Basic Economics Read online

  No doubt there are reasons, or at least rationales, for the many government regulations imposed on businesses in Italy, for example, but the real question is whether their costs exceed their benefits:

  Imagine you’re an ambitious Italian entrepreneur, trying to make a go of a new business. You know you will have to pay at least two-thirds of your employees’ social security costs. You also know you’re going to run into problems once you hire your 16th employee, since that will trigger provisions making it either impossible or very expensive to dismiss a staffer.

  But there’s so much more. Once you hire employee 11, you must submit an annual self-assessment to the national authorities outlining every possible health and safety hazard to which your employees might be subject. These include stress that is work-related or caused by age, gender and racial differences. You must also note all precautionary and individual measures to prevent risks, procedures to carry them out, the names of employees in charge of safety, as well as the physician whose presence is required for the assessment.

  . . . By the time your firm hires its 51st worker, 7% of the payroll must be handicapped in some way. . . Once you hire your 101st employee, you must submit a report every two years on the gender dynamics within the company. This must include a tabulation of the men and women employed in each production unit, their functions and level within the company, details of compensation and benefits, and dates and reasons for recruitments, promotions and transfers, as well as the estimated revenue impact.{108}

  As of the time that this description of Italian labor laws appeared in the Wall Street Journal, the unemployment rate in Italy was 10 percent and the Italian economy was contracting, rather than growing.{109}

  Subsidies and Taxes

  Ideally, prices allow alternative users to compete for scarce resources in the marketplace. However, this competition is distorted to the extent that special taxes are put on some products or resources but not on others, or when some products or resources are subsidized by the government but others are not.

  Prices charged to the consumers of such specially taxed or specially subsidized goods and services do not convey the real costs of producing them and therefore do not lead to the same trade-offs as if they did. Yet there is always a political temptation to subsidize “good” things and tax “bad” things. However, when neither good things nor bad things are good or bad categorically, this prevents our finding out just how good or how bad any of these things is by letting people choose freely, uninfluenced by politically changed prices. People who want special taxes or subsidies for particular things seem not to understand that what they are really asking for is for the prices to misstate the relative scarcities of things and the relative values that the users of these things put on them.

  One of the factors in California’s recurring water crises, for example, is that California farmers’ use of water is subsidized heavily. Farmers in California’s Imperial Valley pay $15 for the same amount of water that costs $400 in Los Angeles.{110} The net result is that agriculture, which accounts for less than 2 percent of the state’s output, consumes 43 percent of its water.{111} California farmers grow crops requiring great amounts of water, such as rice and cotton, in a very dry climate, where such crops would never be grown if farmers had to pay the real costs of the water they use. Inspiring as it may be to some observers that California’s arid lands have been enabled to produce vast amounts of fruits and vegetables with the aid of subsidized water, those same fruits and vegetables could be produced more cheaply elsewhere with water supplied free of charge from the clouds.

  The way to tell whether the California produce is worth what it costs to grow is to allow all those costs to be paid by California farmers who compete with farmers in other states that have higher rainfall levels. There is no need for government officials to decide arbitrarily—and categorically—whether it is a good thing or a bad thing for particular crops to be grown in California with water artificially supplied below cost from federal irrigation projects. Such questions can be decided incrementally, by those directly confronting the alternatives, through price competition in a free market.

  California is, unfortunately, not unique in this respect. In fact, this is not a peculiarly American problem. Halfway around the world, the government of India provides “almost free electricity and water” to farmers, according to The Economist magazine, encouraging farmers to plant too much “water-guzzling rice,” with the result that water tables in the Punjab “are dropping fast.”{112} Making anything artificially cheap usually means that it will be wasted, whatever that thing might be and wherever it might be located.

  From the standpoint of the allocation of resources, government should either not tax resources, goods, and services or else tax them all equally, so as to minimize the distortions of choices made by consumers and producers. For similar reasons, particular resources, goods, and services should not be subsidized, even if particular people are subsidized out of humanitarian concern over their being the victims of natural disasters, birth defects, or other misfortunes beyond their control. Giving poor people money would accomplish the same humanitarian purpose without the same distortion in the allocation of resources created by subsidizing or taxing different products differently.

