Basic Economics by Thomas Sowell

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Intellectual Humiliation

Confront your own ignorance.

Basic Economics by Thomas Sowell

What is Economics?

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. Although this is true, it doesn’t go far enough.

The Garden of Eden was a system of production and distribution of goods and services, but it wasn’t an economy. Why? Because everything there was unlimited. Without scarcity, there is no need to economize – and therefore no economics.


What does “scarce” mean? It means that what everybody wants adds up to more than there is. There has never been enough to satisfy everyone completely. That is the real constraint. That is what scarcity means.

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 kinds of circumstances, whether we have a capitalist, socialist, feudal, or other kinds of economy. These various kinds of economics are just different institutional ways of making trade-offs that are inescapable in any economy.


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 that determines a country’s standard of living.

Not only scarcity but also “alternative uses” are at the heart of economics. If each resource has only one use, economics would be much simpler. Take water, for example, a relatively simple product that can be used to produce ice or steam by itself or innumerable mixtures and compounds in combination with other things.

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 all about. Different kinds of economies are essentially different ways of deciding the allocation of scarce resources – and those decisions have repercussions on the life of the whole society.

Efficient in production – that rate at which inputs are turned into an output – is not just some technicality that economists talk about. It affects the standards 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 about money. Although the word “economics” suggests money to some people, for a society as 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 tells you how to make money or run a business or predict the ups and downs of the stock market.

When an economist analyzes 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 stands 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.

One of the ways of understanding the consequences of economic decisions is to look at the terms of 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.

Economics is a tool of cause and effect analysis, a body of texted knowledge – and principles derived from that knowledge.

Money doesn’t even have to be involved to make a decision economic. When a military medical treatment arrives on a battlefield where soldiers have a variety of wounds, they are confronted with the classic economic problem of allocating scarce resources that have alternative uses. Rarely are there enough doctors, nurses, or paramedics to go around or 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.

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. 

The Role of Prices

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 any economy do that?

Different kinds of economies do it differently. In a feudal economy, the lord of the manor simply tells the people under him what to do and where he wanted resources put. It was the same story in 20th-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 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.

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 decisions with other individuals on whatever terms they can mutually agree on. Prices convey these decisions, not just to particular individuals immediately but through the whole economic system – and indeed, through the world.

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 and when and how the resulting products get transferred to millions of people.

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 getting the things they want. Those who would like to live in a beach-front home, for example, may abandon such plans when they discovered how 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 they are not nearly enough beach-front homes to go around, and prices simply convey that underlying reality. When many people bid for relatively few homes, those homes become very expensive because of supply and demand.

Prices are like messengers conveying news – sometimes bad news, in the case of beach-front property desired by more people than can live at the beach, but often also good news, like the dropping prices of computers or phones.

The discovery of a new copper mine would be news that rarely 1% of the population worldwide would know about, but this discovery would come about with the dropping prices of copper or products that are either related to copper or use this resource to exist.

In short, price changes would enable a whole society to adjust automatically to a greater abundance of known iron ore deposits, even if 99% of those consumers were wholly unaware of the discoveries.

Prices are not just a way of transferring money. Their primary role is to provide financial incentives to affect behavior in the use of resources and their resulting products. Prices are not only guided to consumers, they guide producers as well. When all is said and done, producers cannot possibly know what millions of different consumers want. Low prices are a way to tell producers when to stop making something just as high prices communicate when to start producing something else.

Although a free market economic system is sometimes a profit system, it is, in reality, a profit and loss system – and the losses are equally as important for the efficiency of the economy because losses tell the producer 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 any 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. Although the producers are only looking out for themselves and their company’s bottom line, nevertheless from the standpoint of the economy as a whole society is using its scarce resources more efficiently because decisions are guided by prices.

Price-coordinated markets enable people to signal to either 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 compensation. Prices responding to supply and demand caused natural resources to move from places where they are abundant, like Australia, to places where they are almost non-existent, like Japan.

When more of some item is supplied than demanded, ambitious sellers trying to get rid of the excess will force the prices down, discouraging future productions, 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 away from other parts of the economy to accomplish that.

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 and services you provide, those prices will become economic realities only if others are willing to pay them – and that depends not on the prices of the seller but on how much consumers want what you offer and on what prices other producers charge for the same goods and services.

The problem with prices is that they’re often blamed on the greed of people supplying the items. It is believed that high prices are the effect of greed in the suppliers instead of a set of circumstances that produce those high prices, like low production or high cost of production.

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.

Resource Allocation by Prices

We now need to look more closely at the process by which prices allocate safe resources that have alternative uses. The simplest one is where the consumers want product A and don’t want product B. But prices are equally important in more common and 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, but they also want ice cream and yogurt, as well as other products made from milk. Prices determine how much milk should go to each of these products.

How will each producer know just how much milk to buy? They will buy as much milk as will repay their 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 reduced production of ice cream and more will come from reduced production of yogurt.

What this all means as a general principle is that the price that one producer is willing to pay for any given ingredient becomes the price that other producers are forced to pay for that same ingredient.

The repercussion goes 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 foremast as calves. Nor do the repercussion stop there. As fewer cows are slaughtered, fewer cow sales are available, and their price will rise.

Incremental Substitution

Since scarce resources have alternative uses, the value placed on one of these uses by one individual or company sets the costs that have to be paid by others who want to bid some of these resources away for their 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.

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.

From the standpoint of society as a whole, the “cost” of anything is the value that it has in alternative uses. The cost is reflected in the market when the price that one individual is willing to pay before the cost that others are forced to pay, is 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 system, the real cost of anything is still in its alternative uses.

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 and supply services tend to supply more at a higher price and less at a lower price.

Demand vs. “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 there’s a fixed quantity demanded. For example, communal living in an Israeli kibbutz was based on the idea of its members supplying and producing collectively each other goods and services, without resorting 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 their lights during the day or brought friends for meals. When they started charging prices for these goods, the demand for these goods dropped dramatically.

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 cost of discovery, extraction, and processing of natural resources varies greatly from one place to another. Some oil can be extracted and processed from some places for $20 a barrel and other oil elsewhere cannot repay all its production costs at $40 a barrel but can be 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.

In short, there is no fixed supply of oil – or 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 exact and process varies directly with the price for which it can be sold.

“Real” Value

The most fundamental reason why the 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 new spare, obviously the only reason you do so is that the new space is more valuable to you than the dollar is. At the same time, the only reason people are willing to sell the new spare is that a dollar is more valuable to you than the new spare. If there were any such thing as the “real” or objective value of a newspaper 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 great 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?


Competition is the crucial factor in explaining why prices usually cannot be maintained at arbitrary 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 the competition.

Prices and Supplies

Prices not only ration existing supplies but also act as a powerful incentive to cause supplies to rise or fall in response to changing demand.

Higher prices will force certain goods to be rushed or produced at certain rates as if those prices were invisible or controlled by bureaucrats. The same can be done when prices fall. If the drop in the prices of a given good doesn’t cover the costs of producing that good, most suppliers will stop producing it.

“Unmet Needs”

Unmet need is a concept that journalists, politicians, and intellectuals usually use to argue about the intervention of government in the economy. They claim that these “unmet needs” must be met through government intervention and government spending, but the problem with this statement is that “needs” are infinite while resources are finite.

A great example of this is the frustrating “unmet need” for parking spaces in big cities. Anyone who has ever driven a car in New York City has come across the frustrating concept of trying to find a parking space in the city. This is an unmet need. But even though we may have the technology and economic disposition to create cities with more parking spaces than cars available, we have to remember the basic concept of economics: costs are foregone opportunities. If the government were to take on this endeavor, what would have to be sacrificed to accomplish it? Fewer hospitals? Police? Housing? Water pipes? These are the kinds of things economists must think about when making economic decisions.

By its very nature as a study of the use of scarce resources that have alternative uses, economics is about incremental trade-offs – not about “need” or “solutions”. That may be why economists have never been as popular as politicians who promise to solve our problems and meet our needs. 

Price Controls

Nothing shows more vividly the role and importance of price fluctuations in the 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 to keep prices from rising to the levels that they would reach in response to supply and demand.

To understand the effects of price control, it is first necessary to understand how prices rise and fall in a free market. Price 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 “shortage” and the second is called “surplus” – but both depend on existing prices.

Price “Ceilings” and Shortages

When there is a “shortage” of a product, there’s 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, though the country’s population and its housing supply had both increased about 10% from their prewar levels, there was a shortage of housing. People spent months looking for housing and often resorted to bribing landlords to bump them into the waiting list.

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 previously, 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. 

Demand Under Rent Control

Just as price fluctuations allocate scarce resources which have alternative uses, price controls that limit those fluctuations reduce the incentives for individuals to limit their use of scarce resources desired by others. Rent control, for example, tends to lead to many apartments being occupied by just one person.

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. 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 in their lives.

Given the crucial role of prices in this process, suppression of that process by rent control laws leaves few incentives to tenants to change their behavior as their circumstances change. Rent control incentivizes people to keep their current apartment, even if half of it is empty. It prevents others from finding affordable apartments that they can afford.

Given the crucial role of prices in this process, suppression of that process by rent control always leaves few incentives for tenants to change their behavior as their circumstances change. Elderly people would have less of an incentive to give up apartment space if it meant paying the same or more for a less spacious apartment. 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.

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. After rent control was instituted in Santa Monica, California in 1979, building permits declined less than 1/10th of what they were just five years earlier.

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 builds, 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.

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 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, but even the supply of existing housing also 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 to attract tenants. Thus housing tends to deteriorate faster under rent control and to have fewer replacements when it wears out.

This illustrates the crucial importance of making distinctions between intention and consequences. Economic policies need to be analyzed in terms of the incentives they create, rather than the hopes that inspire them.

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 ordinary 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 of 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.

When rent control always applies 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 exempt from rent control, such exemptions or relaxations of 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.

Scarcity Versus Shortage

One of the crucial distinctions to keep in mind is the distinction between an increased scarcity – where fewer goods are available relative to the population – and a shortage as a price phenomenon. Just as there can be a growling shortage without an increased scarcity, so there can be a growing scarcity without shortage.

Scarcity occurs when there’s more demand for a good than is available at the time. Shortages occur when artificially low or high prices disincentivize people from producing such goods that have high demand.


In addition to shortages and quality deterioration under price controls, there’s often hoarding – that is, individuals keeping a larger inventory of the price-controlled goods than they would ordinarily under free-market conditions, because of the uncertainty of being able to find them in the future.

The feasibility of hoarding varies with different goods, so the effect of price controls also varies. For example, price controls on strawberries might lead to less of a shortage than price controls on gasoline, since strawberries are too perishable to be hoarded for a long.

Hoarding is a special case of the more general economic principle that more is demanded at a lower price and of the corollary that price controls allow lower priority uses to preempt higher priority uses, increasing the severity of the shortages, whether of apartments or gasoline.

Black Markets

While price controls make it illegal for buyers and sellers to make some transactions on terms that they would both prefer to the shortages that price controls entail, bolder and less scrupulous buyers and sellers mark mutually advantageous transactions outside the law. Price controls almost invariably produce black markets, where prices are not only higher than the legally permitted prices, but also higher than they would be in a free market since the legal risk must also be compensated. While small-scale black markets may function in secrecy, large-scale black markets usually require bribes to officials to look the other way.

Quality Deterioration

One of the reasons for the political success of price controls is that part of their costs is concealed. Even the visible shortages do not tell the whole story. Quality deterioration, such as already noted in the case of housing, has been common with many other products and services whose prices have been kept artificially low by government fiat.

One of the fundamental problems of price control is defining just what it is whose price is being controlled. Even something as simple as an apple is not easy to define because apples differ in size, freshness, and appearance, quite aside from the different varieties of apples. Produce stores and supermarkets spend time (and hence money) sorting different kinds of qualities of apples, throwing away those that fall below a certain quality that their respective customers expect. Under price control, however, the number of apples demanded at an artificially low price exceeds the amount supplied, so there is no need to spend so much time and money sorting apples, as they will all be sold anyways.

Some of the most painful examples of quality deterioration have occurred in countries where there are price controls on medical care. At artificially low prices, more people go to doctors’ offices with minor ailments like sniffles or skin rashes that they might otherwise ignore, or else might treat with over-the-counter medications, perhaps with a pharmacist’s advice. But all these changes when price controls reduce the costs of visits to the doctor’s office, especially when these visits are paid for by the government and are therefore free to the patient.

The priorities that prices automatically cause individuals to consider are among the first causalities of price controls.

Delayed medical treatment is one aspect of quality deterioration when prices are set below the levels that would prevail under supply and demand. The quality of the treatment received is also affected when doctors spend less time per patient.

Price “Floors” and Surpluses

Just as a price set below the level that would prevail by supply and demand in a free market tends to cause more to be demanded and less to be supplied, creating a shortage at the imposed price, so a price set above the free market level tends to cause more to be supplied than demanded, creating a surplus.

Price control in the form of a “floor” under prices, preventing these prices from falling further, produced surpluses as dramatic as the shortages produce by price control in the form of a “ceiling” preventing prices from rising higher. In some years, the federal government bought more than one-fourth of all the wheat grown in the United States and took it off the market, to maintain prices at a pre-determined level.

A surplus, like a shortage, is a price phenomenon. A surplus does not mean that there is some excess relative to the people. Surplus simply means that the supply of those goods is reflected in the price sold.

So long as the market price of the goods covered by price controls stays above the level at chic the government is legally obligated to buy it, the level at which the government is legally obligated to buy it, the product is sold in the market at a price determined by supply and demand. But, when there is either a sufficient increase in the amount supplied or a suffice to reduction in the amount demanded, the resulting lower price can fall to a level at which the government buys what the marketing is unwilling to buy. 

What is crucial from the standpoint of undertrained the role of prices in the economy is that persistent surpluses are as much a result of keeping prices artificially high as persistent shortages are keeping prices artificially low. The real losses to the country as a whole come from the misallocation of scarce resources which have alternative uses.

Scare resources such as land, labor, fertilizer, and machinery are endlessly used to produce more food than the consumers are willing to consume at the artificially high prices decreed by the government. Poor people, who spend an especially high percentage of their income on food, are forced to pay far more than necessary to get the amount of food they receive, leaving them with less money for other things.

The Politics of Price Controls

Simple as basic economic principles may be, their ramifications can be quite complex, as we have seen with various effects of rent control laws and agricultural price support laws. However, even this basic level of economics is seldom understood by the public, which often demands political “solutions” that turn out to make matters worse. Nor this new phenomenon of modern times in democratic countries.

Politically, price controls are always a tempting “quick fix” for inflation, and certainly easier than getting the government to cut back on its spending which is often behind inflation. It may be considered especially important to keep the prices of food from rising.

The political reason she has often been to pass laws against “price gouging” to stop such unpopular practices. Yet the role of prices in allocating scarce resources is even more urgently needed when local resources have suddenly become more scarce than usual, relative to the increasing demand from people deprived of the resources normally available to them, as a result of the destruction created by storms or wildfires or some natural disaster.

Such a principle can be seen 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 greatest 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 there will be more flashlights left to others.

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.

An Overview of Prices

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.

Economics has 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.

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 that have alternative uses.

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 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 billiard ball hits another billiard ball and knows it to a pocket.

Systemic Causation

Because systemic causation involves reciprocal international, rather than one-way causation, that reduces the role of individual interactions. As Friedrich Engels put it, “what each will is obstructed by everyone else, and what emerges is something that no one willed.” Economics is concerned with what emerges, not what anyone intended.

While causation can sometimes be explained by intentional actions and sometimes by systemic interactions, too often the results of systemic interaction are falsely explained by individual intentions. 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.

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.

Higher prices for people who can least afford them are tragic results, but the causes are systemic. There are mayoral 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, pawnshops, 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.

Understanding the distinction between systemic causation and intentional causation is one way to do less harm with economic policies. It is especially important to not harm 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 is 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. 

Complexity and Causation

Although the basic principles of economics are not 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 that contradict some of their cherished belfries. Evasions of the obvious are often far more complicated than plain facts. No is ti automatically true that complex effects must have complex causes.

A priori pronouncement about what is “simplistic” cannot. An explanation that 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 the market for goods, electricity, or medical care.

Individual Rationality Versus Systemic Rationality

The tendency to personalize causation leads not only to charges that “greed” causes high prices in market economies but also to charges that “stupidity” among bureaucrats is responsible for many things that go wrong in government economic activities. In reality, many of the things that go wrong in these activities are due to perfectly rational actions, given the incentives faced by government officials who run such activities, and I en the inherent constraints on the amount of knowledge available to any given decision-maker or set of decision-makers.

Incentives Versus Goals

Incentives matter because most people will usually do more for their benefit than for the benefit of others. Incentives link the two concerns together. A waitress brings food to your table, not because of your hunger, but because her salary and tips depend on it. Prices not only help determine which particular things are produced, but they are also ways rationing inherent scarcity, are also one way of rationing the inherent scarcity of all goods and services, as well as rationing the scarce resources that go into producing those goods and services.

Simple as this may seem, it goes counter to many policies and programs designed to make various goods and services “affordable” or to keep them from becoming “prohibitively expensive”. But being prohibitive is precisely how prices limit how much each person uses. If everything were made affordable by government decree, there would still not be any more to go around than when things were prohibitively expensive. There would simply have to be some alternative method of rationing the inherent scarcity. Whether was through the government’s issuing ration coupons, the emergence of black markets or just fighting over things when they go on sale, the rationing would still have to be done, since artificially making things affordable does not create any more total output. On the contrary, price “ceilings” tend to cause less output to be produced. 

The mechanisms of the market are impersonal but the choices made by individuals are as personal as choices made anywhere else. It may be fashionable for the journalists to refer to the “whim of the marketplace” as if that were something different from the desires of people, just as it was once fashionable to advocate “production of use, rather than profit” – as if profits could be made by producing things that people cannot use or do not want to use.  The real contrast is between choices made by individuals for themselves and choices made for them by others who presume to define what these individuals “really” need.

Scarcity and Competition

Scarcity means that everyone’s desires cannot be satisfied completely, regardless of which particular economic system or government policy we choose – and regardless of whether an individual or a society is poor or generous, wise or foolish, noble or ignoble. Competition among people for scarce resources is inherent. It is not a question of whether we like or dislike competition. Scarcity means that we do not have the option to choose whether or not to have an economy in which people are complete. That is the only kind of economy that is possible – and our only choice is among the particular methods that can be used for that competition.

Economic Institutions

Most people may be unaware that they are competing when making purchases, and simply see themselves as deciding how much of various things to buy at whatever prices they find. But scarcity ensures that they are competing with others, even if they are conscious only of weighing their own purchasing decisions against the amount of money they have available.

This economic principle applies to groups that are based on religion, ethnicity, geographic regions, or age brackets. All are inherently competing for the same resources, simply because these resources are scarce. However, competing indirectly by having to keep your demands within the limits of your pocketbook is very different from seeing your desires for benefits thwarted directly by the rival claims of some other group. The self-rationing created by prices not only tends to mean less social and political friction but also more economic efficiency since each individual knows his or her preferences better than any third party can, and can therefore make incremental trade-offs that are more personally satisfying within the limits of the available resources.

Rationing through pricing also limits the number of each individual’s claims on the output of others to what that individual’s productivity has created for others, or thereby earned as income. What price controls, subsidies, or other substitutes for price allocation do is reduce the incentive for self-rationing. That’s whys farmers who get government subsidies on irrigation projects grow crops requiring huge amounts of water, which they would never grow if they had to pay the full costs of that water themselves.

Incremental Substitution

As important as it is to understand the role of substitutions, it is also important to keep in mind that the efficient allocation of resources requires that these substitutions be incremental, not total. For example, one may think that health is more important than entertainment, but no one believes that having a twenty-year supply of Band-AIDS in the closet is more important than having to give up all music to pay for it. A price-coordinated economy facilitates incremental substitution, but political decision-making tends toward categorical priorities – that is, declaring one thing absolute more important than another and creating laws and policies accordingly.

When some political figure says that we need to “set national priorities” about one thing or another, what that amount to is making A categorically more important than B. This is the opposite of incremental substitution, in which the value of each depends on how much of each we already have at the moment, and therefore not the changing the amount of A that we are willing to give to get more B.

Whenever there are two things that each have some aloe, one cannot be categorically more valuable than another.

A what cost?

People who are spending no their own money are confronted with these costs at every turn, but people who are spending the taxpayer’s money – or who are simply imposing uncounted costs on businesses, homeowners, and others – have no real incentives to even find out how much the additional costs are, much less hold off on adding requirements when the incremental costs threaten to become larger than the incremental benefits to those on whom these costs are imposed by the government.

Any attempt to get rid of some of this red tape is likely to be countered by government officials, who can point out what useful purpose these requirements may serve in some circumstances. But they are unlikely even to pose the question of whether the incremental benefit exceeds the incremental costs.

The point is not to look at the benefits that these so-called regulations may or may not bring at any point in time, but the real question is whether their corset exceeds their benefit.

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 subsidies 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 te petition 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 and subsidies for particular things seem not to understand that what they are 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.

From the standpoint of the allocation of resources, the government should either not tax t resources, goods, and services or else tax them all equally, to minimize the distortions of choices made by consumers and producers. For similar, reasons, particular resources, goods, and services should not be subsidized.

The Meaning of “Costs”

Sometimes the rationale for removing particular things from the process of weighing costs against benefits is expressed in some such questions 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 thoughts of other things all require time, effort, and raw material, the costs of these inputs are inherent. The costs do not go away because a law prevents them from being conveyed through prices in the marketplace.

One reason for the popularity of price controls is confusion between prices and costs. For example, politicos who say that they will “bring down the cost of medical care” are almost invariable means that they will bring down the prices paid for medical care. The actual costs of medical care – the years of trading in for doctors, the resources used in building and equipping hospitals, and the hundreds of millions of dollars for years of research to develop a single new medication – are unlike to decline in the slightest. 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 disc tint ion between prices and cost is recognized, then it is not very surprising that price controls have the negative consequence 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 the min the same quantities and qualities when they cannot recover the costs that such Cuanto quantities and qualities required. 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.

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 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.

The Rise and Fall of Businesses

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, so obviously many businesses are losing money. Businesses that have lasted for generations – sometimes more than a century – have eventually been forced to 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 society at large.

Adjusting to Changes

The businesses we hear about, in the mead and elsewhere, are usually those which have succeeded, and especially those which have succeeded on a grand scale – Microsoft, Toyota, Sony, Apple, Google.

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.

At the heart of this is the role of profits – and losses. Each is equally important t 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 every changing detail, within every changing surrounding economic and social environment, mean that the threat of losses hangs over even the biggest and most successful businesses.

Just as companies rise and fall over time, so do profit rates – even more quickly.

This has been a common experience with many products in many industries. The companies which first introduced 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, and drive 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 are at financially sustainable levels.

Although corporations may be thought of as big, impersonal, and inscrutable institutions, they are ultimately run by human beings who all differ from one another and who all have shortcomings and make mistakes, as happens in economic enterprises in every kind of economic system and countries around the world. Companies superbly adapted to a given set of conditions can be left behind when those conditions change suddenly and their competitors are quick to respond. Sometimes the changes are technological, as in the computer industry, and sometimes these changes are social or economic.

Social Changes

Many corporations that once dominated their fields have fallen behind in the face of change or have even gone bankrupt. Pan American Airways, which pioneered commercial flight across the Atlantic and the Pacific in the first half of the 20th century, went out of business in the late 20th century, as a result of increased competition among airlines in the wake of the deregulation of the airline industry.

Famous newspapers like the New York Herald-Tribune, with a pedigree going back more than a century, stopped publishing in a new environment after television became the main source of news, and newspaper unions made publishing more costly. Between 1949 and 1990, the total number of copies of all the newspapers sold daily in New York City fell from more than 6 million copies to less than 3 million. New York was not unique. Nationwide daily newspaper circulation per capita dropped 44% between 1947 and 1998.

By 2004, the only American new spare with daily circulations of a million or more were newspapers sold nationwide – USA Today and Wall Street Journal, and the New York Times.

Other great industrial and commercial firms that have declined or become extinct are likewise a monument to the unrelenting pressure of competition. So is the rising prosperity of the consuming public. The fate of particular companies or industries is not what is most important. Consumers are the principal beneficiaries of lower prices made possible by the more efficient allocation of scarce resources that have alternative uses. The key roles in all of this are played not only by provinces and profits but also by losses. These losses force businesses to change with changing conditions or find themselves losing out to competitors who spot the new trends sooner or who understand their implications better and respond faster.

Individual businesses are forced to make drastic changes internally over time, to survive.

The competitive advantages of those who are right can overwhelm the numerical, or even financial, advantages of those who are wrong.

One of the great handicaps of economies run by police authorities, whether under medieval mercantilism or modern communism, is those insights that arise among the masses that have no such powerful leverage to force those in authority to change the way they do things. Under any form of an economic or political system, those at the top tend to become complacent, if not arrogant. Convincing them of anything is not easy, especially when it is some new way of doing things that are very different from what they are used to. The big advantage of the free market is that you don’t have to convince anybody of anything. You simply compete with them in the marketplace and let that be the rest of what works best.

Economic Changes

Economic changes include not only changes item encompasses but also changes within the management of firms, especially in their response to external economic changes. Many things that we take for granted today, as features of a modern economy, were resisted when first proposed and had to fight uphill to establish themselves by the power of the marketplace.

Neither individuals nor companies are successful forever. Death alone guarantees turnover in management. Given the importance of the human factor and the variability among people – or even with the same person at different stages of life – it can hardly be surprising that dramatic changes over time in the relative positions of businesses have been the norm.

What is important is not the success or failure of particular individuals or companies, but the success of particular knowledge and insight in prevailing despite the blindness or resistance of particular business owners and managers. Given the scarcity of mental resources, an economy in which knowledge and insight have such decisive advantages in the competition of the marketplace is an economy that itself has great advantages in creating a higher standard of living for the population at large. A society in which only members of a hereditary aristocracy, a military junta, or a ruling political party can make major decisions in a society that has thrown away much of the knowledge, insight, and talents of most of its people. A society in which such decisions can only be made by males has thrown away half of its knowledge, talents, and insights.

Changes in Business Leadership

Perhaps the most overlooked fact about industry and commerce is that they are run by people who differ greatly from one another in insight, foresight, leadership, organizational ability, and dedication. Therefore the companies they lead likewise differ in the efficiency with which they perform their work. Moreover, these differences change over time.

Business leadership is a factor, not only in the relative success of various enterprises but more fundamentally in the advance of the economy as a whole through the spread of the impact of new and better business methods to competing companies and other industries. While the motives for these improvements are the bottom line so the companies involved, the bottom line for the economy as a whole is the standard of living of the people who buy products and services that these companies produce.

It is not always one individual who is the key to the success of a given business, as Rockefeller was to the success of Standard Oil. What is key is the role of knowledge and insight in the economy, whether they are concentrated in one individual or more widely dispersed. Some business leaders are very good at some aspects of management and very weak in other aspects. The success of a business then depends on which aspects happen to be crucial at a particular time. Sometimes two executives with very different skills and weaknesses combine to produce a very successful management team, whereas either one of them might have failed in operating alone.

When an industry or a sector of the economy is undergoing rapid change through new ways of doing business, sometimes the leaders of the past find it hardest to break the mold of their previous experience. For example, when the fast-food revolution bursts forth in the 1950s, existing leaders in restaurant franchises such as Howard Johnson were very unsuccessful in trying to compete with upstarts like McDonald’s in their fast-food segment of the market. Even when Howard Johnson set up imitations of hate new fast-food restaurants under the name “Howard Johnson Jr.” these imitations were unable to compete successfully, because they carried over in the fast-food business approaches and practices that were successful in conventional restaurants, which slowed down operations too much to be successful in the new fast-food sector, where rapid turnover with inexpensive food was the key to profits.

Market economies must rely not only on price competition between various producers to allow the most successful to continue to expand, but they must also find some way to weed out those business owners or managers who do not get the most from the nation’s resources. Losses accomplish that. Bankruptcy shuts down the entire enterprise that is consistently failing to come up with the standards of its competitors or is producing a product that has been superseded by some other product.

The Role of Profits and Losses

To those who run businesses, profits are desirable and less deplorable. Economics is not business administration. From the standpoint of the economy as a whole, and the standpoint of the central concern of economics – the allocation of scarce resources which have alternative uses – profits and losses play equally important roles in maintaining and advancing the strands of living of the population as a whole.

Part of the efficiency of a price-coordinated economy comes from the fact that goods can simply “follow the money”, without the producers knowing just why people are buying one thing here and something else there and eating another thing during a different season. However, it is necessary for those who run businesses to keep track not only of the money coming in from the customers, it is equally necessary to keep track of how much money is going out of those who supply raw materials, labor, electricity, and other inputs. Keeping careful track of these numerous flows of money in and out can make the difference between profit and loss.


Profits may be the most misconceived subject in economics. Socialists have long regarded profits as a simple “overcharge”.

With profits eliminated, as they did back in the Soviet Union, prices should have been lower in socialist countries, according to theory, and the standard of living of the masses correspondingly higher. Why then was it not that way in practice?

