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BASIC

ECONOMICS

A Common Sense Guide to the Economy

THOMAS SOWELL

Fifth Edition

BASIC BOOKS

A Member of rhe Perseus Books Group
New York

A few lines of reasoning can change
the way we see the world.

Steven E. Landsburg

Copyright © 2015 Thomas Sowell
Published by Basic Books,

A Member of the Perseus Books Group

All rights reserved. No part of this book may be reproduced in any manner whatsoever without
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Library of Congress Control Number: 2014945836

ISBN: 978-0-465-05684-2

CONTENTS

Preface

Acknowledgments

Chapter 1: What Is Economics?

PART I: PRICES AND MARKETS
Chapter 2: The Role of Prices
Chapter 3: Price Controls
Chapter 4: An Overview of Prices
PART II: INDUSTRY AND COMMERCE
Chapter 5: The Rise and Fall of Businesses
Chapter 6: The Role of Profits-and Losses
Chapter 7: The Economics of Big Business
Chapter 8: Regulation and Anti-Trust Laws
Chapter 9: Market and Non-Market Economies

PART III: WORK AND PAY

Chapter 10: Productivity and Pay

Chapter 11: Minimum Wage Laws

Chapter 12: Special Problems in Labor Markets

PART IV: TIME AND RISK

Chapter 13: Investment

Chapter 14: Stocks, Bonds and Insurance

Chapter 15: Special Problems of Time and Risk

PART V: THE NATIONAL ECONOMY

Chapter 16: National Output

Chapter 17: Money and the Banking System

Chapter 18: Government Functions

Chapter 19: Government Finance

Chapter 20: Special Problems in the National
Economy

PART VI: THE INTERNATIONAL ECONOMY

Chapter 21: International Trade

Chapter 22: International Transfers of Wealth

Chapter 23: International Disparities in Wealth

PART VII: SPECIAL ECONOMIC ISSUES

Chapter 24: Myths About Markets
Chapter 25: "Non-Economic" Values
Chapter 26: The History of Economics
Chapter 27: Parting Thoughts
Questions
Notes

PREFACE

The most obvious difference between this book and other
introductory economics books is that Basic Economics has no graphs
or equations. It is also written in plain English, rather than in economic
jargon, so that it can be readily understood by people with no previous
knowledge of economics. This includes both the general public and
beginning students in economics.

A less obvious, but important, feature of Basic Economics is that it
uses real-life examples from countries around the world to make
economic principles vivid and memorable, in a way that graphs and
equations might not. During the changes in its various editions, the
fundamental idea behind Basic Economics has remained the same:
Learning economics should be as uncomplicated as it is eye-opening.

Readers' continuing interest in these new editions at home, and a
growing number of translations into foreign languages overseas,^'*
suggest that there is a widespread desire for this kind of introduction
to economics, when it is presented in a readable way.

Just as people do, this book has put on weight with the passing
years, as new chapters have been added and existing chapters
updated and expanded to stay abreast of changing developments in

economies around the world.

Readers who have been puzzled by the large disparities in
economic development, and standards of living, among the nations of
the world will find a new chapter—Chapter 23, the longest chapter in
the book—devoted to exploring geographic, demographic, cultural
and other reasons why such striking disparities have existed for so
long. It also examines factors which are said to have been major
causes of international economic disparities and finds that the facts do
not always support such claims.

Most of us are necessarily ignorant of many complex fields, from
botany to brain surgery. As a result, we simply do not attempt to
operate in, or comment on, those fields. However, every voter and
every politician that they vote for affects economic policies. We cannot
opt out of economic issues and decisions. Our only options are to be
informed, uninformed, or misinformed, when making our choices on
issues and candidates. Basic Economics is intended to make it easier to
be informed. The fundamental principles of economics are not hard to
understand, but they are easy to forget, especially amid the heady
rhetoric of politics and the media.

In keeping with the nature of Basic Economics as an introduction
to economics. Jargon, graphs and equations have been left out.
However, endnotes are included in this e-book, for those who may
wish to check up on some of the surprising facts they will learn about
here. For instructors who are using Basic Economics as a textbook in
their courses, or for parents who are homeschooling their children,
more than a hundred questions are in the back of this book, with the
print book page numbers listed after each question, showing where
the answer to that question can be found in the text.

THOMAS SOWELL
Hoover Institution
Stanford University

ACKNOWLEDGMENTS

Like other books of mine, this one owes much to my two
extraordinary research assistants, Na Liu and Elizabeth Costa. In
addition to their tracking down all sorts of information for me, Ms.
Costa did the copy-editing and fact-checking of the manuscript, which
Ms. Liu then converted into galleys and helped to index, after which
the resulting Quark file was sent to the publisher, who could have the
book printed directly from her computer file. The chapter on the
history of economics was read by distinguished emeritus Professor
William R. Allen of UCLA, a former colleague whose insightful
comments and suggestions were very much appreciated, even when I
did not make full use of all of them. Needless to say, any errors or
shortcomings that remain after all these people's efforts can only be
my responsibility.

And of course none of this would be possible without the support
of the Hoover Institution and the research facilities of Stanford
University.

Chapter 1

WHAT IS ECONOMICS?

Whether one is a conservative or a radical, a
protectionist or a free trader, a cosmopolitan ora
nationalist, a churchman or a heathen, it is useful to
know the causes and consequences of economic
phenomena.

George J. Stigler^^^

Economic events often make headlines in the newspapers or
"breaking news" on television. Yet it is not always clear from these
news stories what caused these particular events, much less what
future consequences can be expected.

The underlying principles involved in most economic events are
usually not very complicated in themselves, but the political rhetoric
and economic jargon in which they are discussed can make these
events seem murky. Yet the basic economic principles that would
clarify what is happening may remain unknown to most of the public
and little understood by many in the media.

These basic principles of economics apply around the world and

have applied over thousands of years of recorded history. They apply in
many very different kinds of economies—capitalist, socialist, feudal, or
whatever—and among a wide variety of peoples, cultures, and
governments. Policies which led to rising price levels under Alexander
the Great have led to rising price levels in America, thousands of years
later. Rent control laws have led to a very similar set of consequences
in Cairo, Hong Kong, Stockholm, Melbourne, and New York. So have
similar agricultural policies in India and in the European Union
countries.

We can begin the process of understanding economics by first
being clear as to what economics means. To know what economics is,
we must first know what an economy is. Perhaps most of us thinkof an
economy as a system for the production and distribution of the goods
and services we use in everyday life. That is true as far as it goes, but it
does not go far enough.

The Garden of Eden was a system for the production and
distribution of goods and services, but it was not an economy, because
everything was available in unlimited abundance. Without scarcity,
there is no need to economize—and therefore no economics. A
distinguished British economist named Lionel Robbins gave a classic
definition of economics:

Economics is the study of the use of scarce
resources which have alternative uses.

SCARCITY

What does "scarce" mean? It means that what everybody wants
adds up to more than there is. This may seem like a simple thing, but
its implications are often grossly misunderstood, even by highly
educated people. For example, a feature article in the New York Times
laid out the economic woes and worries of middle-class Americans—
one of the most affluent groups of human beings ever to inhabit this
planet. Although this story included a picture of a middle-class
American family in their own swimming pool, the main headline read:
"The American Middle, Just Getting By." Other headings in the article
included:

Wishes Deferred and Plans Unmet
Goals That Remain Just Out of Sight
Dogged Saving and Some Luxuries

In short, middle-class Americans' desires exceed what they can
comfortably afford, even though what they already have would be
considered unbelievable prosperity by people in many other countries
around the world—or even by earlier generations of Americans. Yet
both they and the reporter regarded them as "just getting by" and a
Harvard sociologist was quoted as saying "how budget-constrained
these people really are." But it is not something as man-made as a
budget which constrains them: Reality constrains them. There has
never been enough to satisfy everyone completely. That is the real
constraint. That is what scarcity means.

The New York Times reported that one of these middle-class
families "got in over their heads in credit card spending" but then "got
their finances in order."

"But if we make a wrong move," Geraldine Frazier said, "the pressure we had
from the bills will come back, and that is painful."^^*

To all these people—from academia and journalism, as well as
the middle-class people themselves—it apparently seemed strange
somehow that there should be such a thing as scarcity and that this
should imply a need for both productive efforts on their part and
personal responsibility in spending the resulting income. Yet nothing
has been more pervasive in the history of the human race than
scarcity and all the requirements for economizing that go with
scarcity.

Regardless of our policies, practices, or institutions—whether
they are wise or unwise, noble or ignoble—there is simply not enough
to go around to satisfy all our desires to the fullest. "Unmet needs" are
inherent in these circumstances, whether we have a capitalist,
socialist, feudal, or other kind of economy. These various kinds of
economies are Just different institutional ways of making trade-offs
that are inescapable in any economy.

PRODUCTIVITY

Economics is not Just about dealing with the existing output of
goods and services as consumers. It is also, and more fundamentally,
about proc/uc/ng that output from scarce resources in the first place—
turning inputs into output.

In other words, economics studies the consequences of decisions
that are made about the use of land, labor, capital and other resources
that go into producing the volume of output which determines a
country's standard of living. Those decisions and their consequences

can be more important than the resources themselves, for there are
poor countries with rich natural resources and countries like Japan
and Switzerland with relatively few natural resources but high
standards of living. The values of natural resources per capita in
Uruguay and Venezuela are several times what they are in Japan and
Switzerland, but real income per capita in Japan and Switzerland is
more than double that of Uruguay and several times that of
Venezuela.^"^*

Not only scarcity but also "alternative uses" are at the heart of
economics. If each resource had only one use, economics would be
much simpler. But water can be used to produce ice or steam by itself
or innumerable mixtures and compounds in combination with other
things. Similarly, from petroleum comes not only gasoline and heating
oil, but also plastics, asphalt and Vaseline. Iron ore can be used to
produce steel products ranging from paper clips to automobiles to the
frameworks of skyscrapers.

How much of each resource should be allocated to each of its
many uses? Every economy has to answer that question, and each one
does, in one way or another, efficiently or inefficiently. Doing so
efficiently is what economics is about. Different kinds of economies are
essentially different ways of making decisions about the allocation of
scarce resources—and those decisions have repercussions on the life
of the whole society.

During the days of the Soviet Union, for example, that country's
industries used more electricity than American industries used, even
though Soviet industries produced a smaller amount of output than
American industries produced.^^* Such inefficiencies in turning inputs
into outputs translated into a lower standard of living, in a country

richly endowed with natural resources—perhaps more richly endowed
than any other country in the world. Russia is, for example, one of the
few industrial nations that produces more oil than it consumes. But an
abundance of resources does not automatically create an abundance
of goods.

Efficiency in production—the rate at which inputs are turned into
output—is not just some technicality that economists talk about. It
affects the standard of living of whole societies. When visualizing this
process, it helps to think about the real things—the iron ore,
petroleum, wood and other inputs that go into the production process
and the furniture, food and automobiles that come out the other end
—rather than think of economic decisions as being simply decisions
about money. Although the word "economics" suggests money to
some people, for a society as a whole money is Just an artificial device
to get real things done. Otherwise, the government could make us all
rich by simply printing more money. It is not money but the volume of
goods and services which determines whether a country is poverty
stricken or prosperous.

THE ROLE OF ECONOMICS

Among the misconceptions of economics is that it is something
that tells you how to make money or run a business or predict the ups
and downs of the stock market. But economics is not personal finance
or business administration, and predicting the ups and downs of the
stock market has yet to be reduced to a dependable formula.

When economists analyze prices, wages, profits, or the
international balance of trade, for example, it is from the standpoint of
how decisions in various parts of the economy affect the allocation of
scarce resources in a way that raises or lowers the material standard of
living of the people as a whole.

Economics is not simply a topic on which to express opinions or
vent emotions. It is a systematic study of cause and effect, showing
what happens when you do specific things in specific ways. In
economic analysis, the methods used by a Marxist economist like
Oskar Lange did not differ in any fundamental way from the methods
used by a conservative economist like Milton Friedman.® It is these
basic economic principles that this book is about.

One of the ways of understanding the consequences of economic
decisions is to look at them in terms of the incentives they create,
rather than simply the goals they pursue. This means that
consequences matter more than intentions—and not just the
immediate consequences, but also the longer run repercussions.

Nothing is easier than to have good intentions but, without an
understanding of how an economy works, good intentions can lead to
counterproductive, or even disastrous, consequences for a whole
nation. Many, if not most, economic disasters have been a result of
policies intended to be beneficial—and these disasters could often
have been avoided if those who originated and supported such
policies had understood economics.

While there are controversies in economics, as there are in
science, this does not mean that the basic principles of economics are
Just a matter of opinion, any more than the basic principles of
chemistry or physics are Just a matter of opinion. Einstein's analysis of

physics, for example, was not just Einstein's opinion, as the world
discovered at Hiroshima and Nagasaki. Economic reactions may not be
as spectacular or as tragic, as of a given day, but the worldwide
depression of the 1930s plunged millions of people into poverty, even
in the richest countries, producing malnutrition in countries with
surplus food, probably causing more deaths around the world than
those at Hiroshima and Nagasaki.

