Basic Economics Read online

Where homes have been destroyed, for example, the demand for local hotel rooms may rise suddenly, while the supply of hotel rooms at best remains the same, assuming that none of these hotels has been damaged or destroyed. When the local population wants more hotel rooms than there are available locally, these rooms will have to be rationed, one way or another, whether by prices or in some other way.

  If the prices of hotel rooms remain what they have been in normal times, those who happen to arrive at the hotels first will take all the rooms, and those who arrive later will either have to sleep outdoors, or in damaged homes that may offer little protection from the weather, or else leave the local area and thus leave their homes vulnerable to looters. But, if hotel prices rise sharply, people will have incentives to ration themselves. A couple with children, who might rent one hotel room for themselves and another for their children, when the prices are kept down to their normal level, will have incentives to rent just one room for the whole family when the rents are abnormally high—that is, when there is “price gouging.”

  Similar principles apply when there are local shortages of other things suddenly in higher demand in the local area. If electric power has been knocked out locally, the demand for flashlights may greatly exceed the supply. If the prices of flashlights remain the same as before, those who arrive first at stores selling flashlights may quickly exhaust the local supply, so that those who arrive later are unable to find any more flashlights available. However, if the prices of flashlights skyrocket, a family that might otherwise buy multiple flashlights for its members is more likely to make do with just one of the unusually expensive flashlights—which means that there will be more flashlights left for others.

  If there is an increased demand for gasoline, whether for electric generators or to drive automobiles to other areas to shop for things in short supply locally, or to move out of the stricken local area entirely, this can create a shortage of gasoline until new supplies can arrive at filling stations or until electric power is fully restored, so that the pumps at more filling stations can operate. If the price of gasoline remains what it has been in normal times, those who get to the filling stations first may fill up their gas tanks and exhaust the local supply, leaving those who arrive later with no gasoline to buy. But, if the price of gasoline skyrockets, motorists who arrive earlier may buy just enough of the unusually expensive gasoline to get them out of the area of local destruction, so that they can then fill up their gas tanks much less expensively in places less affected by the natural disaster. That leaves more gasoline available locally for others.

  When local prices spike, that affects supply as well, both before and after the natural disaster. The arrival of a hurricane is usually foreseen by meteorologists, and their predictions of approaching hurricanes are usually widely reported. Supplies of all sorts of things that are usually needed after a hurricane strikes—flashlights, bottled water, gasoline and lumber, for example—are more likely to be rushed to the area where the hurricane is likely to strike, before the hurricane actually gets there, if suppliers anticipate higher prices. This means that shortages can be mitigated in advance. But if only the usual prices in normal times can be expected, there is less incentive to incur the extra costs of rushing things to an area where disaster is expected to strike.

  Similar incentives exist after a hurricane or other disaster has struck. To replenish supplies in a devastated area can cost more, due to damaged roads and highways, debris and congested traffic from people fleeing the area. Skyrocketing local prices can overcome the reluctance to take on these local obstacles that entail additional costs. Moreover, each supplier has incentives to try to be the first to arrive on the scene, since that is when prices will be highest, before additional suppliers arrive and their competition drives prices back down. Time is also of great importance to people in a disaster area, who need a continuous supply of food and other necessities.

  Prices are not the only way to ration scarce resources, either in normal times or in times of sudden increases in scarcity. But the question is whether alternative systems of rationing are usually better or worse. History shows repeatedly the effect of price controls on food in creating hunger or even starvation. It might be possible for sellers to ration how much they will sell to one buyer. But this puts the seller in the unenviable role of offending some of his customers by refusing to let them buy as much as they want—and he may lose some of those customers after things return to normal. Few sellers may be willing to risk that.

  The net result of having neither price rationing nor non-price rationing may well be the situation described in the wake of the super storm “Sandy” in 2012, as reported in the Wall Street Journal:

  At one New Jersey supermarket, shoppers barely paused for a public loudspeaker announcement urging them to buy only the provisions needed for a couple of days of suburban paralysis. None seemed to be deterred as they loaded their carts to the gunwales with enough canned tuna to last six weeks. A can of Bumblebee will keep for years: Shoppers take no risk in buying out a store’s entire supply at the normal price.{97}

  Appeals to people to limit their purchases during an emergency, like other forms of non-price rationing, are seldom as effective as raising prices.

  Chapter 4

  AN OVERVIEW OF PRICES

  We need education in the obvious more than investigation of the obscure.

  Justice Oliver Wendell Holmes{98}

  Many of the basic principles of economics may seem obvious but the implications to be drawn from them are not—and it is the implications that matter. Someone once pointed out that Newton was not the first man who saw an apple fall. His fame was based on his being the first to understand its implications.