Profits as Incentives

The hope for profits and the threat of losses is what forces a business owner in a capitalist economy to produce at a lower cost and sell what the customers are most willing to pay for. In the absence of these pressures, those who manage enterprises under socialism have far less incentive t one as efficient as possible under given conditions, much less to keep up with changing conditions and respond to them quickly, as capitalist enterprises must do if they expect to survive.

Under free-market capitalism, even the most profitable business can lose its market if it doesn’t keep innovating, to avoid being overtaken by its competitors. But the good side of this from a consumer standpoint is that most consumers benefit from lower prices and better quality that came with competition and innovation.

While capitalism has a visible cost – profit -that does not exist under socialism, socialism has an invisible cost – inefficiency – that gets weeded out by losses and bankruptcy under capitalism. The fact that most goods are more widely affordable in a capitalist economy implies that profit is less costly than inefficiency. Put differently, profit is a price paid for efficiency. The greater efficiency must outright the profit or else aísleme would have had the more affordable prices and greater prosperity that its theorist expected, but which filled to materialize in the real world.

If the cost of profits exceeds the value of efficiency they promote, the non-profit organizations or government agencies could get the same work done cheaper or better than profit-making enterprises, and could therefore displace them in the competition of the marketplace.

While capitalist has been conceived of as people who make profits, what a business owner gets is the legal ownership of whatever residual is left over after the cost of production have been paid out of the money received from customers. That residual can turn out to be positive, negative, or zero. Workers must be paid and creditors must be paid – or else they can take legal action to seize the company’s assets. Even before that happens, they can simply stop supplying their inputs when the company stops paying them. The only person whose payment is contingent on how well the business is doing is the owner of the business.

It is not just ignorant people, but also highly educated and intelligent people who have misconceived profits as arbitrary charges added to the inherent costs of producing goods and services. To many people, high profits are often attributed to high prices charged by those motivated by “greed”.

Profit Rates

When most people are asked how high they think the average rate of profit is, they suggest some numbers much higher than the actual rate of profit. Over the entire period from 1960 through 2005, the average rate of return on corporate assets in the United States ranged from a high of 12.4% to a low of 4.1%, before taxes. After taxes, the rate of profit ranged from a high of 7.8% to a low of 2.2%. However, it is not just the numerical rate of profit that most people misconceive. Many misconceive its whole role in a price-coordinated economy, which is to serve as incentives – and it plays the role wherever its fluctuations take it. Moreover, some people have no idea that there are vast differences between profits on sales and profits on investments.

If a store buys a widget for $10 and then sells it for $15 one would think that $5 would be the profit margin, but of course, the store has other expenses before it can even think about profits. Paying the workers, the cost to maintain the store, and other supplies needed to make the sale in the first place.

It is the profit on the whole investment that matters to the investor. When someone invests $10,000, what the person wants to know is what annual rate of return it will bring, whether it is invested in stores, real estate, or stock and bonds. Profits on particular sales are not what matters most. It is the print on the local capital that has been invested in the business that matters. That profit matters not just to those who received it, but to the economy as a whole, because differences in profit rates in different sectors of the economy are what cause investment to flow into and out of these various sectors until profit rates are equalized.

Profit on sales is a different story. Things may be sold at prices that are much higher than what the seller paid for them and yet, if those items sit on a shelf in the stores for months before being sold, the profit on investment may be less than with other items that have less of a mark-up in price but which sell out within a week.

Cost of Production

Among the crucial factors in prices and profits are the costs of producing whatever goods or services are being sold. Not everyone is equally efficient in producing and not everyone’s circumstances offer equal opportunities to achieve lower costs. Unfortunately, costs are misconceived almost as much as profits.

Economies of Scale

First of all, there is no such thing as “the” cost of producing a given product or service.

Large fixed costs are among the reasons for lower costs of production per unit of output as the number of output increases. Lower costs per unit of output as the number of units increases is what economists call “economies of scale.”

Diseconomies of Scale

Economies of scale are only half the story. If all it took was for the production of something to become bigger and bigger, why wouldn’t two companies merge to create an even bigger economy of scale? Because there comes a point, in every business, beyond which the cost of producing a unit of output no longer declines as the number of production increases. Costs per unit rise after an enterprise becomes so huge that it is difficult to monitor and coordinate, when the right hand may not always know what the left hand is doing. Problems associated with size can affect quality as well as price.

Cost and Capacity

Costs vary not only with the volume of output, and to varying degrees from one industry to another, but they also vary according to the extent to which existing capacity is being used.

In many industries and enterprises, capacity must be built to handle the peak volume – which means that there is excess capacity at other times. The cost of accommodating more users of the product or service during times when there is excess capacity is much less than the cost of handling those who are served at peak times. A cruise ship, for example, must receive enough money from these passengers to cover not only such current costs as paying the crew, buying food, and using fuel, but it must also be able to pay such overhead costs as the purchase price of the ship and the expenses at the headquarters of the cruise line.

“Passing On” Costs and Savings

It is often said that businesses pass on whatever additional costs are placed on them, whether these costs are placed on them by higher taxes, rising fuel costs raises for their employees under a new union contract or a variety of other sources of higher costs. By the same token, whenever costs came down for some reason, whether because of a tax cut or a technological improvement, for example, the question is often raised as to whether these lower costs will be passed on at lower prices to the consumers.

The idea that sellers can charge whatever price they want is seldom expressed explicitly, but the implications that they can often lurk in the background of such Quito’s as what they will pass on to their customers. But the passing on either higher costs or savings in costs is not an automatic process and, in both cases, it depends on the kind of competition faced by each business and how many of the competing companies have the same costs increases or decreases.

In any given industry, you can only pass on the cost of producing something as long as it’s still cheaper than the price of your competitor. If you were to raise the price of your product then your buyer would simply switch to whoever charges the lowest price.

The same principle applies when it comes to passing on Savin to customers. If you alone introduce a new technology that cuts your production in half, then you can keep all the additional profits resulting from these cost savings by continuing to charge what your higher-cost competitors are charging. Alternatively, you can cut your prices and take customers away from your competitors, which can lead to even larger total profits, despite lowering your profits per unit sold.

Specialization and Distribution

A business firm is limited, not only in its overall size but also in the range of functions that it can perform efficiently.


The perennial desire to “eliminate the middlemen” is perennially thwarted by economic reality. The range of human knowledge and expertise is limited for any given person or any manageably-sized collection of administrators. Only a certain number of links in the great chain of production and distribution can be mastered and operated efficiently by the same set of people. Beyond some point, other people with different skills and experience can perform the next step in the sequence more cheaply or more effective – and therefore, at that point it pays a firm to sell its output to some other businesses that can carry on the next part of the operation more efficiently. That is because, as we have noted in earlier chapters, goods tend to flow to their most valued uses in a free market, and goods are more valuable to those who can handle them more efficiently at a given stage.

Prices play a crucial role in all of this, as in other aspects of a market encompass. Any economy must not only allocate scarce resources that have alternative uses, but it must also determine how long the resulting products remain in whose hands before being passed along to others who can handle the next stage more efficiently. Profit-seeking businesses are guided by their bottom line, but this bottom line itself determine by what others can do and at what costs.

When a product becomes more valuable in the hands of somebody else, that somebody else will bid more for the product than it is worth to its current owner. The owner then sells, not for the sake of the economy, but the owner’s own sake. However, the result is a more efficient economy, where goods move to those who value them most. Deputed superficially appealing phrases about “eliminating the middleman,” middlemen continue to exist because they can do their phase of the operation more efficiently than others can. It should hardly be surprising that people who specialize in one phase can do that particular phase more efficiently than others.

Socialist Economies

As in other cases, one of the best ways of understanding the role of prices, and losses is to see what happens in their absence. Socialist economies not only lack the kings of incentives that force individual enterprises toward efficiency and innovation, but they also lack the kinds of financial incentives that lead each given producer in a capitalist economy to limit its work to those stages of production and distribution at which it has lower costs than alternative enterprises. Capitalist enterprises buy components from others who have lower costs in producing those particular components, and sell their output to whatever middlemen can most efficiently carry out its distribution. But a socialist economy may forego these advantages of specialization – and for perfectly rational reasons, given the very different circumstances in which they operate.

The Economics of Big Business

Big business can be big in different ways. They can be big, like Walmart – with billions of dollars in sales annually, making it the biggest business in the nation – without selling more than a modest percent angle of the total merchandise in its industry as a whole. Other businesses can be big in the sense of making a high percentage of operating systems for personal computers around the world. An absolute monopoly in one industry may be smaller in size than a much larger company in another industry where there are numerous competitors.

The incentives and constraints in a competitive market are quite different from those in a maker where one company enjoys a monopoly, and such differences lead to different behavior with different consequences for the economy as a whole.


Corporations are not all businesses. The first corporation in America was the Harvard Corporation, formed in the 17th century from an enterprise owned by individuals, families, or partners. In these other kinds of enterprises, the owners are personally responsible for all the financial obligations of the organization. If such an organization does not happen to have enough money on hand to pay its bills or to pay any damages resulting from lawsuits, a court can order the seizure of the bank accounts or other personal property of those who own the enterprise. A corporation, however, has a separate legal identity, so the individual owners of the corporation are not personally liable for its financial obligations. The corporation’s legal liability is limited to its corporate assets – hence the abbreviation “Ltd.”

Like many other things, the significance of limited legal liability can be understood most easily by seeing what happens in its absence. Back during the First World War, Hebert Hoover organized a philanthropist enterprise to buy and distribute food to vast numbers of people who were suffering hunger and starvation across the continent of Europe, as a result of blockades and disruptions grown out of the military conflict. A banker whom he had recruited to help him in this enterprise asked Hoover if this was a limited liability organization. When Hoover said that it was not, the banker resigned immediately because, otherwise, his life’s savings could be wiped out if the organization did not receive enough donations from the public to pay for all the millions of dollars worth of food that it would buy to feed all the hungry people across Europe.

What limited liability does for the economy and the society as a whole is to permit many gigantic economic activities to be undertaken that would be too large to be financed by a given individual, and too risky to invest in by large numbers of individuals, if each investor became liable for the debts of an enterprise that is too large for all its stockholders to monitor its performance closely.

Executive Compensation

The average compensation package of chief executive officers of corporations large enough to be listed in the Standard & Poor’s index was $10 million a year in 2010. While this is much more than most people make, it is also much less than is made by any number of professional athletes and entertainers, not to mention financiers.

What has provoked special outcries are the severance packages in the millions of dollars for executives who are let go because of their failures. In the corporate world, it is especially important to end a relationship quickly, even at the cost of millions of dollars because keeping a failing CEO on can cost a company billions through the bad decisions the CEO can continue to make.

Monopolies and Cartels

Competitive free markets are not the only kinds of markets, nor are government-imposed price controls or general planning the only interference with the operations of such markets. Monopolies, oligopolies, and cartels also produce economic results very different from those of a free market.

A monopoly means one seller. However, a small number of sellers – an “oligopoly” – may cooperate, either explicitly or tacitly, in setting prices and so produce results similar to those of a monopoly. Although these various kinds of non-competitive industries differ among themselves, their generally detrimental effects have led to laws and government policies designed to prevent or counter these negative effects. Sometimes this government intervention takes the form of direct regulation of the prices and policies of non-competing firms in industries where there is little or no competition. In other cases, the government prohibits particular practices without attempting to micro-manage the companies involved. The first and most fundamental question, however, is: How are monopolistic firms detrimental to the economy?

Sometimes one company produces the total output of a given good or service in a region or a country.

Most big businesses are not monopolies and not all monopolies are big businesses.

Monopoly Prices vs. Competitive Prices

Just as we can understand the function of prices better after we have seen what happens when prices are not allowed to function freely, so we can understand the role of completion in the economy better after we contrast what happens in competitive markets with what happens in markets that are not competitive.

Take something as simple as apple juice: how do consumers know that the price they are being charged for apple juice is not far above the cost of producing and distributing it, including a return on investment sufficient to keep those investments being made? Competition in the market. Those few people who do no such a thing, and who are in the business of making investments, have every incentives to invest where there are higher rates of return and to reduce their investments where the rates of return are lower or negative. If the price of apple juice is higher than necessary to compensate for the costs incurred in producing it, then higher rates of profit will be made – and will attract ever more investment into this industry until the compensation of additional producers drives prices down to a level that just compensates the costs with the same average rate of return on similar investments available elsewhere in the economy.

If, however, there were a monopoly in producing apple juice, the situation would be very different. Chances are that monopoly prices would remain at levels higher than necessary to compensate for the costs and efforts that go into producing apple juice, including paying a rate of return on capital sufficient to attract the capital required. The monopolists would earn a rate of return higher than necessary to attract the capital required. But with no competing company to produce competing output to drive down prices, the monopolist could continue to make profits above and beyond what is necessary to attract investment.

Many people are concerned about the high prices that monopolies would charge, but would concern people is the effect of a monopoly on the allocation of scarce resources which have alternative uses.

When a monopoly charges higher prices than it could charge if it had completion, consumers tend to buy less of the product than they would a lower competitive price. The monopolies stop short at a point where consumers are still willing to pay enough to cover the cost of production of more output.

In terms of the allocation of resources that have alternative uses, the net result is that some resources which could have been used to produce more apple juice instead into producing other things elsewhere in the economy, even if those other things are not as valuable as the apple juice that could and would have been produced in a free competitive market. In short, the economy’s resources are used inefficiently when there is a monopoly because these resources would be transferred from more valued uses to less valued uses.

Fortunately, monopolies are very hard to maintain without laws to protect monopolist firms from competition. The ceaseless search of investors for the highest rates of return virtually ensures that such investments will flood into whatever segment of the economy is earning higher profits until the rate of profit in that segment is driven down by the increased competing cause by that flood of investment.

Governmental and Market Responses

One way to keep out potential competitors is to have the government make it illegal for others to operate in particular industries. Kings granted or sold monopoly rights for centuries, and modern governments have restricted the issuance of licenses for various industries and occupations, ranging from airlines to trucking to the braiding of hair. Political rationales are never lacking for these restrictions, but their net economic effect is to protect existing enterprises from additional potential competitors and therefore to maintain prices at artificially high levels.

In the absence of government prohibition against entry into particular industries, various clever schemes can be used privately to try to erect Barrie’s to keep out competitors and protect monopoly profits. But other businesses have incentives to be just as clever at circumventing these barriers.

Regulation and Anti-Trust Laws

During the era when local telephone companies were monopolies in their respective regions and their parent company – American Telephone and Telegraph Company – had a monopoly on the long-stance service, the Federal Communications Commission controlled the prices charged by AT&T, while state regulatory agencies controlled the price of local phone service. Another approach has been to pass laws against the creation or maintenance of a monopoly or various practices, such as price discrimination, and growing out of non-competitive markets. These anti-trust laws were intended to allow businesses to operate without the kinds of detailed government supervision which exist under regulatory commissions, but with a sort of general surveillance, like that of traffic police, with intervention occurring only when there are specific violations of laws.

Regulatory Commissions

Although the functions of a regulatory commission are fairly straightforward in theory, in practice its stacks are far more complex and in some respects, impossible.

Ideally, a regulatory commission would set prices where they would have been if there were a competitive marketplace. In practice, there is no way to know what those prices would be. No outside observer can know what the most efficient ways of operating a given firm or industry are. The most that a regulatory agency can do is accept what appears to be reasonable production costs and allow the monopoly to make what seems to be a reasonable profit over and above such costs.

Determining the cost of production is by no means always easy.

Take the cost of electricity for example which may vary depending on where, when, and how it’s being generated and used. “The” cost of producing electricity come from fluctuations in the costs of the various fuels – oil, gas, coal, nuclear – used to run the generators. Since these fuels are used for other things besides generating electricity, the fluctuating demand for these fuels from other industries, or for use in homes and automobiles, makes their prices unpredictable.

The economic complexities involved when regulatory agencies set prices are compounded by political complexities. Regulatory agencies are often set up after some political crusader has successfully launched investigations or publicity campaigns that convince the authorities to establish a permanent commission to oversee and control a monopoly or some group of firms few enough in number to be a threat to behave in collusion as if they were one monopoly. However, after a commission has been set up and its power established, crusaders and the media tend to lose interest over the years and turn their attention to other things. Meanwhile, the firms being regulated continue to take an interest in the activities of the commission and lobby the government for favorable regulations and favorable appointments of individuals to these commissions.

Gross inefficiencies under regulation were not peculiar to the logistics business of trucks and railways but were also true of the Civil Aeronautics Board, which kept out potentially competitive airlines and kept the prices of airfares in the United States high enough to ensure the survival of existing airlines, rather than force them to face the competition of other airlines that could carry passengers cheaper or with better service. Once the CAB was abolished, airline fares came down, and some airlines went bankrupt, but new airlines arose, in the end, there were far more passengers being carried than at any time under the constraints of regulation. Savings to airline passengers ran into billions of dollars.

Anti-trust Laws

With anti-trust laws, as with regulatory commissions, a sharp distinction must be made between their original rationales and what they do. The basic rationale for anti-trust laws is to prevent monopoly and other non-competitive conditions which allow prices to rise above where they would be in a free competitive marketplace. In practice, most of the famous anti-trust cases in the United States have involved some businesses that charged lower prices than their competition. Often it has been complaints from these companies which caused the government to act.

Competition vs. Competitors

The basis of many government prosecutions under the anti-trust laws is that some companies’ actions threaten competition. However, the most important thing about competition is that it is a condition in the marketplace. This condition cannot be measured by the number of competitors existing in a given industry at a given time, though politicians, lawyers, and assorted others have confused the existence of competition with the number of surviving competitors. But competition as a condition is precisely what eliminates many competitors.

Thoroughly the history of anti-trust prosecutions, there has been unresolved confusion between what is detrimental to competition and what is detrimental to competitors.

What has often also been lost sight of is the question of the efficiency of the economy as a whole, which is another way of looking after the benefits of the consuming public.

“Control” of the Market

The rarity of genuine monopolies in the American economy has left much legalistic creativity, to define various companies as monopolistic or as potential or “incipient” monopolies. This was illustrated when the Supreme Court broke up in 1966 a merger between two local supermarket chains which, put together, sold less than 8% of the groceries in the Los Angeles area.

A standard practice in American courts and literature on anti-trust laws is to describe the percentage of sales made by a given company as the share of the market that it “controls”. By this standard, such now-defunct companies as Pan American Airways “controlled” a substantial share of their respective markets, when in fact the passages of time showed that they controlled nothing, or else they would never have allowed themselves to be forced out of business.

Even in the rare case where a genuine monopoly exists on its own – that is, has not been created or sustained by government policy – the consequences in practice have tended to be much less dire than in theory.

Percentages of the market “controlled” by this or that company ignore the role of substitutes that may be officially classified as products of other industries, but which can nevertheless be used as substitutes by many buyers, if the price of the monopolized product rises significantly. Whether in a monopolized or a competitive market, a technologically very different product may be served as a substitute, as television did when it replaced many newspapers as a source of information and entertainment or when “smart phones” that could take pictures provided devastating competition for the simple inexpensive cameras that had long been profitable for Eastman Kodak. 

In 2013, the Department of Justice filed an antitrust lawsuit to prevent the brewers of Budweiser and other beers from buying full ownership of the brewer of Corona beer. Ownership of all the different brands of beer involved would have given the brewers of Budweiser “control” of 46% of all beer sales in the United States, as “control” is defined in anti-trust rhetoric. In reality, the merger would still leave a majority of the beer sold in the country in the hands of other brewers, of which more than 400 new brewers were added the previous year, raising the total number of brewers to an all-time high of 2,751. 

The spread of international free trade means that even a genuine monopoly of a particular product in a particular country may mean little if that same product can be imported from other countries.

Even products that have no functional similarity may nevertheless be substitutes in economic terms. If golf courses were to double their fees, many casual golfers might play the game less often or give it up entirely, and in either case seek recreation by taking more trips or cruises or by pursuing a hobby like photography or skiing, using money that might otherwise have been used for playing golf.

“Predatory” Pricing

According to this theory, a big company that is out to eliminate its smaller competitors and take over its share of the market will lower its prices to a level that dooms the competitor to unsustainable losses, forcing it out of business when the smaller company’s resources run out. Then, having acquired a monopolistic position, the larger company will raise its prices – not just to the previous level, but to new higher levels in keeping with its new monopolistic position. Thus, it recoups its losses and enjoys above-normal profits thereafter, at the expense of the consumers, according to the theory of predatory pricing.

One of the most remarkable things about this theory is that those who advocate it seldom even attempt to provide any concrete examples of when this ever actually happened.

Predatory pricing is more than just a theory without evidence. It is something that makes little or no economic sense. A company that sustains losses by selling below cost to drive out a competitor is following a very risky strategy. The only thing it can be sure of is losing money initially. Whether it will ever recover enough extra profits to make the gamble pay off, in the long run, is problematic. Whether it can do so and escape the anti-trust laws as well is even more problematic – and anti-trust laws can lead to millions of dollars in fines and/or the dismemberment of the company. But even if the would-be predator manages somehow to overcome these formidable problems, it is by no means clear that eliminating all existing competitors will mean eliminating competition.

Even when a rival firm has been forced into bankruptcy, its physical equipment, and the skills of the people who once made it viable do not vanish into thin air. A new entrepreneur can come along and acquire both, perhaps at low distress sale prices for both the physical equipment and the unemployed workers, enabling the new competitor to have lower costs than the old – and hence to be a more dangerous competitor, able to afford to charge lower prices or to provide higher quality at the same price.

Benefits and Costs of Anti-Trust Laws

Perhaps the most positive benefit of American anti-trust laws has been a blanket prohibition against collusion to fix prices. This is an automatic violation, subject to heavy penalties, regardless of any justification that might be attempted. Whether this outweighs the various negative effects of the other anti-trust laws on competition in the marketplace is another question.

The more stringent anti-monopoly laws in India produced many counterproductive results before these laws were eventually repealed in 1991. Some of India’s leading industrialists were prevented from expanding their highly successful enterprises, lest they exceed an arbitrary financial limit used to define a “monopoly” – regardless of f how many competitors that “monopolist” might have. As a result, Indian entrepreneurs often applied their efforts and capital outside of India, providing goods, employment, and taxes in other countries where they were not so restricted. One such Indian entrepreneur, for example, produces fiber in Thailand from a pulp bought in Canada and sent this fiber to his factory in Indonesia for conversation to yarn. He then exported the yarn to Belgium, where it would be made into carpets.

Market and Non-Market Economies

Although business enterprises based on profit have become one of the most common economic institutions in modern industrialized nations and understanding how businesses operate internally and how they fit into the larger economy and society is not nearly as common.

Among the many economically productive endeavors at various times and places throughout history, capitalist businesses are just one. Humans lived thousands of years without businesses. Tribes hunted and fished together. During the centuries of feudalism, neither serfs nor novels were businessmen. Even in more recent centuries, millions of families in America lived on self-sufficient farms, growing their food, building their own houses, and making their clothes. In the days of the Soviet Union, a wholly modern, industrial economy had government-owned and government-operated enterprises doing the same kinds of things that businesses do in a capitalist economy, without in fact being businesses in either their incentives or constraints.

Even in countries where profit-seeking businesses have become the norm, there are many private non-profit enterprises such as colleges, foundations, hospitals, symphony orchestras, and museums, providing various goods and services, in addition to government-run enterprises such as post offices and public libraries. Although some of these enterprises supply goods and services differently from those supplied by profit-seeking businesses, others supply similar or overlapping goods and services.

In short, the activities of profit-seeking and non-profit organizations overlap. So do the activities of some governmental agencies, whether local, national, or international. Moreover, many activities can shift from one of these kinds of organizations to another with time.

Misconceptions about business are almost inevitable in a society where most people have neither studied nor run businesses. In a society where most people are employees and consumers, it is easy to think of businesses as “them” – as impersonal organizations, whose internal operations are largely unknown and whose sums of money may sometimes be so huge as to be unfathomable.

Businesses Versus Non-Market Producers

Since non-market ways of producing goods and services preceded markets and businesses by centuries, if not millennia, the obvious question is. Why have businesses displaced these non-market producers to such a large extent in so many countries around the world?

The fact that businesses have largely displaced many other ways of organizing the production of goods and services suggests that the cost advantages, reflected in prices, are considerable.

In principle, either market or non-market economic activity can be carried on by competing enterprises or by monopolistic enterprises. In practice, however, competing enterprises have been largely confined to market economies, while governments have usually created one agency with an exclusive mandate to do one specific thing.

Monopoly is the enemy of efficiency, whether under capitalism or socialism. The difference between the two systems is that monopoly is the norm under socialism. Even in a mixed economy, with some economic activities being carried out by the government and others being carried out by private industry, the government’s activities are typically monopolies, while those in the private marketplace are typically activities carried out by rival enterprises.

From the standpoint of society as a whole, it is not superior quality or efficiency which are the problem, but inertia and inefficiency. Inertia is common to people under both capitalism and socialism, but the market exacts a price for inertia.

Socialist and capitalist economies differ not only in the quantity of output they produce but also in the quality. The incentives are radically different when the producer has to satisfy the consumer, to serve finically, that when the test of survivability is carrying out product quotas set by the government’s central planners. The consumer in a market economy is going to look not only a quantity but quality. But a central planning commission is too overwhelmed with millions of products they oversee to be able to monitor much more than gross output.

The basic fact is that a business is selling not only a physical product but also the reputation which surrounds that product. The reputation of a company – say McDonald’s – translates into dollars and cents.

When speaking of quality in this context, what matters is the kind of quality that is relevant to the particular clientele being served. What businesses can do is assure quality within the limits expected by their particular customers. Those quality standards often exceed those imposed or used by the government.

While a market economy is essentially an imprest mechanism for allocating resources, some of the most successful businesses have prospered by their attention to the personal element. One of the reasons for the success of the Woolworth retail chain in years past was found in F.W. Woolworth’s insistence on the importance of courtesy to customers. This came to his painful memories of store clerks treating him like dirt when he was a poverty-stricken farm boy who went into stores to buy or look.

What is called “capitalism” might more accurately be called consumerism. It is the customers who call the tune, and those capitalists who want to remain capitalist have to learn to dance to it.

Winners and Losers

Many people who appreciate the prosperity created by market economies may nevertheless lament the fact that particular individuals, groups, industries, or regions of the country do not share fully in the general economic advances, and some may even be worse than before. Political leaders or candidates are especially likely to deplore the inequity of it all and to propose various government “solutions” to “correct” the situation.

Whatever the merits or demerits of various political proposals, what must be kept in mind when evaluating them is that the good fortunes and misfortunes of different sectors of the economy may be closely related to cause and effect – and that preventing bad effects can prevent good effects. It is no coincidence that Smith Corona began losing millions of dollars a year on its typewriters when Dell began making millions on its computers.

During all eras, scarcity implies that resources must be taken from some to go to others if new products and new methods of production are to raise living standards.

Few individuals or businesses are going to want to give up what they have been used to doing, especially if they have been successful at it, for the greater good of society as a whole. But in one way or another, under any economic or political system, they are going to have to be forced to relinquish resources and change what they are doing, if rising standards of living are to be achieved and sustained.

The political temptation is to have the government come to the aid of particular industries, regions, or segments of the population that are being adversely affected by economic changes. But this can only be done by taking resources from those parts of the economy that are advancing and redirecting those resources to those whose products or methods are less productive.

Productivity and Pay

In discussing the allocation of resources, we have so far been concerned largely with animate resources. But people are a key part of the inputs which produce outputs. Most people do not volunteer their labor free of charge, so they must be either paid to work or forced to work since the work has to be done in any case. In many societies of the past, people were forced to work, whether as serfs or slaves. In a free society, people are paid for the tower. But the pay is not just income to individuals. It is also a set of incentives facing everyone working or potentially working, and a set of constraints on employers, so that they do not use the scarce resources of labor as was done in the days of the Soviet Union, keeping extra workers on hand “just in case”, when those workers could be doing something productive somewhere else.

In short, the payment of wages and sal roñéis has an economic role that goes beyond the provision of income to individuals. From the standpoint of the economy as a whole, payment for work is a way of allocating scarce resources which have alternative uses. Labor is a scarce resource because there is always more work to do than there are people with the time to do it all, so the time of those people must be allocated among competing uses of their time and talents.

What determines how much people get paid for their work? Supply and demand. However, that is just the beginning. Why do supply and demand cause one individual to earn more than another?

Workers would like to get the highest pay possible and employers would like to pay the least possible. Only where there is an overlap between what is offered and what is acceptable can anyone be hired.


While the term “productivity” may be used to describe an employee’s contribution to a company’s earnings, this word is often also defined inconsistently in other ways. Sometimes the implication is left that each worker has certain productivity that is inherent in that particular worker, rather than being dependent on surrounding circumstances as well.

In general, the productivity of any input in the production process depends on the quantity and quality of other inputs, as well as its own.

More generally, in almost any occupation, your productivity depends not only on your work but also on cooperating factors,s such as the quality of the equipment, management, and other workers around you.