Conversely, when India and China—historically, two of the
poorest nations on earth—began in the late twentieth century to
make fundamental changes in their economic policies, their
economies began growing dramatically. It has been estimated that 20
million people in India rose out of destitution in a decade.^^* In China,
the number of people living on a dollar a day or less fell from 374
million—one third of the country's population in 1990—to 128 million
by 2004,® now Just 10 percent of a growing population. In other words,
nearly a quarter of a billion Chinese were now better off as a result of a
change in economic policy.

Things like this are what make the study of economics important
—and not Just a matter of opinions or emotions. Economics is a tool of
cause and effect analysis, a body of tested knowledge—and principles
derived from that knowledge.

Money doesn't even have to be involved to make a decision be
economic. When a military medical team arrives on a battlefield where
soldiers have a variety of wounds, they are confronted with the classic
economic problem of allocating scarce resources which have
alternative uses. Almost never are there enough doctors, nurses, or
paramedics to go around, nor enough medications. Some of the
wounded are near death and have little chance of being saved, while

others have a fighting chance if they get immediate care, and still
others are only slightly wounded and will probably recover whether
they get immediate attention or not.

If the medical team does not allocate its time and medications
efficiently, some wounded soldiers will die needlessly, while time is
being spent attending to others not as urgently in need of care or still
others whose wounds are so devastating that they will probably die in
spite of anything that can be done for them. It is an economic
problem, though not a dime changes hands.

Most of us hate even to think of having to make such choices.
Indeed, as we have already seen, some middle-class Americans are
distressed at having to make much milder choices and trade-offs. But
life does not ask us what we want. It presents us with options.
Economics is one of the ways of trying to make the most of those
options.

PART I:

PRICES AND MARKETS

Chapter 2

THE ROLE OF PRICES

The wonder of markets is that they reconcile the
choices of myriad individuals.

William Basterly^^^

Since we know that the key task facing any economy is the
allocation of scarce resources which have alternative uses, the next
question is: How does an economy do that?

Different kinds of economies obviously do it differently. In a
feudal economy, the lord of the manor simply told the people under
him what to do and where he wanted resources put: Grow less barley
and more wheat, put fertilizer here, more hay there, drain the
swamps. It was much the same story in twentieth century Communist
societies, such as the Soviet Union, which organized a far more
complex modern economy in much the same way, with the
government issuing orders for a hydroelectric dam to be built on the
Volga River, for so many tons of steel to be produced in Siberia, so
much wheat to be grown in the Ukraine. By contrast, in a market
economy coordinated by prices, there is no one at the top to issue

orders to control or coordinate activities throughout the economy.

How an incredibly complex, high-tech economy can operate
without any central direction is baffling to many. The last President of
the Soviet Union, Mikhail Gorbachev, is said to have asked British
Prime Minister Margaret Thatcher: "How do you see to it that people
get food?" The answer was that she didn't. Prices did that. Moreover,
the British people were better fed than people in the Soviet Union,
even though the British have not produced enough food to feed
themselves in more than a century. Prices bring them food from other
countries.

Without the role of prices, imagine what a monumental
bureaucracy it would take to see to it that the city of London alone is
supplied with the tons of food, of every variety, which it consumes
every day. Yet such an army of bureaucrats can be dispensed with—
and the people that would be needed in such a bureaucracy can do
productive work elsewhere in the economy—because the simple
mechanism of prices does the same job faster, cheaper and better.

This is also true in China, where the Communists still run the
government but, by the early twenty-first century, were allowing free
markets to operate in much of that country's economy. Although
China has one-fifth of the total population of the world, it has only 10
percent of the world's arable land, so feeding its people could continue
to be the critical problem that it once was, back in the days when
recurring famines took millions of lives each in China. Today prices
attract food to China from other countries:

China's food supplement is coming from abroad—from South America,
the U.S. and Australia. This means prosperity for agricultural traders and
processors like Archer Daniels Midland. They're moving into China in all of

the ways you'd expect in a $100 billion national market for processed
food that's growing more than 10% annually. It means a windfall for
farmers in the American Midwest, who are enjoying soybean prices that
have risen about two-thirds from what they were a year ago. It means a
better diet for the Chinese, who have raised their caloric intake by a third
in the past quarter-century.^^°*

Given the attractive power of prices, the American fried-chicken
company KFC was by the early twenty-first century making more sales
in China than in the United States/"’ China's per capita consumption of
dairy products nearly doubled in just five years/^^’ A study estimated
that one-fourth of the adults in China were overweight’^^’—not a good
thing in itself, but a heartening development in a country once
afflicted with recurring famines.

ECONOMIC DECISION-MAKING

The fact that no given individual or set of individuals controls or
coordinates all the innumerable economic activities in a market
economy does not mean that these things Just happen randomly or
chaotically. Each consumer, producer, retailer, landlord, or worker
makes individual transactions with other individuals on whatever
terms they can mutually agree on. Prices convey those terms, not Just
to the particular individuals immediately involved but throughout the
whole economic system—and indeed, throughout the world. If
someone else somewhere else has a better product or a lower price for
the same product or service, that fact gets conveyed and acted upon
through prices, without any elected official or planning commission

having to issue orders to consunners or producers—indeed, faster than
any planners could assemble the information on which to base their
orders.

If someone in Fiji figures out how to manufacture better shoes at
lower costs, it will not be long before you are likely to see those shoes
on sale at attractive prices in the United States or in India, or anywhere
in between. After the Second World War ended, Americans could begin
buying cameras from Japan, whether or not officials in Washington
were even aware at that time that the Japanese made cameras. Given
that any modern economy has millions of products, it is too much to
expect the leaders of any country to even know what all those
products are, much less know how much of each resource should be
allocated to the production of each of those millions of products.

Prices play a crucial role in determining how much of each
resource gets used where and how the resulting products get
transferred to millions of people. Yet this role is seldom understood by
the public and it is often disregarded entirely by politicians. Prime
Minister Margaret Thatcher in her memoirs said that Mikhail
Gorbachev "had little understanding of economics,"^^"^* even though he
was at that time the leader of the largest nation on earth.
Unfortunately, he was not unique in that regard. The same could be
said of many other national leaders around the world, in countries
large and small, democratic or undemocratic.

In countries where prices coordinate economic activities
automatically, that lack of knowledge of economics does not matter
nearly as much as in countries where political leaders try to direct and
coordinate economic activities.

Many people see prices as simply obstacles to their getting the

things they want. Those who would like to live in a beach-front home,
for example, may abandon such plans when they discover how
extremely expensive beach-front property can be. But high prices are
not the reason we cannot all live in beach-front houses. On the
contrary, the inherent reality is that there are not nearly enough
beach-front homes to go around, and prices simply convey that
underlying reality. When many people bid for a relatively few homes,
those homes become very expensive because of supply and demand.
But it is not the prices that cause the scarcity. There would be the same
scarcity under feudalism or socialism or in a tribal society.

If the government today were to come up with a "plan" for
"universal access" to beach-front homes and put "caps" on the prices
that could be charged for such property, that would not change the
underlying reality of the extremely high ratio of people to beach-front
land. With a given population and a given amount of beach-front
property, rationing without prices would have to take place by
bureaucratic fiat, political favoritism or random chance—but the
rationing would still have to take place. Even if the government were
to decree that beach-front homes were a "basic right" of all members
of society, that would still not change the underlying scarcity in the
slightest.

Prices are like messengers conveying news—sometimes bad
news, in the case of beach-front property desired by far more people
than can possibly live at the beach, but often also good news. For
example, computers have been getting both cheaper and better at a
very rapid rate, as a result of technological advances. Yet the vast
majority of beneficiaries of those high-tech advances have not the
foggiest idea of Just what specifically those technological changes are.

But prices convey to thenn the end results—which are all that matter
for their own decision-making and their own enhanced productivity
and general well-being from using computers.

Similarly, if vast new rich iron ore deposits were suddenly
discovered somewhere, perhaps no more than one percent of the
population would be likely to be aware of it, but everyone would
discover that things made of steel were becoming cheaper. People
thinking of buying desks, for example, would discover that steel desks
had become more of a bargain compared to wooden desks and some
would undoubtedly change their minds as to which kind of desk to
purchase because of that. The same would be true when comparing
various other products made of steel to competing products made of
aluminum, copper, plastic, wood, or other materials. In short, price
changes would enable a whole society—indeed, consumers around
the world—to adjust automatically to a greater abundance of known
iron ore deposits, even if 99 percent of those consumers were wholly
unaware of the new discovery.

Prices are not Just ways of transferring money. Their primary role
is to provide financial incentives to affect behavior in the use of
resources and their resulting products. Prices not only guide
consumers, they guide producers as well. When all is said and done,
producers cannot possibly know what millions of different consumers
want. All that automobile manufacturers, for example, know is that
when they produce cars with a certain combination of features they
can sell those cars for a price that covers their production costs and
leaves them a profit, but when they manufacture cars with a different
combination of features, these don't sell as well. In order to get rid of
the unsold cars, the sellers must cut the prices to whatever level is

necessary to get thenn off the dealers' lots, even if that means taking a
loss. The alternative would be to take a bigger loss by not selling them
at all.

Although a free market economic system is sometimes called a
profit system, it is in reality a profit-and-loss system—and the losses
are equally important for the efficiency of the economy, because losses
tell producers what to stop doing—what to stop producing, where to
stop putting resources, what to stop investing in. Losses force the
producers to stop producing what consumers don't want. Without
really knowing why consumers like one set of features rather than
another, producers automatically produce more of what earns a profit
and less of what is losing money. That amounts to producing what the
consumers want and stopping the production of what they don't want.
Although the producers are only looking out for themselves and their
companies' bottom line, nevertheless from the standpoint of the
economy as a whole the society is using its scarce resources more
efficiently because decisions are guided by prices.

Prices formed a worldwide web of communication long before
there was an Internet. Prices connect you with anyone, anywhere in
the world where markets are allowed to operate freely, so that places
with the lowest prices for particular goods can sell those goods
around the world. As a result, you can end up wearing shirts made in
Malaysia, shoes produced in Italy, and slacks made in Canada, while
driving a car manufactured in Japan, rolling on tires produced in
France.

Price-coordinated markets enable people to signal to other
people how much they want and how much they are willing to offer
for it, while other people signal what they are willing to supply in

exchange for what connpensation. Prices responding to supply and
demand cause natural resources to move from places where they are
abundant, like Australia, to places where they are almost non-existent,
like Japan. The Japanese are willing to pay higher prices than
Australians pay for those resources. These higher prices will cover
shipping costs and still leave a larger profit than selling the same
resources within Australia, where their abundance makes their prices
lower. A discovery of large bauxite deposits in India would reduce the
cost of aluminum baseball bats in America. A disastrous failure of the
wheat crop in Argentina would raise the incomes of farmers in
Ukraine, who would now find more demand for their wheat in the
world market, and therefore higher prices.

When more of some item is supplied than demanded,
competition among sellers trying to get rid of the excess will force the
price down, discouraging future production, with the resources used
for that item being set free for use in producing something else that is
in greater demand. Conversely, when the demand for a particular item
exceeds the existing supply, rising prices due to competition among
consumers encourage more production, drawing resources away from
other parts of the economy to accomplish that.

The significance of free market prices in the allocation of
resources can be seen more clearly by looking at situations where
prices are not allowed to perform this function. During the era of the
government-directed economy of the Soviet Union, for example,
prices were not set by supply and demand but by central planners who
sent resources to their various uses by direct commands,
supplemented by prices that the planners raised or lowered as they
saw fit. Two Soviet economists, Nikolai Shmelev and Vladimir Popov,

described a situation in which their government raised the price it
would pay for moleskins, leading hunters to get and sell more of them:

state purchases increased, and now all the distribution centers are filled
with these pelts. Industry is unable to use them all, and they often rot in
warehouses before they can be processed. The Ministry of Light Industry
has already requested Goskomtsen twice to lower purchasing prices, but
the "question has not been decided" yet. And this is not surprising. Its
members are too busy to decide. They have no time: besides setting

prices on these pelts, they have to keep track of another 24 million prices.

{ 15 }

However overwhelming it might be for a government agency to
try to keep track of 24 million prices, a country with more than a
hundred million people can far more easily keep track of those prices
individually, because no given individual or enterprise has to keep
track of more than the relatively few prices that are relevant to their
own decision-making. The over-all coordination of these innumerable
isolated decisions takes place through the effect of supply and
demand on prices and the effect of prices on the behavior of
consumers and producers. Money talks—and people listen. Their
reactions are usually faster than central planners could get their
reports together.

While telling people what to do might seem to be a more rational
or orderly way of coordinating an economy, it has turned out
repeatedly to be far less effective in practice. The situation as regards
pelts was common for many other goods during the days of the Soviet
Union's centrally planned economy, where a chronic problem was a
piling up of unsold goods in warehouses at the very time when there
were painful shortages of other things that could have been produced
with the same resources. In a market economy, the prices of surplus

goods would fall automatically by supply and demand, while the
prices of goods in short supply would rise automatically for the same
reason—the net result being a shifting of resources from the former to
the latter, again automatically, as producers seek to gain profits and
avoid losses.

