, as a result of meeting an unmet need for more parking spaces. We may diﬀer among ourselves as to what is worth sacriﬁcing in order to have more of something else. The point here is more fundamental: Merely demonstrating an unmet need is not suﬃcient to say that it should be met—not when resources are scarce and have alternative uses. In the case of parking spaces, what might appear to be cheaper, when measured only by government expenditures, would be to restrict or forbid the use of private automobiles in cities, adjusting the number of cars to the number of existing parking spaces, instead of vice versa. Moreover, passing and enforcing such a law would cost a tiny fraction of the cost of greatly expanding the number of parking spaces. But this saving in government expenditures would have to be weighed against the vast private expenditures currently devoted to the purchase, maintenance, and parking of automobiles in cities. Obviously these expenditures would not have been undertaken in the ﬁrst place if those who pay these prices did not ﬁnd the beneﬁts to be worth it to them. To go back to square one again, costs are foregone opportunities, not government expenditures. Forcing thousands of people to forego opportunities for which they have willingly paid vast amounts of money is a cost that may far outweigh the money saved by not having to build more parking spaces or do the other things necessary to accommodate cars in cities. None of this says that we should have either more parking spaces or fewer parking spaces in cities. What it says is that the way this issue—and many others—is presented makes no sense in a world of scarce resources which have alternative uses. That is a world of trade-oﬀs, not solutions—and whatever trade-oﬀ is decided upon will still leave unmet needs. So long as we respond gullibly to political rhetoric about unmet needs, we will arbitrarily choose to shift resources to whatever the featured unmet need of the day happens to be and away from other things. Then, when another politician—or perhaps even the same politician at a later time—discovers that robbing Peter to pay Paul has left Peter worse oﬀ, and now wants to help Peter meet his unmet needs, we will start shifting resources in another direction. In short, we will be like a dog chasing his tail in a circle and getting no closer, no matter how fast he runs. This is not to say that we have the ideal trade-oﬀs already and should leave them alone. Rather, it says that whatever trade-oﬀs we make or change should be seen from the outset as trade-oﬀs—not meeting unmet needs. The very word “needs” arbitrarily puts some desires on a higher plane than others, as categorically more important. But, however urgent it may be to have some food and some water, for example, in order to sustain life itself, nevertheless—beyond some point—both become not only unnecessary but even counterproductive and dangerous. Widespread obesity among Americans shows that food has already reached that point and anyone who has suﬀered the ravages of ﬂood (even if it is only a ﬂooded basement) knows that water can reach that point as well. In short, even the most urgently required things remain necessary only within a given range. We cannot live half an hour without oxygen, but even oxygen beyond some concentration level can promote the growth of cancer and has been known to make newborn babies blind for life. There is a reason why hospitals do not use oxygen tanks willy-nilly. In short, nothing is a “need” categorically, regardless of how urgent it may be to have particular amounts at particular times and places. Unfortunately, most laws and government policies apply categorically, if only because of the dangers in leaving every government oﬃcial to become a petty despot in interpreting what these laws and policies mean and when they should apply. In this context, calling something a “need” categorically is playing with ﬁre. Many complaints that some basically good government policy has been applied stupidly may fail to address the underlying problem of categorical laws in an incremental world. There may not have been any intelligent way to apply categorically a policy designed to meet desires whose beneﬁts vary incrementally and ultimately cease to be beneﬁts. By its very nature as a study of the use of scarce resources which have alternative uses, economics is about incremental trade-oﬀs—not about “needs” or “solutions.” That may be why economists have never been as popular as politicians who promise to solve our problems and meet our needs. Chapter 3 PRICE CONTROLS The record of price controls goes as far back as human history. They were imposed by the Pharaohs of ancient Egypt. They were decreed by Hammurabi, king of Babylon, in the eighteenth century B.C. They were tried in ancient Athens. Henry Hazlitt{37} Nothing makes us understand the many roles of electricity in our lives like a power failure. Similarly, nothing shows more vividly the role and importance of price ﬂuctuations in a market economy than the absence of such price ﬂuctuations when the market is controlled. What happens when prices are not allowed to ﬂuctuate freely according to supply and demand, but instead their ﬂuctuations are ﬁxed within limits set by law under various kinds of price controls? Typically, price controls are imposed in order to keep prices from rising to the levels that they would reach in response to supply and demand. The political rationales for such laws have varied from place to place and from time to time, but there is seldom a lack of rationales whenever it becomes politically expedient to hold down some people’s prices in the interest of other people whose political support seems more important. To understand the eﬀects of price control, it is ﬁrst necessary to understand how prices rise and fall in a free market. There is nothing esoteric about it, but it is important to be very clear about what happens. Prices rise because the amount demanded exceeds the amount supplied at existing prices. Prices fall because the amount supplied exceeds the amount demanded at existing prices. The ﬁrst case is called a “shortage” and the second is called a “surplus”—but both depend on existing prices. Simple as this might seem, it is often misunderstood, sometimes with disastrous consequences. PRICE “CEILINGS” AND SHORTAGES When there is a “shortage” of a product, there is not necessarily any less of it, either absolutely or relative to the number of consumers. During and immediately after the Second World War, for example, there was a very serious housing shortage in the United States, even though the country’s population and its housing supply had both increased by about 10 percent from their prewar levels—and there was no shortage when the war began.