Whatever the source of a given individual’s productivity, that productivity determines the upper limit of how far an employer will go in bidding for that person’s services. Just as any worker’s value can be enhanced by complementary factors – whether fellow workers, machinery, or more efficient management – so the worker’s value can also be reduced by other factors over which the individual worker has no control.

Even workers whose output per hour is the same can be of very different value if the transportation costs in one place are higher than in another so that the employer’s net revenue from sales is lower where these higher transportation costs must be deducted from the revenue received. Where the same product is produced by businesses with different transportation costs and sold in a competitive market, those firms with higher transportation costs cannot pass those costs along to their customers because competing firms whose costs are not as high would be able to charge a lower price and take their customers away.

Transportation costs, and bribes necessary in corrupt places to continue or produce in certain ways, are some of the costs that companies must swallow to sell the product in a competitive market. They might have the same productivity output as other companies, but these invisible costs of production may be the sole reason why some companies fail in open markets.

Pay Differences

What about the supply? Employers seldom bid as much as they would if they had to because other individuals are willing and able to supply the same services for less.

Wages and salaries serve the same economic function as other prices – that is, they guide the utilization of scarce resources which have alternative uses so that each resource gets used where it is most valued. Yet because these scarce resources are human beings, we tend to look at wages and salaries differently from the way we look at prices paid for other inputs into the production process. Often we ask emotionally powerful questions, even if they are logically meaningless and wholly undefined. For example: are the wages “fair”? Are the workers “exploited”? Is this a “living wage”?

Income “Distribution”

Nothing is more straightforward to understand than the fact that some people earn more than others, for a variety of reasons. Some people are simply older than others, for example, and their additional years have given them opportunities to acquire more experience, skills, formal education, and on-the-job-training – all of which allow them to do a given job more efficiently or to take one more complicated jobs that would be overwhelming for a beginner or someone with only limited experience or training. It is hardly surprising that this leads to higher incomes. It is not uncommon for most of the people in the top 5% of income earners to be 45 old and up.

These and other common sense reasons for income differences among individuals are often lost sight of in abstract discussions of the ambiguous term “income distribution”. Although people in the top income brackets and the bottom income brackets – “the rich” and “the poor” – may be discussed as if they were different classes of people, often they are people at different stages in their lives. Three-quarters of those American workers who were in the bottom 20% in income in 1975 were also in the top 40% at some point over the next 16 years.

This is not unique to the United States. A study in Britain found similar patterns when following thousands of individuals over five years. At the end of the five years, nearly two-thirds of the individuals who were initially in the bottom 10% in income had risen out of that bracket.

People in media and academia often cited typically proceed to forget how age has a major impact on income. Moreover, those who publicize such statistics usually proceed as if they are talking about income differences between classes rather than differences between age brackets. But, while it is possible for people to stay in the same income bracket for life, though they seldom do, it is not equally possible for them to stay in the same age bracket for life. 

Because of the movement of people from one income bracket to another over the years, the degree of income inequality over a lifetime is not the same as the degree of income inequality in a given year. A study in New Zealand found that the degree of income inequality over a working lifetime there was less than the degree of inequality in any given year during those lifetimes.

Describing people in certain income brackets as “rich” is false for a more fundamental reason: income and wealth are different things. No matter how much income passes through your hands in a given year, your wealth depends on how much you have retained and accumulated over the years.

Often the very unions in which income differences are discussed are as misleading as the metaphor. Family income or household income statistics can be especially misleading as compared to invidious income statistics. An individual always means the same thing – one person – but the sizes of families and households differ substantially from one time period to another, from one racial or ethnic group to another, and from one income bracket to another.

Not only do the numbers of people differ considerably between low-income households and high-income households, but the proportions of people who work also differ by very substantial amounts between these households. In the year 2010, the top 20% of households contained 20.6 million households who worked, compared to 7.5 million heads of households who worked in the bottom 20% of households. These striking disparities do not even take into account whether they are working full-time or part-time. When it comes to working full-time year-round, even the top 5% of households contained more heads of households who worked full-time for 50 or more weeks than the bottom 20%. That is, there were more heads of households in absolute numbers – 4.3 million versus 2.2 million – working full-time and year-round in the top 5% of households compared to the bottom 20%.

Today the author is not talking about the idle rich and the toiling poor. Today he is usually talking about those who work regularly and those who, in most cases, do not work regularly, or at all. Under these conditions, the more that pay for work increases the more income inequality increases.

Difference in Skills

Among the many reasons for differences in productivity and pay is that some people have more skills than others. Although workers may be thought of as people who simply supply labor, what most people supply is not just their ability to engage in physical exteriors, but also their ability to apply mental proficiency to their tasks.

In those times and places where physical strength and stamina have been the principal work requirements, productivity and pay have tended to reach their peak in the youthful prime of life, with middle-aged laborers receiving less pay or less frequent employment, or both. A premium on physical strength likewise favored male over female workers.

Today the skills needed for peak performance in most jobs have peaked upwards. In 1951, most Americans reached their peak earnings between 35 and 44 years of age, and people in that age bracket earned 60% more than workers in their early twenties. By 1973, people in the 35 to 44-year-old bracket earned more than double the income of younger workers. Twenty years later, the peak earnings bracket had moved up to people aged 45 to 54 years, and people in that bracket earned more than three times what workers in their early twenties earned.

Meanwhile, the dwindling importance of physical strength also recused or eliminated the premium for male workers in an ever-widening range of occupations. This did not require all employers to have enlightened self-interest. Those who persisted in paying more for male workers who were not correspondingly more productive were at a competitive disadvantage compared to rival firms that go their work done at lower costs by eliminating the male premium, equalizing the pay of women and men to match their productivity.

While the growing importance of skills tended to reduce economic inequalities between the sexes, it tended to increase the inequality between those with skills and those without skills. Moreover, rising earnings in general, growing out of a more productive economy with more skilled people, tended to increase the inequality between those who worked regularly and those who did not.

One of the seemingly most obvious reasons for different individuals (or nations) to live at very different economic levels is that they produce at very different economic levels. As economics grow more technologically and economically complex, and the work less physically demanding, those individuals with higher skills are more in demand and more highly rewarded. The growing disparities between upper-level income brackets and lower-level income brackets are hardly surprising under these conditions.

Job Discrimination

While pay differences often reflect differences in skills, experience, or willingness to do hard or dangerous work, these differences may also reflect discrimination against particular segments of society, such as ethnic minorities, women, lower castes, or other groups.

Sometimes discrimination is defined as judging individuals from different groups by different standards when hiring, paying, or promoting. In its severest form, this can mean refusal to hire at all.

None of this has been peculiar to the United States or the modern era. On the contrary, members of different groups have been treated differently in laws and practices all around the world and for thousands of years of recorded history. It is the idea of treating all individuals the same, regardless of what group they come from, that is relatively recent in historical measures, and by no means universally observed around the world today.

Overlapping with discrimination, and often confused with it, are employment differences based on n substantial differences in skills, experiences, work habits, and behavior patterns from one group to another.

While preferences for some groups and reluctance or unwillingness to hire others have often been described as due to “bias,” “prejudice,” or “stereotypes,” third-party observers cannot so easily dismiss the first-hand knowledge of those who are backing their beliefs by risking their own money. Even the absence of different beliefs about different groups can result in very different proportions of these groups being hired, fired, or promoted. Distinguishing discrimination from differences in qualifications and performance is not easy in practice, though the distinction is fundamental in principle. Seldom do statistical data contain sufficiently detailed information on skills, experience, performance, or absenteeism, much fewer work habits and attitudes, to make a possible comparison between truly comparable individuals from different groups.

Women, for example, have long had lower incomes than men, but most women give birth to children at some point in their lives, and many stay out of the labor force until their children reach an age where they can be put into some form of daycare while their mothers return to work. Those interruptions of their careers cost women workplace experience and seniority, which in turn inhibit the rise of their incomes over the years, relative to that of men who have been working continuously in the meantime.

Similar problems in trying to compare truly comparable individuals make it difficult to determine the presence and magnitude of discrimination between groups that differ by race or ethnicity. It is not uncommon, both in the United States and in other countries, for one radical or ethnic group to differ in age from another by a decade or more.

Much discussion of discrimination proceeds as if employers are free to make whatever arbitrary decisions they wish as to hiring or pay. This ignores the fact that employers do not operate in isolation but in markets. Businesses compete to teach others for employees as well as compete for customers. Mistaken decisions incur costs in both product markets and labor markets and, as we have seen in earlier chapters, the costs of being wrong can have serious consequences. Moreover, these costs vary with conditions in the market.

While it is obvious that discrimination imposes a cost on those being discriminated against, in the form of lost opportunities for higher incomes, it is also true that discrimination can impose costs on those who do the discriminating, were they to lose opportunities for higher incomes. For example, when a landlord refuses to rent an apartment to people from the “wrong” group, that can mean leaving the apartment vacant longer.

This can be applied to the workforce too. If an employer refuses to hire qualified individuals from the “wrong” groups risks leaving his jobs unfilled longer in a free market. However, in a market where wages are set artificially above the level that would exist through supply and demand, the resulting surplus of job applicants can mean that discrimination costs the employer nothing since there would be no delay in filling the job under these conditions.

Empirical evidence strongly indicates that racial discrimination tends to be greater when the costs are lower and lower when the costs are greater.

Capital, Labor, and Efficiency

While everything requires some labor for its production, practically nothing can be produced by labor alone. Farmers need land, taxi drivers need cards, and artists need something to draw on and something to draw with.

Capital complements labor in the production process, but it also competes with employment labor. In other words, many goods and services can be produced either with much labor and little capital or much capital and little labor.

“Efficiency” cannot be meaningfully defined without regard to human desires and preferences.

Europe long regarded American agriculture as “inefficient” because output per acre was much lower in the United States than in much of Europe. The reason was the farmers in the United States labor was more scarce. An American farmer would have to spread himself thinner over far more land and would have correspondingly less time to devote to each acre. In Europe, where land was more scarce, and therefore more expensive, the European farmer concentrated on the more intensive cultivation of what land he could get, spending more time clearing away weeds and rocks, or otherwise devoting more attention to ensuring the maximum output per acre.

Minimum Wage Laws

Minimum wage laws make it illegal to pay less than the government-specified price for labor. By the simplest and most basic economics, a price artificially raised tends to cause more to be supplied and less to be demanded than when prices are left to be determined by supply and demand in a free market. The result is a surplus, whether the price that is set artificially high is that of farm produced or labor.

Making it illegal to pay less than a given amount does not make a worker’s productivity worth that amount – and if it’s not, that worker is unlikely to be employed. Yet minimum wage laws are almost always discussed politically in terms of the benefits they cover for workers receiving those wages.


Since the government does not hire surplus labor the way it buys surplus agricultural output, a labor surplus takes the form of unemployment, which tends to be higher under minimum wage law than in a free market.

Unemployed workers are not surplus in the sense of being useless or in the sense that no workaround needs doing. Most of these workers are perfectly capable of producing goods and services, even if not to the same extent as more skilled or experienced workers. The unemployed are made idle by wage rates artificially set above the level of their productivity.

The minimum wage usually hurt most of those people who are trying to get to an entry-level kind of job to gain the skills and experience necessary to get promoted or transition into another job that requires such skills.

Labor unions also benefit from minimum wage laws and are among the strongest proponents of such laws, events thought their members typically make much more than the minimum wage rate. There is a reason for this. Just as most goods and services can be produced with either much labor and little capital or vice versa, so can most things be produced using varying proportions of low-skilled labor and high-skilled labor, depending on their respective costs, relative to one another. Thus experienced unionized workers are competing for employment against younger, inexperienced, and less skilled workers, whose pay is likely to be at or near the minimum wage. The higher the minimum wage goes, the more unskilled and inexperienced workers are likely to be displaced by more experience and higher-skilled unionized workers.

Just as businesses seek to have government impose tariffs on imported goods that competed with their products, so labor unions use minimum wage laws as tariffs to force up the price of non-union labor that competes with their members for jobs.

It would be comforting to believe that the government can simply degree higher pay for low-wage workers, without having to worry about unfortunate repercussions, but the preponderance of evidence indicates that labor is not exempt from the basic economic principle that artificially high prices cause surpluses. In the case of surplus human beings that can be a special tragedy when they are already from low-income, unskilled, or minority backgrounds and urgently need to get on the job ladder, if they are to move up the ladder by acquiring experiences and skills.

Unemployment varies not only in the quantity of a given time, but it varies also in how long workers remain unemployed. Like the unemployment rate, the duration of unemployment varies considerably from country to country. Countries that drive up labor costs with either high minimum wages or generous employee benefits imposed on employers by law, or both, tend to have longer-lasting unemployment, as well as higher rates of unemployment.

Informal Minimum Wages

Sometimes a minimum wage is imposed not by law, but by customs, informal government pressures, labor unions, or – especially in the case of Third World countries – by international public opinion or boycotts pressuring multinational companies to pay Third World workers wages comparable to the wages usually found in more industrially developed countries.

It is not at all clear that workers as a whole are benefitted from artificially high wage rates in the Third World. Employed workers – those on the inside looking out – obviously benefit, while those on the outside looking in lose. For the population as a whole, including consumers, it would be hard to make a case that there is a net benefit since there are fewer consumer goods when people who are willing to work cannot find jobs producing those consumer goods.

Just as a price set by the government below the free market level tends to cause quality deterioration in the product that is being sold because a shortage means that buyers will be forced to accept things of lower quality than they would have otherwise, so a price set above the free market levels tend to cause a rise in average quality, as the surplus allows the buyers to cherry-pick and purchase only the better quality items. What that means in the labor market is that job qualification requirements are likely to rise and that some workers who would ordinarily be hired in a free market may become “unemployable” when there are minimum wage laws. Unemployability, like shortages and surpluses, is not independent of price.

Differential Impact

People differ in many ways. Those who are unemployed are not likely to be a random sample of the labor force. In country after country around the world, those whose employment prospects are reduced most to minimum wage laws are those who are younger, less experienced, or less skilled.

In Australia, the lowest unemployment rate for workers used there at the age of 25, during the entire period from 1978 to 2002, never fell below 10%, while the highest unemployment rate for the population in general barely reached 10% once during the same period. Australia has an unusually high minimum wage, relative speaking, since its minimum wage level is nearly 60% of that country’s median wage rate, while the minimum wage in the United States has been less than 40% of the American median wage rate. 

Another group disproportionately affected by minimum wage laws is members of unpopular racial or ethnic minority groups. Indeed, minimum wage laws were once advocated explicitly because of the likelihood that such laws would reduce or eliminate the competition of particular minorities, whether they were Japanese in Canada during the 1920s or blacks in the United States and South Africa.

Special Problems in Labor Markets

Unemployment Statistic

The unemployment rate is a very important statistic, as an indicator of the health of the economy and society. But it’s also important to know the limitations of such statistics.

Human beings have volitions and make choices, unlike inanimate factors of production, many people choose not to be in the labor force at a given time and place. They may be students, retired people, or housewives who work in their own homes, taking care of their families, but are not on any employee’s payroll. Those people who are officially counted as unemployed are people who are in the labor force, seeking employment but not finding it.

The unemployment rate is based on what percentage of people who are in the labor force who are not working. However, people’s choices as to whether or not to be in the labor force at any given time mean that unemployment rates are not wholly objective data,b they vary with choices made differently under different conditions, and vary from country to country.

Although the unemployment rate is supposed to indicate what proportion of the people in the labor force do and do not have jobs, sometimes the unemployment rate goes down while the number of people without jobs is going up. The reason is that a prolonged recession or depression may lead some people to stop looking for a job, after many long and futile searches. Since such people are no longer counted as being in the labor force, their exodus will reduce the unemployment rate, even if the proportion of people without jobs has not been reduced at all.

Such transacted unemployment must be distinguished from long-term unemployment.

One form of Jen politeness that has long stirred political emotions and led to economic fallacies is technological unemployment. Virtually every advance in technological efficiency puts somebody out of work. This is nothing new:

By 1830 Barthelemy Thimonnier, a French tailor who had long been obsessed with the idea had patented and perfected an effective sewing machine. When eight of his machines were making uniforms for the French army, Paris tailors, alarmed at the threat to their jobs, smashed the machines and drive Thimonnier out of the city.

Working Conditions

Both government and labor unions have regulated working conditions, such as the maximum hours of work power week, safety rules, and various amenities to make the job less stressful or more pleasant.

The economic effects of regulating working conditions are very similar to the effects of regulating wages, because better working conditions, like higher wage rates, tend to make a given job both more attractive to the worker and more costly to the employer. Moreover, employers take these costs into account thereafter, when deciding how many workers they can afford to hire when there are higher costs per worker, as well as how high they can afford to bid for workers since money spent creating better working conditions is the same as money spent for higher wage rates per hour.

Other things being equal, better working conditions mean lower pay than otherwise, so workers are in effect buying improved conditions on the job. Employers may not cut pay whenever working conditions are improved but, when rising workers’ productivity leads to rising pay scales through competition among employers for workers, those pay scales are unlikely to rise as much as they would have if the costs of better working conditions did not have to be taken into account. That is, employers’ bids are limited not only by the productivity of the workers but also by all the other costs besides the ratepayers.

While it is always politically tempting for gong rents to mandate benefits for workers, to be paid by employers the economic repercussions seldom receive much attention from either the politicians who created such mandates or from the voting public. But one of the reasons why the unemployed may not being to be hired as output increases, such as when an economy is rising out of a recession, is that working the existing worker overtime may be cheaper for the employer than hiring new workers.

That is because an increase in working hours from existing employees does not require paying for additional mandated benefits, as hiring new workers would. Despite higher pay required for overtime hours, it may in many cases still be chapters to work the existing employees longer, instead of hiring new workers.

Because working conditions were often worse in the past – fewer safety precautions, longer hours, more unpleasant and unhealthy surroundings – some advocates of externally regulated working conditions, whether regulated by government or unions, argue as is working conditions would never have improved otherwise. But wage rates were much lower in the past, and yet they have risen in both unionized and non-unionized occupations, and in occupations covered and those not covered by minimum wage laws.

Safety Laws

While safety is one aspect of working conditions, it is a special aspect because, in some cases, leaving its costs and benefits to be weighed by employers and employees leaves out the safety of the general public that may be affected by the actions of employers and employees.

Hours of Work

One of the working conditions that can be quantified is the length of the work week. Most modern industrial countries specify the maximum number of hours per week that can be worked, either absolutely or before the employer is forced by law to pay higher rates for overtime work beyond those specified hours. This imposed work week varies from country to country. France, for example, specified 35 hours as the standard work week, with employers being mandated to continue to pay the same amount for this shorter work week as they had paid in weekly wages before. In addition, French law requires employers to be given 25 days of paid vacation per year, plus paid holidays – neither of which are required under American law.

Given these facts, it is hardly surprising that the average number of hours worked annually in France is less than 1,500 compared to more than 1,800 in the United States and Japan. The extra 300 or more hours a year worked by American workers affects annual output and therefore the standard of living.

Third World Countries

Some of the worst working conditions exist in some of the hate poorest countries – that is, countries where the workers could least afford to accept lower pay as the price of better surroundings or circumstances on the job. Multination companies with factories in the Third World often come under severe criticism in Europe or America for having working conditions in those factories that would not be tolerated in their own countries. What this means is that more prosperous workers in Europe or America in effect buy better working conditions, just as they are likely to buy better housing and better clothing than people in the Third World can afford. If employers in the Third World are forced by law or public pressure to provide better working conditions, the additional expense reduces the number of workers hired, just as wage rates are higher than would be required by supply and e and left many Africans frustrated in their attempts to get jobs with multinational companies.

However much the jobs provided by multinational companies to Third World workers might be disdained for their low pay or poor working conditions by critics in Europe and the United States, the real question for workers in poor countries is how these jobs compare with their local alternatives.

Would it not be even better if workers in Third World could be paid what workers in Europe or America are paid, and work under the same kinds of conditions found in their jobs? Of course, it would. The real question is: how can her productivity be raised to the same level as that of workers in Europe and the United States?

This does not mean that workers in the Third World are doomed forever t low wages and bad working conditions. On the contrary, to the extent that more and more multinational companies locate in poor countries, working conditions, as well as productivity and pay, are affected when increasing numbers of multinationals compete for labor that is increasingly experienced in modern production methods.

Collective Bargaining

Employer Organizations

In earlier centuries, it was the employers who were more likely to be organized and set pay and working conditions as a group. In medieval guilds, the master craftsmen collectively made the rules determining the conditions under which apprentices and journeymen would be hired and how much customers would be charged for the products. Today, Major League Baseball owners collectively make the rules as to what is the maximum total salaries that any given team can pay to its players without incurring financial penalties from the leagues.

Pay and working conditions tend to be different when determined collectively than in a labor market where employers compete against one another individually for workers and workers compete against one another individually for jobs. It would not be worth the trouble of organizing employers if they were not able to gain by keeping the salaries they pay lower than they would be in a free market.

Almost by definition, all these organizations exist to keep the price of labor from being what it would be otherwise in free and open competition in the market. Just as market competition tends to base rates of pay open the productivity of the worker, thereby bidding labor way from where it is less productive to where it is more productive, so organized efforts to make wages artificially low or artificially high defeat this process and thereby make the allocations of resources less efficient for the economy as a whole.


Usually, those who decry “exploitation” make no serious attempt to define it, so the word is often used simply to condemn either prices that are higher than the observer would like to see or wages lower than the observer would like to see.

The general idea behind “exploitation” theories is that some people are somehow able to receive more than enough menos to compensate for their contributions to the production and distribution of output, by either charging more than is necessary to consumers or paying less than is necessary to employees.

As we have seen before, earning a rate of return on investment that is great than what is required to compensate people for their risks and contributions to output is virtually guaranteed to attract other people who wish to share in this bounty by either investing in existing firms or setting up their new firms. This in turn virtually guarantees that the above-average rate of return will be driven back down by increased competition caused by expanded investment and production whether by existing firms or by new firms. Only when there is some way to prevent this new competition can the above-average earnings on investment persist.

Governments are among the most common and most effective barriers to entry of new competition.

The purpose of the net effect of barriers to entry has been a persistence of a level of earnings higher than that which would exist under free market competition and higher than necessary to attract the resources required. This could legitimately be considered “exploitation” of the consumers since it is a payment over and beyond what is necessary to cause people to supply the product or service in question.

While such situations could legitimately be called exploitation – defined as prices higher than necessary to supply the goods or services in question – these are not usually the kinds of situations that provoke that label. It would also be legitimate to describe as exploitation a situation where people are paid less for their work than they would receive in a free market or less than the amount necessary to attract a continuing supply of people with their levels of skills, experience, and talents. However, such situations are far more likely to involve people with high skills and high incomes than people with low skills and low incomes.

In some situations, people in a given occupation may be paid less currently than the rate of pay necessary to con in a tube to attract a sufficient supply of qualified people to that occupation. Doctors are a good example of that.

Low-paid workers can also be exploited in circumstances where they are unable to move, or where the cost of moving would be high, whether because of transportation costs or because they live in government-subsidized housing that they would lose if they moved somewhere else, where they would have to pay market prices for a home or an apartment, at least while being on waiting lists for government-subsidized housing at their new location.

Where there is only one employer for a particular kind of labor, then of course that employer can set pay scales that are lower than what is required to attract new people into the occupation. But this is more likely to happen to highly specialized and skilled people, such as astronauts, rather than to unskilled workers since unskilled workers are employed by a wide variety of businesses, government agencies, and even private individuals.

Once we see that barriers to entry or exit are key, then the term exploitation is often legitimately applied to people very different from those to whom this term is usually applied. It would also apply to businesses that have invested large amounts of fixed and hard-to-remove capital at a particular location. A company that builds a hydroelectric dam, for example, cannot move that dam elsewhere if the local government doubles or triples its tax rates or requires the company to pay a much higher wage rate to its workers than similar workers receive elsewhere in a free market.

Whether the term “exploitation” applies or does not apply to a particular situation is not simply a matter of semantics. Different consequences follow when policies are based on a belief that is false instead of true beliefs.

Job Security

In some countries – France, Germany, India, and South Africa – job security laws make it difficult and costly for private employers to fire anyone. Labor unions try to have job security policies in many industries and many counties around the world.

The obvious purpose of job security laws is to reduce unemployment but that is very different from saying that it is the actual effect of such a law. Countries with strong job security laws typically do not have lower unemployment rates, but instead have higher unemployment rates, than countries without widespread job protection laws.

The very thing that makes a modern industrial society so efficient and so effective in raising living standards – the constant quest for newer and better ways of getting work done and more goods produced – makes it impossible to keep on having the same workers doing the same jobs in the same way.

In Europe, where job security laws and practices are much stronger than in the United States, jobs have been harder to come by. During the decade of the 1990s, the United States created jobs at triple the rate of industrial nations in Europe. In the private sector, Europe lost jobs, and only its increased government employment led to any net again at all. This should not be surprising. Job security laws make it more expensive to hire workers – and, like anything else that is made more expensive, labor is less in demand at a higher price than at a lower price. Job security policies save the jobs of existing workers, but at the cost of reducing the flexibility and efficiency of the economy as a whole, thereby inhibiting the production of the wealth needed for the creation of new jobs for other workers.

Because job security laws make it risky for private enterprises to hire new workers, during periods of rising demand for their products existing employees may be worked overtime instead, or capital may be substituted for labor, such as using huge buses instead of hiring more drivers for more regular-sized buses. However it is done, increase substitution of capital for labor leaves other workers unemployed.

Occupational Licensing

Job security laws and minimum wage laws are just some of the hate ways in which government intervention in labor markets makes those markets differ from what they would be under free competition. Another way that government intervention changes labor markets is through laws requiring a government-issued license to engage in some occupations. One cannot be a physician or an attorney without a license, for the obvious reason that people without the requisite training and skills would be perpetrating a dangerous fraud if they sought to practice in these professions. However, once the government has a rationale for exercising a particular power that power can be extended to other circumstances far removed from that rationale. That has been the history of occupational licensing.

Although the rationale for requiring licensees in particular occupations has usually been to protect the public from various risks created by unqualified or unscrupulous practitioners, the demand for such protection has seldom come from the public. Almost invariable the demand for requiring a license has come from existing practitioners in a particular occupation. That the real goal is to protect themselves from the competition is suggested by the fact that it is common for occupational licensing legislation to exempt existing practitioners, who are automatically licensed, as if it can be assumed that the public requires no protection from incompetent or dishonest practitioners already in the occupation.

Occupation licensing can take many forms. In some cases, the license is automatically issued to all the applicants who can demonstrate competence in the particular occupation, with perhaps an additional requirement of a clean record as a law-abiding citizen. In other cases, there is a numerical limit placed on the number of licenses to be issued, regardless of how many qualified applicants there are.


Some people may think of investment as simply a transaction with money. But, more broadly and more fundamentally, it is the sacrificing of real things today to have more real things in the future.

For society as a whole, investment is more likely to take the form of foregoing the production of some consumer goods today so that the labor and capital that would have been used to produce those consumer goods will be used instead to produce machinery and factories that will cause future production to be greater than it would be otherwise.

Because the future cannot be known in advance, investments necessarily involve risks, as well as the tangible things that are invested. These risks must be compensated if investments are to continue.

The repaying of investment is not a matter of morality, but economics. If the return on investments is not enough to make it worthwhile, fewer people will mark that particular investment in the future, and future consumers will therefore be denied the use of the goods and services that would otherwise have been produced.

No one is under any obligation to make all investments pay off, but how many need to pay off, and to what extent, is determined by how many consumers value the benefits of other people’s investments, and to what extent.

Where the consumers do not value what is being produced, the investment should not pay off. When people insist on specializing in a field for which there is little demand, their investment has been a waste of scarce resources that could have produced something else that others wanted.

The principles of investment are involved in activities that do not pass through the marketplace and are not normally thought of as economic. Putting things away after you use them is an investment of time in the present to reduce the time required to find them in the future.

Kinds of Investments

Human Capital

While human capital can take many forms, there is a tendency for some to equate it with formal education. However, not only may many other valuable forms of human capital be overlooked this way, the value of formal schooling may be exaggerated and its counterproductive consequences in some cases not understood.

The industrial revolution was not created by highly educated people but by people with practical industrial experience. The airplane was invented by a couple of bicycle mechanics who had never gone to college. Electricity and many inventions run by electricity became central parts of the modern world because of a man with only three months of formal schooling, Thomas Edison. Yet all these people had enormous valuable knowledge and insight – human capital – acquired from expertise rather than in classrooms.

Education has of course also made major contributions to economic development and rising standards of living. But this is not to say that all kinds of education have. From an economic standpoint, some education has great value, some have no value and some can even have negative value while it is easy to understand the great value of specific skills in medical science or engineering, for example, or the more general foundation for several professions provided by mathematics, other subjects such as literature make no pretense of producing marketable skills but are available for whatever they may contribute in other ways.