The problem was not that particular planners made particular
mistakes in the Soviet Union or in other planned economies. Whatever
the mistakes made by central planners, there are mistakes made in all
kinds of economic systems—capitalist, socialist, or whatever. The
more fundamental problem with central planning has been that the
task taken on has repeatedly proven to be too much for human beings,
in whatever country that task has been taken on. As Soviet economists
Shmelev and Popov put it:

No matter how much we wish to organize everything rationally, without
waste, no matter how passionately we wish to lay all the bricks of the
economic structure tightly, with no chinks in the mortar, it is not yet
within our power/^^*

PRICES AND COSTS

Prices in a market economy are not simply numbers plucked out
of the air or arbitrarily set by sellers. While you may put whatever price
you wish on the goods or services you provide, those prices will
become economic realities only if others are willing to pay them—and
that depends not on whatever prices you have chosen but on how
much consumers want what you offer and on what prices other

producers charge for the same goods and services.

Even if you produce something that would be worth $100 to a
customer and offer it for sale at $80, that customer will still not buy it
from you if another producer offers the same thing for $70. Obvious as
all this may seem, its implications are not at all obvious to some
people—those who blame high prices on "greed," for example, for that
implies that a seller can set prices at will and make sales at those
arbitrary prices. For example, a front-page newspaper story in The
Arizona Republic began:

Greed drove metropolitan Phoenix's home prices and sales to new
records in 2005. Fear is driving the market this year.^^^*

This implies that lower prices meant less greed, rather than
changed circumstances that reduce the sellers' ability to charge the
same prices as before and still make sales. The changed circumstances
in this case included the fact that homes for sale in Phoenix remained
on the market longer before being sold than during the year before,
and the fact that home builders were "struggling to sell even deeply
discounted new homes."^^®’ There was not the slightest indication that
sellers were any less interested in getting as much money as they
could for the houses they sold—that is, that they were any less
"greedy."

Competition in the market is what limits how much anyone can
charge and still make sales, so what is at issue is not anyone's
disposition, whether greedy or not, but what the circumstances of the
market cause to happen. A seller's feelings—whether "greedy" or not
—tell us nothing about what the buyer will be willing to pay.

Resource Allocation by Prices

We now need to look more closely at the process by which prices
allocate scarce resources that have alternative uses. The situation
where the consumers want product A and don't want product B is the
simplest example of how prices lead to efficiency in the use of scarce
resources. But prices are equally important in more common and
more complex situations, where consumers want both A and B, as well
as many other things, some of which require the same ingredients in
their production. For example, consumers not only want cheese, they
also want ice cream and yogurt, as well as other products made from
milk. How do prices help the economy to determine how much milk
should go to each of these products?

In paying for cheese, ice cream, and yogurt, consumers are in
effect also bidding indirectly for the milk from which these products
are produced. In other words, money that comes in from the sales of
these products is what enables the producers to again buy milk to use
to continue making their respective products. When the demand for
cheese goes up, cheese-makers use their additional revenue to bid
away some of the milk that before went into making ice cream or
yogurt, in order to increase the output of their own product to meet
the rising demand. When the cheese-makers demand more milk, this
increased demand forces up the price of milk—to everyone, including
the producers of ice cream and yogurt. As the producers of these other
products raise the prices of ice cream and yogurt to cover the higher
cost of the milkthat goes into them, consumers are likely to buy less of
these other dairy products at these higher prices.

How will each producer know just how much milk to buy?
Obviously they will buy only as much milk as will repay its higher costs

from the higher prices of these dairy products. If consumers who buy
ice cream are not as discouraged by rising prices as consumers of
yogurt are, then very little of the additional milkthat goes into making
more cheese will come from a reduced production of ice cream and
more will come from a reduced production of yogurt.

What this all means as a general principle is that the price which
one producer is willing to pay for any given ingredient becomes the
price that other producers are forced to pay for that same ingredient.
This applies whether we are talking about the milk that goes into
making cheese, ice cream, and yogurt or we are talking about the
wood that goes into making baseball bats, furniture, and paper. If the
amount of paper demanded doubles, this means that the demand for
wood pulp to make paper goes up. As the price of wood rises in
response to this increased demand, that in turn means that the prices
of baseball bats and furniture will have to go up, in order to cover the
higher costs of the wood from which they are made.

The repercussions go further. As the price of milk rises, dairies
have incentives to produce more milk, which can mean buying more
cows, which in turn can mean that more cows will be allowed to grow
to maturity, instead of being slaughtered for meat as calves. Nor do
the repercussions stop there. As fewer cows are slaughtered, there is
less cowhide available, and the prices of baseball gloves can rise
because of supply and demand. Such repercussions spread throughout
the economy, much as waves spread across a pond when a stone drops
into the water.

No one is at the top coordinating all of this, mainly because no
one would be capable of following all these repercussions in all
directions. Such a task has proven to be too much for central planners

in country after country.

Incremental Substitution

Since scarce resources have alternative uses, the value placed on
one of these uses by one individual or company sets the cost that has
to be paid by others who want to bid some of these resources away for
their own use. From the standpoint of the economy as a whole, this
means that resources tend to flow to their most valued uses when
there is price competition in the marketplace. This does not mean that
one use categorically precludes all other uses. On the contrary,
adjustments are incremental. Only that amount of milk which is as
valuable to ice cream consumers or consumers of yogurt as it is to
cheese purchasers will be used to make ice cream or yogurt. Only that
amount of wood which is as valuable to the makers of baseball bats or
furniture as it is to the producers of paper will be used to make bats
and furniture.

Now look at the demand from the consumers' standpoint:
Whether considering consumers of cheese, ice cream, or yogurt, some
will be anxious to have a certain amount, less anxious to have
additional amounts, and finally—beyond some point—indifferent to
having any more, or even unwilling to consume any more after
becoming satiated. The same principle applies when more wood pulp
is used to make paper and the producers and consumers of furniture
and baseball bats have to make their incremental adjustments
accordingly. In short, prices coordinate the use of resources, so that
only that amount is used for one thing which is equal in value to what
it is worth to others in other uses. That way, a price-coordinated
economy does not flood people with cheese to the point where they

are sick of it, while others are crying out in vain for more ice cream or
yogurt.

Absurd as such a situation would be, it has happened many times
in economies where prices are not used to allocate scarce resources.
Pelts were not the only unsalable goods that were piling up in Soviet
warehouses while people were waiting in long lines trying to get other
things that were in short supply.^''* The efficient allocation of scarce
resources which have alternative uses is not just some abstract notion
of economists. It determines how well or how badly millions of people
live.

Again, as in the example of beach-front property, prices convey an
underlying reality: From the standpoint of society as a whole, the
"cost" of anything is the value that it has in alternative uses. That cost
is reflected in the market when the price that one individual is willing
to pay becomes a cost that others are forced to pay, in order to get a
share of the same scarce resource or the products made from it. But,
no matter whether a particular society has a capitalist price system or
a socialist economy or a feudal or other system, the real cost of
anything is still its value in alternative uses. The real cost of building a
bridge is whatever else could have been built with that same labor
and material. This is also true at the level of a given individual, even
when no money is involved. The cost of watching a television sitcom
or soap opera is the value of the other things that could have been
done with that same time.

Economic Systems

Different economic systems deal with this underlying reality in
different ways and with different degrees of efficiency, but the

underlying reality exists independently of whatever particular kind of
economic system happens to exist in a given society. Once we
recognize that, we can then compare how economic systems which
use prices to force people to share scarce resources among themselves
differ in efficiency from economic systems which determine such
things by having kings, politicians, or bureaucrats issue orders saying
who can get how much of what.

During a brief era of greater openness in the last years of the
Soviet Union, when people became more free to speak their minds,
the two Soviet economists already mentioned wrote a book giving a
very candid account of how their economy worked, and this book was
later translated into English.^'''* As Shmelev and Popov put it,
production enterprises in the Soviet Union "always ask for more than
they need" from the government in the way of raw materials,
equipment, and other resources used in production. "They take
everything they can get, regardless of how much they actually need,
and they don't worry about economizing on materials," according to
these economists. "After all, nobody'at the top' knows exactly what the
real requirements are," so "squandering" made sense^^^*—from the
standpoint of the manager of a Soviet enterprise.

Among the resources that were squandered were workers. These
economists estimated that "from 5 to 15 percent of the workers in the
majority of enterprises are surplus and are kept 'Just in case.'"^^°’ The
consequence was that far more resources were used to produce a
given amount of output in the Soviet economy as compared to a
price-coordinated economic system, such as that in Japan, Germany
and other market economies. Citing official statistics, Shmelev and
Popov lamented:

To make one ton of copper we use about 1,000 kilowatt hours of
electrical energy, as against 300 in West Germany. To produce one ton of
cement we use twice the amount of energy that Japan does.^^^*

The Soviet Union did not lack for resources, but was in fact one of
the most richly endowed nations on earth—if not the most richly
endowed in natural resources. Nor was it lacking in highly educated
and well-trained people. What it lacked was an economic system that
made efficient use of its resources.

Because Soviet enterprises were not under the same financial
constraints as capitalist enterprises, they acquired more machines
than they needed, "which then gather dust in warehouses or rust out
of dooras the Soviet economists put it. In short, Soviet enterprises
were not forced to economize—that is, to treat their resources as both
scarce and valuable in alternative uses, for the alternative users were
not bidding for those resources, as they would in a market economy.
While such waste cost individual Soviet enterprises little or nothing,
they cost the Soviet people dearly, in the form of a lower standard of
living than their resources and technology were capable of producing.

Such a waste of inputs as these economists described could not of
course continue in the kind of economy where these inputs would
have to be purchased in competition with alternative users, and where
the enterprise itself could survive only by keeping its costs lower than
its sales receipts. In such a price-coordinated capitalist system, the
amount of inputs ordered would be based on the enterprise's most
accurate estimate of what was really required, not on how much its
managers could persuade higher government officials to let them
have.

These higher officials could not possibly be experts on all the wide
range of industries and products under their control, so those with the
power in the central planning agencies were to some extent
dependent on those with the knowledge of their own particular
industries and enterprises. This separation of power and knowledge
was at the heart of the problem.

Central planners could be skeptical of what the enterprise
managers told them but skepticism is not knowledge. If resources
were denied, production could suffer—and heads could roll in the
central planning agencies. The net result was the excessive use of
resources described by the Soviet economists. The contrast between
the Soviet economy and the economies of Japan and Germany is just
one of many that can be made between economic systems which use
prices to allocate resources and those which have relied on political or
bureaucratic control. In other regions of the world as well, and in other
political systems, there have been similar contrasts between places
that used prices to ration goods and allocate resources versus places
that have relied on hereditary rulers, elected officials or appointed
planning commissions.

When many African colonies achieved national independence in
the 1960s, a famous bet was made between the president of Ghana
and the president of the neighboring Ivory Coast as to which country
would be more prosperous in the years ahead. At that time, Ghana was
not only more prosperous than the Ivory Coast, it had more natural
resources, so the bet might have seemed reckless on the part of the
president of the Ivory Coast. However, he knew that Ghana was
committed to a government-run economy and the Ivory Coast to a
freer market. By 1982, the Ivory Coast had so surpassed Ghana

economically that the poorest 20 percent of its people had a higher
real income per capita than most of the people in Ghanaj^^*

This could not be attributed to any superiority of the country or
its people. In fact, in later years, when the government of the Ivory
Coast eventually succumbed to the temptation to control more of
their country's economy, while Ghana finally learned from its mistakes
and began to loosen government controls on the market, these two
countries' roles reversed—and now Ghana's economy began to grow,
while that of the Ivory Coast declined.^^"^*

Similar comparisons could be made between Burma and
Thailand, the former having had the higher standard of living before
instituting socialism, and the latter a much higher standard of living
afterwards. Other countries—India, Germany, China, New Zealand,
South Korea, Sri Lanka—have experienced sharp upturns in their
economies when they freed those economies from many government
controls and relied more on prices to allocate resources. As of 1960,
India and South Korea were at comparable economic levels but, by the
late 1980s, South Korea's per capita income was ten times that in India.

{ 25 }

India remained committed to a government-controlled economy
for many years after achieving independence in 1947. However, in the
1990s, India "jettisoned four decades of economic isolation and
planning, and freed the country's entrepreneurs for the first time since
independence," in the words of the distinguished London magazine
The Economist. There followed a new growth rate of 6 percent a year,
making it "one of the world's fastest-growing big economies."^^^* From
1950 to 1990, India's average growth rate had been 2 percent.^^^* The
cumulative effect of growing three times as fast as before was that
millions of Indians rose out of poverty.

In China, the transition to a market economy began earlier, in the
1980s. Government controls were at first relaxed on an experimental
basis in particular economic sectors and in particular geographic
regions earlier than in others. This led to stunning economic contrasts
within the same country, as well as rapid economic growth overall.

Back in 1978, less than 10 percent of China's agricultural output
was sold in open markets, instead of being turned over to the
government for distribution. But, by 1990,80 percent was sold directly
in the market.^^®’ The net result was more food and a greater variety of
food available to city dwellers in China, and a rise in farmers' income
by more than 50 percent within a few years.^^^* In contrast to China's
severe economic problems when there was heavy-handed
government control under Mao, who died in 1976, the subsequent
freeing up of prices in the marketplace led to an astonishing economic
growth rate of 9 percent per year between 1978 and 1995.