  Economists have understood for centuries that when prices are higher, people tend to buy less than when prices are lower. But, even today, many people do not yet understand the many implications of that simple fact. For example, one consequence of not thinking through the implications of this simple fact is that government-provided medical care has repeatedly cost far more than initially estimated, in various countries around the world. These estimates have usually been based on current usage of doctors, hospitals, and pharmaceutical drugs. But the introduction of free or subsidized medical care leads to vastly greater usage, simply because its price is lower, and this entails vastly greater costs than initially estimated.

  Understanding any subject requires that it first be defined, so that you are clear in your own mind as to what you are talking about—and what you are not talking about. Just as a poetic discussion of the weather is not meteorology, so an issuance of moral pronouncements or political creeds about the economy is not economics. Economics is an analysis of cause-and-effect relationships in an economy. Its purpose is to discern the consequences of various ways of allocating scarce resources which have alternative uses. It has nothing to say about social philosophy or moral values, any more than it has anything to say about humor or anger.

  These other things are not necessarily any less important. They are simply not what economics is about. No one expects mathematics to explain love, and no one should expect economics to be something other than what it is or to do something other than what it can. But both mathematics and economics can be very important where they apply. Careful and complex mathematical calculations can be the difference between having an astronaut who is returning to earth from orbit end up crashing in the Himalayas or landing safely in Florida. We have also seen similar social disasters from misunderstanding the basic principles of economics.

  CAUSE AND EFFECT

  Analyzing economic actions in cause-and-effect terms means examining the logic of the incentives being created, rather than simply thinking about the desirability of the goals being sought. It also means examining the empirical evidence of what actually happens under such incentives.

  The kind of causation at work in an economy is often systemic interactions, rather than the kind of simple one-way causation involved when one bill
iard ball hits another billiard ball and knocks it into a pocket. Systemic causation involves more complex reciprocal interactions, such as adding lye to hydrochloric acid and ending up with salty water,{viii} because both chemicals are transformed by their effects on one another, going from being two deadly substances to becoming one harmless one.

  In an economy as well, the plans of buyers and sellers are transformed as they discover each other’s reactions to supply and demand conditions, and the resulting price changes that force them to reassess their plans. Just as those who start out planning to buy a villa at the beach may end up settling for a bungalow farther inland, after they discover the high prices of villas at the beach, suppliers likewise sometimes end up selling their goods for less than they paid to buy them or produce them, when the demand is inadequate to get any higher price from the consuming public, and the alternative is to get nothing at all for an item that is unsalable at the price originally planned.

  Systemic Causation

  Because systemic causation involves reciprocal interactions, rather than one-way causation, that reduces the role of individual intentions. As Friedrich Engels put it, “what each individual wills is obstructed by everyone else, and what emerges is something that no one willed.”{99} Economics is concerned with what emerges, not what anyone intended. If the stock market closes at 14,367 on a given day, that is the end result of a process of complex interactions among innumerable buyers and sellers of stocks, none of whom may have intended for the market to close at 14,367, even though it was their own actions in pursuit of other intentions which caused it to do so.

  While causation can sometimes be explained by intentional actions and sometimes by systemic interactions, too often the results of systemic interactions are falsely explained by individual intentions. Just as primitive peoples tended to attribute such things as the swaying of trees in the wind to some intentional action by an invisible spirit, rather than to such systemic causes as variations in atmospheric pressure, so there is a tendency toward intentional explanations of systemic events in the economy, when people are unaware of basic economic principles. For example, while rising prices are likely to reflect changes in supply and demand, people ignorant of economics may attribute price rises to “greed.”

  People shocked by the high prices charged in stores in low-income neighborhoods have often been quick to blame greed or exploitation on the part of the people who run such businesses. Similar conclusions about intentions have often been reached when people noticed the much higher interest rates charged by pawnbrokers and small finance companies that operate in low-income neighborhoods, as compared to the interest rates charged by banks in middle-class communities. Companies that charge for cashing checks also usually operate in low-income neighborhoods, while people in middle-class neighborhoods usually get their checks cashed free of charge at their local banks. Yet profit rates are generally no higher in inner city businesses than elsewhere, and the fact that many businesses are leaving such neighborhoods—and others, such as supermarket chains, are staying away—reinforces that conclusion.

  The painful fact that poor people end up paying more than affluent people for many goods and services has a very plain—and systemic—explanation: It often costs more to deliver goods and services in low-income neighborhoods. Higher insurance costs and higher costs for various security precautions, due to higher rates of crime and vandalism, are just some of the systemic reasons that get ignored by those seeking an explanation in terms of personal intentions. In addition, the cost of doing business tends to be higher per dollar of business in low-income neighborhoods. Lending $100 each to fifty low-income borrowers at pawn shops or local finance companies takes more time and costs more money to process the transactions than lending $5,000 at a bank to one middle-class customer, even though the same total sum of money is involved in both cases.{ix}

  About 10 percent of American families do not have a checking account,{100} and undoubtedly this percentage is higher among low-income families, so that many of them resort to local check-cashing agencies to cash their paychecks, Social Security checks or other checks. An armored car delivering money in small denominations to a neighborhood finance company or a small check-cashing agency in a ghetto costs just as much as an armored car delivering a hundred times as much value of money, in larger denominations of bills, to a bank in a suburban shopping mall. With the cost of doing business being higher per dollar of business in the low-income community, it is hardly surprising that these higher costs get passed on in higher prices and higher interest rates.