In counties where education or higher levels of education are new or rare, those who have obtained diplomas or greeters may feel that many kinds of work are now beneath them. In such societies, even engineers may prefer sitting at a desk to standing in the mud in hip boots at the construction site. Depending on what they have studied, the newly educated may have higher levels of expectations that they have higher levels of ability to create the wealth from which their expectations can be met.

In the Third World especially, those who are the first members of their families to reach higher education typically do not study difficult and demanding subjects like science, medicine, or engineering, but instead tend toward easier and fuzzier subjects which provide them with little in the way of marketable skills – which is to say, a skill that can create prosperity from themselves or their country.

Large numbers of young people with schooling, but without economically meaningful skills, have produced much unemployment in Third World nations. Since the marketplace has little to offer such people that would be commensurate with their expectations, governments have created swollen bureaucracies to hire them, to neutralize their potential for political disaffection, civil unrest, or insurrection. In turn, these bureaucracies and the voluminous and time-consuming red tape they generate can become obstacles to others who do have the skills and entrepreneurship needed to contribute to the country’s economic advancement.

In short, more schooling is not automatically more human capital. It can in some cases reduce a country’s ability to use the human capital that it already possesses. Moreover, to the extent that some social groups specialize in different kinds of education, have different levels of performance as students, or attend education institutes of differing quality, the same number of years of schooling does not mean that the same education is in any economically meaningful sense.

Financial Investments

When millions of people invest money, what they are doing more fundamentally is foregoing the use of currency goods and services, which they have the money to buy, in hopes that they will receive back more money in the future. From the standpoint of the economy as a whole, investments mean that many resources that would otherwise have gone into producing currency consumer goods like clothing, furniture, or pizzas will instead go into producing goods and services. Money totals give us some idea of the magnitude of investments but the investments themselves are ultimately additions to the real capital of the country, whether physical capital or human capital. 

Investments may be directed by individuals who buy corporate stock, for example, supplying corporations with money now in exchange for a share of additional future value that these corporations are expected to add by using the money productively.

Much investment, however, is by institutions such as banks, insurance companies, and pension funds. Financial institutions around the world owned a total of $60 trillion in investments in 2009, of which American institutions owned 45%.

The staggering sums of money owned by various investment institutions are often a result of aggregating individually modest sums of money from millions of people, such as stockholders in giant corporations, depositors in savings banks, or workers who pay modest regular amounts into pension funds.

Financial institutions allow vast numbers of individuals who cannot possibly all know each other personally to nevertheless use one another’s money by going through some intermediary institution that assumes the responsibility of assessing risk, taking precautions to reduce those risks, and making transfers through loans to individuals or institutions, or by making investments in businesses, real estate or other ventures.

Financial intermediaries not only allow the pooling of money from innumerable individuals to finance huge economic undertakings by businesses, but they also allow individuals to redistribute their consumption over time. Borrowers in effect draw on future income to pay for currency purchases, paying interest for convenience. Conversely, savers postpone purchases till a later time, receiving interest for the delay.

In short, from the standpoint of society as a whole, present goods and services are sacrificed for the sake of future goods and services. Only where those future goods and services are more valuable than the present goods and services that are being sacrificed will financial institutions be able to receive a rate of return on their investments that will allow them to offer a high enough rate of return to innumerable individuals to induce those individuals to sacrifice their current consumptions by supplying the savings required.

With financial intermediaries as with other economic institutions, nothing shows their function more clearly than seeing what happens when they are not able to function. A society without well-functioning financial institutions has fewer opportunities to generate greater wealth over time. Poor contours may remain poor, despite having an abundance of natural resources, when they have not yet developed the complex financial institutions required to mobilize the scattered saving of innumerable individuals, to be able to make the large investments required to turn natural resources into usable output.

Financial institutions not only transfer resources from one set of consumers to another and transfer resources from one use to another, but they also create wealth by joining the entrepreneurial talents of people who lack money to the savings of many others, to finance new firms and new industries.

It is not that wealth is not there in less developed economies. The problem is that their wealth cannot be collected from innumerable small sources, concentrated, and then allocated in large amounts to particular entrepreneurs, without financial institutions equal to the complex task of evaluating risks, markets, and rates of return.

The complexity of financial institutions means that relatively few people are likely to understand them – which makes them vulnerable politically to critics who can depict their activities as sinister. Many unthinking people in many countries and many periods of history have regarded people in financial activities as not “really” contributing anything to the economy, and have regarded the people who engage in such financial activities as mere parasites.

This is especially so at a time when most people engage in hard physical labor in agriculture or industry and were both suspicious and resentful of people who simply sat around handling pieces of paper while producing nothing that could be seen or felt.

Those with such misconceptions have often been surprised to discover economic activity and the standard of living dealing in the wake of their departure.

Returns of Investment

The delayed reward for costs incurred earlier is a return on investment, whether these rewards take the form of dividends pain in corporate stock, or increases in income resulting from having gone to college or medical school. One of the largest investments in people’s lives consists of the time and energy expended over years in raising their children.

“Unearned Income”

Although making investments and receiving the delayed return on those investments takes many forms and has been going on all over the world throughout the history of the human race, misunderstanding of this process has also been long trading and widespread. Sometimes these delayed benefits are called “unearned” income, simply because they do not resent rewards for contributions made during the current period. Investments that build a factor may not be repaired until years later after workers and managers have been hired and products manufactured and sold.

What can be seen physically is always more vivid than what cannot be seen. Those who watch a factor in operation can see the workers creating a product before their eyes. They cannot see the invention which made that factory possible in the first place. Risks are invisible, even when they are present risks, and the past risks surrounding the initial creation of the business are readily forgotten by observers who see only a successful enterprise after the fact.

It is easy to regard the visible factors as the sole or most important factor, even when other businesses with those same visible factors went bankrupt, while an expertly managed enterprise in the same industry flourished and grew. Many laws and government economic policies have been based on these misunderstandings. Elaborate ideologies and mass movements have also been based on the notion that only the workers “really” create wealth, while others merely skim off profits, without having contributed anything to produce the wealth which they unjustly share.

Misconceptions about money leading often take the form of laws attempting to help borrowers by giving them more leeway in repaying loans. But anything that makes it difficult to collect a debt when it is due makes it less likely that loans will be made in the first place, or will be made at the lower interest rates that would prevail in the basemen of such debtor-protection policies by governments.

Investment and Allocation

Interest, as the price paid for investment funds, plays the same allocation role as the other prices in bringing supply and demand into balance. When interest rates are low, it is more profitable to borrow money to invest in building houses or modernizing a factory, or launching other economic ventures. On the other hand, low-interest rates reduce the incentives to save. Higher interest rates lead more people to save more money but lead fewer investors to borrow that money when borrowing is more expensive. As with support and demand for products in general, imbalances between supply and demand for money lead to rises or falls in the price – in this case, the interest rate.

In the real world as it is, interest rate fluctuations, like price fluctuations in general, constantly redirect resources in different directions as technology, demand, and other factors change. Because interest rates are symptoms of an underlying reality, and of the constraints inherent in that reality, laws or government policies that change interest rates have repercussions far beyond the purpose for which the interest rate is changed,d with reverberations through the economy.

Not everything that is called interest is in fact interest, however. When loans are made, for example, what is charged as interest includes not only the rate of return necessary to compensate for the time delay in receiving the money back, but also an additional amount to compensate for the risk that the loan will not be repaid, or repaid on time, or repaid in full.  What is called interest also includes the costs of processing the loan. With small loans, especially, these process costs can become a significant part of what is charged because process costs do not vary as much as the amount of the loans vary. In other words, process costs on small loans can be a larger share of what is loosely called interest.

The lower the interest rate ceiling, the more reliable the borrowers would have to be, to make it pay to lend to them. At a sufficiently low-interest rate ceiling, it would pay to lend only to millionaires and, at a still lower interest rate ceiling, it would pay to lend only to billionaires. Since different ethnic groups have different incomes and different average credit scores, interest rate ceilings virtually guarantee that there will be disparities in the proportions of these groups who are approved for mortgage loans, credit cards, and other forms of lending.


Most market transactions involve buying things that exist, based on whatever value they have to the buyer and whatever price is charged by the seller. Some transactions, however, involved buying things that do not yet exist or whose value has yet to be determined – or both. For example, the price of a stock in the internet company rose for years before the company made its first dollar of profits.

One of the professional speculator’s main roles is in relieving other people from having to speculate as part of their regular economic activity, such as in the farming example, where both the weather during the growing season and the prices at harvest time are unpredictable. Speculations are one way of having some people specialize in bearing these risks, for a price. For such a transaction to take place, the cost of the risk being transferred from whoever initially bears that risk must be greater than what is charged by whoever agrees to take on the risk. At the same time, the cost of whoever takes on that risk must be less than the price charged.

In other words, the risk must be reduced by this transfer, for the transfer to make sense to both parties. The reason for the speculator’s lower cost may be more sophisticated methods of assessing risk, a larger amount of capital available to ride out short-run losses, or because the number and variety of the speculator’s risks lower his overall risk. No speculator can expect to avoid losses on particular speculations but, so long as the gains exceed the losses over time, speculations can be viable businesses.

Speculation is often misunderstood as being the same as gambling, when in fact it is the opposite of gambling. What gambling involves, whether in games of chance or in activities like playing Russian roulette, is creating a risk that would otherwise not exist, in order either to profit or to exhibit one’s skill or lack of fear. What economic speculation involves is pacing with inherent risks in such a way as to minimize them and to leave them to be borne by whoever is best equipped to bear them.

Although speculators seldom make a profit on every transaction, they must come out ahead in the long run, to stay in business. From the standpoint of the economy as a whole, competition determines what the price will be and therefore what the speculator’s profit will be. If that print exceeds what it takes to entice investors to risk their money in this volatile field, more investments will flow into this segment of the market until competition drives profits down to a level that just compensates the expenses, efforts, and risks.


Inherent risks must be dealt with by the economy not only through economic speculation but also by maintaining inventories. Put differently, inventories are substituted for knowledge. No food would ever be thrown out after a meal if the cook knew beforehand exactly how much each person would eat and could therefore cook just that amount. Since inventory costs money, a business enterprise must try to limit how much inventory it has on hand, while at the same time not risking running out of their product and thereby missing sales.

Having either too large or too small inventory means losing money. Those businesses which come closest to the optimal size to inventory will have their profit prospects enhanced. More importantly, the total resources of the economy will be allocated more efficiently, not only because each enterprise has an incentive to be efficient, but also because those firms which turn out to be right more often are more likely to survive and continue making such decisions, while those who repeatedly carry far too large an inventory, or far too small, are likely to disappear from the market through bankruptcy.

Inventory is related to knowledge and risk in another way. In normal times, each business tends to keep a certain ratio of inventory to its sales. However, when times are more uncertain, such as during a recession or depression, sales may be made from existing inventories without producing replacements.

Present Value

Although many goods and services are bought for immediate use, many other benefits come in a stream over time, whether as a season ticket to baseball games or an annuity that will make monthly pension payments to you after you retire. The implications of present value affect economic decisions and their consequences, even in areas that are not normally thought of as economic, such as determining the number of natural resources available for future generations.

Prices and Present Values

The “present value” of assets is nothing more than its anticipated future benefits, added up and discounted for the fact that they are delayed. Your home, business, or farm may be functioning no better than your neighbor’s today, but if the prospective tool of wear and tear on your property over time is reduced by installing heavier pipes, stronger woods, or other more durable building materials, then your property’s market value will immediately be worth more than that of your neighbor, even if there is no visible difference in the way they are functioning today.

Present value links the future to the present in many ways. It makes no sense for a ninety-year-old man to be planting fruit trees that will take 20 years before they reach their maturity because his land will immediately be worth more as a result of those trees.

One of the big differences between economics and politics is that politicians are not forced to pay attention to future consequences that lie beyond the next election. An elected official whose policies keep the public happy through Election Day stands a good chance of being voted in another time in office, even if those policies will have ruinous consequences in later years. There is no “present value” to make political decision-makers today take future consequences into account when those consequences will come after Election Day.

Natural Resources

Present value profoundly affects the discovery and use of natural resources. There may be enough oil underground to last for centuries or millennia, but its present value determines how much oil will repay what it costs anyone to discover it at any given time – and that may be no more than enough oil to last for a dozen or so years. A failure to understand this basic economic reality has, for generations, led to numerous and widely publicized false predictions that we were “running out” of petroleum, coal, or some other natural resource.

Just as shortages and surpluses are not simply a matter of how much physical stuff there is, either absolutely or relative to the population, so known reserves of natural resources are not simply a matter of how much physical stuff there is in the ground. For natural resources as well, prices are crucial. So are present values.

How much of any given natural resource is known to exist depends on how much it costs to know.

Stocks, Bonds, and Insurance

Risks inherent in economic activities can be dealt with in a wide variety of ways. In addition to commodity speculation and inventory management, other ways of dealing with risk include stocks and bonds. There are also other economic activities analogous to stock and bonds which deal with risks in ways that are legally different, though similar economically.

Whenever a home, a business, or any other asset increases in value over time, that increase is called “capital gain.” While it is another form of income, it differs from wages and salaries in not being paid right after it is earned, but usually only after some years. If you never sell your home, then whatever increase in value it has will be called an “unrealized capital gain.”

Sometimes a capital gain comes from a purely financial transaction, where you simply pay someone a certain amount of money today to get back a somewhat larger amount of money later on.

However it is done, this is trade-oof of money today for money in the future. The fact that interest is paid implies that money today is worth more than the same amount of money in the future. How much more depends on many things and varies from time to time, as well as from country to country.

Inflation, which is just one varying risk, is reflected in varying risk premiums added to the underlying pure interest rate, which is a payment for postponed repayment.

To give an example, how much would a $10,000 bond that matures an ear from now be with you today? It would not be worth $10,000 because future money is not as valuable as the same amount of present money. You would rather have the same amount of money right now rather than later.

What this says is that the same nominal amount of money has different values, depending on how long you must wait to receive it. At a sufficiently high-interest rate, you might be willing to wait decades to get your money back.

Somewhere in between is an interest rate at which you would be indifferent between lending money or keeping it. At that interest rate, the present value of a given amount of future money is equal to some smaller amount of present money. For example, if you are indifferent at 4%, then 100 dollars today is worth $104 a year for now to you. Any business or government agency that wants to borrow $100 from you today with a promise to pay you back a year from now will have to make that repayment of at least $104.

Lets us return to the question of how much you would be willing to bid for a $10,000 bond that matures a year from now. With an interest rate of 5% being available in the economy as a whole, it would not pay you to bid more than $9,523.81 for a $10,000 bond that matures a year from now. By inspecting that same amount of money somewhere lost today at 5%, you could get back $10,000 in a year. Therefore, there is no reason for you to bid more than $9,523.81 for the $10,000 bond.

This raises questions about the taxation of capital gains. If someone buys a bond for the former price and sells it a year later for the latter rice, the government will of course want to tax the $476.19 difference. But is that the same as an increase in value, if the two sums of me only are just equivalent to one another? What if there has been a one percent inflation so that the $10,000 received back would have been enough to compensate for waiting if the investor had expected inflation to reduce the real value of the bond? What if there had been a 5% inflation, so that the amount received back was worth no more than the amount originally lent, with no reward at all for waiting for the postponed repayment?

These are just some of the considerations that make the taxation of capital gains more complicated than the taxation of such other forms of income as wages and salaries.

Variable Returns Versus Fixed Returns

Stocks Versus Bonds

Bonds differ from stocks because bonds are legal commitments to pay a fixed amount of money on a fixed date. Stocks are simply shares of a business that issues them, and there is no guarantee that the business will make a profit in the first place, much less pay out dividends instead of re-investing their profits in the business itself. Bondholders have a legal right to be paid what they were promised whether the business is making money or losing money. In that respect, they are like the business’ employees, in how fixed commitments have been made as to how much they would be paid per hour or week, or month.  They are legally entitled to those amounts, regardless of whether the business is profitable or unprofitable.

Risk and Time

Risk is always specific to the time at which a decision is made. Risk always involves looking forward, not backward. During the early, financially shaky years of McDonald’s, the company was desperate for cash at one point that its founder, Ray Kroc, offered to sell half interest in McDonald’s for $25,000 – and no one accepted his offer. If anyone had, that person would have become a billionaire over the years. But, at the time, it was either foolish for Ray Kroc to make that offer or for others to turn it down.

The relative safety and profitability of various kinds of investments also depend on your knowledge. An expert in financial transactions may grow rich speculating in gold, while people of more modest knowledge are losing big. However, with gold, you are unlikely to be completely wiped out, since gold always has a value for jewelry or industrial uses, while any given stock can end up not worth the paper it is written on.

Investing in Human Capital

Investing in human capital is in some ways similar to investing in other kinds of capital and some ways different. People who accept jobs with no pay, or with pay much less than they could have gotten elsewhere, are in effect investing their working time, rather than money, in hopes of a larger future return than they would get by accepting a job that pays a higher salary initially. But, when someone invests in another person’s human capital, the return on this investment is not as readily recovered by the investor.


Many things are called “insurance” but all those things are in fact insurance. After first dealing with the principles on which insurance has operated for centuries, we can then see the difference between insurance and various other programs which have arisen in more recent times and have been called “insurance” in political rhetoric.

Insurance in the Marketplace

Like commodity speculators, insurance companies switch to inherent and inescapable risks. Insurance both transfers and reduces those risks. In exchange for the premium paid by its policy-holder, the insurance company assumes the risks of compensating for losses caused by automobile accidents, houses catching fire, earthquakes, hurricanes, and numerous other misfortunes that befall human beings.

In addition to transferring risks, an insurance company seeks to reduce them. For example, it charges lower prices to safe drivers and refuses to insure some homes until brush and other flammable materials near a house are removed. People working in hazardous occupations are charged higher premiums. In a variety of ways, insurance companies segment the population and charge different prices to people with different risks. That way it reduces its overall risks and, in the process, sends a signal to people working in dangerous jobs or living in dangerous neighborhoods, conveying to them the costs created by their chosen activity, behavior, or location.

Insurance companies do not simply save the premiums they receive and later pay them out when the time comes. In 2012, for example, more than half the current premiums on homeowners’ insurance were paid out in current claims – 60% by State Farm and 53% by Allstate. Insurance companies can then invest what is left over after paying claims and other costs of doing business. Because of these investments, the insurance companies will have more money available than if they had let the money they receive from policyholders gather dust in the vault. About 2/3 of life insurance companies’ income comes from the premiums paid by their policyholders and about 1/4 comes from earnings on their investments.

While it might seem that an insurance company could just keep the profit from its investments for itself, in reality, competition forces the price of insurance down, as it forces other prices down, to a level that will cover costs and provide other prices down, to a level that will cover costs and provide a rate of return sufficient to compensate investors, without attracting additional competing investments. In an economy where investors are always on the lookout for higher profits, an inflated rate of profit in the insurance industry would tend to cause new insurance companies to be created, to share in this bonanza.

The role of competition in forcing prices and profits into line can be seen in the decline of the price. Other changes in circumstances are also reflected in chasing prices, as a result of competition. For example, when the large baby boomer generation became middle-aged, their declining automobile accident rates as they moved not the safest age brackets were reflected in the ending of the sharply rising automobile insurance rates in previous years.

Since the whole point of buying insurance is to reduce risk, the cost of the insurance has to be less than the cost of the uninsured risks. Therefore the costs of producing the insured product are less than the cost of producing the product without insurance so the price tends to be lower than it would be if the risk had to be guarded against by charging higher prices.

“Moral Hazards” and “Adverse Selection”

While insurance generally reduces risks as it transfers them, there are also risks created by the insurance itself. Someone who is insured may engage in more risky behavior than if he or she were not insured. Jewelry that is insured may not be as carefully kept under lock and key as if it were uninsured. Such increased risk as a result of having insurance is known as a “moral hazard.”

“Adverse selection” is when an insurance company charges higher premiums for people who are more likely to get into an accident or disease (in the case of health insurance). For example: what if people who work in and around water are more likely to come down with a certain disease than people who work in dry, air-conditioned offices? Then, fishermen, lifeguards, and sailors are more likely to buy this insurance coverage for this disease than people living in Arizona.

Although determining costs and probabilities for various kinds of insurance involve complex statistical calculations of risks, this can never be reduced to pure science because of such unpredictable things as changes in behavior caused by the insurance itself as well as differences among people who choose or do not choose to be insured against a given risk.

Government Regulation

Government regulation can either increase or decrease the risk faced by insurance companies and their customers. The power of government can be used to forbid some dangerous behavior, such as storming flammable liquids in schools or driving on tires with thin treads. This limits “moral hazards” – that is, how much additional risky behavior and its consequent damage may occur among people who are insured. Forcing everyone to have a given kind of insurance coverage, such as automobile insurance for all drivers,s likewise eliminates the “adverse selection” problem. But government regulation of the insurance industry does not always bring net benefits, however, because there are other kinds of government regulations that increase risks and costs.

Government regulation can also adversely affect insurance companies and their customers when insurance principles conflict with political principles. For example, arguments are often made that it is “unfair” that a safe young driver is charged a higher premium because other young drivers have higher accident rates, or that young male drivers are charged more than female drivers of the same age for similar reasons, or that people with similar driving records are charger different premiums according to where they live.

Implicit in such political argument is the notion that it is wrong for people to be penalized for things that are not their fault. But insurance is about risk – not fault – and risks are greater when you live where your car is more likely to be stolen, vandalized, or wrecked in a collision with local drag racers.

Forcing companies to charge the same premiums to groups of people with different risks means that premiums must rise overall, with safer groups subsidizing those who are either more dangerous in themselves or who live where they are vulnerable to more dangerous other people or where insurance fraud rings operate. In the case of automobile insurance, this also means that more unsafe drivers can afford to be on the road so that their victims pay the highest and most unnecessary price of all in injuries and deaths.

Government “Insurance”

Government problems that deal with risk as often analogized to insurance, or may even be officially called “insurance” without in fact being insurance. For example, the National Flood Insurance Program in the United States ensures homes in places too risky for a real insurance company, and charges premiums far below what would be necessary to ver the costs, so that taxpayers cover the remainder. In addition, the Federal Emergency Management Agency (FEMA) helps victims of floods, hurricanes, and other natural disasters to recover and rebuild. Far from being confined to helping people struck by unpredictable disasters, FEMA also helps affluent resort communities built in areas known in advance to face high levels of danger.

Unlike real insurance, such programs as FEMA and the National Flood Insurance Program do not reduce the overall risks. Often people rebuild homes and businesses in the well-known paths of hurricanes and floods, often to the applause of the media for their “courage.” But the financial risks created are not paid by those who create them, as with insurance, but are instead paid by the taxpayers. What this means is that the government makes it less expensive for people to live in risky places – and more costly to society as a whole, when people distribute themselves in more risky patterns than they would do if they had to bear the cost themselves, either in higher insurance premiums or in financial losses and anxieties.

Special Problems of Time and Risk

Perhaps the most important thing about risk is its inescapability. Particular individuals, groups, or institutions may be sheltered from risk – but only at the cost of hanging someone else bear that risk. For society as a whole, there is no someone else. Obvious as this may seem, it is easy to forget, especially by those who are sheltered from risk, as many are, to varying degrees. At one time, when most people were engaged in farming, the risk was as widely perceived as it was pervasive: droughts, floods, insects, and plant diseases were just some of the risks of nature, while economic risk hung over each farmer in the form of the uncertainties about the price that the crop would bring at harvest time.

Most people today are employees with guaranteed rates of pay, and sometimes with guaranteed tenured on their jobs, when they are career civil servants, tenured professors, or federal judges. All that this means is that the inescapable risk is now concentrated on those who have given them these guarantees.

Many think that the government should intervene when business earnings deviate from what is or is thought to be, a normal profit rate. The concept of a “normal” rate of profits may be useful in some contexts but it can be a source of much confusion and mischief in others. The rate of return on investment or entrepreneurship is, by its very nature and the unpredictability of events, a variable return. Both profits and losses serve a key economic function, moving resources from where they are less in demand to where they are more in demand. If the government steps in to reduce profits when they are so caring or to subsidize large losses, then it defeats the whole purpose of market prices in allocating scarce resources which have alternative uses.

Economic systems that depend on individual rewards to get all the innumerable things that have to be done – whether labor, investment, invention, research, or managerial organization – must confront the fact that time must elapse between the performance of these vital tasks and receiving the rewards that flow form completing them successfully. Moreover, the amount of time varies enormously.

Different people are willing to wait different amounts of time. One labor contract created a profitable business by hiring men who normally worked only intermittently for money to meet their immediate wants. Such men were unwilling to work on Monday morning for wages that they would not receive until Friday afternoon, so the labor contract paid them all at the end of each day, waiting until Friday to be reimbursed by the employer for whom the work was being done. On the other hand, some people buy thirty-year bonds and wait for them to mature during their retirement years. Most of us are somewhat in between.

Somehow, all these different periods between contributions and their rewards must be coordinated with innumerable individual differences in patience and risk-taking. But, for this to happen, there must be some overall assurance that the reward will be there when it is due. That is, there must be property rights that specify who has exclusive access to particular things and to whatever financial benefits flow from those things. Moreover, the protection of these property rights of individuals is a precondition for the economic benefits to be reaped by society at large.


In addition to risk, there is another form of contingency known as “uncertainty.” Risk is calculable.

The distinction between risk and uncertainty is important in economics because market competition can take risk into account more readily, whether by buying insurance or setting aside a calculable sum of money to cover contingencies. But, if the market has uncertainty as to what the government’s ever-changing policies are likely to be during the life of an investment that may take years to pay off, then many investors may choose not to invest until the situation becomes clarified. When investors, consumers, and others simply sit on their money because of uncertainty, this lack of demand can then adversely affect the whole economy.

Time and Money

The adage, “time is money” is not only true but has many serious implications. Among other things, it means that whoever can delay can impose costs on others – sometimes devastating costs.

People who are planning to build housing, for example, often borrow millions of dollars to finance the construction of homes or apartments buildings and must pay the interest of these millions, whether or not their construction is proceeding on schedule or is being delayed by some legal challenge or by some political decision or indecision by officials who are in no hurry to decide. Huge interest payments can be added to the cost of the construction itself while claims of environmental dangers are investigated or while local planning commissioners wrangle among themselves or with the builders over whether the builder should be required to add various amenities such as gardens, pond, or bicycle paths, including amenities for the benefit of the general public, as well as those to whom homes will be sold or apartments rented.

Slow-moving government bureaucracies are a common complaint around the world, not only because bureaucrats usually receive the same pay whether they move slowly or quickly, but also because in some countries corrupt bureaucrats can add substantially to their incomes by accepting bribes to spend things up. The greater the scope of the government’s power and the more red tape is required, the greater the costs that can be imposed by delay and the more lucrative the bribes that can be extorted.

Time is money in yet another way. Merely by changing the age of retirement, governments can help stave off the day of reckoning when the pensions they have promised exceed the money available to pay those pensions. Hundred of billions of dollars may be saved by raising the retirement age by a few years. This violation of contract amounts to a government default on a financial obligation that millions of people were defending. But, to those who do not stop to think that time is money, it may all be explained away politically in wholly different terms.

Sometimes time costs money, not as a deliberate strategy, but as a by-product of delays that grow out of an impasse between contending individuals or groups who pay no price for their failure to reach an agreement.

Economic Adjustments

Time is important in another sense, in that most economic adjustments take time, which is to say, the consequences of decisions unfold over time – and markets adjust at different rates for different decisions.

The fact that economic consequences take time to unfold has enabled government officials in many countries to have successful political careers by creating current benefits at future costs. Government-provided pension plans, while only a few economists and actuaries point out that there is not enough wealth being set aside to cover the promised benefits – but it will be decades before the economists and actuaries are proved right.

With time comes risk, given the limitations of human foresight. This inherent risk must be sharply distinguished from the kinds of risk that are created by such activities as gambling or playing Russian roulette. Economic activities for dealing with inescapable risks seek to minimize these risks and shift them to those best able to carry them. Those who accept these risks typically have not only the financial resources to ride out short-run losses but also have lower risks from a given situation than the person who transferred the risk. A commodity speculator can reduce risk overall by engaging in a wider variety of risky activities than a farmer does, for example.

Time and Politics

Politics and economists differed radically in the way they deal with time. For example, when it becomes clear that the fares being charged on municipal buses are too low to permit those buses to be replaced as they wear out, the logical economic conclusion, in the long run, is to raise the fares. However, a politician who opposes the fare increase as “unjustified” may gain the votes of bus riders in the next election. Moreover, since all the buses are not going to wear out immediately, or even simultaneously at some future date, the consequences of holding down the fare will not appear at all once but will spread out over time. It may be some years before enough busses start breaking down and wearing out, without adequate replacements, for the bus riders to notice that there now seem to be long waits between buses and busses do not arrive on schedule as often as they used to.

In economics, however, future consequences are anticipated in the concept of “present value.” If instead of fares beings regulated by a municipal government, these fares were set by a private bus company operating in a free market, any neglect of financial provision for repealing buses as they wear out would immediately reduce the value of the bus company’s strike. In other words, the present value of the bus company would decline as a result of the long-run consequences anticipated by professional investors concerned about the safety and profitability of their own money.