While history can tell us that such things happened, economics
helps explain why they happened—what there is about prices that
allows them to accomplish what political control of an economy can
seldom match. There is more to economics than prices, but
understanding how prices function is the foundation for
understanding much of the rest of economics. A rationally planned
economy sounds more plausible than an economy coordinated only by
prices linking millions of separate decisions by individuals and
organizations. Yet Soviet economists who saw the actual
consequences of a centrally planned economy reached very different
conclusions—namely, "there are far too many economic relationships,
and it is impossible to take them all into account and coordinate them
sensibly."^^°*

Knowledge is one of the most scarce of all resources, and a
pricing system economizes on its use by forcing those with the most
knowledge of their own particular situation to make bids for goods
and resources based on that knowledge, rather than on their ability to
influence other people in planning commissions, legislatures, or royal
palaces. However much articulation may be valued by intellectuals, it
is not nearly as efficient a way of conveying accurate information as
confronting people with a need to "put your money where your mouth
is." That forces them to summon up their most accurate information,
rather than their most plausible words.

Human beings are going to make mistakes in any kind of
economic system. The key question is: What kinds of incentives and
constraints will force them to correct their own mistakes? In a price-
coordinated economy, any producer who uses ingredients which are
more valuable elsewhere in the economy is likely to discover that the
costs of those ingredients cannot be repaid from what the consumers
are willing to pay for the product. After all, the producer has had to bid
those resources away from alternative users, paying more than the
resources are worth to some of those alternative users. If it turns out
that these resources are not more valuable in the uses to which this
producer puts them, then he is going to lose money. There will be no
choice but to discontinue making that product with those ingredients.

For those producers who are too blind or too stubborn to change,
continuing losses will force their businesses into bankruptcy, so that
the waste of the resources available to the society will be stopped that
way. That is why losses are just as important as profits, from the
standpoint of the economy, even though losses are not nearly as
popular with businesses.

In a price-coordinated economy, employees and creditors insist
on being paid, regardless of whether the managers and owners have
made mistakes. This means that capitalist businesses can make only so
many mistakes for so long before they have to either stop or get
stopped—whether by an inability to get the labor and supplies they
need or by bankruptcy. In a feudal economy or a socialist economy,
leaders can continue to make the same mistakes indefinitely. The
consequences are paid by others in the form of a standard of living
lower than it would be if there were greater efficiency in the use of
scarce resources.

In the absence of compelling price signals and the threat of
financial losses to the producers that they convey, inefficiency and
waste in the Soviet Union could continue until such time as each
particular instance of waste reached proportions big enough and
blatant enough to attract the attention of central planners in Moscow,
who were preoccupied with thousands of other decisions.

Ironically, the problems caused by trying to run an economy by
direct orders or by arbitrarily-imposed prices created by government
fiat were foreseen in the nineteenth century by Karl Marx and Friedrich
Engels, whose ideas the Soviet Union claimed to be following.

Engels pointed out that price fluctuations have "forcibly brought
home to the individual commodity producers what things and what
quantity of them society requires or does not require." Without such a
mechanism, he demanded to know "what guarantee we have that
necessary quantity and not more of each product will be produced,
that we shall not go hungry in regard to corn and meat while we are
choked in beet sugar and drowned in potato spirit, that we shall not
lack trousers to cover our nakedness while trouser buttons flood us in

millions."^^^* Marx and Engels apparently understood economics much
better than their latter-day followers. Or perhaps Marx and Engels
were more concerned with economic efficiency than with maintaining
political control from the top.

There were also Soviet economists who understood the role of
price fluctuations in coordinating any economy. Near the end of the
Soviet Union, two of these economists, Shmelev and Popov, whom we
have already quoted, said: "Everything is interconnected in the world
of prices, so that the smallest change in one element is passed along
the chain to millions of others."^^^* These Soviet economists were
especially aware of the role of prices from having seen what happened
when prices were not allowed to perform that role. But economists
were not in charge of the Soviet economy. Political leaders were.
Under Stalin, a number of economists were shot for saying things he
did not want to hear.

SUPPLY AND DEMAND

There is perhaps no more basic or more obvious principle of
economics than the fact that people tend to buy more at a lower price
and less at a higher price. By the same token, people who produce
goods or supply services tend to supply more at a higher price and less
at a lower price. Yet the implications of these two simple principles,
singly or in combination, cover a remarkable range of economic
activities and issues—and contradict an equally remarkable range of
misconceptions and fallacies.

Demand versus "Need"

When people try to quantify a country's "need" for this or that
product or service, they are ignoring the fact that there is no fixed or
objective "need." Seldom, if ever, is there a fixed quantity demanded.
For example, communal living in an Israeli kibbutz was based on its
members' collectively producing and supplying each other with goods
and services, without resort to money or prices. However, supplying
electricity and food without charging prices led to a situation where
people often did not bother to turn off electric lights during the day
and members would bring friends from outside the kibbutz to Join
them for meals. But, after the kibbutz began to charge prices for
electricity and food, there was a sharp drop in the consumption of
both.^^^’ In short, there was no fixed quantity of "need" or demand for
food or electricity, despite how indispensable both might be.

Likewise, there is no fixed supply. Statistics on the amount of
petroleum, iron ore, or other natural resources seem to indicate that
this is Just a simple matter of how much physical stuff there is in the
ground. In reality, the costs of discovery, extraction and processing of
natural resources vary greatly from one place to another. There is
some oil that can be extracted and processed from some places for
$20 a barrel and other oil elsewhere that cannot repay all its
production costs at $40 a barrel, but which can at $60 a barrel. With
goods in general, the quantity supplied varies directly with the price,
Just as the quantity demanded varies inversely with the price.

When the price of oil falls below a certain point, low-yield oil wells
are shut down because the cost of extracting and processing the oil
from those particular wells would exceed the price that the oil would
sell for in the market. If the price later rises—or if the cost of extraction

or processing is lowered by sonne new technology—then such oil wells
will be put back into operation again. Certain sands containing oil in
Venezuela and in Canada had such low yields that they were not even
counted in the world's oil reserves until oil prices hit new highs in the
early twenty-first century. That changed things, as the Wall Street
Journal reported:

These deposits were once disnnissed as "unconventional" oil that couldn't
be recovered economically. But now, thanks to rising global oil prices and
improved technology, most oil-industry experts count oil sands as
recoverable reserves. That recalculation has vaulted Venezuela and
Canada to first and third in global reserves rankings..

The Economist magazine likewise reported:

Canada's oil sands, or tar sands, as the goo is known, are outsized in
every way. They contain 174 billion barrels of oil that can be recovered
profitably, and another 141 billion that might be worth exploiting if the
oil price rises or the costs of extraction decrease—enough to give Canada
bigger oil reserves than Saudi Arabia.^^^*

In short, there is no fixed supply of oil—or of most other things. In
some ultimate sense, the earth has a finite amount of each resource
but, even when that amount may be enough to last for centuries or
millennia, at any given time the amount that is economically feasible
to extract and process varies directly with the price for which it can be
sold. Many false predictions over the past century or more that we
were "running out" of various natural resources in a few years were
based on confusing the economically available current supply at
current prices with the ultimate physical supply in the earth, which is
often vastly greater.

Natural resources are not the only things that will be supplied in
greater quantities when their prices rise. That is true of many
commodities and even workers. When people project that there will
be a shortage of engineers or teachers or food in the years ahead, they
usually either ignore prices or implicitly assume that there will be a
shortage at today's prices. But shortages are precisely what cause
prices to rise. At higher prices, it may be no harder to fill vacancies for
engineers or teachers than today and no harder to find food, as rising
prices cause more crops to be grown and more livestock to be raised.
In short, a larger quantity is usually supplied at higher prices than at
lower prices, whether what is being sold is oil or apples, lobsters or
labor.

"Real" Value

The producer whose product turns out to have the combination
of features that are closest to what the consumers really want may be
no wiser than his competitors. Yet he can grow rich while his
competitors who guessed wrong go bankrupt. But the larger result is
that society as a whole gets more benefits from its limited resources
by having them directed toward where those resources produce the
kind of output that millions of people want, instead of producing
things that they don't want.

Simple as all this may seem, it contradicts many widely held ideas.
For example, not only are high prices often blamed on "greed," people
often speak of something being sold for more than its "real" value, or
of workers being paid less than they are "really" worth—or of
corporate executives, athletes, and entertainers being paid more than
they are "really" worth. The fact that prices fluctuate over time, and

occasionally have a sharp rise or a steep drop, nnisleads sonne people
into concluding that prices are deviating from their "real" values. But
their usual level under usual conditions is no more real or valid than
their much higher or much lower levels under different conditions.

When a large employer goes bankrupt in a small community, or
simply moves away to another region or country, many of the
business' former employees may decide to move away themselves
from a place that now has fewer jobs—and when their numerous
homes go on sale in the same small area at the same time, the prices
of those houses are likely to be driven down by competition. But this
does not mean that people are selling their homes for less than their
"real" value. The value of living in that particular community has
simply declined with the decline of Job opportunities, and housing
prices reflect this underlying fact.

The most fundamental reason why there is no such thing as an
objective or "real" value is that there would be no rational basis for
economic transactions if there were. When you pay a dollar for a
newspaper, obviously the only reason you do so is that the newspaper
is more valuable to you than the dollar is. At the same time, the only
reason people are willing to sell the newspaper is that a dollar is more
valuable to them than the newspaper is. If there were any such thing
as a "real" or objective value of a newspaper—or anything else—
neither the buyer nor the seller would benefit from making a
transaction at a price equal to that objective value, since what would
be acquired would be of no greater value than what was given up. In
that case, why bother to make the transaction in the first place?

On the other hand, if either the buyer or the seller was getting
more than the objective value from the transaction, then the other

person nnust be getting less—in which case, why would the other
party continue making such transactions while being continually
cheated? Continuing transactions between buyer and seller make
sense only if value is subjective, each getting what is worth more
subjectively. Economic transactions are not a zero-sum process, where
one person loses whatever the other person gains.

Competition

Competition is the crucial factor in explaining why prices usually
cannot be maintained at arbitrarily set levels. Competition is the key
to the operation of a price-coordinated economy. It not only forces
prices toward equality, it likewise causes capital, labor, and other
resources to flow toward where their rates of return are highest—that
is, where the unsatisfied demand is greatest—until the returns are
evened out through competition, much like water seeking its own
level. However, the fact that water seeks its own level does not mean
that the ocean has a glassy smooth surface. Waves and tides are
among the ways in which water seeks its own level, without being
frozen indefinitely at a given level. Similarly, in an economy, the fact
that prices and rates of return on investments tend to equalize means
only that their fluctuations, relative to one another, are what move
resources from places where their earnings are lower to where their
earnings are higher—that is, from where the quantity supplied is
greatest, relative to the quantity demanded, to where there is the
most unsatisfied demand. It does not mean that prices remain the
same over time or that some ideal pattern of allocation of resources
remains the same indefinitely.

Prices and Supplies

Prices not only ration existing supplies, they also act as powerful
incentives to cause supplies to rise or fall in response to changing
demand. When a crop failure in a given region creates a sudden
increase in demand for imports of food into that region, food suppliers
elsewhere rush to be the first to get there, in order to capitalize on the
high prices that will prevail until more supplies arrive and drive food
prices back down again through competition. What this means, from
the standpoint of the hungry people in that region, is that food is
being rushed to them at maximum speed by "greedy" suppliers,
probably much faster than if the same food were being transported to
them by salaried government employees sent on a humanitarian
mission.

Those spurred on by a desire to earn top dollar for the food they
sell may well drive throughout the night or take short cuts over rough
terrain, while those operating "in the public interest" are more likely to
proceed at a less hectic pace and by safer or more comfortable routes.
In short, people tend to do more for their own benefit than for the
benefit of others. Freely fluctuating prices can make that turn out to be
beneficial to others. In the case of food supplies, earlier arrival can be
the difference between temporary hunger and death by starvation or
by diseases to which people are more susceptible when they are
undernourished. Where there are local famines in Third World
countries, it is not at all uncommon for food supplied by international
agencies to the national government to sit spoiling on the docks while
people are dying of hunger inland.^'''* However unattractive greed may
be, it is likely to move food much faster, saving more lives.

In other situations, the consumers may not want more, but less.

Prices also convey this. When automobiles began to displace horses
and buggies in the early twentieth century, the demand for saddles,
horseshoes, carriages and other such paraphernalia declined. As the
manufacturers of such products faced losses instead of profits, many
began to abandon their businesses or were forced to shut down by
bankruptcy. In a sense, it is unfair when some people are unable to
earn as much as others with similar levels of skills and diligence,
because of innovations which were as unforeseen by most of the
producers who benefitted as by most of the producers who were made
worse off. Yet this unfairness to particular individuals and businesses is
what makes the economy as a whole operate more efficiently for the
benefit of vastly larger numbers of others. Would creating more
fairness among producers, at the cost of reduced efficiency and a
resulting lower standard of living, be fair to consumers?