  However much economic efficiency would be promoted by letting resource prices be unchanged by taxes or subsidies, from a political standpoint politicians win votes by doing special favors for special interests or putting special taxes on whomever or whatever might be unpopular at the moment. The free market may work best when there is a level playing field, but politicians win more votes by tilting the playing field to favor particular groups. Often this process is rationalized politically in terms of a need to help the less fortunate but, once the power and the practice are established, they provide the means of subsidizing all sorts of groups who are not the least bit unfortunate. For example, the Wall Street Journal reported:

  A chunk of the federal taxes and fees paid by airline passengers are awarded to small airports used mainly by private pilots and globe-trotting corporate executives.{113}

  The Meaning of “Costs”

  Sometimes the rationale for removing particular things from the process of weighing costs against benefits is expressed in some such question as: “How can you put a price on art?”—or education, health, music, etc. The fundamental fallacy underlying this question is the belief that prices are simply “put” on things. So long as art, education, health, music, and thousands of other things all require time, effort, and raw material, the costs of these inputs are inherent. These costs do not go away because a law prevents them from being conveyed through prices in the marketplace. Ultimately, to society as a whole, costs are the other things that could have been produced with the same resources. Money flows and price movements are symptoms of that fact—and suppressing those symptoms will not change the underlying fact.

  One reason for the popularity of price controls is a confusion between prices and costs. For example, politicians who say that they will “bring down the cost of medical care” almost invariably mean that they will bring down the prices paid for medical care. The actual costs of medical care—the years of training for doctors, the resources used in building and equipping hospitals, the hundreds of millions of dollars for years of research to develop a single new medication—are unlikely to decline in the slightest. Nor are these things even likely to be addressed by politicians. What politicians mean by bringing down the cost of medical care is reducing the price of medicines and reducing the fees charged by doctors or hospitals.

  Once the distinction between prices and costs is recognized, then it is not very surprising that price controls have the negative consequences that they do, because price ceilings mean a refusal to pay the full costs. Those who supply housing, food, medications or innumerable other goods and services are unlikely to keep on supplying them in the same quantities and qualities when they cannot recover the costs that such quantities and qualities requ
ire. This may not become apparent immediately, which is why price controls are often popular, but the consequences are lasting and often become worse over time.

  Housing does not disappear immediately when there is rent control but it deteriorates over time without being replaced by sufficient new housing as it wears out. Existing medicines do not necessarily vanish under price controls but new medicines to deal with cancer, AIDS, Alzheimer’s and numerous other afflictions are unlikely to continue to be developed at the same pace when the money to pay for the costs and risks of creating new medications is just not there any more. But all this takes time to unfold, and memories may be too short for most people to connect the bad consequences they experience to the popular policies they supported some years back.

  Despite how obvious all this might seem, there are never-ending streams of political schemes designed to escape the realities being conveyed by prices—whether through direct price controls or by making this or that “affordable” with subsidies or by having the government itself supply various goods and services free, as a “right.” There may be more ill-conceived economic policies based on treating prices as just nuisances to get around than on any other single fallacy. What all these schemes have in common is that they exempt some things from the process of weighing costs and benefits against one another{xii}—a process essential to maximizing the benefits from scarce resources which have alternative uses.

  The most valuable economic role of prices is in conveying information about an underlying reality—while at the same time providing incentives to respond to that reality. Prices, in a sense, can summarize the end results of a complex reality in a simple number. For example, a photographer who wants to buy a telephoto lens may confront a choice between two lenses that produce images of equal quality and with the same magnification, but one of which admits twice as much light as the other. This second lens can take pictures in dimmer light, but there are optical problems created by a wider lens opening that admits more light.

  While the photographer may be wholly unaware of these optical problems, their solution can require a more complex lens made of more expensive glass. What the photographer is made aware of is that the lens with the wider opening has a higher price. The only decision to be made by the photographer is whether the higher price is worth it for the particular kinds of pictures he takes. A landscape photographer who takes pictures outdoors on sunny days may find the higher-priced lens not worth the extra money, while a photographer who takes pictures indoors in museums that do not permit flashes to be used may have no choice but to pay more for the lens with the wider opening.

  Because knowledge is one of the scarcest of all resources, prices play an important role in economizing on the amount of knowledge required for decision-making by any given individual or organization. The photographer needs no knowledge of the science of optics in order to make an efficient trade-off when choosing among lenses, while the lens designer who knows optics need have no knowledge of the rules of museums or the market for photographs taken in museums and in other places with limited amounts of light.

  In a different economic system which does not rely on prices, but relies instead on a given official or a planning commission to make decisions about the use of scarce resources, a vast amount of knowledge of the various complex factors behind even a relatively simple decision like producing and using a camera lens would be required, in order to make an efficient use of scarce resources which have alternative uses. After all, glass is used not only in camera lenses but also in microscopes, telescopes, windows, mirrors and innumerable other things. To know how much glass should be allocated to the production of each of these many products would require more expertise in more complex subjects than any individual, or any manageable sized group, can be expected to master.