Time can turn the economics of sale from an economic advantage to a political liability. After a business has made a huge invention in a fixed installation – a gigantic automobile factory, a hydroelectric dam, or a skyscraper, for example – the fact that this asset cannot be moved makes it a tempting target for high local taxation or for the unionization of employees who can shut down with a strike and impose huge losses unless their demands are met. Where labor costs are a small fraction of the total costs of an enterprise with huge capital investment, even a doubling of wages may be a price worth paying to keep multi-billion-dollar operations going. This does not mean that investors will simply accept a permanently reduced rate of return in this company or industry. As in other aspects of an economy, a change in one factor has repercussions elsewhere.

Time and Foresight

Even though many government officials may not look ahead beyond the next election, individual citizens who are subjected to the laws and policies that officials impose nevertheless have the foresight that causes many of these laws and policies to have very different consequences from those that were intended. For example, when money was appropriated by the U.S. government to help children with learning disabilities and psychological problems, the implicit assumption was there was a more or less given number of such children. But the availably of the money created incentives for more children to be classified into these categories. Organizations running programs for such children had incentives to diagnose problem children as having the particular problem for which government money was available.

New laws and new government policies often have unanticipated consequences when those subject to these laws and policies react to the changed incentives.

Where third world governments have contemplated confiscation of land for redistribution to poor farmers, many years can elapse between the political campaign for redistribution of land and the time when the land is transferred. During those years, the foresight of existing landowners is likely to lead them to neglect to maintain the property as well as they did when they expected to reap the long-term benefits of investing time and money in weeding, draining, fencing, and otherwise caring for the land. By the time the land reaches the poor, it may be much poorer land.

In short, people have foresight, whether they are landowners, welfare mothers, investors, taxpayers, or whatever. A government that proceeds as if the planned effect of its policies is the only effect often finds itself surprised or shocked because those subject to its policies react in ways that benefit or protect themselves, often with the side effect of causing the policies to pounce very different results from what was planned.

Both social and economic policies are often discussed in terms of the goals they proclaim, rather than the incentives they create. For many, this may be due simply to short-sightedness. For professional politicians, however, the fact that their time horizon is often bounded by the next election means that any goal that is widely accepted can gain their votes, while the long-run consequences come too late to be politically relevant at election time, and the lapse of time can make the connection between cause and effect too difficult to prove without complicated analysis that most voters cannot or will not engage in.

National Output

Just as there are basic economic principles that apply in particular markets for particular goods and services, so there are provinciales that apply to the economy as a whole. For example, just as there is a demand for particular goods and services, so there is aggregate demand for the total output of the whole nation. Moreover, aggregated demand can fluctuate, just as demand for individual products can fluctuate.

The Fallacy of Composition

While some of the same principles which apply when discussing markets for particular goods, industries, or occupations may also apply when discussing the national economy, it cannot be assumed in advance that this is always the case. When thinking about the national economy, a special challenge will be to avoid what philosophers call “the fallacy of composition” – the mistaken assumption that what applies to a part applies automatically to the whole. For example, the 1990s were dominated by news stories about massive reductions in employment in particular American firms and industries, with tens of thousands of workers in some industries. Yet the rate of unemployment in the U.S. economy as a whole was the lowest in years during the 1990s, while the number of jobs nationwide rose to record high levels.

What was true for various sectors of the economy that made news in the media was the opposite of what was true of the economy as a whole.

Another example of the fallacy of compositions would be adding up invidious investments to the total investments of the country. When individuals buy government bonds, for example, that is an investment for the individual. But for the country as a whole, there are no more real investments – no more factories, office buildings, hydroelectric, etc. – than those bonds have never been purchased. What the individuals have purchased is a right to sums of money to be collected from future taxpayers. These individuals’ additional assets are the taxpayers’ additional liabilities, which cancel out for the country as a whole.

What is at the heart of the fallacy of composition is that it ignores interaction among individuals, which can prevent what is true for one of them from being true for them all.

Among the common economic examples of the fallacy of composition attempt to “save jobs” in some industries threatened with higher unemployment for one reason or another. Any given firm or industry can always be rescued by sufficiently large government intervention, whether in the form of subsidies, purchase of the firm’s or industry’s products by government agencies, or by other such means. The interaction that is ignored by those advocating such policies is that everything the government spends is taken from somebody else. The 10,000 jobs asked in the wedge industry may be at the expense of 15,000 jobs lost elsewhere in the economy by the government taxing away the resource needed to keep those other people employed. The fallacy is not in believing that jobs can be saved in a given industry or given sectors of the economy. The fallacy is in believing that these are net savings for jobs for the economy as a whole.

Output and Demand

One of the most basic things to understand about the national economy is how much its total output adds up. We also have to understand the important role of memory in the national economy, which was so painfully demonstrated in the Great Depression of the 1930s. The government is almost always another major factor in the national economy, even though it may or may not be in particular industries. As in many other areas, the facts are relatively straightforward and not difficult to understand. What gets complicated are the misconceptions that have to be unraveled.

One of the oldest confusion about national economies is reflected in fears that the growing abundance of output threatens to reach the point where it exceeds what the economy is capable of absorbing. If this were true, then masses of unsold goods would lead to permanent cutbacks in production, leading in turn to massive and enduring unemployment. Such an idea has appeared from time to time over more than two centuries, though usually not among economists.

President Franklin D. Roosevelt blamed the Great Depression of the 1930s on people of whom it could be said that “the products of their hands had to exceed the purchasing power of their pockets.” A widely used history textbook likewise explained the origins of the Great Depression of the 1930s this way:

What caused the Great Depression? One basic explanation was overproducing by both farms and factories. Ironically, the depression of the 1930s was one of abundance, not want. It was the “great glut” or the “plague of plenty.”

Yet today’s output is several times what it was during the Great Depression, and many times what it was in the 18th and 19th centuries when others expressed similar views. Why was this not created the problems that so many have fared for so long, the problem of insufficient income to buy the ever-growing output that has been produced?

First of all, while income is usually measured in money, real income is measured by what the money can buy, and how much real goods and services. The total real income of everyone in the national economy and the total national output are the same thing. They do not simply happen to be equal at a given time or place. They are necessarily equal always because they are the same thing looked at from different angles. The fear of a permanent barrier to economic growth, based on output exceeding real income, is inherently groundless today as it was in past centuries when output was a small fraction of what it is today.

What has lent an appearance of plausibility to the idea that total output can exceed total real income is the act that both output and income fluctuate over time, sometimes disastrously, as in the Great Depression of the 1930s. At any given time, for any of several reasons, either consumers or businesses – or both – may hesitate to spend their income. Since everyone’s income depends on someone else’s spending, such hesitations can reduce aggregate money income and with it aggregate money demand. When various government policies generate uncertainty and apprehensions, this can lead individuals and businesses to want to hold on to their money until they see how things are going to turn out.

When millions of people do this at the same time, that in itself can make things turn out badly because aggregate demand falls below aggregate income and aggregate output. An economy cannot continue producing at full capacity if people are no longer spending and investing at full capacity, so cutbacks in production and employment may follow until things sort themselves out.

Simply saving part of their income will not necessarily reduce aggregate demand because the money that is put into banks and other financial institutions is in turn lent or invested elsewhere. That money is then spent by different people for different things but it is spent nonetheless, whether to buy homes, build factories, or otherwise. For aggregate demand to decline, either consumers or investors, or both, have to hesitate to part with their money, for one reason or another.

Measuring National Output

A country’s total wealth includes everything it has accumulated in the past. Its income or national output, however, is what is produced during the current year. Accumulated wealth and current output are both important, in different ways, for indicating how much is available for different purposes, such as maintaining or improving the people’s standard of living or for caring out the functions of government, business, or other institutions.

National output during a year can be measured in several ways. The most common measure today is the Gross Domestic Product (GDP), which is the total of everything produced within a nation’s borders. An older and related measure, the Gross National Product (GNP) is the total of all the goods and services produced by the country’s people, wherever they or their resources may be located.

The real distinction that must be made is between both these measures of national output during a given year – a flor of real income – versus the accumulated stock of wealth as of a given time. At any given time, a country can live beyond its current product by using up part of its accumulated stock of wealth from the past. During World War II, for example, American production of automobiles stopped, so factories that normally produced cars could instead produce tanks, planes, and other military equipment. This meant that existing cars simply deteriorated with age, without being replaced. So did most refrigerators, apartment buildings, and other parts of the national stock of wealth.

Just as antisolar income does not refer to money or other paper assets, so national wealth does not consist of these pieces of paper either, but of real goods and services that money can buy. Otherwise, any country could get rich immediately just by pointing out more money. Sometimes national output or national wealth is added up by using the money prices of the moment, but most serious long-run studies measure output and wealth in real terms, taking into account price changes over time.

The Changing Composition of Output

Prices are not the only things that change over time. The real goods and services which make up the national output also change. The cars of 1950 were not the same as the cars of 200. The older cars usually did not have air conditioning, seat belts, anti-lock breakers, or many other features that have been added over the years. So when we try to measure how much the production of automobiles has increased in real-time, a mere count of how many such vehicles there were in both periods misses a huge qualitative difference in what we are arbitrarily defining as being the same thing – cars.

Throughout generations, the goods, and services that constitute national output change so much that statistical comparison can become practically meaningless because they are comparing apples to oranges. At the beginning of the 20th century, the national output of the United States did not include airplanes, television sets, computers, or nuclear power plants. At the end of that century, American national output no longer included typewriters, slide rulers, or a host of equípeme and supplies once widely used in connection with horses that formerly provided the basic transportation of many societies around the world.

What then, does it mean to say that the Gross Domestic Product was X percent more than the year 2000 than in 1990 when it consisted largely of very different things at these different times? It may mean something to say that output this year is 5% higher or 3% lower than it was last year because it consists of much the same things in both years.

A further complication in comparisons over time is that attempts to measure real income depend on statistical adujé sent which have a built-in inflationary bias. Money income is adjusted by taking into account the cost of living, which is measured by the cost of some collection of items commonly bought by most people. The problem with that approach is that what people buy is affected by price.

Some items, when they were first introduced, could be categorized as luxury items for their steep price. It’s not until the item is massively produced and massively adapted that such a price comes down. Innumerable goods went from being rare luxuries of the rich to common items used by most consumers since it was only after becoming commonly purchased items that they began to be included in the collection of goods and services whose prices were used to determine the consumer price index.

Thus, while many goods that are declining in price are not counted when measuring the cost of living, common goods that are increasing in price are measured. A further inflationary bias in the consumer price index or another measure of the cost of living is that many goods which are increasing in price are also increasing in quality so the higher prices do not necessarily reflect inflation, as they would if the prices of the same goods were rising. The practical – and political – effects of these biased can be seen in such assertions as the claim that the real wages of Americans have been declining for years. Real wages are simply money wages adjusted for the cost of living, as measured by the consumer price index. But if that index is biased upward, then that means that real wage statistics are biased downward.

International Comparisons

The same problems which apply when comparing a given country’s output over time can also apply when comparing the output of two very different countries at the same time. If some Caribbean nations’ output consists largely of bananas and other tropical crops, while some Scandinavian countries’ output consists more of industrial products and crops more typical of cold climates, how is it possible to compare totals made up of such differing items? This is not just comparing apples to oranges, it may be comparing cars and sugar.

Just as some statistics understate the economic differences between nations, other statistical data overstate these differences. Statistical comparison of incomes in Western and non-Western nations are affected by the same age differences that exist among a given population within a given nation. For example, the median ages in Nigeria, Afghanistan, and Tanzania are all below twenty, while the median ages in Japan, Italy, and Germany are all over forty. Such huge age gaps mean that the real significance of some international differences in income may be seriously overstated.

Enormously expensive medications and treatments for dealing with the many physical problems that come with aging are all counted in statistics about the country’s output, but fewer such things are necessary for a country with a younger population. Thus statistics on real income per capita overstate the difference in economic well-being between older people in Western nations and younger people in non-western nations.

If it were feasible to remove from national statistics all the additional medical bills that are forced upon an aging nation then the international comparison of real income would more accurately reflect actual levels of economic well-being.

One of the usual ways of making international comparisons is to compare the total money value of outputs in one country versus another. However, this gets us into other complications created by official exchange rates between their respective currencies, which may or may not reflect the actual purchasing power of those currencies. Governments may set their official exchange rates anywhere they wish, but that does not mean that the actual purchasing power of the money will be whatever they say it is. Purchasing power depends on what sellers are willing to sell for a given amount of money. That is why there are black markets in foreign currencies, where unofficial money changers may offer more of the local currency for a dollar than the government specifies when the official exchange rates overstate what the local currency is worth in the market.   

Another complication in the comparison of output between nations is that more of one nation’s output may have been sold through the marketplace, while more of the other nation’s output may have been produced by the government and others given away or sold at less than its cost of production. When too many automobiles have been produced in a market economy to be sold profitably, the excess cars have been sold for whatever price they can get, even if that is less than what it cost to produce them. When the value of a nation’s output is added up, these cars are accounted for according to what they are sold for. But, in an economy where the government provides many free or subsidized goods, these goods are valued at what it cost the government to produce them.

These ways of counting exaggerate the value of government-provided goods and services, many of which are provided by the government precisely because they would never cover their costs of production if sold in a free market economy.

Despite all the problems with a comparison of national output between very different countries or between periods far removed from one another, GDP statistics provide a reasonable, thorough rough, basis for comparing similar countries at the same time – especially when the population size differences are taken into account by comparing GDP per capita.

Money and the Banking System

Y is of interest to most people but why should baking be of interest to anyone who is not a banker? Both money and banking play crucial roles in promoting the production of goods and services, on which everyone’s standard of living depends, and they are crucial factors in the ability of the economy as a whole to maintain the full employment of its people and resources. While money is not wealth – otherwise the government could make us all twice as rich by simply printing twice as much money – a well-designed and well-maintained monetary system facilitates the production and distribution of wealth.

The banking system plays a vital role in that process because of the vast amounts of real resources – raw materials, machines, labor – which are transferred by use of money, and whose allocation is affected by the huge sums of money that pass through the banking system.

The Role of Money

Many economies in the distant past functioned without money. People simply bartered their products and labor with one another. Built these have usually been small, uncomplicated economies, with relatively few things to trade, because most people provided themselves with goods, shelter, and clothing while trading with others for a limited range of implements, amenities, or luxuries.

Barter is awkward. If you produce hair and want some apples, you certainly are not likely to trade one chair for one apple, and you may not want enough apples to add up the value of a chair. But if chairs and apples can both be exchanged for some third thing that can be subdivided into very small units, then more trade scans take place using the intermediary means of exchange, benefitting both chair makers and apple growers, as well as everyone else. All that people have to do is agree on what will be used as an intermediary means to exchange and that means of exchange becomes money.

Money is equivalent to wealth for an individual only because other individuals will supply the real goods and services desired in exchange for that money. But, from the standpoint of the national economy as a whole, money is not wealth. It is just an artifact used to transfer wealth or to give people incentives to produce wealth.

While money facilitates the production of wealth this is not to say that its role is inconsequential. When a monetary system breaks down for one reason or another, and people are forced to resort to barter, the clumsiness of that method quickly becomes apparent to all.

Although money itself is not wealth, an absence of a well-functioning monetary system can cause losses of real wealth, when transactions are recude to the crude level of barter.

Usually, everyone seems to want money, but there have been particular times in particular countries when no one wanted money because they consider it worthless. In reality, it was the fact that one would accept money that made it worthless. When you can’t buy anything with money, it becomes just useless pieces of paper or useless little metal disks.


Inflation is a general rise in prices. The national price level rises for the same reason that prices of particular goods and services rise – namely, that there is more demand than supply at a given price. When pole has more money, they tend to spend more. Without a corresponding increase in the volume of output, the prices of existing goods and services simply rise because the quantity demanded exceeds the quantity supplied at current prices and either people bid against each other during the shortage or sellers realized that increased demand for their products at existing prices and raise their prices accordingly.

Whatever the money consists of more of it in the national economy means higher prices,s unless there is a correspondingly larger supply of goods and services. This relationship between the total amount of money and the general price level has been seen for centuries. When Alexander the Great began spending the captured treasures of the Persians, prices rose in Greece. Si military, when the Spaniards removed vast amounts of gold from their colonies in the Western Hemisphere, price levels rose not only in Spain but across Europe, because the Spaniards used much of their wealth to buy imports from other European countries. Sending their gold to those countries to pay for these purchases added to the total money supply across the continent.

None of this is hard to understand. Complications and confusions come in when we start thinking about cut mystical and fallacious things as the “intrinsic value” of money or believe that gold somehow “backs up” our money or in some mysterious ways gives it value.

For much of history, gold has been used as money by many countries. Sometimes the gold was used directly in coins or (for large purchases) in nuggets, gold bars, or other forms. Even more convenient for carrying around were pieces of paper money printed by the government that was redeemable in gold whenever you wanted it redeemed. It was not only more convenient to carry around paper money it was also safer than carrying large sums of money as metal that jingled in your pockets or was conspicuous in bags, attracting the attention of criminals.

The big problem with money created by the government is that those who run the government always face the temptation to create more money and spend it. Whether among ancient kings or modern politicians, this has happened again and again over the centuries, leading to inflation and the many economic and social problems that follow from inflation. For this reason, many countries have preferred using gold, silver, or some other material that is inherently limited in supply, such as money. It is a way of depriving governments of the power to expand the money supply to inflationary levels.

Gold has long been considered ideal for this purpose since the supply of gold in the world usually cannot increase rapidly. When paper money is convertible into gold whenever the individual chooses to do so, then the money is said to be “backed up” by gold.  This expression is misleading only if we imagine that the value of the gold is somehow transferred to the paper money, when in fact the real point is that the gold simply limits the amount of paper money that can be issued.

Since money is whatever we accept as money in payment for real goods and services, there are a variety of other things that function in a way very similar to the office money issued by the government. Credit cards, debit cards, and checks are obvious examples. Mere promises may also function as money, serving to acquire real goods and services, when the person who makes the promises is highly trusted. IOUs from realizable merchants were once passed from hand to hand as money.

What this means is that aggregate demand is created not only by the money issued by the government but also by credits originating from a variety of other sources. What this also means is that the liquidation of credits, for whatever reason, reduces aggregate demand, just as if the official money supply had contracted.

Some banks used to issue their currency, which had no legal standing but was nevertheless widely accepted in payment when the particular banks were regarded as sufficiently reliable and willing to redeem their currency in gold.

Sometimes money issued by some other country is preferred to money issued by one’s own. Beginning in the 10th century, Chinese money was preferred to Japanese money in Japan.

Gold continues to be preferred to many national currencies, even though gold earns no interest, while money in the bank does. The fluctuating price of gold reflects not only the changing demands for it for making jewelry or in some industrial uses but also, more fundamentally, these fluctuations reflect the degree of worry about the possibility of inflation that could erode the purchasing power of official currencies. That’s why a major political or military crisis can send the price of gold shooting up, as people dump their holdings of currencies that might be affected and begging bidding against each other to buy gold, as a more reliable way to hold their existing wealth, even if it does not earn any interest or dividends.

Existing or expected inflation usually leads to rising prices of gold, as people seek to shelter their wealth from the government’s silent confiscations by inflation. But long periods of prosperity with price stability are likely to see the price of gold fall, as people move their wealth out of gold and into other financial assets that earn interest or dividends and can therefore increase their wealth.

The great unspoken fear behind the demand for gold is the fear of inflation. Nor is this fear irrational, given how often governments of all types have resorted to inflation, as a means of testing more wealth without having to directly confront the public with higher taxes.

Raising tax rates has always created political dangers for those who hold political power. Political careers can be destroyed when the voting public turns against those who raised their tax rates. Sometimes public reactions to higher taxes can range up to armed revolts, such as those that led to the American war of independence from Britain. In addition to adverse political reactions to higher taxes, there can be adverse economic reactions. As tax rates reach ever higher lives, particular economic activities may be abandoned by those who do not find the net rate of these activities, after taxes, to be enough to justify their efforts.

To avoid the political danger of raising tax rates can create, governments around the world have for thousands of years resorted to inflation instead.

Put differently, inflation is in effect a hidden tax. The money that people saved is robbed of part of its purchasing power, which is quietly transferred to the government that issues new money.

Inflation is not only a hidden tax, it is also a broad-based tax. A government may announce that it will not raise taxes, or will raise tax only on “the rich” – however that is defined – but, by creating inflation, it in effect transfers some of the wealth of everyone who has money, which is to say, it siphons off wealth across the whole range of incomes and wealth, from the richest to the poorest. To the extent that the rich have their wealth invested in stocks, real estate, or other tangible assets that rise in value along with inflation, they escape some of this de facto taxation, which people in lower income brackets may not be able to escape.

The rate of inflation is often measured by changes in the consumer price index. Like other indexes, the consumer price index is only an approximation because the prices of different things change differently.

While the effects of deflation are more obvious that the effects of inflation – since less money means fewer purchases, and therefore lower production of new goods, with correspondingly less demand for labor – the effects of inflation can likewise bring an economy to a half. Runway inflation means that producers find it risky to produce, web the price at which they can sell their output may not represent as much purchasing power as the money they spent producing that output.


While inflation has been a problem that is centuries old, at particular times and places deflation has also created problems, some of them devastating.

From 1983 through 1896, price levels declined by 22% in Britain, and 32% in the United States. These and other industries nations were on the gold standard and output was growing faster than the world’s gold supply. While the prices of currency output and inputs were declining, debts specified in money terms remained the same – in effect making mortgages and other debts more of a burden in real purchasing power terms than when these debts were incurred. This problem for debtors became a problem for creditors as well, when the debtors could no longer pay and simply defaulted.

Farmers were especially hard hit by declining price levels because agricultural produce declined especially sharply in price, while the things that farmers bought did not decline as much, and mortgages and other farm debts required the same amount of money as before.

Just as inflation tends to be made worse by the fact that people spend a depreciating currency faster than usual, to buy something with it before it loses still more value, so deflation tends to be made worse by the fact that people hold on to money longer, especially during a depression, with widespread unemployment making everyone’s job or business insecure. Not only was there less money in circulation during the downturn in the economy from 1929 to 1932, but what money there was circulated more slowly, which further reduced demand for goods and services. That in turn reduced demand for the labor to produce them, creating mass unemployment.

Deflation like inflation affects different prices differently. In the United States, the price of what farmers sold tended to fall faster than that of what they bought:

“The price of wheat, which had hovered around a dollar a bushel for decades, closed amount 1892 under ninety cents, 1893 around seventy-five cents, 1894 barely sixty cents. In the dead of winter of 1895-1896, the price went below 59 cents a bushel.”

Meanwhile, farmer’s mortgage payments remained where they had ways been in money terms – and therefore were growing in real terms during deflation. Moreover, payments on these mortgages now had to be paid out of arm incomes that were half or less of what they had been when these mortgages were taken out.

The Banking System

Why are there banks in the first place? One reason is that there are economies of scale in guarding money. If restaurants or hardware stores kept all the money they received from their customers in a back room somewhere, criminals would hold up far more restaurants, hardware stores, and other businesses and homes than they do. By transferring their money to a bank, individuals and enterprises can have their money guarded by others at lower costs than by guardian it themselves.

In short, economies of scale enable banks to guard wealth at lower costs per unit of wealth than either private businesses or homes and enable the Federal Reserve Banks to guard wealth at lower costs per unit of wealth than private banks.

The Role of Banks

Banks are not just storage places for money. They place a more active role than that in the economy. As noted in earlier chapters, businesses’ incomes are unpredictable and can go from profits to losses and back again repeatedly. Meanwhile, businesses’ legal obligations – to pay their employees every payday and pay their electricity bills regularly, as well as pay those who supply them with all the other things needed to keep the business running – must be paid steadily, whether or not the bottom line has red ink or black in at the moment. This means that someone must supply businesses with money when they don’t have enough of their own to meet their obligations at the time when payment is due. Banks are a major source of this money, which must of course be repaid from later profits. 

Banks not only have economies of scale, but they are also one of several financial institutions which enable individual businesses to achieve economies of scale – and thereby raise the general public’s standard of living through lower production costs that translate into lower prices. In a complex modern economy, businesses achieve lower production costs by operating on a huge scale requiring far more labor, machinery, electricity, and other resources than even rich individuals can afford. Most giant corporations are not owned by a few rich people but draw on money from vast numbers of people whose individually modest sums of money are aggregated and then transferred in vast amounts to the business by financial intermediaries like banks, insurance companies, mutual funds, and pension funds.

Banks also finance consumer purchases by paying for credit card purchases by people who later reimburse the credit card companies and the banks behind them, by paying monthly installments that include interest. The banking system is thus a major part of an elaborate system of indícenla intermediaries which enables millions of people to spend money that belongs to millions of strangers, not only for investments in businesses but also for consumer purchases.

The importance of financial intermediaries to the economy as a whole can be seen by looking at places where there are not enough sufficiently knowledgeable, experienced, and trustworthy intermediaries to enable strangers to turn vast sums of money over to other strangers. Such countries are often poor, even when they are rich in natural resources. Financial intermediaries can facilitate turning these natural resources into goods and services, homes, and businesses – in short, wealth.

Although money itself is not wealth, from the standpoint of society as a whole, its role in facilitating the production and transfer of wealth is important. The real wealth – the tangible things – that people are entitled to withdraw from a nation’s output can instead be redirected toward others through banks and other financial institutions, using money as the means of transfer. Thus wood that could have been used to build furniture, if consumers had chosen to spend their money on that, is instead redirected toward creating paper for printing magazines when those customers put their money into banks instead of spending it, and the banks then lend it to magazine publishers.

Modern banks, however, do more than simply transfer cash. Such transfers do not change the total demand in the economy but simply change who demands what. The total demand for all goods and services combined is not changed by transactions, important as these transactions are for other purposes. But what the banking system does, over and beyond what other financial intermediaries do, is affect the total demand in the economy as a whole. The banking system creates credits which in effect, add to the money supply through what is called “fractional reserve banking.”

Banking Laws and Policies

Banks and banking systems vary from one country to another. They differ not only in particular institutional practices but more fundamentally in the general setting and historical experiences of the particular country. Such differences can help illustrate some of the general requirements of a successful banking system and also evaluate the effects of particular policies.

Government and Risk

While banks manage money, what they must also manage is a risk. Runs on banks are just one of those risks. Making loans that do not get repaid is a more common, if less visibly spectacular, risk. Either risk may not only inflict financial losses but can do so to the point of destroying the institution itself. As already noted, the government can do things that either increase or decrease these risks.

Insecure property risks are just one of the things within the control of the government that has a major impact on the risks of banking. Because banks are almost invariably regulated by governments around the world, more so than other businesses, because of the potential impact of banking crises on the economy as a whole, the specific nature of that regulation can increase or decrease the riskiness of banking.

One of the most prominent ways of reducing risk in the United States has been the government’s Federal Deposit Insurance Corporation.

Deposit insurance can create risks as well as reduce risk. People who are insured against risk – whether banking risks or risks to automobiles or homes, for example – may engage in more risky behavior than before, now that they have been insured. That is, they might park their cars in rougher neighborhoods than they would take them to if they were not insured against vandalism or theft.

Government restrictions on the activities of banks insured by the Federal Deposit Insurance Corporation seek to minimize such risky investments. But containing the risk does not make the incentives for risk go away. Moreover, the government can misjudge some of the many risks that come and go, and sol leaves the taxpayers liable for losses that exceed the money collected from the banks as premiums paid for deposit insurance.

Government Finance

Market transactions take place within a framework of rules, and require compone with the authority to enforce those rules. Government not only enforces its own rules but also enforces contracts and other agreements and understandings among the numerous parties transacting with one another in the economy.

Beyond these basic functions, which virtually everyone can agree on, governments can play more expansive roles, all the way up to directly owning and operating all the farms and industries in a nation.

Despite the wide range of functions that governments can engage in, and have engaged in, here we can examine the basic functions of government that virtually everyone can agree on and explain why those functions are important for the allocation of scarce resources that have alternative uses.

One of the most basic functions of government is to provide a framework of law and order, within which the people can engage in whatever economic and other activities they choose, making such mutual accommodations and agreements among themselves as they see fit. Certain activities generate significant costs or benefits that extend beyond those individuals who engage in those activities. Here government can take account of such costs and benefits when the marketplace does not.

Law and Order

When government restricts its economic role to that of an enforcer of laws and contracts, some people say that such policy amounts to “doing nothing” as far as the economy is concerned. However, what is called “nothing” has often taken centuries to achieve – namely, a reliable framework of laws, within which economic activity can flourish, and without which even vast amounts of rich natural resources may fail to be developed into a corresponding level of output and the resulting prosperity.


Like the role of prices, the role of a reliable framework of laws may be easier to understand by observing what happens in times and places where such a framework does not exist. Countries whose governments are ineffectual, arbitrary, or thoroughly corrupt can neither foreign nor domestic entrepreneurs want to risk the kinds of large investments which are required to develop natural resources into finished products that raise the general standard of living.