The gains and losses are not isolated or independent events. The
crucial role of prices is in tying together a vast network of economic
activities among people too widely scattered to all know each other.
However much we may think of ourselves as independent individuals,
we are all dependent on other people for our very lives, as well as
being dependent on innumerable strangers who produce the
amenities of life. Few of us could grow the food we need to live, much
less build a place to live in, or produce such things as computers or
automobiles. Other people have to be induced to create all these
things for us, and economic incentives are crucial for that purpose. As
Will Rogers once said, "We couldn't live a day without depending on
everybody."^^^* Prices make that dependence viable by linking their
interests with ours.

"UNMET NEEDS"

One of the nnost connnnon—and certainly one of the most
profound—misconceptions of economics involves "unmet needs."
Politicians, journalists, and academicians are almost continuously
pointing out unmet needs in our society that should be supplied by
some government program or other. Most of these are things that
most of us wish our society had more of.

What is wrong with that? Let us go back to square one. If
economics is the study of the use of scarce resources which have
alternative uses, then it follows that there will always be unmet needs.
Some particular desires can be singled out and met 100 percent, but
that only means that other desires will be even more unfulfilled than
they are now. Anyone who has driven in most big cities will
undoubtedly feel that there is an unmet need for more parking spaces.
But, while it is both economically and technologically possible to build
cities in such a way as to have a parking space available for anyone
who wants one, anywhere in the city, at any hour of the day or night,
does it follow that we should do it?

The cost of building vast new underground parking garages, or of
tearing down existing buildings to create parking garages above
ground, or of designing new cities with fewer buildings and more
parking lots, would all be astronomically costly. What other things are
we prepared to give up, in order to have this automotive Utopia?
Fewer hospitals? Less police protection? Fewer fire departments? Are
we prepared to put up with even more unmet needs in these areas?
Maybe some would give up public libraries in order to have more
places to park. But, whatever choices are made and however it is done.

there will still be more unmet needs elsewhere, as a result of meeting
an unmet need for more parking spaces.

We may differ among ourselves as to what is worth sacrificing in
order to have more of something else. The point here is more
fundamental: Merely demonstrating an unmet need is not sufficient to
say that it should be met—not when resources are scarce and have
alternative uses.

In the case of parking spaces, what might appear to be cheaper,
when measured only by government expenditures, would be to
restrict or forbid the use of private automobiles in cities, adjusting the
number of cars to the number of existing parking spaces, instead of
vice versa. Moreover, passing and enforcing such a law would cost a
tiny fraction of the cost of greatly expanding the number of parking
spaces. But this saving in government expenditures would have to be
weighed against the vast private expenditures currently devoted to
the purchase, maintenance, and parking of automobiles in cities.
Obviously these expenditures would not have been undertaken in the
first place if those who pay these prices did not find the benefits to be
worth it to them.

To go back to square one again, costs are foregone opportunities,
not government expenditures. Forcing thousands of people to forego
opportunities for which they have willingly paid vast amounts of
money is a cost that may far outweigh the money saved by not having
to build more parking spaces or do the other things necessary to
accommodate cars in cities. None of this says that we should have
either more parking spaces or fewer parking spaces in cities. What it
says is that the way this issue—and many others—is presented makes
no sense in a world of scarce resources which have alternative uses.

That is a world of trade-offs, not solutions—and whatever trade-off is
decided upon will still leave unmet needs.

So long as we respond gullibly to political rhetoric about unmet
needs, we will arbitrarily choose to shift resources to whatever the
featured unmet need of the day happens to be and away from other
things. Then, when another politician—or perhaps even the same
politician at a later time—discovers that robbing Peter to pay Paul has
left Peter worse off, and now wants to help Peter meet his unmet
needs, we will start shifting resources in another direction. In short, we
will be like a dog chasing his tail in a circle and getting no closer, no
matter how fast he runs.

This is not to say that we have the ideal trade-offs already and
should leave them alone. Rather, it says that whatever trade-offs we
make or change should be seen from the outset as trade-offs—not
meeting unmet needs.

The very word "needs" arbitrarily puts some desires on a higher
plane than others, as categorically more important. But, however
urgent it may be to have some food and some water, for example, in
order to sustain life itself, nevertheless—beyond some point—both
become not only unnecessary but even counterproductive and
dangerous. Widespread obesity among Americans shows that food has
already reached that point and anyone who has suffered the ravages
of flood (even if it is only a flooded basement) knows that water can
reach that point as well. In short, even the most urgently required
things remain necessary only within a given range. We cannot live half
an hour without oxygen, but even oxygen beyond some concentration
level can promote the growth of cancer and has been known to make
newborn babies blind for life. There is a reason why hospitals do not

use oxygen tanks willy-nilly.

In short, nothing is a "need" categorically, regardless of how
urgent it may be to have particular amounts at particular times and
places. Unfortunately, most laws and government policies apply
categorically, if only because of the dangers in leaving every
government official to become a petty despot in interpreting what
these laws and policies mean and when they should apply. In this
context, calling something a "need" categorically is playing with fire.
Many complaints that some basically good government policy has
been applied stupidly may fail to address the underlying problem of
categorical laws in an incremental world. There may not have been
any intelligent way to apply categorically a policy designed to meet
desires whose benefits vary incrementally and ultimately cease to be
benefits.

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

Chapters

PRICE CONTROLS

The record of price controls goes as far back as
human history. They were imposed by the Pharaohs
of ancient Egypt. They were decreed by Hammurabi,
king of Babylon, in the eighteenth century B.C. They
were tried in ancient Athens.

Henry HazlitT^^^

Nothing makes us understand the many roles of electricity in our
lives like a power failure. Similarly, nothing shows more vividly the role
and importance of price fluctuations in a market economy than the
absence of such price fluctuations when the market is controlled.
What happens when prices are not allowed to fluctuate freely
according to supply and demand, but instead their fluctuations are
fixed within limits set by law under various kinds of price controls?

Typically, price controls are imposed in order to keep prices from
rising to the levels that they would reach in response to supply and
demand. The political rationales for such laws have varied from place
to place and from time to time, but there is seldom a lack of rationales

whenever it beconnes politically expedient to hold down some
people's prices in the interest of other people whose political support
seems more important.

To understand the effects of price control, it is first necessary to
understand how prices rise and fall in a free market. There is nothing
esoteric about it, but it is important to be very clear about what
happens. Prices rise because the amount demanded exceeds the
amount supplied at existing prices. Prices fall because the amount
supplied exceeds the amount demanded at existing prices. The first
case is called a "shortage" and the second is called a "surplus"—but
both depend on existing prices. Simple as this might seem, it is often
misunderstood, sometimes with disastrous consequences.

PRICE "CEILINGS" AND SHORTAGES

When there is a "shortage" of a product, there is not necessarily
any less of it, either absolutely or relative to the number of consumers.
During and immediately after the Second World War, for example,
there was a very serious housing shortage in the United States, even
though the country's population and its housing supply had both
increased by about 10 percent from their prewar levels—and there
was no shortage when the war began.^^®’ In other words, even though
the ratio between housing and people had not changed, nevertheless
many Americans looking for an apartment during this period had to
spend weeks or months in an often futile search for a place to live, or
else resorted to bribes to get landlords to move them to the top of

waiting lists. Meanwhile, they doubled up with relatives, slept in
garages or used other makeshift living arrangements, such as buying
military surplus Quonset huts or old trolley cars to live in.

Although there was no less housing space per person than before
the war, the shortage was very real and very painful at existing prices,
which were kept artificially lower than they would have been, because
of rent control laws that had been passed during the war. At these
artificially low prices, more people had a demand for more housing
space than before rent control laws were enacted. This is a practical
consequence of the simple economic principle already noted in
Chapter 2, that the quantity demanded varies according to how high
or how low the price is.

When some people used more housing than usual, other people
found less housing available. The same thing happens under other
forms of price control: Some people use the price-controlled goods or
services more generously than usual because of the artificially lower
price and, as a result, other people find that less than usual remains
available for them. There are other consequences to price controls in
general, and rent control provides examples of these as well.

Demand under Rent Control

Some people who would normally not be renting their own
apartments, such as young adults still living with their parents or some
single or widowed elderly people living with relatives, were enabled by
the artificially low prices created by rent control to move out and into
their own apartments. These artificially low prices also caused others
to seek larger apartments than they would ordinarily be living in or to
live alone when they would otherwise have to share an apartment

with a roommate, in order to be able to afford the rent.

Some people who do not even live in the same city as their rent-
controlled apartment nevertheless keep it as a place to stay when they
are visiting the city—Hollywood movie stars who keep rent-controlled
apartments in New York or a couple living in Hawaii who kept a rent-
controlled residence in San Francisco,for example. More tenants
seeking both more apartments and larger apartments create a
shortage, even when there is not any greater physical scarcity of
housing relative to the total population.

When rent control ended after World War II, the housing shortage
quickly disappeared. After rents rose in a free market, some childless
couples living in four-bedroom apartments could decide that they
would live in two-bedroom apartments and save the difference in
rent. Some late teenagers could decide that they would continue
living with their parents a little longer, until their pay rose enough for
them to be able to afford their own apartment, now that rent was no
longer artificially cheap. The net result was that families looking for a
place to stay found more places available, now that rent-control laws
were no longer keeping such places occupied by people with less
urgent requirements. In other words, the housing shortage
immediately eased, even before there was time for new housing to be
built, in response to market conditions that now made it possible to
recover the cost of building more housing and earn a profit.

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

Francisco showed that 49 percent of that city's rent-controlled
apartments had only a single occupant/'^”* while a severe housing
shortage in the city had thousands of people living considerable
distances away and making long commutes to their jobs in San
Francisco. Meanwhile, a Census report showed likewise that 46 percent
of all households in Manhattan, where nearly half of all apartments are
under some form of rent control, are occupied by only one person—
compared to 27 percent nationwide.^'^^’

In the normal course of events, people's demand for housing
space changes over a lifetime. Their demand for space usually
increases when they get married and have children. But, years later,
after the children have grown up and moved away, the parents'
demand for space may decline, and it often declines yet again after a
spouse dies and the widow or widower moves into smaller quarters or
goes to live with relatives or in an institution for the elderly. In this
way, a society's total stock of housing is shared and circulated among
people according to their changing individual demands at different
stages of their lives.

This sharing takes place, not because the individuals themselves
have a sense of cooperation, but because of the prices—rents in this
case—which confront them. In a free market, these prices are based
on the value that other tenants put on housing. Young couples with a
growing family are often willing to bid more for housing, even if that
means buying fewer consumer goods and services, in order to have
enough money to pay for additional housing space. A couple who
begin to have children may cut back on how often they go out to
restaurants or to movies, or they may wait longer to buy new clothes
or a new car, in order that each child may have his or her own

bedroom. But, once the children are grown and gone, such sacrifices
may no longer make sense, when additional other amenities can now
be enjoyed by reducing the amount of housing space being rented.

Given the crucial role of prices in this process, suppression of that
process by rent control laws leaves few incentives for tenants to
change their behavior as their circumstances change. Elderly people,
for example, have less incentive to vacate apartments that they would
normally vacate when their children are gone, or after a spouse dies, if
that would result in a significant reduction in rent, leaving them more
money with which to improve their living standards in other respects.
Moreover, the chronic housing shortages which accompany rent
control greatly increase the time and effort required to search for a
new and smaller apartment, while reducing the financial reward for
finding one. In short, rent control reduces the rate of housing turnover.

New York City has had rent control longer and more stringently
than any other major American city. One consequence has been that
the annual rate of turnover of apartments in New York is less than half
the national average, and the proportion of tenants who have lived in
the same apartment for 20 years or more is more than double the
national average.^"^^’ As the New York Times summarized the situation:

New York used to be like other cities, a place where tenants moved
frequently and landlords competed to rent empty apartments to
newcomers, but today the motto may as well be: No Immigrants Need
Apply. While immigrants are crowded into bunks in illegal boarding
houses in the slums, upper-middle-class locals pay low rents to live in
good neighborhoods, often in large apartments they no longer need after
their children move out.^^^*

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.^"^"^’ In Egypt,
rent control was imposed in 1960. An Egyptian woman who lived
through that era and wrote about it in 2006 reported:

The end result was that people stopped investing in apartment buildings,
and a huge shortage in rentals and housing forced many Egyptians to live
in horrible conditions with several families sharing one small apartment.
The effects of the harsh rent control is still felt today in Egypt. Mistakes
like that can last for generations.^^^*

Declines in building construction have likewise followed in the
wake of rent control laws elsewhere. After rent control was instituted
in Santa Monica, California in 1979, building permits declined to less
than one-tenth of what they were just five years earlier.^"^^* A housing
study in San Francisco found that three quarters of its rent-controlled
housing was more than half a century old and 44 percent of it was
more than 70 years old.^"^^’

Although the construction of office buildings, factories,
warehouses, and other commercial and industrial buildings requires
much of the same kind of labor and materials used to construct
apartment buildings, it is not uncommon for many new office
buildings to be constructed in cities where very few new apartment
buildings are built. Rent control laws often do not apply to industrial
or commercial buildings. Thus, even in cities with severe housing
shortages, there may be much vacant space in commercial and
industrial buildings. Despite a severe housing shortage in New York,

San Francisco, and other cities with rent control, a nationwide survey
in 2003 found the vacancy rates in buildings used by business and
industry to be nearly 12 percent, the highest in more than two
decades

This is just one more piece of evidence that housing shortages are
a price phenomenon. High vacancy rates in commercial buildings
show that there are obviously ample resources available to construct
buildings, but rent control keeps those resources from being used to
construct apartments, and thereby diverts these resources into
constructing office buildings, industrial plants, and other commercial
properties.