{38} In other words, even though the ratio between housing and people had not changed, nevertheless many Americans looking for an apartment during this period had to spend weeks or months in an often futile search for a place to live, or else resorted to bribes to get landlords to move them to the top of waiting lists. Meanwhile, they doubled up with relatives, slept in garages or used other makeshift living arrangements, such as buying military surplus Quonset huts or old trolley cars to live in. Although there was no less housing space per person than before the war, the shortage was very real and very painful at existing prices, which were kept artiﬁcially lower than they would have been, because of rent control laws that had been passed during the war. At these artiﬁcially low prices, more people had a demand for more housing space than before rent control laws were enacted. This is a practical consequence of the simple economic principle already noted in Chapter 2, that the quantity demanded varies according to how high or how low the price is. When some people used more housing than usual, other people found less housing available. The same thing happens under other forms of price control: Some people use the price-controlled goods or services more generously than usual because of the artiﬁcially lower price and, as a result, other people ﬁnd that less than usual remains available for them. There are other consequences to price controls in general, and rent control provides examples of these as well. Demand under Rent Control Some people who would normally not be renting their own apartments, such as young adults still living with their parents or some single or widowed elderly people living with relatives, were enabled by the artiﬁcially low prices created by rent control to move out and into their own apartments. These artiﬁcially low prices also caused others to seek larger apartments than they would ordinarily be living in or to live alone when they would otherwise have to share an apartment with a roommate, in order to be able to aﬀord the rent. Some people who do not even live in the same city as their rent- controlled apartment nevertheless keep it as a place to stay when they are visiting the city—Hollywood movie stars who keep rent-controlled apartments in New York or a couple living in Hawaii who kept a rent- controlled residence in San Francisco,{39} for example. More tenants seeking both more apartments and larger apartments create a shortage, even when there is not any greater physical scarcity of housing relative to the total population. When rent control ended after World War II, the housing shortage quickly disappeared. After rents rose in a free market, some childless couples living in four-bedroom apartments could decide that they would live in two-bedroom apartments and save the diﬀerence in rent. Some late teenagers could decide that they would continue living with their parents a little longer, until their pay rose enough for them to be able to aﬀord their own apartment, now that rent was no longer artiﬁcially cheap. The net result was that families looking for a place to stay found more places available, now that rent-control laws were no longer keeping such places occupied by people with less urgent requirements. In other words, the housing shortage immediately eased, even before there was time for new housing to be built, in response to market conditions that now made it possible to recover the cost of building more housing and earn a proﬁt. Just as price ﬂuctuations allocate scarce resources which have alternative uses, price controls which limit those ﬂuctuations reduce the incentives for individuals to limit their own use of scarce resources desired by others. Rent control, for example, tends to lead to many apartments being occupied by just one person. A study in San Francisco showed that 49 percent of that city’s rent-controlled apartments had only a single occupant,{40} while a severe housing shortage in the city had thousands of people living considerable distances away and making long commutes to their jobs in San Francisco. Meanwhile, a Census report showed likewise that 46 percent of all households in Manhattan, where nearly half of all apartments are under some form of rent control, are occupied by only one person— compared to 27 percent nationwide.{41} In the normal course of events, people’s demand for housing space changes over a lifetime. Their demand for space usually increases when they get married and have children. But, years later, after the children have grown up and moved away, the parents’ demand for space may decline, and it often declines yet again after a spouse dies and the widow or widower moves into smaller quarters or goes to live with relatives or in an institution for the elderly. In this way, a society’s total stock of housing is shared and circulated among people according to their changing individual demands at diﬀerent stages of their lives. This sharing takes place, not because the individuals themselves have a sense of cooperation, but because of the prices—rents in this case—which confront them. In a free market, these prices are based on the value that other tenants put on housing. Young couples with a growing family are often willing to bid more for housing, even if that means buying fewer consumer goods and services, in order to have enough money to pay for additional housing space. A couple who begin to have children may cut back on how often they go out to restaurants or to movies, or they may wait longer to buy new clothes