Whatever the merits or demerits of particular laws, someone must administer those laws – and how efficiently or how honestly that is done can make a huge economic difference. The phrase “the law’s delay” goes back at least as far as Shakespeare’s time. Such delay imposes costs and those whose investments are idled, whose shipments are held up, and whose ability to play their economic activities is crippled by red tape and slow-moving bureaucrats. Moreover, bureaucrats’ ability to create delay often means an opportunity for them to collect bribes to speed things up – all of which adds up to the higher costs of doing business. That, in turn, means higher prices for consumers, and correspondingly lower standards of living for the country as a whole.

The costs of corruption are not limited to the bribes collected, since these are internal transfers, rather than net reductions of national wealth themselves. Because scarce resources have alternative uses, the real cost is the foregone alternatives – delayed and aborted economic activity, the enterprises that are not started, the investments that are not made, the expansion of output and employment that does not take place in a thoroughly corrupt society, as well as the loss of skilled, educated, and entrepreneurial people who leave the country.

Corruption can of course take many forms besides the direct bribe. It can take the form of appointing politicians or their relatives to a company board of directors, with expectations of receiving more favorable treatment from the government.

It is not just corruption but also sheer bureaucracy which can stifle economic activity. Even one of India’s most spectacular and successful industrialists, Aditya Birla, found himself forced to look to other countries which to expand his investments, because of India’s slow-moving bureaucrats.

The Framework of Laws

For fostering economic activities and the prosperity resulting from them, laws must be reliable, above all. If the application of the law varies with the whims of kings or dictators, with changes in democratically elected governments, or with the caprices or corruption of appointed officials, then the risks surrounding invented rise, and consequently the amount of investment is likely to be much less than purely economic considerations would produce in a market economy under a reliable framework of laws.

One of the major advantages that enabled 19th country Britain to become the first industrialized nation was the dependability of its laws. Not only could Britons feel confident when investing in their country’s economy, without fear that their earnings would be confiscated, or dissipated in bribes, or that the contracts they made would be changed or voided for political reasons, but so could foreigners doing business in Britain or making investments there.

While impartiality is a desirable quality in law, discriminatory laws can still promote economic development, if the nature of the discrimination is spelled out in advance, rather than taking the form of unpredictably biased and corrupt decisions by judges, juries, and officials. The Chinese and Indians who settled in the European colonial empires of Southeast Asia never had the same legal rights as Europeans there, nor the same rights as the indigenous population. Yet, whatever rights they did have could rely upon, and therefore served as a foundation for the creation of Chinese and Indian businesses inout the region.

Dependability is not simply a matter of the government’s treatment of people. It must also prevent some people from interfering with other people so that criminals and mobs do not make the economy risky and thereby stifle the economic development required for prosperity.

Governments differ in the effectiveness with which they can enforce their laws in general, and even a given government may be able to enforce its laws more effectively in some places than in others.

Property Rights

Among the most misunderstood aspects of law and order are property rights. While these rights are cherished as personal benefits by those fortunate enough to own a substantial amount of property, what matters from the standpoint of economics is how property rights affect the allocation of scarce resources which have alternative uses. What property rights mean to property owners is far less important than what they mean to the economy as a whole. In other words, property rights need to be assessed in terms of their economic effects on the well-being of the population at large. These effects are ultimately an empirical question that cannot be settled based on assumptions or rhetoric.

Despite a tendency to think of property rights as a special privilege for the rich, many property rights are more valuable to people who are not rich – such as property rights have often been infringed or violated for the benefit of the rich.

Although the average rich person, by definition, has more money than the average person who is not rich, in the aggregate the non-rich population often has far more money. This means, among other things, that many properties owned by the rich would be bid away from them by the greater purchasing power of the non-rich if unrestricted property rights prevailed in a free market. Thus land occupied by mansions located on huge estates can pass through the market to entrepreneurs who build smaller and more numerous homes or apartment buildings on these sites – all for the use of people with more modest incomes, but with more money in the aggregate.

Wealthy people have often forestalled such transfers of property by getting laws passed to restrict property rights in a variety of ways. For example, various affluent communities in California, Virginia, and other places have required land to be sold only in lots of one acre or more per house, thereby pricing such land and homes beyond the reach of most people and thus neutralizing the greater aggregate purchasing power of less affluent people.

By infringing or negating property rights, affluent and wealthy property owners are thus able to keep out people of average or low incomes and, at the same time, increase the value of their property by ensuring its growing scarcity as the population increases in the area.

External Costs and Benefits

Economic decisions made through the marketplace are not always better than a decision that governments can make. Much depends on whether those market transactions accurately reflect both the cost and the benefits that result. Under some conductions, they do not.

When someone buys a table of a tractor, the question as to whether it is worth what it cost is answered by the actions of the purchaser who decided to buy it. However, when an electric utility company buys coal to burn to generate electricity, a significant part of the costs of the electricity-generating process is paid by people who breathe the smoke that results from the burning of the coal and whose homes and cars are dirtied by the soot. Cleaning, repairing, and medical costs paid by these people are not taken into account in the marketplace, because these people do not participate in the transactions between the coal producer and the utility company.

Such costs are called “external costs” by economists because such costs fall outside the parties to the transaction which creates these costs. External costs are therefore not taken into account in the marketplace, even when these are very substantial costs, which can extend beyond monetary losses to include bad healthy and premature death. While many decisions can be made more efficiently through the marketplace than by the government, this is one of those decisions that can be made more efficiently by the government than by the marketplace.

Clean air laws can reduce harmful emissions through legislation and regulations.

By the same token, many transactions would be beneficial to people who are not a party to the decision-making, and whose interests are therefore not taken into account. The benefits of mud flaps on cars and trucks may be apparent to anyone who has ever driven in a rainstorm behind a car or truck that was throwing so much water or mud onto his windshield as to dangerously obscure vision.

These are “external benefits.” Here again, it is impossible to obtain collectively through the government what cannot be obtained individually through the marketplace, simply by having laws passed requiring all cars and trucks to have mud flaps on them.

Some other benefits are indivisible. Either everybody gets these kinds of benefits or nobody gets them. Military defense is an example. If the military defense had to be purchased individually through the marketplace, then those who felt threatened by foreign powers could pay for guns, troops, cannons, and all the other means of military deterrence and defense, while those who saw no dangers could refuse to spend their money on such things. However, the level of military security would be the same for both, since supporters and non-supporters of military forces are intermixed in the same society and exposed to the same dangers from enemy action.

By collectivizing this decision and having it made by the government, a result can be achieved that is more in keeping with what most people want than if those people were allowed to decide individually what to do.

In short, there are things that government can do more efficiently than individuals because external costs, external benefits, or indivisibilities make individual decisions in the marketplace, based on individual interest, a less effective way of weighing costs and benefits to the whole society.

Incentives and Constraints

Governments are of course inseparable from politics, especially in a democratic country, so a distinction must be made and constantly kept in mind between what a government can do to make things better than they would be in free markets and what is, in fact, likely to do under the influence of political incentives and constraints. The dis action tino between what a government can do and what it is likely to do can be lost when the thinks of the government as simply an agent of a society or even as one integral performer. In reality, the many individuals and agencies within a national government have their separate interests, incentives, and agendas, to which they may respond far more often than they respond to either the public interest or the policy agendas set by political leaders.

Under a popularly elected government, the political incentives are to do what is popular, even if the consequences are worse than the consequences of doing nothing, or doing something less popular.

Government Finance

Like individuals, businesses, and other organizations governments must have resources to continue to exist. In centuries past, some governments would take these resources directly in the form of a share of crops, livestock, or other tangible assets of the population but, in modern industrial and commercial society, the governments take a share of the national output in the form of money.

Consumers can change what they buy when some of the goods they used are heavily taxed and other goods are not. Businesses can change what they produce when some kinds of output are taxed and others are subsidized. Investors can decide to put their money into tax-free municipal bonds, or into some foreign country with lower tax rates, when taxes on earnings from their investments rise – and they can reverse this decision when tax rates fall. In short, people change their behavior in response to government financial operations. These operations include taxation, the sale of government bonds, and innumerable ways of spring money currently, or priming to spend money in the future, such as guaranteeing bank deposits or establishing pension systems to cover some or all of the population when they retire.

Acquiring wealth has long been one of the main preoccupations of governments, whether in the days of the Roman Empire, in the ancient Chinese dynasties, or modern Europe or America. Today, tax revenues and bond sales are usually the largest stories of menos for the national government. The choice between financing government activities with current tax revenues or with revenues from the mésale of bonds – in other words going into debt – has further repercussions on the economy at large. As in many other areas of economies, the facts are relatively straightforward, but the words to describe the facts can lead to needless complications and misunderstandings. Some of the words used to discuss the financial o perítanos of the government – “balanced budget,” “deficit,” “surplus,” and “national debt” – need to be plainly defined to avoid misunderstandings or even hysteria.

If all current government spending is paid for with money received in taxes, then the budget is said to be balanced. If current tax receipts exceed current spending, there is said to be a budget surplus. If tax revenues do not recall all of the government’s spending, some of which are covered by revenue from the sale of bonds, then the government is said to be operating in a deficit, since bonds are debt for government to repay in the future. The accumulation of deficits over time adds up to the government’s debt, which is called “the national debt.”

Government Revenues

Government revenues come not only from taxes and the sale of bonds, but also from the prices charged for various goods and services that governments provide, as well as from the sale of assets that the government owns, such as land, old office furniture, or surplus military equipment.

Another way for governments to get money to spend I simply to rope it, as many governments have done at various periods of history. However, the disastrous consequences of resulting inflation have made this too risky politically for most governments to rely on this as a common practice.

Tax Rates and Tax Revenues

The various ways in which taxes can be collected used, and which particular tax rate is imposed, makes a difference in the way individuals, enterprise, and the national economy as a whole respond. Depending on those responses, a higher tax rate may or may not lead to higher tax revenues, or lower tax rates to lower tax revenues.

Although it is common in politics and in the media to refer to government’s “raising taxes” or “cutting taxes,” this terminology blurs the crucial distinction between tax rates and tax revenues. The government can change tax rates but the reaction of the public to those changes can result in either higher or lower amounts of tax revenues being collected, depending on the circumstances and responses.

The Incidence of Taxation

Knowing who is legally required to pay a given tax to the government does not automatically tell us who ultimately bears the burden created by the tax – a burden which in some cases can be passed on to theirs, and in other cases cannot.

Who pays how much of the taxes collected by the government?

These questions cannot be answered simply by looking at tax laws or even at the table of estimates based on those laws. People may react to tax changes by changing their behavior, and different people have different abilities to change their behavior to avoid taxes.

Various complex arrangements can spare wealthy people from having to pay taxes on all their income but, since these complex arrangements require lawyers, accountants, and other professionals to make such arrangements, people of more modest incomes may not be equally able to escape their tax burden, and can even end up paying higher percentages of their income in taxes than someone who is in a higher income bracket that is officially taxed at a higher rate.

Since income is not the only thing that is taxed, how much total tax any given individual pays depends also on how many other taxes apply and what that individual’s situation is.

Issues and controversies about tax rates often discuss the incident of taxes on “the rich” or “the poor,” when in fact taxes fall on income rather than wealth. A genuinely rich person, someone with enough wealth not to have to work at all, may have a very modest income or no income at all during a given year. Moreover, even during years of high incomes and high rates of taxation on that income, this taxation does not touch the rich individual’s accumulated wealth. Most of the people described as “rich” in discussions of tax issues are not rich at all but simply people who have reached their peak earning years, often having worked their way up to that peak after decades of earning much more modest salaries. Progressive income taxes typically hit such people rather than the genuinely rich.

Since each individual pays a mixture of progressive and regressive taxes, as well as taxes that apply to some goods and not others, it is by no means easy to determine who is paying what share of the country’s taxes.

What is even more difficult is to determine who bears the real burden of a given tax by suffering the consequences of changed outcomes.

Taxes cannot be passed on to consumers when a particular tax falls on business or product products in a particular place if consumers have the option of buying the same product produced in other places not subject to the same tax.

Whatever the product and whatever the tax, where the actual burden of that tax falls in practice depends on many economic factors, not just on who is compelled by law to deliver the money to the government.

Inflation can change the incident of taxation in other ways. Under what is called “progressive taxation,” people with higher incomes pay not only a higher amount of taxes but also a higher percentage of their incomes. During periods of substantial inflation, people of modest means find their dollar incomes rising as the cost of living rises, even if on net balance they are unable to purchase any more goods and services than before. But, because tax laws are written in terms of money, citizens with only average levels of income can end up paying a higher percentage of their incomes in taxes when their money incomes rise to levels once reached by affluent or wealthy people.

Local Taxation

Taxation of course occurs at both times the national and the local level. In the United States, local property taxes supply much of the revenue used by local governments. Like other governmental units, local governments tend to want to maximize the revenues they receive, which in turn enables local officials to maximize the favorable publicity they receive from spending money in ways that will increase their chances of re-election. At the same time, raising tax rates produced adverse political reactions, which can reduce these officials’ re-election prospects.

Among the ways used by local officials to escape this dilemma has been one also used by national officials: issue bonds to pay for much of the current spending, thereby producing immediate benefits to dispense and thereby gain votes, while effect taxing future taxpayers who will have to pay the bondholders when the bonds reach their maturity dates. Since such taxpayers include many who are too young to vote currently – including some who are not yet born – current deficit spending maximized the current political benefits to current officials while minimizing effects on current taxpayers and voters.

One of the things that make deficit spending especially attractive to local politicians is that many municipal and state bonds are tax-exempt. That makes such bonds especially valuable to people with high incomes when the federal taxes on such incomes are very high. Among the repercussions of this are the large sums of money that are often available to finance local projects with tax-exempt bonds, regardless of whether these projects would meet any criteria based on weighing costs against benefits. What the high-income purchaser of these bonds is paying for is the exemption of income from federal taxation.

From the standpoint of government revenue, what is gained by the local government is being able to readily sell its bonds that pay a lower interest rate than private securities whose purchasers have to pay taxes on that interest. What is gained financially but the local government may be a fraction of what is lost financially but the federal government is unable to tax the income of these local bonds. Finally, what is lost by the local taxpayer is having to pay higher taxes because of the ease of financing politically chosen projects with tax-exempt bonds.

Another way of raising local tax revenues without raising local tax rates is to replace the low-valued property with the higher-valued property since the latter yields more tax revenue at a given tax rate.

What this means economically, in terms of the allocations of scarce resources that have alternative uses, is that the alternative uses no longer have to be of higher value than the original uses, since the alternative users no longer have to bid the property away from the original owners. Instead, those who want the property can rely on government officials to simply take it, exercising the power of an eminent domain, and then sell it to them for less than they would have had to pay the existing property owners to get the latter to transfer the property to them voluntarily.

Government Bonds

Selling government bonds is simply borrowing money to be repaid from future tax revenues. Government bonds can also be a source of confusion under their other name, “the national debt.”

Like other statistical aggregates, the national debt tends to grow over time as the population and the national income grow, and as inflation causes a given number of dollars to represent smaller amounts of real wealth or real liabilities. Depending on the specific circumstances of a particular country at a particular time, this may the reason for serious concern, or the criticisms may be simply political theater.

National debts must be compared not only to national output or national income but also to the alternatives facing a given nation at a given time. For example, the federal debt of the United States in 1945 was $258 billion, at a time when the national income was $182 billion. In other words, the national debt was 41% higher than the national income, as a result of paying the enormous cost of fighting World War II. The cost of not fighting the Nazis or imperial Japan was considered to be so much worse than the national debt and seemed secondary at the time.

Even if peacetime, if a nation’s highways and bridges are crumbling from a lack of maintenance and repair, that does not appear in national debt statistics, but the neglected infrastructure is a burden being passed on to the next generation, just as surely as national debt would be. If the costs of repairs are worth the benefits, then issuing government bonds to raise the money needed to restore this infrastructure makes sense – and the burden on future generations may be no greater than if the bonds had never been issued, though it takes the form of money owed rather than the form of crumbling and perhaps dangerous infrastructure that may become even more costly to repair in the next generation, due to continued neglect.

Going into debt to create long-term investment makes as much sense for the government as a private individual borrowing more than his annual income to buy a house.

What must be taken into account when assessing a national debt is to whom it is owed. When a government sells all of its bonds to its citizens, that is very different from selling all or a substantial part of its bonds to people in other countries. The difference is that an internal debt is held by the same population that is responsible for paying the taxes to redeem the principal and pay the interest.

Even when the national debt is held entirely by citizens of the country that issued the bonds, different individuals hold different shares of the bonds and pay different shares of the taxes. Much also depends on how members of future generations acquire the bonds issued to the current generation. If the next generation simply inherits the bonds bought by the current generation, then they Inter hit both the debt and the wealth required or pay off the debt, so that there is no net burden passed on from one generation to the next. If, however, the older generation sells its bonds to the younger generation – either directly from individual to individual or by cashing in the bonds, which the government pays for by issuing new bonds to new people – then the burden of the debt may be liquidated, as far s the older generation is concerned and passed on to the next generation.

In general, the government’s choice of acquiring money through the collection of taxes or the sale of government bonds does not relieve the current population of its economic burden unless the government sells the bonds to foreigners. Even in that case, however, this merely postpones the burden. The choice may be more significant politically to the government itself, as it may encounter less resistance when it does not raise taxes to cover all current spending but relies on bond sales to supplement its tax revenues. This convenience for the government is a temptation to use bond sales to cover current expenses instead of reserving such sales to cover spending on long-term projects. There are obvious political benefits available to those currently in power by passing the costs on to those currently too young to vote, including those who are not yet born.

Although government bonds get pions off when they reach their maturity, usually new bonds are issued and sold, so that the national debt is turned over rather than being paid off, though at particular periods of history some countries have paid off their national debts, either partially or completely.

When the national debt reaches a size where investors begin to worry about whether it can continue to be turned over as government bonds mature, without raising interest rates to attract the needed buyers, that can lead to expectations that higher interest rates will inhibit future investment. Rising interest rates for government bonds tend to affect other interest rates, which also rise, due to competition for investment funds in the financial markets – and that in turn tends to reduce credit and aggregate demand on which continuing prosperity depends.

How serious such dangers depend on the siege of the national debt – not absolutely but relative to the nation’s income. Professional financiers and investors know this, and so are unlikely to panic even when there is a record-breaking national debt if that is not a large debt relative to the size of the economy.

While the absolute siege of the national debt may overstate the economic risks to the economy under some conditions, it may also understate the risk under other circumstances. Where the government has large financial liabilities looming on the horizon, but not yet part of the official budget, then the official national debt may be considerably less than what the government owes.

Charges for Goods and Services

Incentives to price government-provided goods and services at lower levels than in private businesses are not uncommon. Since lower prices mean more demand than at higher prices, those who set prices for government-provided goods and services have incentives to assure a sufficient continuing demand for the goods and services they sell and therefore continuing jobs for themselves. Moreover, since lower prices are less likely to provoke political protest and pressures than are higher prices, the jobs of those controlling the sales of government-provided goods and services are easier, as well as more secure and less stressful when prices are kept below the level that would prevail in a free market, where costs must be covered by sales revenues.

In short, the normal function provided by prices of causing consumers to ration themselves and producers to keep costs below what consumers are willing to pay is non-existing in these situations.

Although there are many contexts in which government-provided goods and services are priced below cost, there is another context in which these services are priced well above their costs. Bridges, for example, are often built with the idea that the tolls collected from bridge users over the years will eventually cover the cost of building them. However, it is not uncommon for the tolls to continue to be collected long after the original cost has been covered several times over, and when the tolls necessary to cover maintenance and repairs are a fraction of the money that continues to be charged to cross the bridge.

In general, government charges for goods and services are not simply a matter of transferring money but of redirecting resources in the economy, usually without much concern for the allocation of those resources that maximize net benefits to the population at large.

Government Expenditures

The government spends both voluntarily and involuntarily. Officials may voluntarily decide to create a new program or department or to increase or decrease their appropriations. Alternatively, the government may be forced by pre-existing laws to pay unemployment insurance when the downturn in the economy causes more people to lose their jobs.

In short, although government spending and the annual deficits and accumulated national debts which often result from that spending are often blamed on those officials who happen to be in charge of the government at a given time, much of the spending is not at their discretion but is mandated by pre-existing laws.

Government spending has repercussions on the economy, just as taxation does – and both the spending going out and tax revenues coming in are to some extent beyond the existing administration’s control. When production and employment go down in the economy, the tax revenues collected from businesses and workers tend to go down as well. Meanwhile, subsidies and other outlays tend to go up. This means that the government is spending more money while receiving less. The fore, on net balance, the government takes money from one place – from taxpayers or from those who buy government bonds – and transfers it somewhere else, the loss of purchasing power in one place offsets the grain in purchasing power elsewhere. Only if, for some reason, the government is more likely to spend the money than those from whom it was taken, is there a net increase in spending for the country as a whole.

Costs vs. Expenditures

When discussing government policies or programs, the “cost” of those policies or programs is often spoken of without specifying whether that means the cost to the government or the cost to the economy.

As an example, it may cost the government large sums of money to build and maintain levees along the bank of a river but, if the government did not spend this money, the people could suffer even bigger losses from floods. When the cost of any given policy is considered, it is important to be very clear as to whose costs are being discussed or considered – the cost to the government or the cost to the economy.

Another area where government expenditures are grossly misleading indicators of the cost to the country is land acquisition costs under either “redevelopment” programs or “open space” policies. When local government officials merely begin discussing publicly the prospect of “redeveloping” a particular neighborhood by tearing down existing homes and businesses there, under the power of an eminent domain, that alone is enough to discourage potential buyers of homes or businesses in that neighborhood, so that the present values of those homes and businesses being declining long before any concrete actions are taken by the government.

By the time the government acts, which may be years later, the values of properties in the affected neighbors may be far lower than before the redevelopment plan was discussed.

Benefits vs. Net Benefits

The weighing of costs against benefits which is part of the allocation of scarce resources that have alternative uses can be greatly affected by government expenditures.

While there are some goods and services which virtually everyone considers desirable, different people may consider them desirable to different degrees and are correspondingly willing to pay for them to different degrees. If some product X costs ten dollars but the average person is willing to pay only six dollars for it, then that product will be purchased by only a minority, even if the vast majority regard product X as desirable to some extent.

What is the common situation from an economic standpoint can be redefined politically as a “problem” – namely that most people want something that costs more than they feel like paying for it. The proposed solution to this problem is often that the government should in one way or another make this widely desired product more “affordable” to more people. Price control is likely to reduce the supply, so the more viable options are government subsidies for the production of the desired product or government subsidies for its purchase.

Many government expenditure patterns that would be hard to explain in terms of the costs and benefits to the public are by no means irrational in terms of the incentives and constraints facing elected officials responsible for these patterns.

The top priority of an elected official is usually to get re-elected, and that requires a steady stream of favorable publicity to keep the official’s name in the public good light.

Government Budgets

Government budgets, including both taxes and expenditures, are not records of what has already happened. They are plans or predictions about what is going to happen. But of course, no one knows what is going to happen, so everything depends on how projections about the future are made.

Neither the Congressional Budget Office nor anyone else can predict with certainty the consequences of a given tax rate increase or decrease. It is not just the exact amount of revenue that cannot be predicted. Whether revenue will move in one direction or the opposite direction is not a foregone conclusion. The choice is among alternative educated guesses – or mechanically calculating how much revenue will come in if no one’s behavior changes in the wake of a tax proceed on that assumption.

Since budgets are not records of what has read happened, but projections of what is supposed to happen in the future, everything depends on what assumptions are made – and by whom.

Special Problems in the National Economy

Economic decisions affect more than the economy. They affect the scope of government power and the growth of government financial obligations, including the national debt. They are also sometimes misconceptions of the nature of government, leading to unrealistic demands being made on it, followed by hasty denunciations of the “stupidity” or “irrationality” of government officials when those demands are not met.

The Scope of the Government

While some decisions are political decisions and others are economic decisions, there are large areas where choices can be made through either process. Both the government and the marketplace can supply housing, transportation, education, and many other things. For those decisions that can be made either politically or economically, it is necessary not only to decide which particular outcome would be preferred but also which process offers the best prospect of actually reaching that outcome. This in turn requires understanding how each process works in practice, under their respective incentives and constraints, rather than how they should work ideally.

Political choices are offered less often and are usually binding until the next election. Moreover, the política process offers “package deal” choices, where one candidate’s whole spectrum of positions on economic, military, environmental, and other issues must be accepted or rejected as a whole, in comparison with another candidate’s spectrum of positions on the same range of issues. The voter may prefer one candidate’s position on some of these issues and another candidate’s position on other issues, but no such choice is available on Election Day. By contrast, consumers make their choices in the marketplace every day and can buy one company’s milk and another company’s cheese, or ship some packages by Federal Express, and other packages by United Parcel Service. Then they can change their minds a day or week later and make wholly different choices.

The public usually buys finished products in the marketplace but can choose only among competing promises in the political arena. In the marketplace, the strawberries or the car that you are considering buying are right before your eyes when you make your decision, while the policies that a candidate promises to follow must be accepted more or less on faith. Speculation is just one aspect of a market economy but it is the essence of elections.

On the other hand, each voter has the same single vote on Election Day, whereas consumers have very different amounts of dollars with which to express their desires in the marketplace.

Too often there has been a tendency to regard government as a monolithic decision-maker or as the public interest personified. But different elements within the government respond to different outside constituencies and are often in opposition to one another for that reason, as well as because of jurisdiction frictions among themselves.

Politicians like to come to the rescue of particular industries, professions, classes, or racial-ethnic groups, from whom votes or financial support can be expected – and to represent the benefit to these groups as net benefits to the country.

One of the pressures on governments in general, and elected governments in particular, is to “do something” – even when there is nothing they can do that is likely to make things better and much that they can do that will risk making things worse. Economic processes, like other processes, take time but politicians may be unwilling to allow these processes the time to run their course, especially when their political opponents are advocating quick fixes, such as wage and price controls.

Government Obligations

In addition to what the government currently spends, it has various legal obligations to make future expenditures. These obligations are specified and quantified in the case of government bonds that must be redeemed for various amounts of money at various future dates. Other obligations are open-ended, such as legal obligations to pay whoever qualifies for unemployment compensation or agricultural subsidies in the future. These obligations are not only open-ended but difficult to estimate, since they depend on things beyond the government’s control, such as the level of unemployment and the size of the farmer’s crops.

Other open-ended obligations that are difficult to estimate are government “guarantees” of loans made by others to private borrowers or guarantees to those who lend to foreign governments. These guarantees appear to cost nothing, so long as the loans are repaid – and the fact that these guarantees cost the taxpayer nothing is likely to be trumpeted in the media by advocates of such guarantees, who can point out how businesses and jobs are saved without any expense to the government. But, at unpredictable times, the loans do not get paid and then huge amounts of the taxpayer’s money get spent over one of these supposedly cost-less guarantees.

Among the largest obligations of many, governments are pensions that have been promised to future retirees. These are more predictably given the size of the aging population and their mortality rates, but the problem here is that very often there is not enough money put aside to cover the promised pensions. This problem is not peculiar to any given country but is widespread among countries around the world since elected officials everywhere benefit at the polls by promising pensions to people who vote but stand to lose votes by raising tax rates high enough to pay what it would cost to redeem those promises.

The difference between political incentives and economic incentives is shown by the difference between government-provided pensions and annuities provided by insurance companies. Government programs may be analogized to the activities of insurance companies by referring to these poor as “social insurance,” but without in fact having either the same incentives, the same legal obligations, or the same results as private insurance companies selling annuities. The most fundamental difference between private annuities and government pensions is that the former creates real wealth by investing in premiums, while the latter creates no real wealth but simply uses current premiums from the working population to pay current pensions to the retired population.

Government pension plans enable current politicians to make promises that future governments will be expected to keep. These are virtually ideal political conditions for producing generous pension benefits – and future financial crises resulting from those generous benefits.

Market Failure and Government Failure

The imperfections of the marketplace – including such things as external costs and benefits, as well as monopolies and cartels – have led many to see government interventions as necessary and beneficial. Yet the imperfections of the market must be weighed against the imperfections of the government whose interventions are prescribed. Both markets and governments must be examined in terms of their incentives and constraints.

Where there are elected governments, their officials must be concerned about being re-elected – which is to say that mistakes cannot be admitted and reversed as readily as they must be by a private business operating in a competitive market, for the business to survive financially. No one likes to admit being a mistake but, under the incentives and constraints of profit and loss, there is often no choice but to reverse course before financial losses threaten bankruptcy. In politics, however, the costs of the government’s mistakes are often paid by the taxpayers, while the cost of admitting mistakes is paid by elected officials.

International Trade

Posing the issue of international trade as a country being “the winner” and another country being “the loser” is a central fallacy of political rhetoric. International trade is not a zero-sum contest. Both sides midst gain or it would make no sense to continue trading. But to understand this we must go back to square one.

What happens when a given country, in isolation, becomes more prosperous? It tends to buy more because it has more to buy with. And what happens when it buys more? There are more jobs created for workers producing additional goods and services. Rising prosperity usually means rising employment.