Not only is the supply of new apartment construction less after
rent control laws are imposed, even the supply of existing housing
tends to decline, as landlords provide less maintenance and repair
under rent control, since the housing shortage makes it unnecessary
for them to maintain the appearance of their premises in order to
attract tenants. Thus housing tends to deteriorate faster under rent
control and to have fewer replacements when it wears out. Studies of
rent control in the United States, England, and France have found rent-
controlled housing to be deteriorated far more often than non-rent-
controlled housing.

Typically, the rental housing stock is relatively fixed in the short
run, so that a shortage occurs first because more people want more
housing at the artificially low price. Later, there may be a real increase
in scarcity as well, as rental units deteriorate more rapidly with
reduced maintenance, while not enough new units are being built to
replace them as they wear out, because new privately built housing
can be unprofitable under rent control. Under rent control in England

and Wales, for exannple, privately-built rental housing fell from being
61 percent of all housing in 1947 to being just 14 percent by 1977.^"^^* A
study of rent control in various countries concluded: "New investment
in private unsubsidized rented housing is essentially nonexistent in all
the European countries surveyed, except for luxury housing"^^°’

In short, a policy intended to make housing affordable for the
poor has had the net effect of shifting resources toward the building of
housing that is affordable only by the affluent or the rich, since luxury
housing is often exempt from rent control. Just as office buildings and
other commercial properties are. Among other things, this illustrates
the crucial importance of making a distinction between intentions and
consequences. Economic policies need to be analyzed in terms of the
incentives they create, rather than the hopes that inspired them.

The incentives towards a reduced supply of housing under rent
control are especially pronounced when people who have been
renting out rooms or apartments in their own homes, or bungalows in
their back yards, decide that it is no longer worth the bother, when
rents are kept artificially low under rent control laws. In addition, there
are often conversions of apartments to condominiums. During 8 years
of rent control in Washington during the 1970s, that city's available
rental housing stock declined absolutely, from Just over 199,000 units
on the market to Just under 176,000 units.^^^’ After rent control was
introduced in Berkeley, California, the number of private rental
housing units available to students at the university there declined by
31 percent in five years.^^^’

None of this should be surprising, given the incentives created by
rent control laws. In terms of incentives, it is likewise easy to
understand what happened in England when rent control was

extended in 1975 to cover furnished rental units. According to The
Times of London:

Advertisements for furnished rented accommodation in the London
Evening Standard plummeted dramatically in the first week after the Act
came into force and are now running at about 75 per cent below last
year's levels.^^^^

Since furnished rooms are often in people's homes, these
represent housing units that are easily withdrawn from the market
when the rents no longer compensate for the inconveniences of
having renters living with you. The same principle applies where there
are small apartment buildings like duplexes, where the owner is also
one of the tenants. Within three years after rent control was imposed
in Toronto in 1976, 23 percent of all rental units in owner-occupied
dwellings were withdrawn from the housing market.^^'^*

Even when rent control applies to apartment buildings where the
landlord does not live, eventually the point may be reached where the
whole building becomes sufficiently unprofitable that it is simply
abandoned. In New York City, for example, many buildings have been
abandoned after their owners found it impossible to collect enough
rent to cover the costs of services that they are required by law to
provide, such as heat and hot water. Such owners have simply
disappeared, in order to escape the legal consequences of their
abandonment, and such buildings often end up vacant and boarded
up, though still physically sound enough to house people, if they
continued to be maintained and repaired.

The number of abandoned buildings taken over by the New York
City government over the years runs into the thousands.^^^’ It has been
estimated that there are at least four times as many abandoned

housing units in New York City as there are homeless people living on
the streets thereJ^^* Homelessness is not due to a physical scarcity of
housing, but to a price-related shortage, which is painfully real
nonetheless. As of 2013, there were more than 47,000 homeless people
in New York City, 20,000 of them children.^^^*

Such inefficiency in the allocation of resources means that people
are sleeping outdoors on the pavement on cold winter nights—some
dying of exposure—while the means of housing them already exist,
but are not being used because of laws designed to make housing
"affordable." Once again, this demonstrates that the efficient or
inefficient allocation of scarce resources is not just some abstract
notion of economists, but has very real consequences, which can even
include matters of life and death. It also illustrates that the goal of a
law—"affordable housing," in this case—tells us nothing about its
actual consequences.

The Politics of Rent Control

Politically, rent control is often a big success, however many
serious economic and social problems it creates. Politicians know that
there are always more tenants than landlords and more people who
do not understand economics than people who do. That makes rent
control laws something likely to lead to a net increase in votes for
politicians who pass rent control laws.

Often it is politically effective to represent rent control as a way to
keep greedy rich landlords from "gouging" the poor with
"unconscionable" rents. In reality, rates of return on investments in
housing are seldom higher than on alternative investments, and
landlords are often people of very modest means. This is especially so

for owners of small, low-end apartment buildings that are in constant
need of repair, the kinds of places where tenants are likely to be low-
income people. Many of the landlords with buildings like this are
handymen who use their own skills and labor as carpenters or
plumbers to repair and maintain the premises, while trying to pay off
the mortgage with the rents they collect. In short, the kind of housing
likely to be rented by the poor often has owners who are by no means
rich.^''*

Where rent control laws apply on a blanket basis to all housing in
existence as of the time the law goes into effect, even luxurious
housing becomes low-rent housing. Then, after the passage of time
makes clear that no new housing is likely to be built unless it is
exempted from rent control, such exemptions or relaxations of rent
control for new housing mean that even new apartments that are very
modest in size and quality may rent for far more than older, more
spacious and more luxurious apartments that are still under rent
control. This non-comparability of rents has been common in
European cities under rent control, as well as in New York and other
American cities. Similar incentives produce similar results in many
different settings. A news story in the Wall Street Journal pointed up
this non-comparability of rents under New York City's rent control
laws:

Les Katz, a 27-year-old acting student and doorman, rents a small
studio apartment on Manhattan's Upper West Side for $1,200—with two
roommates. Two sleep in separate beds in a loft built atop the kitchen,
the third on a mattress in the main room.

Across town on Park Avenue, Paul Haberman, a private investor, and his
wife live in a spacious, two-bedroom apartment with a solarium and two
terraces. The apartment in an elegant building on the prestigious avenue

is worth at least $5,000 a month, real-estate professionals say. The couple
pay around $350, according to rent records.^^®*

This example of cheap rent for the affluent or the wealthy under
rent control was by no means unique. Ironically, a statistical study
indicated that the biggest difference between prices under New York's
rent control law and free-market prices is in luxury apartments.^^^* In
other words, the affluent and the wealthy get more economic benefit
from rent control than do the poor who are invoked to justify such
laws. Meanwhile, city welfare agencies have paid much higher rents
than those Just mentioned when they housed poverty-stricken
families in cramped and roach-infested apartments in run-down
hotels. In 2013, the New York Times reported that the city's
Department of Homeless Services was "spending over $3,000 a month
for each threadbare room without a bathroom or kitchen" in a single
room occupancy hotel—half of that money going to the landlord for
rent and the other half for "security and social services for homeless
tenants."^^°’

The image that rent control protects poor tenants from rich
landlords may be politically effective, but often it bears little
resemblance to the reality. The people who actually benefit from rent
control can be at any income level and so can those who lose out. It
depends on who happens to be on the inside looking out, and who
happens to be on the outside looking in, when such laws are passed.

San Francisco's rent control laws are not as old as those in New
York City but they are similarly severe—and have produced very
similar results. A study published in 2001 showed that more than one-
fourth of the occupants of rent-controlled apartments in San Francisco
had household incomes of more than $100,000 a year.^^^* It should also

be noted that this was the first ennpirical study of rent control
commissioned by the city of San Francisco. Since rent control began
there in 1979, this means that for more than two decades these laws
were enforced and extended, with no serious attempt being made to
measure their actual economic and social consequences, as
distinguished from their political popularity.

Ironically, cities with strong rent control laws, such as New York
and San Francisco, tend to end up with higher average rents than
cities without rent control.^^^’ Where such laws apply only to rents
below some specified level, presumably to protect the poor, builders
then have incentives to build only apartments luxurious enough to be
priced above the rent-control level. Not surprisingly, this leads to
higher average rents, and homelessness tends to be greater in cities
with rent control—New York and San Francisco again being classic
examples.

One of the reasons for the political success of rent control laws is
that many people accept words as indicators of reality. They believe
that rent control laws actually control rents. So long as they believe
that, such laws are politically viable, as are other laws that proclaim
some apparently desirable goals, whether those goals end up being
served or not.

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 growing shortage without an increased scarcity,
so there can be a growing scarcity without a shortage.

As already noted, there was a severe housing shortage in the
United States during and immediately after the Second World War,
even though the ratio of housing to people was the same as it had
been before the war, when there was no housing shortage. It is also
possible to have the opposite situation, where the actual amount of
housing suddenly declines in a given area without any price control—
and without any shortage. This happened in the wake of the great San
Francisco earthquake and fire of 1906. More than half the city's
housing supply was destroyed in just three days during that
catastrophe. Yet there was no housing shortage. When the San
Francisco Chronicle resumed publication a month after the
earthquake, its first issue contained 64 advertisements of apartments
or homes for rent, compared to only 5 ads from people seeking
apartments to live in.

Of the 200,000 people suddenly made homeless by the
earthquake and fire, temporary shelters housed 30,000 and an
estimated 75,000 left the city.^^^* Still, that left nearly 100,000 people to
be absorbed into the local housing market. Yet the newspapers of that
time mention no housing shortage. Rising prices not only allocate
existing housing, they provide incentives for rebuilding and for renters
to use less space in the meantime, as well as incentives for those with
space in their homes to take in roomers while rents are high. In short.
Just as there can be a shortage without any greater physical scarcity, so
there can be a greater physical scarcity without any shortage. People
made homeless by the huge 1906 San Francisco earthquake found
housing more readily than people made homeless by New York's rent
control laws that tookthousands of buildings off the market.

Hoarding

In addition to shortages and quality deterioration under price
controls, there is 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 it in the future. Thus, during the gasoline shortages of the
1970s, motorists were less likely to let their gas tanks get down as low
as usual before going to a filling station to buy more gas.

Some motorists with their tanks half full would drive into any
filling station that happened to have gas, and fill up the other half, as a
precaution. With millions of motorists driving around with their gas
tanks more full than usual, vast amounts of gasoline disappeared into
individual inventories, leaving less available for sale from the general
inventory at filling stations. Thus a relatively small shortage of
gasoline nationally could turn into a very serious problem for those
motorists who happened to run out of gas and had to look for a filling
station that was open and had gas to sell. The sudden severity of the
gasoline shortage—given how little difference there was in the total
amount of gasoline produced—baffled many people and produced
various conspiracy theories.

One of these conspiracy theories was that oil companies had their
tankers from the Middle East circling around in the ocean, waiting for
a price increase before coming ashore with their cargoes. Although
none of these conspiracy theories stood up under scrutiny, there was a
kernel of sense behind them, as there usually is behind most fallacies.
A severe shortage of gasoline with very little difference in the total
amount of gasoline produced meant that there had to be a large
amount of gasoline being diverted somewhere. Few of those who

created or believed conspiracy theories suspected that the excess was
being stored in their own gas tanks, rather than in oil tankers circling
in the ocean. This increased the severity of the gasoline shortage
because maintaining millions of larger individual inventories of
gasoline in cars and trucks was less efficient than maintaining general
inventories in filling stations' storage tanks.

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 long.
Price controls on haircuts or other services may also create less of a
shortage because services cannot be hoarded. That is, you would not
get two haircuts on the same day if you found a barber with time
available, in order to go twice as long before the next haircut, even
though barbers might be less available when the price of haircuts was
kept down by price controls.

Nevertheless, some unlikely things do get hoarded under price
controls. For example, under rent control, people may keep an
apartment that they seldom use, as some Hollywood stars have kept
rent-controlled apartments in Manhattan where they would stay when
visiting New York.^^'^’ Mayor Ed Koch kept his rent-controlled apartment
during the entire 12 years when he lived in Gracie Mansion, the official
residence of New York's mayor.^^^* In 2008, it was revealed that New
York Congressman Charles Rangel had four rent-controlled
apartments, one of which he used as an office.^^^*

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 of
gasoline.

Sometimes the reduction in supply under price controls takes
forms that are less obvious. Under World War II price controls,
Consumer Reports magazine found that 19 out of 20 candy bars that it
tested in 1943 were smaller in size than they had been four years
earlier.^^^* Some producers of canned foods let the quality deteriorate,
but then sold these lower quality foods under a different label, in order
to preserve the reputation of their regular brand.