or a new car, in order that each child may have his or her own bedroom. But, once the children are grown and gone, such sacriﬁces may no longer make sense, when additional other amenities can now be enjoyed by reducing the amount of housing space being rented. Given the crucial role of prices in this process, suppression of that process by rent control laws leaves few incentives for tenants to change their behavior as their circumstances change. Elderly people, for example, have less incentive to vacate apartments that they would normally vacate when their children are gone, or after a spouse dies, if that would result in a signiﬁcant reduction in rent, leaving them more money with which to improve their living standards in other respects. Moreover, the chronic housing shortages which accompany rent control greatly increase the time and eﬀort required to search for a new and smaller apartment, while reducing the ﬁnancial reward for ﬁnding one. In short, rent control reduces the rate of housing turnover. New York City has had rent control longer and more stringently than any other major American city. One consequence has been that the annual rate of turnover of apartments in New York is less than half the national average, and the proportion of tenants who have lived in the same apartment for 20 years or more is more than double the national average.{42} As the New York Times summarized the situation: New York used to be like other cities, a place where tenants moved frequently and landlords competed to rent empty apartments to newcomers, but today the motto may as well be: No Immigrants Need Apply. While immigrants are crowded into bunks in illegal boarding houses in the slums, upper-middle-class locals pay low rents to live in good neighborhoods, often in large apartments they no longer need after their children move out.{43} Supply under Rent Control Rent control has eﬀects on supply as well as on demand. Nine years after the end of World War II, not a single new apartment building had been built in Melbourne, Australia, because of rent control laws there which made such buildings unproﬁtable.{44} In Egypt, rent control was imposed in 1960. An Egyptian woman who lived through that era and wrote about it in 2006 reported: The end result was that people stopped investing in apartment buildings, and a huge shortage in rentals and housing forced many Egyptians to live in horrible conditions with several families sharing one small apartment. The eﬀects of the harsh rent control is still felt today in Egypt. Mistakes like that can last for generations.{45} Declines in building construction have likewise followed in the wake of rent control laws elsewhere. After rent control was instituted in Santa Monica, California in 1979, building permits declined to less than one-tenth of what they were just ﬁve years earlier.{46} A housing study in San Francisco found that three quarters of its rent-controlled housing was more than half a century old and 44 percent of it was more than 70 years old.{47} Although the construction of oﬃce buildings, factories, warehouses, and other commercial and industrial buildings requires much of the same kind of labor and materials used to construct apartment buildings, it is not uncommon for many new oﬃce buildings to be constructed in cities where very few new apartment buildings are built. Rent control laws often do not apply to industrial or commercial buildings. Thus, even in cities with severe housing shortages, there may be much vacant space in commercial and industrial buildings. Despite a severe housing shortage in New York, San Francisco, and other cities with rent control, a nationwide survey in 2003 found the vacancy rates in buildings used by business and industry to be nearly 12 percent, the highest in more than two decades.{48} This is just one more piece of evidence that housing shortages are a price phenomenon. High vacancy rates in commercial buildings show that there are obviously ample resources available to construct buildings, but rent control keeps those resources from being used to construct apartments, and thereby diverts these resources into constructing oﬃce buildings, industrial plants, and other commercial properties. Not only is the supply of new apartment construction less after rent control laws are imposed, even the supply of existing housing tends to decline, as landlords provide less maintenance and repair under rent control, since the housing shortage makes it unnecessary for them to maintain the appearance of their premises in order to attract tenants. Thus housing tends to deteriorate faster under rent control and to have fewer replacements when it wears out. Studies of rent control in the United States, England, and France have found rent- controlled housing to be deteriorated far more often than non-rent- controlled housing. Typically, the rental housing stock is relatively ﬁxed in the short run, so that a shortage occurs ﬁrst because more people want more housing at the artiﬁcially low price. Later, there may be a real increase in scarcity as well, as rental units deteriorate more rapidly with reduced maintenance, while not enough new units are being built to replace them as they wear out, because new privately built housing can be unproﬁtable under rent control. Under rent control in England and Wales, for example, privately-built rental housing fell from being 61 percent of all housing in 1947 to being just 14 percent by 1977.{49} A study of rent control in various countries concluded: “New investment in private unsubsidized rented housing is essentially nonexistent in all the European countries surveyed, except for luxury housing.”