There is no fixed number of jobs that countries must fight over. When countries become more prosperous, they all tend to create more jobs. The only query is whether international trade tends to make countries more prosperous.

The basic facts about international trade are not difficult to understand. What is difficult to untangle is all the misconceptions and jargon which so often clutter up the discussion.

For example, the terminology used to describe an export surplus as a “favorable” balance of trade and an import surplus as an “unfavorable” balance of trade goes back centuries. At one time, it was widely believed that importing more than was exported impoverished a nation because the difference between imports and exports had to be paid in gold, and the loss of gold was seen as a loss of national wealth. However, as early as 1776, Adam Smith’s classic The Wealth of Nations argued that the real wealth of a nation consists of its goods and services, not its gold supply.

If the goods and services available to the American people are greater as a result of international trade, then Americans are wealthier, not poorer, regardless of whether there is a “deficit” or a “surplus” in the international balance of trade.

The Basis for International Trade

While international trade takes place for the same reason that other trade takes place – because booths sides gain – it is necessary to understand just why both countries gain, especially since they’re so many politicians and journalists who muddy the waters with claims to the contrary.

Absolute Advantage

Sometimes the advantage that one country has over another, or the rest of the world, are extreme. Growing coffee, for example, requires a peculiar combination of climactic conditions – warm but not too hot, nor with sunlight beating down on the plants directly all day, nor with too much moisture or too little moisture, and in some kinds of soils but not others. Putting together these and other requirements for ideal coffee-growing conditions drastically reduces the number of places that are best suited for producing coffee.

In the early 20th, more than half the coffee in the entire world was grown in just three countries – Brazil, Vietnam, and Colombia. This does not mean that other countries were completely incapable of growing coffee. It is just that the amount and quality of coffee that most countries could produce would not be worth the resources it would cost when coffee can be bought from these three countries at lower costs.

Sometimes an absolute advantage consists simply of being located in the right place or speaking the right language. India for example is used as an outsourced country for round-the-clock computer services.

These are all examples of what economists call “absolute advantage” – one country, for any of several reasons, can produce some things cheaper or better than another. Those reasons may be due to climate, geography, or a mixture of skills in their respective populations. A foreigner who buys the country’s products benefits from the lower costs, while the country itself benefits from the larger market for its product or services, and sometimes for the fact that part of the inputs needed to create the products is free, such as warmth in the tropics or rich nutrient in the soil in various places around the world.

Comparative Advantage

To illustrate what is meant by comparative advantage, suppose that one country is so efficient that is capable of producing anything more cheaply than a neighboring county. Is there any benefit that the more efficient country can gain from trading with its neighbor?


Why? Because being able to produce anything more cheaply is not the same as being able to produce everything more cheaply. When there are scarce resources that have alternative uses, producing more of one product means producing less of some other product. The question is not simply how much it cost, in either money or resources, to produce chairs or television sets in one country, compared to another country, but how many chairs it costs to produce a television set when resources are shifted from producing one product to producing the other.

If that trade-off is different between the two countries, then the country that can get more television sets by foregoing the production of chairs can benefit from trading with the country that gets more chairs by not producing television sets.

The benefits of comparative advantage are particularly important to poorer countries. Someone put it this way:

“Comparative advantage means there is a place under the free-trade sun for every nation, no matter how poor, because every nation can produce some products relatively more efficiently than they produce other products.”

Comparative advantage is not just a theory but a very important fact in the history of many nations. It has been more than a century since Great Britain produced enough food to feed its people. Britons have been able to get enough to eat only because the country has concentrated its efforts on producing those things in which it has had a comparative advantage, such as manufacturing, shipping, and financial services – and using the proceeds to buy food from other countries.

Since the real cost of anything that is produced are the other things that could have been produced with the same efforts, it would cost the British too much industry and commerce to transfer enough resources into agriculture to become self-sufficient in food. They are better off getting off from some country whose comparative advantage is in agriculture, even if that other country’s farmers are not as efficient as British farmers.

Economies of Scale

While the absolute and comparative advantage is the key reason for benefits from international trade, they are not the only reasons. Sometimes a particular product requires such a huge investment in machinery, in the engineering required to create the machinery and the product, as well as in developing a specialized labor force, that the resulting output can be sold at a low enough price to be competitive only when some enormous amount of output is produced, because of economies of scale.

Exports enable some countries to live in economies of scale that would not be possible from domestic sales alone. Some business enterprises make most of their sales outside their respective countries’ borders. For example, Heineken does not have to depend on the small Holland market for its beer sales, since it sells beer in 170 countries. Nokia sells its phones around the world, not just in its native Finland. Small countries like South Korea and Taiwan depend on international trade to be able to produce many products on a scale exceeding what can be sold domestically.

In short, international trade is necessary for many countries to achieve economies of scale that will enable the moto to sell at prices that can compete with the prices of similar products in the world market. For some products requiring huge investments in machinery and research, only a very few large and prosperous countries could reach the levels of output needed to repay all these costs from domestic sales alone. International trade creates greater efficiency by allowing more economies of scale around the world, even in countries whose domestic markets are not larger enough to absorb all the output of mass production industries, as well as by taking advantage of each country’s absolute or comparative advantage.

International Trade Restrictions

While there are many advantages to international trade for the world as a whole and countries individually, like all forms of greater economic efficiency, whether at home or abroad, it displaces less efficient ways of doing things.

Despite offsetting economic gains that typically far outright the losses, politically it is almost inevitable that there will be loud calls for government protection from foreign competition through various restrictions against imports. Many of the most long-lived fallacies in economics have grown out of attempts to justify these international trade restrictions.

Some people argue that wealthy countries cannot compete with countries whose wages are much lower. Poorer countries, on the other hand, may say that they must protect their “in fact industries” from the competition with more developed industrial nations until the local industries acquire the experience and know-how to compete on even terms. In all countries, there are complaints that other nations are not being “fair” in their laws regarding imports and exports.

In the complexities of real life, seldom is any argument right 100% of the time or wrong 100% of the time.

The High-Wage Fallacy

Historically, high-wage countries have been exporting to low-wage countries for centuries. The Dutch Republic was a leader in international trade for nearly a century and a half – from the 1590s to the 1740s – while having some of the highest-paid workers in the world. Britain was the world’s greatest exporter in the 19th century and its wage rates were much higher than the wage rates in many, if not most, of the countries to which it sold its goods.

Economically, the key flaw in the high-wage argument is that it confused wage rates with labor costs – and labor costs with total costs. Wage rates are measured per hour of work. Labor costs are measured per unit of output. Total costs include not only the costs of labor but also the cost of capital, raw materials, transportation, and other things needed to produce output and bring the finished product to market.

When workers in a prosperous country receive wages twice as high as workers in a poorer country and produce three times the output per hour, then it is the high-wage country that has the lower labor costs per unit of output. That is, it is cheaper to get a given amount of work done in a more prosperous country simply because it takes less labor, even though individual workers are paid more for their time. The higher-paid workers may be more efficiently organized and managed or have more or better machinery to work with or work with companies or industries with greater economies of scale.

There are, after all, reasons why one country is more prosperous than another in the first place – and often that reason is that they are more efficient at producing and delivering output, for several reasons. In short, higher wage rates per unit of time are not the same as higher costs per unit of output.

None of this means that no low-wage county can ever gain jobs at the experience of a high-wage country. All other forms of comparative advantage will also mean a shift of jobs to countries with particular advantages in doing particular things. But this does not imply a net loss of jobs in the economy as a whole, any more than another form so f greater efficiency, domestically or internationally, implies a net loss of jobs in the economy. The job losses are quite real to those who suffer them, whether due to domestic or international competition, but restrictions on either domestic or international markets usually cost jobs or net balance because such restrictions reduce the prosperity on which the demand for goods and labor depends.

Labor costs are only part of the story. The costs of capital and management are a considerable part of the cost of many products. In some cases, capital costs exceed labor costs, especially in industries with high fixed costs, such as electric utilities and railroads, both of which have huge investments in infrastructure. A prosperous country usually has a greater abundance of capital and, because of supply and demand, capital tends to be cheaper there than in poorer countries where capital is more scarce and earns a correspondingly higher rate of return.

Saving Jobs

During periods of high unemployment, politicians are especially likely to be under pressure to come to the rescue of particular industries that are losing money and jobs, by restricting imports that compete with them. One of the most tragic examples of such restrictions occurred during the worldwide depression of the 1930s when tariffs barriers and other restrictions went up around the world. The net result was that world exports in 1933 were only one-third of what they had been in 1929. Just as free trade provides economic benefits to all countries simultaneously, so trade restrictions reduce the efficiency of all countries simultaneously, lowering standards of living, without producing the increased employment that was hoped for.

At any given time, a protective tariff or other import restrictions may provide immediate relief to a particular industry and thus gain the political and financial support of corporations and labor unions in that industry. But, like many political benefits, it comes at the expense of others who may not be as organized, as visible, or as vocal.

When the number of jobs in the American steel industry fell from 340,000 to 125,000 during the decade of the 1980s, it had a devastating impact and was big encomiums and political news. It also led to a variety of laws and regulations designed to reduce the amount of steel imported into the country that competed with domestically produced steel. Of course, this reduction in supply led to higher steel prices within the United States, therefore higher costs for all other American industries that were manufacturing products made of steel, which range from automobiles to oil rigs.

International trade restrictions provide yet another example of the fallacy of composition, the belief that what is true of a part is true of the whole. There is no question that a particular industry or occupation can be benefited from international trade restrictions. The fallacy is in the belief that this means the economy as a whole benefited, whether as regards jobs or profits.


A common argument for government protection against a competitor in other countries is that the latter is not competing “fairly” but is instead “dumping” its products on the market at prices below their costs of production. The argument is that this is being done to drive the domestic producers out of business, letting the foreign producer take over the market, after which prices will be raised to monopolistic levels. In response to this argument, governments have passed “anti-dumping” laws, which ban, restrict, or heavily tax the importation of products from foreign companies declared to be guilty of this practice.

Everything in this argument depends on whether or not the foregoing producer is selling goods below their cost of production. Determining production costs is not easy in practice, even for a firm operating within the same country as the government agencies that are trying to determine its costs.

Whatever the theory behind anti-dumpling laws, in practice they are part of the arsenal of protectionism for domestic producers, at the expense of domestic consumers. Moreover, even the theory is not without its problem.s dumping theory is an international version of the theory of “predatory pricing.” Predatory pricing is a charge that is easy to make and hard to either prove or disprove, whether domestically or internationally.

Kinds of Restrictions

Tariffs are taxes on imports that serve to raise the prices of those imports, and thus enable domestic producers to charge higher prices for competing products than they could in the face of cheaper foreign competition. Import quotas likewise restrict foreign companies from competing on even terms with domestic producers. Although tariffs and quotas may have the same economic result, these effects are not equally obvious to the public. Thus, while a $10 tariff on imported widgets may enable the domestic producers of widgets to charge $10 more than they could otherwise, without losing business to foreign producers, a suitable quote limitation of the number of imported widgets can also drive up the price of widgets by $10 through its efecto on supply and demand. In the latter case, however, it is by no means as easy for the voting public to see and quantify the effects. What that can mean politically is that a quota restriction that raises the price of widgets by $15 may be as easy for elected officials to pass as traffic of $10.

Even more effective disguises for international trade restrictions are health and safety rules applied in imports, rules which often go far beyond what is necessary for health and safety. Mere red tape requirements can also grow to the point where the time needed to comply adds enough cost to be prohibitive, especially for perishable imports. If it takes a week to get your strawberries through customs, you may as well not ship them.

Changing Conditions

Over time, comparative advantages change, causing international production centers to shift from country to country.

Regardless of the industry or the country, if a million new and well-paying jobs are created in companies scattered all across the country as a result of international free trade, that may carry less weight politically than if half a million jobs are lost in one industry where labor unions and employer associations can raise a clamor. When the million new jobs represent a few dozen jobs here and there in innumerable businesses scattered across the nation, there is not enough concentration of economic interest and political clout in any one place to make it worthwhile to mount a comparable counter-campaign. Therefore laws are often passed restricting international trade for the benefit of some concentrated and vocal constituency, even though these restrictions may abuse far more losses in jobs nationwide.

The direct transfer of particular jobs to a foreign country – “outsourcing” – arouses much political and media attention, as when American and British telephone-answering jobs are transferred to India, where English-speaking Indians answer calls made to Harrod’s department store in London.

That decoy the numbers of jobs transferred to another country rarely state whether these are net losses of jobs. While many American jobs have been “outsourced” to India and other countries, many other countries “outsource” jobs to the United States.

How many jobs are being outsourced in one direction, compared to how many are being outsourced in the other direction, changes with time.

Even a country that is losing jobs to other countries, on net balance, through outsourcing may nevertheless have more jobs than it would have had without outsourcing. That is because the increase in wealth from international transactions means increased demand for goods and services in general, including goods and services produced by workers in purely domestic industries.

Free trade may have wide support among economists, but its support among the public at large is considerably less. Part of the reason is that the public has no idea how much protectionism costs and how little net benefit it produces. It has been estimated that all the protectionism in the European Union countries put together saves no more than a total of 200,000 jobs – a cost of $43 billion. That works out to about $215,000 a year for each job saved.

Another reason for public support for protectionism is that many economies do not bother to answer either the special interests or those who oppose free trade refuted centuries ago and are now regarded within the economics profession as beneath consideration.

Because the buzzword “globalization” has been coined to describe the growing importance of international trade and global economic interdependence, many tend to see international trade and international financial transactions as something new – allowing both special interest and ideologues to play on the public’s fear of the unknown. However, the term “globalization” also covers more than simply free trade among nations. It includes institutional rules governing the reduction of trade barriers and the movement of money. Among the international organizations involved in creating these rules are the World Bank, the International Monetary Fund, and the World Trade Organization.

International Transfer of Wealth

Transfers of wealth among nations take many forms. In visuals and businesses in one country may invest directly in the business enterprises of another country. Citizens of a given country may also put their money in another country’s banks, which will in turn make loans to individuals and enterprises so this is indirect foreign investment. Yet another option is to buy the bonds issued by the foregoing government.

In addition to investments of various kinds, there are remittances from people living in foreign countries sent back to family members in their countries of origin.

Other international transfers of wealth have not been so benign. In centuries past, imperial powers simply transferred vast amounts of f wealth from the nations they conquered.

None of this is very complicated – so long as we remember Justice Oliver Wendell Holme’s admonition to “think things instead of words.” When it comes to international trade and international transfers of wreaths, things are relatively straightforward, but the words are often slippery and misleading.

International Investment

Theoretically, investments might be expected to flow from where capital is abundant to where it is in short supply. In a perfect world, wealthy nations would invest much of their capital in poorer nations, where capital is more scarce and would therefore offer a higher rate of return. However, in the highly imperfect world we live in, that is by no means what usually happens. For example, out of a worldwide total of about $21 trillion in international bank loans in 2012, only about $2.5 trillion went to poor countries. In short, rich countries tend to invest in other rich countries.

The biggest deterrent to investing in any country is the danger you will never get your money back. Investors are wary of unstable governments, whose changes of personnel or policies create risks that the con idiot so under which the investment was made a change -the most drastic change being outright confiscation by the government, or “nationalization” as it is called politically. Widespread corruption is another deterrent to investment, as it is economic activity in general.

Even aside from confiscation and corruption, many poorer countries “do not let capital come and go freely”. Where capital cannot get out easily, it is less likely to go in, in the first place. It is not those countries’ poverty, as such, that deters investments.

With trade deficits, as with many other things, what matters is not the absolute size but the size relative to the size of the economy as a whole.

When you count all the money and resources moving in and out of a country for all sorts of reasons, then you are no longer talking about the “balance of trade” but about the “balance of payments” – regardless of whether the payments were made for goods and services.

This is not to say that countries with trade surpluses or payment surpluses are at an economic disadvantage. It I just that these numbers by themselves, do not necessarily indicate either the prosperity or the poverty of any economy.

The point is that neither international deficits nor surpluses are inevitable consequences of either prosperity or poverty and neither word, by itself, tells much about the condition of a country’s economy. The word “debt” covers very different kinds of transactions, some of which may present problems and some of which do not.

Remittances and Human Capital


Emigrants working in foreign countries often send money back to their families to support them. During the 19th century and early 20th centuries, Italian emigrant men were particularly noted for enduring terrible living conditions in various countries around the world, and even skimping on food, to send money back to their families in Italy.

In the 20th century, remittances are moon the main sources of outside money flowing into poorer countries. In 2009, for example, the worldwide remittances to these counties were more than two and a half times the value of all foreign aid.

Emigrants and Immigrants

People are one of the biggest sources of wealth. Whole industries have been created and economies have been transformed by immigrants.

Historically, it has not been at all unusual for a particular ethnic or immigrant group to create or dominate a whole industry. German immigrants created the leading beer breweries in the United States in the 19th century, and most of the leading brands of American beer in the 20th country are still produced in breweries created by people of German descent. There were no watches manufactured in London until Huguenots fled France to watch king skills with them to England and Switzerland, making both these nations among the leading watchmakers in the world.

Among the vital sources of the skills and entrepreneurship behind the rise of first Britain, and later the United States, to the position of the leading industrial and commercial nation in the world were the numerous immigrant groups who settled in these countries, often to escape persecution or destitution in their native lands.

Throughout history, national economic losses from emigration have been as striking as gains from receiving immigrants. After the Moriscos were expelled from Spain in the early 17th country, a Spanish cleric asked: “Who will make shoes now?” Some countries have exported human capital on a large scale – for example, when their educated young people migrate because other countries offer better opportunities.

Although it is not easy to quantify human per capita, the emigration of educated people on this scale represents a serious loss of national wealth. One of the most striking examples of a country’s losses due to those who emigrated was that of Nazi Germany, whose anti-Semitic policies led many Jewish scientists to feel to America, where they played a major role in making the United States the First Nation with an atomic bomb.

It would be misleading to assess the economic impact of immigrants solely in terms of their positive contributions. Immigrants have also brought disease, crime, internal strife, and terrorism. Nor can all immigrants be lumped together. When only 2% of immigrants from Japan go on welfare, while 46% of immigrants from Laos do, there is no single pattern that applies to all immigrants. There are similar disparities in crime rates and other both negative and positive factors that immigrants from different countries bring to the United States and other countries in other parts of the world.

Everything depends on which immigrants you are talking about, which countries you are talking about, and which periods of history.


Plunder of one nation or people by another has been all common thought human history.

Although imperialism is one of how wealth can be transferred from one country to another, there are also non-economy reasons for imperialism that have caused it to be persisted, even when it was costing the conquering country money on net balance. 19th-century missionaries urged the British government toward acquiring control of various countries in Africa where there was much missionary work going on – such urging often being opposed by chancellors of the exchequer, who realized that Britain would never get enough wealth out of these poor countries to repay the costs of establishing and maintaining colonial regimes there.

Even at the height of the British Empire in the early 20th century, the British invested more in the United States than in all of Asia and Africa put together. Quite simply, there is more wealth to be made from rich countries than from poor countries.

Perhaps the strongest evidence against the economic significance of colonies in the modern world is that Germany and Japan lost all of their colonies and conquered lands as a result of their defeat in the Second World War and both countries rebounded to reach unprecedented levels of prospective thereafter.

Imperialism has often caused much suffering among the conquered peoples. But, in the modern industrial world at least, imperialism has seldom been a major source of international transfers of wealth.

While investors have tended to invest in more prosperous nations, making both themselves and these nations wealthier, some people have depicted investment in poor countries as somehow making the latter even poorer. The Marxian concept of “exploitation2 was applied internationally in Lenin’s book Imperialism, where investments by industrial nations in non-industrial countries were treated as being economically equivalent to the looting done by earlier imperialist conquerors. Tragically, however, it is in precisely those less developed countries where little or no foreign investments have taken place that poverty is at its worst.

Similarly, those poor countries with less international trade as a percentage of their national economies have usually had lower economic growth rates than poor countries where international trade plays a larger economic role. Indeed, during the date of the 1990s, the former countries had declining economies, while those more “globalized” countries had growing economies.

Wealthy individuals in poor countries often invest in richer countries, where their money is safer from political upheavals and confiscation. Ironically, poorer countries are thus helping richer industrial nations to become still richer. Meanwhile, under the influence of theories of economic imperialism which depicted international investment as being the equivalent of imperialist looting, governments in many poorer countries pursued policies that discouraged investments from being made there by foreigners.

By the late 20th century, the painful economic consequences of such policies had become sufficiently apparent to many people in the third world that some governments began moving away from such policies, to gain some of the befits recited by other countries which had raised from poverty to prosperity with the help of investment made in their countries by enterprises in other countries.

Foreign Aid

What is called “foreign aid” are the transfer of wealth from foreign governmental organizations, as well as international agencies, to the governments of poorer countries. The term “aid” assumes a priori that such transfers will in fact aid the poorer countries’ economies to develop. In some cases it does, but in other cases, foreign aid simply enables the existing politicians in power to enrich themselves through graft and to dispense largess in politically strategic weary to others who help to keep them in power. Because it is a transfer of wealth to governments, as distinguished from investment in private enterprises, foreign aid has encouraged many countries to set up government-run enterprises that have failed, or to create palaces, plazas, or other things meant to impress onlookers rather than produce things that raise the material standard of living in the recipient country.

While most people cite the Marshall Plan as a successful foreign aid plan, what is being ignored is the fact that in Europe, after the war, what needed to be rebuilt was physical capital. What needed to care for in much of the Third World was more human capital. The latter proved harder to do, just as the vast array of skills needed in a modern economy had taken centuries to develop in Europe.

In addition to the “foreign aid” dispensed by international agencies, there are also direct government-to-government grants to money, shipments of free food, and loans which are made available on terms more lenient than those available in the financial markets, and which are from time to time “forgiven,” allowed to default, or “rolled over” by being repaid from the proceeds of a new and larger loan.

The International Monetary System

Wealth may be transferred from country to country for mod goods and services, but by far the greatest transfers are made in the form of money. Just as a stable monetary unit facilitates economic activity within a country, so international economic activity is facilitated when there are stable relationships between one country’s currency and another’s. It is not simply a question of the ease or difficulty of converting dollars into yen or euros at a given moment. A far more important question is whether an investment made in the United States, Japan, or France today will be repaid a decade or more from now in money of the same purchasing power.

Where millions of dollars are invested overseas, the stability of the various currencies is urgently important. It is important not simply to those whose money is directly involved, it is important in maintaining the flows of trade and investment which affect the material well-being of the general public in the countries concerned.

Money fluctuations have had repercussions on such real things as output and employment since it is difficult to plan and invest when there is cut uncertainty about what the money will be worth, even if the investment is successful otherwise.

As in other areas of economics, it is necessary to be on guard against emotionally loaded words that may confuse more than they clarify. Among the terms widely used in discussing the relative values of various national currencies are “strong” and “weak.” Thus, when the euro was first introduced as a monetary unit in the European Union countries, its value fell from $1.18 to 83 cents and it was said to be “weakening” relative to the dollar. Later it rose again, to reach $1.16 in early 2003, and was then said to be “strengthening.”

One thing that a “strong” currency does not mean is that the economies which use that currency are necessarily better off. Sometimes it means the opposite. A “strong” currency means that the prices of exports from countries that house the currency have risen in price to people in other countries.

Just as “strong” currency is not always good, it is not always bad either. In the countries that use the euro, businesses that borrow from the Americas find the burden of that debt to be less, and therefore easier to repay, when fewer euros are needed to pay back the dollar they owe.

International Disparities in Wealth

Any study of international economic activities inevitably encounters the fact of vast differences among nations in their incomes and wealth.

Many find such disparities both puzzling and troubling, especially when contemplating the fate of people born in such dire poverty that their chances of a fulfilling life seem very remote. Among the many explanations that have been offered for this painful situation, some are more emotionally satisfying or politically popular than others. But a more fundamental question might be: was there ever any real chance that the nations of the world would have had similar prospects of economic development?

Innumerable factors go into economic development. For all the possible combinations and permutations of these factors to work out in such a way as to produce even approximately equal results for all countries around the world would be a staggering coincidence.

Geographic Factors

Whether human beings are divided into countries, races, or other categories, geography is just one of the reasons why they have never had either the same direct economic benefits or the same opportunities to develop their human capital. Virtually none of the geographic factors that promote economic prosperity and human development is equal in all parts of the world.

To begin with, the most basic, the land is not equally fertile everywhere. The Mollisols are distributed around the world in a very uneven pattern. Large concentrations of these rich soils are found in the American upper midwestern and plains states, extending into parts of Canada, and a vast swath of these soils spread across the Eurasian landmass, from the southern part of Eastern Europe to northeastern China. A smaller concentration of these soils is found in the temperate zone of South America, in southern Argentina, southern Brazil, and Uruguay.

While such soils are found in various parts of the temperate zones of both the Northern Hemisphere and the Southern Hemisphere, they are seldom found in the tropics. The soils of sub-Saharan Africa have multiple and severe deficiencies, leading to crop yields that are a fraction of those in China or the United States. In many parts of Africa, the topsoil is shallow, allowing little space for the roots of plants to go down and collect nutrients and water. The dryness of much of Africa inhibits the use of fertilizers to supply the nutrients missing in the soil because fertilizers used without adequate water can inhibit the growth of crops.

Even within a given country, such as China, there are very different varieties of soil – predominantly rich, black soils in the northeast and less fertile soils in the southeast. Not only does the fertility of the land vary greatly in different regions of the world, but it has also varied over time.

The rain that falls on the land is not equal in amount or reliability in different regions of the world, nor does all land absorb and hold rainwater equally. Loess soil, such as that in northern China, can absorb and hold much more of the rain that falls on it than can the limestone soils in parts of the Balkans, through which the water drains more quickly, leaving less moisture behind that help crops grow. In some places, such as Western Europe, the rain falls more or less evenly throughout the year, whereas in other places, such as sub-Saharan Africa, there are long dry spells followed by torrential downpours that can wash away topsoil.

During the many centuries when agriculture was the most important economic activity in countries around the world, there was no way that this crucial activity could produce similar economic results everywhere – whether in terms of a general standard of living or in terms of an ability to develop and sustain major urban communities dependent on local agriculture for their food.

Such fundamental things as sunshine and rain vary greatly from one place to another. The average annual hours of sunshine in Athens are nearly double that in London, and the annual hours of sunshine in Alexandria are more than double.

The larger point here is that the effect of different geographic factors, such as sunshine and rain, cannot be considered in isolation, because their interactions are crucial and their timing is crucial. The possible combinations and permutations of these factors are exponentially greater than the number of factors considered in isolation, leading to great variations in economic outcomes in places that may seem to be similar, when the interaction of factors is not taken into account. This applies not only to variations in the land but also to variations in waterways, and not not to effects in agriculture but also effects on cities, industries, and commerce.

In addition to natural resources such as land and the minerals in it, which can contribute directly to economic prosperity and development, other geographic factors contribute indirectly but importantly, by facilitating various economic activities. Among these are navigable waterways and animals that facilitate both travel and agriculture.

Navigable Waterways

There is an economic reason why most cities around the world are located on waterways, whether rivers, harbors, or lakes. Some of the most famous cities are located at or near the terminus of great rivers that empty into the open seas (New York, London, Shanghai, Rotterdam), and some are located beside huge lakes or inland seas (Geneva, Chicago, Odessa, Detroit), and some are located on great harbor emptying into the open seas (Sydney, San Francisco, Tokyo, Rio de Janeiro).

Among the economic reasons for these locations are transportation costs. Land transport has cost far more than water transport, especially in the millennia before self-propelled vehicles appeared, less than two centuries ago. Even today, it can cost more to ship cargo a hundred miles by land than to ship it a thousand miles by water. Given the vast amount of things that have to be constantly transported into cities, such as food and fuel, and the huge volume of a city’s output that must be transported out to sell elsewhere, it is not surprising that so many cities are located on navigable waterways.

The navigability of rivers is limited by the shapes of the lands through which they flow. Western Europe, for example, is crisscrossed with rivers flowing gently across wide and level coastal plains into the open seas, which provide access to countries around the world. By contrast, most of sub-Saharan Africa, except for narrow coastal plains, is more than 1,000 feet in elevation and much of it is more than 2,000 feet high. Africa’s narrow coastal plains are often backed by steep escarpments that block the penetration of the interior by vessels coming in from the sea, and prevent boats from the interior from reaching the coast.

Because of the physical shape of the land, rivers in sub-Saharan Africa plunge from a height of a thousand feet or more, down through cascades and waterfalls on their way to the sea. Such rivers are navigable only for limited-level stretches, usually navigable for boats of only limited sizes, and often for only limited times of the year, given the more sporadic rainfall patterns in sub-Saharan Africa compared to the more even rainfall patterns in Western Europe.

Although the Zaire river empties more water into the sea than does the Misisipi, the Yangtze, the rhine, or many other great commercial waterways of the word, the thousand of feet that Zaire must come down on its way to the sea, through rapids, cascades, and waterfalls, preclude any comparable volume cargo traffic. Ships coming in from the Atlantic on the Zaire river cannot get very far inland before they are stopped by a series of cataracts. Neither the length of a river nor even its volume of water says anything about its economic value as an artery of transportation.