Black Markets

While price controls make it illegal for buyer and seller 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 make 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 risks 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. In Russia, for example, a local embargo on the
shipment of price-controlled food beyond regional boundaries was
dubbed the "150-ruble decree," since this was the cost of bribing police
to let the shipments pass through checkpoints.^^®’

Even during the early Soviet period, when operating a black
market in food was punishable by death, black markets still existed. As
two Soviet economists of a later era put it: "Even at the height of War
Communism, speculators and food smugglers at the risk of their lives

brought as much grain into the cities as all the state purchases made
under prodrazverstka'.'^^^^

Statistics on black market activity are by nature elusive, since no
one wants to let the whole world know that they are violating the law.
However, sometimes there are indirect indications. Under American
wartime price controls during and immediately after the Second
World War, employment in meat-packing plants declined as meat was
diverted from legitimate packing houses into black markets. This often
translated into empty meat counters in butcher shops and grocery
stores.^'''*

As in other cases, however, this was not due simply to an actual
physical scarcity of meat but to its diversion into illegal channels.
Within one month after price controls were ended, employment in
meat-packing plants rose from 93,000 to 163,000 and then rose again
to 180,000 over the next two months.^^°* This nearly doubling of
employment in meat-packing plants in just three months indicated
that meat was clearly no longer being diverted from the packing
houses after price controls were ended.

In the Soviet Union, where price controls were more pervasive
and longer lasting, two Soviet economists wrote of a "gray market"
where people paid "additional money for goods and services."
Although these illegal transactions "are not taken into account by
official statistics," the Soviet economists estimated that 83 percent of
the population used these forbidden economic channels. These illegal
markets covered a wide range of transactions, including "almost half
of the repair of apartments," 40 percent of automobile repairs and
more video sales than in the legal markets: "The black market trades
almost 10,000 video titles, while the state market offers fewer than

1 , 000 ."''”

Quality Deterioration

One of the reasons for the political success of price controls is
that part of their costs are concealed. Even the visible shortages do
not tell the whole story. Qua/ity 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 out different kinds and qualities of apples, throwing away
those that fall below a certain quality that their respective customers
expect. Under price control, however, the amount 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 out apples, as they
will all be sold anyway. Some apples that would ordinarily be thrown
away under free market conditions may, under price control, be kept
for sale to those people who arrive after all the good apples have been
sold.

As with apartments under rent control, there is less incentive to
maintain high quality when everything will sell anyway during a
shortage.

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 this changes when price controls
reduce the cost of visits to the doctor's office, and especially when
these visits are paid for by the government and are therefore free to
the patient.

In short, more people make more claims on doctors' time under
price control, leaving less time for other people with more serious, or
even urgent, medical problems. Thus, under Britain's government-
controlled medical system, a twelve-year-old girl was given a breast
implant while 10,000 people waited 15 months or more for surgery.^^^*
A woman with cancer had her operation postponed so many times
that the malignancy eventually became inoperable.^^'^* The priorities
which prices automatically cause individuals to consider are among
the first casualties of price controls.

A study conducted by the international agency Organisation for
Economic Co-operation and Development found that, among five
English-speaking countries surveyed, only in the United States was the
percentage of patients waiting for elective surgery for more than four
months in single digits. All the other English-speaking countries—
Australia, Canada, New Zealand, and the United Kingdom—had more
than 20 percent of their patients waiting more than four months, with
38 percent of those in the United Kingdom waiting at least that long.
In this group, the United States was the only country without
government-set prices for medical treatment. Incidentally, the term
"elective surgery" was not confined to cosmetic surgery or other
medically unnecessary procedures, but in this study included cataract

surgery, hip replacement and coronary bypass surgery/^^*

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. In countries around the
world, the amount of time that physicians spend per patient visit has
been shorter under government-controlled medical care prices,
compared to the time spent by physicians where prices are not
controlled.

Black markets are another common feature of price controls that
apply to medical care as to other things. In China and Japan, black
markets have taken the form of bribes to doctors to get expedited
treatment. In short, whether the product or service has been housing,
apples, or medical care, quality deterioration under price control has
been common in the most disparate settings.

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.

Among the tragedies of the Great Depression of the 1930s was
the fact that many American farmers simply could not make enough
money from the sale of their crops to pay their bills. The prices of farm

products fell much more drastically than the prices of the things that
farmers bought. Farm income fell from just over $6 billion in 1929 to
$2 billion in 1932.^^^*

As many farmers lost their farms because they could no longer
pay the mortgages, and as other farm families suffered privations as
they struggled to hang on to their farms and their traditional way of
life, the federal government sought to restore what was called "parity"
between agriculture and other sectors of the economy by intervening
to keep farm prices from falling so sharply.

This intervention took various forms. One approach was to reduce
by law the amount of various crops that could be grown and sold, so as
to prevent the supply from driving the price below the level that
government officials had decided upon. Thus, supplies of peanuts and
cotton were restricted by law. Supplies of citrus fruit, nuts and various
other farm products were regulated by local cartels of farmers, backed
up by the authority of the Secretary of Agriculture to issue "marketing
orders" and prosecute those who violated these orders by producing
and selling more than they were authorized to produce and sell. Such
arrangements continued for decades after the poverty of the Great
Depression was replaced by the prosperity of the economic boom
following World War II, and many of these restrictions continue to this
day.

These indirect methods of keeping prices artificially high were
only part of the story. The key factor in keeping farm prices artificially
higher than they would have been under free market supply and
demand was the government's willingness to buy up the surpluses
created by its control of prices. This they did for such farm products as
corn, rice, tobacco, and wheat, among others—and many of these

programs continue on to the present as well. Regardless of what group
was initially supposed to be helped by these programs, the very
existence of such programs benefitted others as well, and these new
beneficiaries made it politically difficult to end such programs, even
long after the initial conditions had changed and the initial
beneficiaries were now a small part of the constituency politically
organized and determined to keep these programs going.^''''*

Price control in the form of a "floor" under prices, preventing
these prices from falling further, produced surpluses as dramatic as
the shortages produced 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, in order to maintain
prices at a pre-determined level.

During the Great Depression of the 1930s, agricultural price
support programs led to vast amounts of food being deliberately
destroyed, at a time when malnutrition was a serious problem in the
United States and hunger marches were taking place in cities across
the country. For example, the federal government bought 6 million
hogs in 1933 alone and destroyed them.^^^* Huge amounts of farm
produce were plowed under, in order to keep it off the market and
maintain prices at the officially fixed level, while vast amounts of milk
were poured down the sewers for the same reason. Meanwhile, many
American children were suffering from diseases caused by
malnutrition.

Still, there was a food surplus. A surplus, like a shortage, is a price
phenomenon. A surplus does not mean that there is some excess
relative to the people. There was not "too much" food relative to the

population during the Great Depression. The people simply did not
have enough money to buy everything that was produced at the
artificially high prices set by the government. A very similar situation
existed in poverty-stricken India at the beginning of the twenty-first
century, where there was a surplus of wheat and rice under
government price supports. The Far Eastern Economic Review
reported:

India's public stock of food grains is at an all-time high, and next spring, it
will grow still further to a whopping 80 million tonnes, or four times the
amount necessary in case of a national emergency. Yet while that wheat
and rice sits idle—in some cases for years, to the point of rotting—
millions of Indians don't have enough to eat.^^^*

A report from India in the New York Times told a very similar story
under the headline, "Poor in India Starve as Surplus Wheat Rots":

Surplus from this year's wheat harvest, bought by the government
from farmers, sits moldering in muddy fields here in Punjab State. Some
of the previous year's wheat surplus sits untouched, too, and the year's
before that, and the year's before that.

To the south, in the neighboring state of Rajasthan, villagers ate boiled
leaves or discs of bread made from grass seeds in late summer and
autumn because they could not afford to buy wheat. One by one, children
and adults—as many as 47 in all—wilted away from hunger-related
causes, often clutching pained stomachs.^^^*

A surplus or "glut" of food in India, where malnutrition is still a
serious problem, might seem like a contradiction in terms. But food
surpluses under "floor" prices are just as real as the housing shortages
under "ceiling" prices. In the United States, the vast amount of storage
space required to keep surplus crops off the market once led to such
desperate expedients as storing these farm products in unused

warships, when all the storage facilities on land had been filled to
capacity. Otherwise, American wheat would have had to be left
outside to rot, as in India.

A series of bumper crops in the United States could lead to the
federal government's having more wheat in storage than was grown
by American farmers all year. In India, it was reported in 2002 that the
Indian government was spending more on storage of its surplus
produce than on rural development, irrigation and flood control
combined.^®”’ It was a classic example of a misallocation of scare
resources which have alternative uses, especially in a poor country.

So long as the market price of the agricultural product covered by
price controls stays above 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 sufficient reduction in
the amount demanded, the resulting lower price can fall to a level at
which the government buys what the market is unwilling to buy. For
example, when powdered milk was selling in the United States for
about $2.20 a pound in 2007, it was sold in the market but, when the
price fell to 80 cents a pound in 2008, the U.S. Department of
Agriculture found itself legally obligated to buy about 112 million
pounds of powdered milk at a total cost exceeding $90 million.^®^*

None of this is peculiar to the United States or to India. The
countries of the European Union spent $39 billion in direct subsidies in
2002 and their consumers spent twice as much as that in the inflated
food prices created by these agricultural programs.^®^’ Meanwhile, the
surplus food has been sold below cost on the world market, driving
down the prices that Third World farmers could get for their produce.

In all these countries, not only the government but also the consumers
are paying for agricultural price-support programs—the government
directly in payments to farmers and storage companies, and the
consumers in inflated food prices. As of 2001, American consumers
were paying $1.9 billion a year in artificially higher prices, just for
products containing sugar, while the government was paying $1.4
million per month Just to store the surplus sugar. Meanwhile, the New
York Times reported that sugar producers were "big donors to both
Republicans and Democrats" and that the costly sugar price support
program had "bipartisan support."^®^*

Sugar producers are even more heavily subsidized in the
European Union countries than in the United States, and the price of
sugar in these countries is among the highest in the world. In 2009, the
New York Times reported that sugar subsidies in the European Union
were "so lavish it even prompted cold-weather Finland to start
producing more sugar,"^®"^* even though sugar can be produced from
cane grown in the tropics for much lower costs than from sugar beets
grown in Europe.

In 2002, the U.S. Congress passed a farm subsidy bill that was
estimated to cost the average American family more than $4,000 over
the following decade in taxes and inflated food prices.^®®’ Nor was this a
new development. During the mid-1980s, when the price of sugar on
the world market was four cents a pound, the wholesale price within
the United States was 20 cents a pound.^®®* The government was
subsidizing the production of something that Americans could have
gotten cheaper by not producing it at all, and buying it from countries
in the tropics. This has been true of sugar for decades. Moreover, sugar
is not unique in this respect, nor is the United States. In the nations of

the European Union, the prices of lamb, butter, and sugar are all more
than twice as high as their world market prices As a writer for the
Wall Street Journal put it, every cow in the European Union gets more
subsidies per day than most sub-Saharan Africans have to live on

Although the original rationale for the American price-support
programs was to save family farms, in practice more of the money
went to big agricultural corporations, some of which received millions
of dollars each, while the average farm received only a few hundred
dollars. Most of the money from the 2002 bipartisan farm bill will
likewise go to the wealthiest 10 percent of farmers—including David
Rockefeller, Ted Turner, and a dozen companies on the Fortune 500 list.

In Mexico as well, 85 percent of agricultural subsidies go to the
largest 15 percent of farmers.^^®’

What is crucial from the standpoint of understanding 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 of keeping
prices artificially low. Nor were the losses simply the sums of money
extracted from the taxpayers or the consumers for the benefit of
agricultural corporations and farmers. These are internal transfers
within a nation, which do not directly reduce the total wealth of the
country. The real losses to the country as a whole come from the
misallocation of scarce resources which have alternative uses.

Scarce resources such as land, labor, fertilizer, and machinery are
needlessly used to produce more food than the consumers are willing
to consume at the artificially high prices decreed by the government.
All the vast resources used to produce sugar in the United States are
wasted when sugar can be imported from countries in the tropics,
where it is produced much more cheaply in a natural environment

more conducive to its growth. 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. Those on food stamps are able to buy
less food with those stamps when food prices are artificially inflated.

From a purely economic standpoint, it is working at cross
purposes to subsidize farmers by forcing food prices up and then
subsidize some consumers by bringing down their particular costs of
food with subsidies—as is done in both India and the United States.
However, from a political standpoint, it makes perfect sense to gain
the support of two different sets of voters, especially since most of
them do not understand the full economic implications of the policies.

Even when agricultural subsidies and price controls originated
during hard times as a humanitarian measure, they have persisted
long past those times because they developed an organized
constituency which threatened to create political trouble if these
subsidies and controls were removed or even reduced. Farmers have
blocked the streets of Paris with their farm machinery when the
French government showed signs of scaling back its agricultural
programs or allowing more foreign farm produce to be imported. In
Canada, farmers protesting low wheat prices blocked highways and
formed a motorcade of tractors to the capital city of Ottawa.