  Although the twentieth century began with many individuals and groups looking forward to a time when price-coordinated economies would be replaced by centrally planned economies, the rise and fall of centrally planned economies took place over several decades. By the end of the twentieth century, even most socialist and communist governments around the world had returned to the use of prices to coordinate their economies. However attractive central planning may have seemed before it was tried, concrete experience led even its advocates to rely more and more on price-coordinated markets. An international study of free markets in 2012 found the world’s freest market to be in Hong Kong{114}—in a country with a communist government.

  PART II:

  INDUSTRY AND COMMERCE

  Chapter 5

  THE RISE AND FALL

  OF BUSINESSES

  Failure is part of the natural cycle of business. Companies are born, companies die, capitalism moves forward.

  Fortune magazine{115}

  Ordinarily, we tend to think of businesses as simply money-making enterprises, but that can be very misleading, in at least two ways. First of all, about one-third of all new businesses fail to survive for two years, and more than half fail to survive for four years,{116} so obviously many businesses are losing money. Nor is it only new businesses that lose money. Businesses that have lasted for generations—sometimes more than a century—have eventually been forced by red ink on the bottom line to close down. More important, from the standpoint of economics, is not what money the business owner hopes to make or whether that hope is fulfilled, but how all this affects the use of scarce resources which have alternative uses—and therefore how it affects the economic well-being of millions of other people in the society at large.

  ADJUSTING TO CHANGES

  The businesses we hear about, in the media and elsewhere, are usually those which have succeeded, and especially those which have succeeded on a grand scale—Microsoft, Toyota, Sony, Lloyd’s of London, Credit Suisse. In an earlier era, Americans would have heard about the A & P grocery chain, once the largest retail chain in any field, anywhere in the world. Its 15,000 stores in 1929 were more than that of any other retailer in America.{117} The fact that A & P has now shrunk to a minute fraction of its former size, and is virtually unknown, suggests that industry and commerce are not static things, but dynamic processes, in which particular products, individual companies and whole industries rise and fall, as a result of relentless competition under ever changing conditions.

  In just one year—between 2010 and 2011—26 businesses dropped off the list of the Fortune 500 largest companies, including Radio Shack and Levi Strauss.{118} Such processes of change have been going on for centuries and include changes in whole financial centers. From the 1780s to the 1830s, the financial center of the United States was Chestnut Street in Philadelphia but, for more than a century and a half since then, New York’s Wall Street replaced Chestnut Street as the leading financial center in America, and later replaced the City of London as the financial center of the world.

  At the heart of all of this is the role of profits—and of losses. Each is equally important from the standpoint of forcing companies and industries to use scarce resources efficiently. Industry and commerce are not just a matter of routine management, with profits rolling in more or less automatically. Masses of ever-changing details, within an ever-changing surrounding economic and social environment, mean that the threat of losses hangs over even the biggest and most successful businesses. There is a reason why business executives usually work far longer hours than their employees, and why only 35 percent of new companies survive for ten years.{119} Only from the outside does it look easy.

  Just as companies rise and fall over time, so do profit rates—even more quickly. When the Wall Street Journal reported the profits of Sun Microsystems at the beginning of 2007, it noted that the company’s profit was “its first since mid-2005.”{120} When compact discs began rapidly replacing vinyl records back in the late 1980s, Japanese manufacturers of CD players “thrived” according to the Far Eastern Economic Review. But “within a few years, CD-players only offered manufacturers razor-thin margins.”{121}

  This has been
a common experience with many products in many industries. The companies which first introduce a product that consumers like may make large profits, but those very profits attract more investments into existing companies and encourage new companies to form, both of which add to output, driving down prices and profit margins through competition, as prices decline in response to supply and demand. Sometimes prices fall so low that profits turn to losses, forcing some firms into bankruptcy until the industry’s supply and demand balance at levels that are financially sustainable.

  Longer run changes in the relative rankings of firms in an industry can be dramatic. For example, United States Steel was founded in 1901 as the largest steel producer in the world. It made the steel for the Panama Canal, the Empire State Building, and more than 150 million automobiles.{122} Yet, by 2011, U.S. Steel had fallen to 13th place in the industry, losing $53 million that year and $124 million the following year.{123} Boeing, producer of the famous B-17 “flying fortress” bombers in World War II and since then the largest producer of commercial airliners such as the 747, was in 1998 selling more than twice as many such aircraft as its nearest rival, the French firm Airbus. But, in 2003, Airbus passed Boeing as the number one producer of commercial aircraft in the world and had a far larger number of back orders for planes to be delivered in the future.{124} Yet Airbus too faltered and, in 2006, its top managers were fired for falling behind schedule in the development of new aircraft, while Boeing regained the lead in sales of planes.{125}