Sometimes canoes may be emptied of their cargo and carried around the cascade or waterfall, to be reloaded for the next portion of the journey. But this not only limits the size of the vessels used, and therefore the size of the cargoes, but also increases the cost of the additional time and labor required to get cargo to its destination. The next result is that only cargoes with a very high value in small physical size are economically viable to transport.

Harbors are likely neither as common nor as useful in some parts of the world as in others. Although Africa is more than twice the size of Europe, the African coastline I shorter than the European coastline. This is possible only because the European coastline twist and turns far more, creating many more harbors where ships can dock, sheltered from the rough waters of the open seas.

When one considers the depths of rivers, there are still more inequalities that are economically relevant. Although the Nile is the longest reviver in the world, its depth was not great enough for the largest ships in the days of the Roman Empire, much less for the aircraft carriers and other giant ships of today. Yet an aircraft carrier can sail up the Hudson River and dock right up against the land in midtown manhattan. Some of the rivers in Angola are navigable only by boats requiring no more than 8 feet of water. During the dry seasons, even a major west African river like the Niger will carry barges weighing no more than 12 tons. By contrast, this weighing 10,000 tons has been able to go hundreds of miles up the Yangtze River in China, and smaller vessels another thousand miles beyond that.

Given the dependence of cities on waterways, it can hardly be surprising that Western Europe became one of the most urbanized regions of the world, and sub-Saharan Africa remained one of the least urbanized. What urbanization means in terms of one people, and the range of their knowledge, skill, and experience – their human capital – is that first the Chinese, and later Western Europeans, had opportunities to develop urban industrial, commercial and financial skills and orientations far more often, and far longer, than the peoples of the Balkans or sub-Saharan Africa. For centuries, in countries around the world, achievements, and advances in many fields of endearing have been far greater in cities than among the similar numbers of people scattered in the hinterlands.

The direct economic benefits created by low transport costs on navigable waterways must be added t the value of greater human capital resulting from exposure to the wider cultural university that includes the products, technology, and ideas of countries around the world. The economic benefits of this exposure to a wider cultural universe may well equal or exceed that of the direct economic benefits of international trade.


The pattern of both economic and cultural lags among people living in the mountains, compared with their contemporaries on the land below, has been as common in America’s Appalachian Mountains as in the Rif Mountains of Morocco or the Pindus Mountains of Greece. Take the Scotts for example, whose economic and cultural success depends on whether they came from the highlands of Scotland or the lowlands. Even in countries of immigration like America and Australia, the low landers had much more economically successful and more socially integrated with both countries. Cultural differences that develop over the centuries do not vanish overnight when people move from one environment to another, or when the environment around them at given places changes.

Technological economic and other developments likewise tend to reach the mountains long after they had spread across the lowlands, so the mountain peoples have long been known for their poverty and backwardness – whether in the Himalayas, the Appalachians, or the mountains of Albania, Morocco or other places around the world.

Neither geographic isolation nor its economic and cultural handicaps have been confined to people living in mountains. Similar effects have been seen where isolation has been due to islands located far from the nearest mainland. When the Spaniards discovered the Canary Islands in the 15th century, for example, they found people of the Caucasian race living at a Stone Age level.


Something as simple as the fact that Russian rivers run north-south and most traffic moves east-west means that the economic value of those rivers as transportation arteries was greatly reduced. Differences in location can also mean differences in climate that affect how much a particular waterway is subject to being frozen, and therefore unable to carry any cargo.

Although the Volga is Russia’s most important river economically, in terms of the cargo it carries, there are two other Russian rivers which each have more than twice as much water as the Volga. But the Volga happens to be located near centers of population, industry, and farmland, and the others are not. Location can matter more than the physical characteristic of a river – or mountains or other geographic features.

The happenstance of being in the right place at the right time has made a huge difference in the economic fate of whole peoples. Moreover, what the right place has varied greatly at different periods of history. After many centuries, the peoples of Northern Europe would eventually surpass the peoples of Southern Europe economically and technologically – as the people of japan would likewise surpass the people of china who had for centuries been far more advanced than the Japanese. Economic inequalities between peoples or nations have been pervasive in both ancient times and modern times, though the particular patterns nor that inequality have changed drastically over the centuries.


Places blessed with beneficial climates, waterways, and other natural advantages can nevertheless remain poverty-stricken if the culture of the people living there presents many obstacles to their developing the resources that nature has provided. What has sometimes been called “loving in harmony with nature” can also be called stagnating in poverty amid potential wealth? Other peoples from other cultures often move into the same geographic setting and thrive by developing its resources.

Cultures that promote the rule of law, rather than arbitrary powers exercised by leaders, have increasingly been recognized as major factors promoting economic development. So too are cultures where honesty is highly valued in both principle and practice.

Cultural attitudes toward work also affect economic development, and these attitudes have also varied, for centuries, even within the same European civilization.

Sometimes economic progress depends on whether people in a particular culture are seeking progress, rather than being contended with doing things the way things have always been done. The proportion of the population who seek progress and the proportions who are satisfied with doing things in facials ways can differ between societies, thereby affecting economic differences among regions and nations.

Differences in habits and attitudes are differences in human capital, which can mean different ends in economic outcomes.

The advantages of a larger cultural universe do not end with the particular products, technologies, or ideas that come from other cultures. Repeatedly seeing how things are done differently in other societies, with better results in particular cases, not only brings those particular foreign products, technologies, and ideas but also counters the normal human tendency toward initial that keeps individuals and societies doing things in the same old familiar ways. In other words, a particular culture may develop its original new ways of doing things, as a result of seeing repeatedly how others have done other things differently.

Human Capital

Physical wealth may be highly visible, but human capital, invisible inside people’s heads, is often more crucial to the long-run prosperity of a nation or a people.

The difference between sending economic aid to war-torn Europe and sending economic aid to third-world countries is that the latter didn’t have the human capital to make good use of those resources.

Confiscation of physical capital has likewise seldom produced any major or lasting enrichment of those who do the confiscating – whether these are third-world governments confiscating (“nationalizing”) foreign investments or urban rioters looting stores in their neighborhoods. What they cannot confiscate is the human capital that created the physical things that are taken. However serious the losses suffered by those who have been robbed, whether by the government or by mobs, the physical things have a limited duration. Without the human capital required to create their replacements, the robbers are unlikely to prospect in future years as well as those who were robbed.

Sometimes the very advantages of a given geographic setting can make it unnecessary for the people of indigenous in that setting to have to develop their human capital to the fullest. For example, a tropical land capable of producing crops year-round can make it unnecessary for the people there to develop the same sense of urgency about time, and the resulting habits of economic self-disciple, that are necessary for sheer physical survival in a climate where people must begin plowing the land soon after it thaws s in the spring if they are to raise a crop during the limited growling season in the temperate zone that will enable them to feed themselves through the long winter months.

Like many other things, natural abundance can have both positive and negative effects.

Cultural Isolation

One of the aspects of a culture that can be very important in its economic consequences is a willingness, or unwillingness, to learn from other cultures. This can vary greater from one culture to another. Both Britain and Japan, for example, rose from being island nations lagging economically for centuries behind their respective continental neighbors, before eventually catching up and then surging ahead of them, largely as a result of absorbing the cultural and economic advances of other nations and then carrying these advances further themselves.

By way of contrast, the Arab Middle East – once a culture more advanced than that in Europe – become resistant to learning from others, lost its lead, and fell behind other nations that were advancing faster.

Cultural isolation can be a factor in wealth differences among nations, just as geographic isolation can be.

Sometimes cultural isolation has been the result of a government decision, as in 5th-century china, when the country was far more advanced than many other nations. China’s rulers deliberately chose to isolate china from what they saw as foreign barbarians. In the 17th century, the rules of japan likewise chose to isolate their country from the rest of the world. In later centuries, both countries were shocked to discover that some other nations had far surprised them technologically, economically, and militarily during their self-imposed isolation.

Another the other way in which cultures handicap themselves is by limiting which segments of their population are allowed to play which roles in the economy or society. If only people from certain preselected groups – whether defined by class, caste, tribe, race, religion, or sex – are allowed to have particular careers, this cultural distribution of economic roles can differ greatly from the individual distribution of inborn talents. The net result can be that, by forfeiting the potentialities of many of its people, such societies end up with a less productive economy than in other societies without such self-imposed restrictions on the development and use of their people’s talents and potentialities.

Cultural isolation takes many forms, creating economic and other handicaps that differ from group to group and form one society, nation, or civilization to another. Different levels of cultural isolation within and between societies add to geographic and other factors making economic equality unlike among groups, societies, nations, and civilizations.


Populations can affect economic outcomes by size, demographic characteristics, or mobility, among other factors. The concentration or dispersion of a population can also greatly affect economic progress, which often varies with the degree of urbanization.

Population Size

The danger of “overpopulation” has long been a recurrent concern, even before Malthus raised his history Alamar at the end of the 18th century that the number of human beings threaten to exceed the number for which there was an adequate food supply. At various places and times throughout history, famines have been monumental tragedies that some have regarded as confirmation of Malthus’s theory.

As late as the 20th century, a famine in the Soviet Union under Stalin took millions of lives and, in China under Mao, tens of millions. But even catastrophes of this almost unimaginable magnitude do not prove that the world’s food supply is inadequate to feed the world’s population. Famines in particular countries or regions are often due to factors at work in those particular countries and regions at the time, such as local crop failures or the disruption of transport ion due to war, weather, or other causes.

Crop failures are not sufficient, by themselves, to bring on famine, unless food from other parts of the world cannot reach the stricken areas in a term, and on a scale sufficiently to head off mass starvation or the disease to which undernourished people become vulnerable. Poor countries lacking transportation networks capable of moving vast amounts of food in a short time have been especially susceptible to famines. The modern transportation revolution has reduced such conditions over most of the world. But a count or region isolated for political reasons can remain susceptible to famine, as in the Soviet Union understating and China under Mao.

The indisputable fact that there are finite limits to the amount of each natural resource has led to a non sequitur that we are nearing those limits. Similarly, the indisputable fact that there are finite limits to the number of people the planet can feed has led to the non sequitur that we are nearing those limits.

What seems to matter more is not the number of people but the productivity of those people which is dependent on many factors, including their habits, skills, and experiences.

Population Movements

While peoples in different regions of the world might live, and their cultures and societies evolve, in their respective regions for millennia, at various times they have also moved to other regions of the world, whether as conquerors, immigrants, or slaves. Some have migrated singly or in families, and others have migrated en masse, whether settling among existing inhabitants or driving the existing inhabitants out and displacing them.

In the early years of the industrial revolution, when technology advanced through the direct practical work of people in factories, mines, and other production facilities, rather than through the application of science as in altering times, the movement of migrants was the principal means of diffusion of technology form it sources to other nations and regions. Thus British technological advances could spread more readily to an English-speaking country like the United States than to nearer countries on the continent of Europe.

In countries around the world, the movements of people are also a movement of their cultures. This can result in a displacement of existing cultures at their destination, a planting of a new culture amid one already in place, or assimilation to the destination culture by the migrants. These varied prospects add more combinations and permutations to the possibilities affecting economic and social development – making equal development among reigns, races, and nations even less likely than with geographic or cultural differences alone.

Sometimes the newcomers end up adopting the culture of the surrounding society, beginning with the language, as most of the millions of immigrants to the United States did in the 19th and 20th centuries. In other cases, such as the settlements of Western Europeans in Eastern Europe during the Middle Ages, the migrants retained their langue and culture for centuries and, assimilated members of the indigenous population to the transplanted cultures. This was especially so when the transplanted peoples were more prosperous, more highly skilled, and better educated.


Conquest has transferred wealth, as well as cultures, among nations and peoples.

From a purely economic standpoint, the question is: how much do the conquest and enslavements of the past explain economic disparities among nations and peoples in the present?

Take Spain, for example, who extracted around 200 tons of gold from the American nations of Peru and Mexico, and yet European countries that have never had empires, such as Switzerland and Norway, have higher standards of living than Spain.

While the vast wealth that poured into Spain from its colonies could have been invested in building up the commerce and industry of the country, and building up the literary and occupation skills of its people, this wealth was largely dissipated in the consumption of imported luxuries and military adventures during the “golden age” of Spain in the 16th century. But luxuries and war were primarily for the benefit of the ruling elite, rather than the adjacent Spanish people at large. As late as 1900, more than half the population of Spain remains illiterate. By contrast, in the United States that same year a majority of the black population could read and write, despite having been free for less than 50 years.

Like many conquering peoples, the Spaniards in their “golden age” disdained commerce, industry, and labor – and their elites revealed leisurely and luxurious living. This led to a large and continuous drain of precious metals from Spain to other countries, to pay for imports.

Britain might seem to be an excepción, in that it once had the largest empire of all and today has a high standard of living. However, it is questionable whether the Bristol empire had a net profit over the relatively brief span of history in which it was at its ascendency. Individual Britons such as Cecil Rhodes grew rich in the empire, but the British taxpayers bore the heavy costs of conquering and maintaining the empire, including the world’s largest burden of military expenditures per capita.

Britain also had at one time the world’s largest slave trade in its empire. But even if all the profits from slavery had been invested in British industry, this would have amounted to less than 2% of Britain’s domestic investments during the era. 

In short, forcible transfers of wealth from some nations or peoples other nations or peoples, whether through conquest or enslavement, can be larger without producing lasting economic development.

By and large, imperialism cannot be said unequivocally to have been a net economic benefit or a net economic loss to those who were conquered. In some cases, it was one rather than the other. But even where there were long-run benefits to the descendants of the conquered peoples, as in Western European nations conquered by the Romans, the generations that were conquered and lived under Roman oppression were by no means necessarily better off.

What can new said from an economic standpoint is that there is little compelling evidence that current economic disparities between nations in cíñame and wealth can be explained by a history of imperial exploitation. There were usually large economic or other disparities before this conquest, and these pre-existing disparities facilitated worldwide conquest by relatively modest-sized nations like Spain and Britain, each of which conquered vastly large lands and populations than their own.

Myths About Markets

We tend to think of a market as a thing when in fact it is people engaging in economic transactions among themselves on whatever terms their competition and mutual accommodations lead to. A market in this sense can be contrasted with central planning or government regulation. Too often when a market is conceived of as a thing, it is regarded as an impersonal mechanism, when in fact it is as personal as the people in it. This misconception allows third parties to seek to take away the freedom of individuals to transact with one another on mutually agreeable terms and to depict this restriction of their freedom as rescuing people from the “dictates” of the impersonal market, when in fact this would be subjecting them to the dictates of third parties.

Since there are so many myths about markets only a sample can be presented here, but we’ll look at the most prevalent.


There seem to be almost as many myths about prices as there are prices. Most involve ignoring the role of supply and demand but some involve confusing prices with costs.

The Role of Prices

The very reason for the existence of prices and the role or role they place in the economy has often been misunderstood. One of the oldest and most consequential of these myths is a notion summarized this way:

Prices have been compared to tolls levied for private profits or to Barrie’s which, again for private profits, keep the potential stream of commodities from the masses who need them.

Implicit in this vision is the assumption that what entrepreneurs and investors receive as income from the production process exceeds the value of any contribution they may have made to that process. The plausibility of this belief and the conviction that it truly inspired people from many walks of life to dedicate their lives to the cause of ending “exploitation.” During the 20th century, evidence that eliminating price coordination and profits did not raise living standards but tended to make them lower than in countries where prices remained the prevailing method of allocating resources.

Different Prices for the “Same” Thing

Physically identical things are often sold for different prices, usually because of accompanying conditions that are quite different. Goods sold in attractively decorated stores with pleasant, polished, and sophisticated sales staff, as well as easy return policies, are likely to cost more than physically identifiable products sold in stark warehouse stores with a no-refund policy.

Another reason for price differences is the cost of inventory. The cheapest store had only 49% of the items on the shopping list in stock at a given time, while all three Safeway stores had more than 3/4 of the items in stock. Price differences reflected differences in the cost of maintaining a larger inventory, even when the particular commodities were physically the same.

Customers’ costs, mesure in the time spent shopping, also varied. It varied both in the time that a customer would have to spend going from store to store to find all the items on a shopping list and in the time spent to store to find all the items on a shopping list and in the time spent in checkout lines.

In short, people shopping at different supermarkets were paying different prices for different things, although superficially these might be called the “same” things, based solely on their physical characteristics.

“Reasonable” or “Affordable” Prices

A long-standing staple of political rhetoric has been the attempt to keep their rice of housing, medical care, or other goods and services “reasonable” or “affordable.” But to say that prices should be reasonable or affordable is to say that economic realities have to adjust to our budget, or to what we are willing to pay because were are not going to adjust to the realities. Yet the number of resources required to manufacture and transport the things we want are wholly independent of what we are willing or able to pay. It is completely unreasonable to expect reasonable prices. Price controls can of course be imposed by the government but we already have seen the consequences of that. Subsidies can also be used to keep prices down, but that does not change the costs of producing goods and services in the slightest. It just means that part of those costs is paid in taxes.

Often related to the notion of reasonable or affordable prices is the idea of keeping “costs” down by various government policies. But prices are not costs. Prices are what pay for costs. Where the costs are not covered by the prices that are legally allowed to be charged, the supply of the goods and services simply tends to decline in quantity or quality.

Refusing to pay all the costs is not the same as lowering the costs. It usually leads to a reduction of either the quantity or the quality of the goods and services provided or both.

Brand Names

Brand names are often thought to be just ways of being able to charge higher prices for the same product persuading people through advertising that there is a quality difference, when in fact there is no such difference. In other words, some people consider brand names to be useless from the standpoint of the consumer’s interest.

In reality, brand names serve several purposes from the standpoint of the consumer. Brands are a way of economizing on scarce knowledge, and of forcing producers to compete in quality as well as prices.

Since brand names are a substitute for specific knowledge, how valuable they depend on how much knowledge you already have about the particular product or service.

The rise of brands promoted better quality by allowing consumers to distinguish and chose, and by forcing producers to take responsibility for what they made, reaping rewards when it was good and losing customers when it was not.

Like many other things, the importance of brand names can be seen more clearly by seeing what happens in their absence. In counties where there are no brand names, or where there is only one producer created or authorized by the government, the quality of the product or service tends to be lower. 

Non-profit Organizations

Non-profit organizations can be better understood when they are seen as institutions that are insulated from a need to respond to feedback from those who use their goods and services, or those whose money enables them to be founded and to continue operating.

The tendency of those who run any organization – whether profit-seeking or non-profit, military, religious, educational, or other – is to use the resources of the organization to benefit themselves in one way or another, even at the expense of the ostensible goals of the organization. How far this tendency can go can be limited by powerful outside interests on which the organization depends for its existence, such as investors who will either get a satisfactory return on their investment or take their money elsewhere.

This does not mean that non-profit organizations have unlimited money or that they do not need to worry about spending more than they take in. It does mean that with whatever money they do have, non-profit organizations are under very little pressure to achieve their institutional goals to the maximum extent possible with the resources at their disposal.

A non-profit organization’s goods and services may be worth what it costs the recipients – sometimes nothing – without being worth what it costs to produce. In other words, while an enterprise constrained by profit and loss considerations cannot continue to use resources that have greater value in alternative uses elsewhere in the economy, a non-profit organization can, since it needs to recover the full costs of the resources it uses from the recipients of the goods and services it provides. Where non-profit organizations are making grants of money, the recipients of that money are in no position to influence the way the non-profit organization operates, as customers of profit-seeking organizations can and do.

The aims of the organization can be bent to the aims of its current officials or to decisions and activities that will gain public visibility and applause, whether or not any of this serves the original purpose for which the non-profit organization was founded or even its current ostensible purpose.

The performances of non-profit organizations shed light on the role of profit when it comes to efficiency. If those who conceive of profit as simply an unnecessary change added on to the costs of production of goods and services are correct, then non-profit organizations should be able to produce those goods and services at a lower cost and sell them at a lower price. Over the years, this should lead to non-profit enterprises taking away the customers of profit-seeking enterprises and increasingly replacing them in the economy.

Not only have non-profit organizations not usually taken away the customers of profit-seeking enterprises, but increasingly the direct opposite has happened: non-profit organizations have seen more and more of their economic activities taken over by profit-seeking businesses.

Despite a tendency in the media to treat non-profit institutions as disinterested sources of information, those non-profit organizations which depend on continuing current donations from the public have incentives to be alarmist, to scare more money out of their donors. For example, one non-profit organization which regularly issues dire warnings about health risks in the environment has admitted to not having a single doctor or scientist on its staff.

“Non-economic” Values

While economics offers many insights and makes it easier to see through some popular notions that sound good but will not stand up under scrutiny, economics has also acquired the name “the dismal science” because it pours cold water on many otherwise attractive and exciting – but fallacious – notions about how the world can be arranged. One of the last refuges of someone whose pet project or pet theory has been exposed as economic nonsense is to say: “Economics is all very well, but there are also non-economic values to consider.” Presumably, these are supposed to be higher and nobler concerns that soar above the level of crass materialism.

Of course, there are non-economic values. There are only non-economic values. Economics is not a value in itself. It is only a way of weighing one value against another. Economics does not say that you should make the most money possible.

What lofty talk about “non-economic values” often boils down to is that some people do not want their particular values weighted against anything. If they are for staging Mono lake or preserving some historic building, then they do not want that weighed against the costs – which is to say, ultimately, against the other things that might be done instead of the same resources. For such people, there is no point in considering how many third-world children could be vaccinated against fatal diseases with the money that is spent saving Mono lake or preserving a historic building. We should vaccinate those children and save Mono lake and preserve the historic building – as well as do innumerable other good things, according to this way of looking at the world.

Economics seems a needlessly narrow, if not morally wrapped, way of looking at the world. Such condemnations of economics are due to the fundamental fact that economics is a study of the use of scarce resources which have alternative uses. We might all be happier in a world where there were no such constraints to force us into choices and trade-offs that we would rather not face.

Politics has sometimes been called “the art of the possible,” but that phrase applies far more accurately to economics. Politics allow people to vote for the impossible, which may be one reason why políticas are often more popular than economists, who keep reminding people that there is no free lunch and that there are no “solutions” but only trade-offs.

Saving Lives

Perhaps the strongest arguments for “non-economic values” are those involving human lives. Many highly costly laws, policies, or devices designed to safeguard the public from lethal hazards are defended on grounds that “if it saves just one life human life” it is worth whatever it costs. Powerful as the moral and emotional appeal of such pronouncements may be, they annoy withstand scrutiny in a world where scarce resources have alternative uses.

One of those alternative uses is saving other human lives in other ways. Few things have saved as many lives as simply the growth of wealth.

There have been various calculations of how much of a rise in national income was saved and how many lives. Whatever the correct figure might be – x millions of dollars to save one life – anything that prevents national income from rising that much has, in effect, cost a life. If some particular safety law, policy, or device costs 5x million dollars, either directly or by its inhibiting effect on economic growth, then it can no longer be said to be worth it “if it saves just one human life” because it does so at the costs of 5 other human lives. There are no escaping trade-offs, so long as resources are scarce and have alternative uses.

There is also the question of how much life is being saved and at how much cost. Some might say that there is a limit on how much value should be placed on human life. But, however noble such words may sound, in the real world no one would favor spending half the annual output of a nation to keep one person alive 30 seconds longer. Yet that would be the logical implication of a Valium that life is of infinite value.

When we look beyond words to behavior, people do not behave as if they regard even their own lives as being of infinite value. For example, people take life-threatening jobs as test pilots or explosives experts when such jobs pay a high enough salary for them to feel compensated for the risk. They even risk their lives for purely recreational purposes, such as skydiving, white-water rafting, or mountain climbing.

How much it costs to save one life varies with the method used. Vaccinating children against deadly diseases in third-world countries costs very little per child and saves many lives, including decades of life per child. Meanwhile, a heart transplant on an 80-year-old man is enormously expensive and can yield only a limited amount of additional life, even if the transplant surgery is completely successful since the life expectancy of an octogenarian is not very great in any case.

Market and Values

Often the market is blamed for obstructing moral and social values. For example, writers of the San Francisco Chronicle referred to “how amoral the marketplace can be” when explaining why the water supply owned by the city of Stockton, California, could not be entrusted to private enterprise. “Water is too life-sustaining a commodity to go into the marketplace with,” the Chronicle quoted the mayor of Stockton as saying. Yet, every day, life-sustaining food is supplied through private enterprise. Moreover, most new life-savoring medicines are developed in market economies, notably that of the United States, rather than government-run economies.

The idea that third party observes can impose morally better decisions often includes the idea that they can define what is “Luxuries of the rich,” when it is precisely the progress of free market economies which has turned many luxuries of the rich into common amenities of people in general, including the poor.

In past centuries, even such things as organs, sugar, and cocoa were luxuries of the rich in Europe. Not only do third-party definitions of what is luxury of the rich fail to account for such changes, but the stifling of free markets by third parties can also enable such things to remain exclusive luxuries longer than they would otherwise.

Market and Greed

Those who condemn greed may espouse “non-economic values.” But lofty talk about “non-economic values” too often amounts to very selfish attempts to have one’s values subsidized by others, obviously at the expense of those other people’s values.

Why should financial analysts, as the intermediaries handling pensions funds and other investments from vast numbers of people betray those people, who have entrusted their savings to them, by accepting less of a return from newspapers than what is available from other sectors of the economy?

What should the sacrifice be forced on mechanics, nurses, teachers, etc? Around the country whose personal savings and pension funds propicie the money that newspaper chains acquire by selling corporate stocks and bonds? Why should sectors of the encompass that are willing to pay more for the use of these funds be deprived of such resources for the sake of one particular sector?

The point here is not how to solve the financial problems of the newspaper industry. The point is to show different things look when considered from the standpoint of allocating scarce resources which have alternative uses. This fundamental economic reality is obscured by emotional rhetoric that ignores the interests and values of many people by summarizing them via unsympathetic intermediaries such as “insensitive” financial analysts, while competing interests are expressed in idealistic terms, such as journalistic quality. Financial analysts may be as sensitive to the people they are serving as others are the very different constituencies they represent.

Often what critics of the market want are special dispensations for particular individuals or groups, whether these are newspapers, ethnic groups, social classes, or others – without acknowledging that these dispensations will inevitably be at the expense of other individuals or groups, who are either arbitrarily ignored or summarized in impersonal terms as “the market.”

Both in the private sector and the government sector, there are always values that some people think are worthy enough that other people should have to pay for them – but not worthy enough that they should have to pay for themselves.

Markets and Morality

Whether assessing the effects of market economies or government or other institutions, it is a challenge to make a clear distinction between results that emerge from those institutions and results caused by those institutions. Because a given institution or process conveys a certain outcome does not mean that it caused that outcome.

Similarly, everything that happens in a market economy, a socialist economy, or in a government agency, is not necessarily caused by those institutions. Everything depends on the particular facts of the particular situation. This affects not only questions about causation but also moral questions. Income differences, for example, may be a result of barriers created against some groups or a result of factors internal to the groups themselves, such as average age, years of education, and other factors that vary from one group to another.

In short, moral decisions depend on factual realities. However, people with different moral values can make different decisions about the same facts. Therefore the policy question often comes down to whether some people feel that their moral values should be imposed on other people with different moral values through the power of government. Market economies permit individuals to make decisions for themselves, based on their moral values or other personal considerations – and at the same time, the market forces them to pay the costs that their decision create. The question is therefore not whether moral values should guide market economies, but whose moral values, if any should be imposed on others or subsidized by others.

Many whose sense of morality is offended by large economic disparities among individuals, groups, and nations tend to see the causes of these differences as “advantages” or “privileges” that some people have over others. But it is crucial to make a distinction between achievement and privileges. This is not simply a matter of semantics. Privileges come at the expense of others, but achievements add to the benefits of others.

All these things, and more, create economic disparities among individuals, groups, and nations with different achievements. That may seem morally offensive to some observers. But, here again, moral decisions require an accurate understanding of facts and causes, as well as a clear distinction between privileges and achievements. Moral decisions and policies based on those decisions, cannot be made on the simplest basis of statistics, visions, and rhetoric – not if the purpose is to make human life better, either materially or otherwise, rather than to indulge one’s emotions in disregard of the actual consequences for others.

We also need to keep in mind a clear moral distinction between doing things that let us vent our pent-up feelings and doing things likely to help those who have been unfortunate in the circumstances into which they were born. Transferring income or wealth is relatively easy. But developing human capital among those who lag is far more effective, even if it is also far more difficult. After all, the income and wealth that are transferred have a limited time before it is gone, and continued economic progress depends on having the human capital to replenish this income and wealth as it is used up. Moral decisions cannot be divorced from the consequences they create.

My rating:

This book in 3 key points

  1. Economics is the science of scarce resources that have alternative uses.
  2. The purpose of economics is to figure out how to satisfy human needs and desires with the scarce resources that have alternative uses in our universe.
  3. Economics is about incentives and trade-offs, there are no solutions.

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