{50} In short, a policy intended to make housing aﬀordable for the poor has had the net eﬀect of shifting resources toward the building of housing that is aﬀordable only by the aﬄuent or the rich, since luxury housing is often exempt from rent control, just as oﬃce buildings and other commercial properties are. Among other things, this illustrates the crucial importance of making a distinction between intentions and consequences. Economic policies need to be analyzed in terms of the incentives they create, rather than the hopes that inspired them. The incentives towards a reduced supply of housing under rent control are especially pronounced when people who have been renting out rooms or apartments in their own homes, or bungalows in their back yards, decide that it is no longer worth the bother, when rents are kept artiﬁcially low under rent control laws. In addition, there are often conversions of apartments to condominiums. During 8 years of rent control in Washington during the 1970s, that city’s available rental housing stock declined absolutely, from just over 199,000 units on the market to just under 176,000 units.{51} After rent control was introduced in Berkeley, California, the number of private rental housing units available to students at the university there declined by 31 percent in ﬁve years.{52} None of this should be surprising, given the incentives created by rent control laws. In terms of incentives, it is likewise easy to understand what happened in England when rent control was extended in 1975 to cover furnished rental units. According to The Times of London: Advertisements for furnished rented accommodation in the London Evening Standard plummeted dramatically in the ﬁrst week after the Act came into force and are now running at about 75 per cent below last year’s levels.{53} Since furnished rooms are often in people’s homes, these represent housing units that are easily withdrawn from the market when the rents no longer compensate for the inconveniences of having renters living with you. The same principle applies where there are small apartment buildings like duplexes, where the owner is also one of the tenants. Within three years after rent control was imposed in Toronto in 1976, 23 percent of all rental units in owner-occupied dwellings were withdrawn from the housing market.{54} Even when rent control applies to apartment buildings where the landlord does not live, eventually the point may be reached where the whole building becomes suﬃciently unproﬁtable that it is simply abandoned. In New York City, for example, many buildings have been abandoned after their owners found it impossible to collect enough rent to cover the costs of services that they are required by law to provide, such as heat and hot water. Such owners have simply disappeared, in order to escape the legal consequences of their abandonment, and such buildings often end up vacant and boarded up, though still physically sound enough to house people, if they continued to be maintained and repaired. The number of abandoned buildings taken over by the New York City government over the years runs into the thousands.{55} It has been estimated that there are at least four times as many abandoned housing units in New York City as there are homeless people living on the streets there.{56} Homelessness is not due to a physical scarcity of housing, but to a price-related shortage, which is painfully real nonetheless. As of 2013, there were more than 47,000 homeless people in New York City, 20,000 of them children.{57} Such ineﬃciency in the allocation of resources means that people are sleeping outdoors on the pavement on cold winter nights—some dying of exposure—while the means of housing them already exist, but are not being used because of laws designed to make housing “aﬀordable.” Once again, this demonstrates that the eﬃcient or ineﬃcient allocation of scarce resources is not just some abstract notion of economists, but has very real consequences, which can even include matters of life and death. It also illustrates that the goal of a law —“aﬀordable housing,” in this case—tells us nothing about its actual consequences. The Politics of Rent Control Politically, rent control is often a big success, however many serious economic and social problems it creates. Politicians know that there are always more tenants than landlords and more people who do not understand economics than people who do. That makes rent control laws something likely to lead to a net increase in votes for politicians who pass rent control laws. Often it is politically eﬀective to represent rent control as a way to keep greedy rich landlords from “gouging” the poor with “unconscionable” rents. In reality, rates of return on investments in housing are seldom higher than on alternative investments, and landlords are often people of very modest means. This is especially so for owners of small, low-end apartment buildings that are in constant need of repair, the kinds of places where tenants are likely to be low- income people. Many of the landlords with buildings like this are handymen who use their own skills and labor as carpenters or plumbers to repair and maintain the premises, while trying to pay oﬀ the mortgage with the rents they collect. In short, the kind of housing likely to be rented by the poor often has owners who are by no means rich.{v} Where rent control laws apply on a blanket basis to all housing in existence as of the time the law goes into eﬀect, even luxurious housing becomes low-rent housing. Then, after the passage of time makes clear that no new housing is likely to be built unless it is exempted from rent control, such exemptions or relaxations of rent control for new housing mean that even new apartments that are very modest in size and quality may rent for far more than older, more spacious and more luxurious apartments that are still under rent control. This non-comparability of rents has been common in European cities under rent control, as well as in New York and other American cities. Similar incentives produce similar results in many diﬀerent settings. A news story in the Wall Street Journal pointed up this non-comparability of rents under New York City’s rent control laws: Les Katz, a 27-year-old acting student and doorman, rents a small studio apartment on Manhattan’s Upper West Side for $1,200—with two roommates. Two sleep in separate beds in a loft built atop the kitchen, the third on a mattress in the main room. Across town on Park Avenue, Paul Haberman, a private investor, and his wife live in a spacious, two-bedroom apartment with a solarium a

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