  Higher prices for people who can least afford them are a tragic end-result, but the causes are systemic. This is not merely a philosophic or semantic distinction. There are major practical consequences to the way causation is understood. Treating the causes of higher prices and higher interest rates in low-income neighborhoods as being personal greed or exploitation, and trying to remedy it by imposing price controls and interest rate ceilings only ensures that even less will be supplied to people living in low-income neighborhoods thereafter. Just as rent control reduces the supply of housing, so price controls and interest rate controls can reduce the number of stores, pawn shops, local finance companies, and check-cashing agencies willing to operate in neighborhoods with higher costs, when those costs cannot be recovered by legally permissible prices and interest rates.

  The alternative, for many residents of low-income neighborhoods, may be to go outside the legal money-lending organizations and borrow from loan sharks, who charge even higher rates of interest and have their own methods of collecting, such as physical violence.

  When stores and financial institutions close down in low-income neighborhoods, more people in such neighborhoods are then forced to travel to other neighborhoods to shop for groceries or other goods, paying money for bus fare or taxi fare, in addition to the costs of their purchases. Such business closings have already occurred for a variety of reasons, including riots and higher rates of shoplifting and vandalism, with the net result that many people in low-income neighborhoods already have to go elsewhere for shopping or banking.

  “First, do no harm” is a principle that has endured for centuries. Understanding the distinction between systemic causation and intentional causation is one way to do less harm with economic policies. It is especially important to do no harm to people who are already in painful economic circumstances. It is also worth noting that most people are not criminals, even in high-crime neighborhoods. The fraction of dishonest people in such neighborhoods are the real source of many of the higher costs behind the higher prices charged by businesses operating in those neighborhoods. But it is both intellectually and emotionally easier to blame high prices on those who collect them, rather than on those who cause them. It is also more politically popular to blame outsiders, especially if those outsiders are of a different ethnic background.

  Systemic causes, such as those often found in economics, provide no such emotional release for the public, or moral melodrama for the media and politicians, as such intentional causes as “greed,” “exploitation,” “gouging,” “discrimination,” and the like. Intentional explanations of cause and effect may also be more natural, in the sense that less sophisticated individuals and less sophisticated societies tend to turn first to such explanations. In some cases, it has taken centuries for intentional explanations embodied in superstitions about nature to give way to systemic explanations based on science. It is not yet clear whether it will take that long for the basic principles of economics to replace many people’s natural tendency to try to explain systemic results by intentional causes.

  Complexity and Causation

  Although the basic principles of economics are not really complicated, the very ease with which they can be learned also makes them easy to dismiss as “simplistic” by those who do not want to accept analyses which contradict some of their cherished beliefs. Evasions of the obvious are often far more complicated than the plain facts. Nor is it automatically
true that complex effects must have complex causes. The ramifications of something very simple can become enormously complex. For example, the simple fact that the earth is tilted on its axis causes innumerable very complex reactions in plants, animals, and people, as well as in such non-living things as ocean currents, weather changes and changes in the length of night and day.

  If the earth stood straight up on its axis,{x} night and day would be the same length all year round and in all parts of the world. Climate would still differ between the equator and the poles but, at any given place, the climate would be the same in winter as in summer. The fact that the earth is tilted on its axis means that sunlight is striking the same country at different angles at different points during the planet’s annual orbit around the sun, leading to changing warmth and changing lengths of night and day.

  In turn, such changes trigger complex biological reactions in plant growth, animal hibernations and migrations, as well as psychological changes in human beings and many seasonal changes in their economies. Changing weather patterns affect ocean currents and the frequency of hurricanes, among many other natural phenomena. Yet all of these complications are due to the one simple fact that the earth is tilted on its axis, instead of being straight up.

  In short, complex effects may be a result of either simple causes or complex causes. The specific facts can tell us which. A priori pronouncements about what is “simplistic” cannot. An explanation is too simple if its conclusions fail to match the facts or its reasoning violates logic. But calling an explanation “simplistic” is too often a substitute for examining either its evidence or its logic.

  Few things are more simple than the fact that people tend to buy more at lower prices and buy less at higher prices. But, when putting that together with the fact that producers tend to supply more at higher prices and less at lower prices, that is enough to predict many sorts of complex reactions to price controls, whether in the housing market or in the market for food, electricity, or medical care. Moreover, these reactions have been found on all inhabited continents and over thousands of years of recorded history. Simple causes and complex effects have been common among wide varieties of peoples and cultures.