While only about one-tenth of farm income in the United States
comes from government subsidies, about half of farm income in South
Korea comes from such subsidies, as does 60 percent in Norway.^^^*

THE POLITICS OF PRICE CONTROLS

Simple as basic economic principles may be, their ramifications
can be quite complex, as we have seen with the 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 is this a new phenomenon of modern times in democratic
countries.

When a Spanish blockade in the sixteenth century tried to starve
Spain's rebellious subjects in Antwerp into surrender, the resulting
high prices of food within Antwerp caused others to smuggle food
into the city, even through the blockade, enabling the inhabitants to
continue to hold out. However, the authorities within Antwerp
decided to solve the problem of high food prices by laws fixing the
maximum price to be allowed to be charged for given food items and
providing severe penalties for anyone violating those laws.

There followed the classic consequences of price control—a
larger consumption of the artificially lower-priced goods and a
reduction in the supply of such goods, since suppliers were less willing
to run the risk of sending food through the Spanish blockade without
the additional incentive of higher prices. Therefore, the net effect of
price control was that "the city lived in high spirits until all at once
provisions gave out" and Antwerp had no choice but to surrender to
the Spaniards.^^^*

Halfway around the world, in eighteenth-century India, a local
famine in Bengal brought a government crackdown on food dealers
and speculators, imposing price controls on rice. Here the resulting

shortages led to widespread deaths by starvation. However, when
another famine struck India in the nineteenth century, now under the
colonial rule of British officials and during the heyday of free market
economics, opposite policies were followed, with opposite results:

In the earlier famine one could hardly engage in the grain trade without
becoming amenable to the law. In 1866 respectable men in vast
numbers went into the trade; for the Government, by publishing weekly
returns of the rates in every district, rendered the traffic both easy and
safe. Everyone knew where to buy grain cheapest and where to sell it
dearest and food was accordingly bought from the districts which could
best spare it and carried to those which most urgently needed it.^^^*

As elementary as all this may seem, in terms of economic
principles, it was made possible politically only because the British
colonial government was not accountable to local public opinion. In
an era of democratic politics, the same actions would require either a
public familiar with basic economics or political leaders willing to risk
their careers to do what needed to be done. It is hard to know which is
less likely.

Politically, price controls are always a tempting "quick fix" for
inflation, and certainly easier than getting the government to cut back
on its own spending that is often behind the inflation. It may be
considered especially important to keep the prices of food from rising.
Accordingly, Argentina put price controls on wheat in the early
twenty-first century. Predictably, Argentine farmers reduced the
amount of land that they planted with wheat, from 15 million acres in
2000 to 9 million acres in 2012.^^"^* Since there is a large international
market for wheat, where the price is higher than the price permitted
domestically in Argentina, the government also found it necessary to

block wheat exports that would have made the domestic wheat
shortage worse.

The greater the difference between free market prices and the
prices decreed by price control laws, the more severe the
consequences of price control. In 2007, Zimbabwe's government
responded to runaway inflation by ordering sellers to cut prices in half
or more. Just a month later, the New York Times reported,
"Zimbabwe's economy is at a halt." It detailed some specifics:

Bread, sugar and cornmeal, staples of every Zimbabwean's diet, have
vanished, seized by mobs who denuded stores like locusts in wheat
fields. Meat is virtually nonexistent, even for members of the middle
class who have money to buy it on the black market. Gasoline is nearly
unobtainable. Hospital patients are dying for lack of basic medical
supplies. Power blackouts and water cutoffs are endemic.^^^^

As with price controls in other times and places, price controls
were viewed favorably by the public when they were first imposed in
Zimbabwe. "Ordinary citizens initially greeted the price cuts with a
euphoric—and short-lived—shopping spree," according to the New
York TimesP^^ Both the initial reactions and the later consequences
were much as they had been in Antwerp, centuries earlier.

When a local area is devastated by a hurricane or some other
natural disaster, many people consider it unconscionable if businesses
in that area suddenly raise the prices of such things as bottled water,
flashlights or gasoline—or if local hotels double or triple the prices of
their rooms when there are many local people suddenly made
homeless who are seeking temporary shelter. Often price controls are
regarded as a necessary quick fix in this situation.

The political response 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 increased demand from people suddenly deprived of the resources
normally available to them, as a result of the destruction created by
storms or wildfires or some other natural disaster.

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

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

Similar principles apply when there are local shortages of other
things suddenly in higher demand in the local area. If electric power
has been knocked out locally, the demand for flashlights may greatly
exceed the supply. If the prices of flashlights remain the same as
before, those who arrive first at stores selling flashlights may quickly

exhaust the local supply, so that those who arrive later are unable to
find any more flashlights available. However, if the prices of flashlights
skyrocket, a family that might otherwise buy multiple flashlights for its
members is more likely to make do with just one of the unusually
expensive flashlights—which means that there will be more flashlights
left for others.

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

When local prices spike, that affects supply as well, both before
and after the natural disaster. The arrival of a hurricane is usually
foreseen by meteorologists, and their predictions of approaching
hurricanes are usually widely reported. Supplies of all sorts of things
that are usually needed after a hurricane strikes—flashlights, bottled
water, gasoline and lumber, for example—are more likely to be rushed
to the area where the hurricane is likely to strike, before the hurricane
actually gets there, if suppliers anticipate higher prices. This means

that shortages can be nnitigated in advance. But if only the usual prices
in normal times can be expected, there is less incentive to incur the
extra costs of rushing things to an area where disaster is expected to
strike.

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

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

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

At one New Jersey supermarket, shoppers barely paused for a public

loudspeaker announcement urging them to buy only the provisions
needed for a couple of days of suburban paralysis. None seemed to be
deterred as they loaded their carts to the gunwales with enough canned
tuna to last six weeks. A can of Bumblebee will keep for years: Shoppers
take no risk in buying out a store's entire supply at the normal price.^^^*

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

Chapter 4

AN OVERVIEW OF PRICES

l/l/e need education in the obvious more than
investigation of the obscure.

Justice Oliver Wendell Holmes^^^^

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

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

medical care leads to vastly greater usage, simply because its price is
lower, and this entails vastly greater costs than initially estimated.

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

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

CAUSE AND EFFECT

Analyzing economic actions in cause-and-effect terms means

examining the logic of the incentives being created, rather than simply
thinking about the desirability of the goals being sought. It also means
examining the empirical evidence of what actually happens under
such incentives.

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

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

Systemic Causation

Because systemic causation involves reciprocal interactions,
rather than one-way causation, that reduces the role of individual
intentions. As Friedrich Engels put it, "what each individual wills is

obstructed by everyone else, and what emerges is something that no
one willed."^^^’ Economics is concerned with what emerges, not what
anyone intended. If the stock market closes at 14,367 on a given day,
that is the end result of a process of complex interactions among
innumerable buyers and sellers of stocks, none of whom may have
intended for the market to close at 14,367, even though it was their
own actions in pursuit of other intentions which caused it to do so.

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

People shocked by the high prices charged in stores in low-
income neighborhoods have often been quick to blame greed or
exploitation on the part of the people who run such businesses.
Similar conclusions about intentions have often been reached when
people noticed the much higher interest rates charged by
pawnbrokers and small finance companies that operate in low-income
neighborhoods, as compared to the interest rates charged by banks in
middle-class communities. Companies that charge for cashing checks
also usually operate in low-income neighborhoods, while people in
middle-class neighborhoods usually get their checks cashed free of

charge at their local banks. Yet profit rates are generally no higher in
inner city businesses than elsewhere, and the fact that many
businesses are leaving such neighborhoods—and others, such as
supermarket chains, are staying away—reinforces that conclusion.

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

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

hardly surprising that these higher costs get passed on in higher prices
and higher interest rates.

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

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

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

neighborhoods already have to go elsewhere for shopping or banking.

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

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

Complexity and Causation

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

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

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

In short, complex effects may be a result of either simple causes

or complex causes. The specific facts can tell us which. A priori
pronouncements about what is "simplistic" cannot. An explanation is
too simple if its conclusions fail to match the facts or its reasoning
violates logic. But calling an explanation "simplistic" is too often a
substitute for examining either its evidence or its logic.

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

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 given the inherent constraints on
the amount of knowledge available to any given decision-maker or set
of decision-makers.

Where a policy or institution has been established by top political

leaders, officials subject to their authority may well hesitate to
contradict their beliefs, much less point out the counterproductive
consequences that later follow from these policies and institutions.
Messengers carrying bad news could be risking their careers or—
under Stalin or Mao—their lives.

Officials carrying out particular policies may be quite rational,
however negative the impact of these policies may prove to be for
society at large. During the Stalin era in the Soviet Union, for example,
there was at one time a severe shortage of mining equipment, but the
manager of a factory producing such machines kept them in storage
after they were built, rather than sending them out to the mines,
where they were sorely needed. The reason was that the official orders
called for these machines to be painted with red, oil-resistant paint
and the manufacturer had on hand only green, oil-resistant paint and
red varnish that was not oil-resistant. Nor could he readily get the
prescribed paint, since there was no free market.

Disobeying official orders in any respect was a serious offense
under Stalin and "I don't want to get eight years," the manager said.

When he explained the situation to a higher official and asked for
permission to use the green, oil-resistant paint, the official's response
was: "Well, I don't want to get eight years either." However, the higher
official cabled to his ministry for their permission to give his
permission. After a long delay, the ministry eventually granted his
request and the mining machinery was finally shipped to the mines.^^°^*
None of these people was behaving stupidly. They were responding
quite rationally to the incentives and constraints of the system in
which they worked. Under any economic or political system, people
can make their choices only among the alternatives actually available

—and different economic systems present different alternatives.

Even in a democratic government, where the personal dangers
would be far less, a highly intelligent person with a record of
outstanding success in the private sector is often unable to repeat that
success when appointed to a high position in government. Again, the
point is that the incentives and constraints are different in different
institutions. As Nobel Prizewinning economist George J. Stigler put it:

A large number of successful businessmen have gone on to high
administrative posts in the national government, and many—I think most
—have been less than distinguished successes in that new environment.
They are surrounded and overpowered by informed and entrenched
subordinates, they must deal with legislators who can be relentless in
their demands, and almost everything in their agency that should be
changed is untouchable.^^°^*

INCENTIVES VERSUS GOALS

Incentives matter because most people will usually do more for
their own 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. In the
absence of such incentives, service in restaurants in the Soviet Union
was notoriously bad. Unsold goods piling up in warehouses were not
the only consequences of a lack of the incentives that come with a free
market price system. Prices not only help determine which particular
things are produced, they are also one of the ways 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.
However, prices do not create that scarcity, which will require some
form of rationing under any other economic system.

Simple as all 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 that method 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.

Many apparently humanitarian policies have backfired
throughout history because of a failure to understand the role of
prices. Attempts to keep food prices down by imposing price controls
have led to hunger and even starvation, whether in seventeenth-
century Italy, eighteenth-century India, France after the French
Revolution, Russia after the Bolshevik revolution, or in a number of
African countries after they obtained independence during the 1960s.
Some of these African countries, like some of the countries in Eastern
Europe, once had such an abundance of food that they were food
exporters before the era of price control and government planning
turned them into countries unable to feed themselves.^^°^*

Failure to supply goods, as a result of government restrictions.

must be sharply distinguished from an inability to produce them. Food
can be in short supply in a country with extraordinarily fertile soil, as in
post-Communist Russia that had not yet achieved a free-market
economy:

Undulating gently through pastoral hills 150 miles south of Moscow, the
Plava River Valley is a farmer's dream come true. This is the gateway to
what Russians call "Chernozym"—"Black Earth country"—which boasts
some of the most fertile soil in Europe, within three hours' drive of a giant,
hungry metropolis... Black Earth country has the natural wealth to feed an
entire nation. But it can barely feed itself.^^°^*

It is hard even to imagine, in a free market economy, a hungry
city, dependent on imports of foreign food, when there is
extraordinarily fertile farmland not far away. Yet the people on that
very fertile farmland were as poor as the city dwellers were hungry.
The workers harvesting that land earned the equivalent of about $10 a
week, with even this small amount being paid in kind—sacks of
potatoes or cucumbers—because of a lack of money. As the mayor of a
town in this region said:

We ought to be rich. We have wonderful soil. We have the scientific
know-how. We have qualified people. But what does it add up to?^^°^*

If nothing else, it adds up to a reason for understanding
economics as a means of achieving an efficient allocation of scarce
resources which have alternative uses. All that was lacking in Russia
was a market to connect the hungry city with the products of the
fertile land and a government that would allow such a market to
function freely. But, in some places, local Russian officials forbad the
movement of food across local boundary lines, in order to assure low

food prices within their own jurisdictions, and therefore local political
support for themselvesJ^°^* Again, it is necessary to emphasize that this
was not a stupid policy, from the standpoint of officials trying to gain
local popularity with consumers by maintaining low food prices. This
protected their political careers, however disastrous such policies
were for the country as a whole.

While systemic causation in a free market is in one sense
impersonal, in the sense that its outcomes are not specifically
predetermined by any given person, "the market" is ultimately a way
by which many people's individual personal desires are reconciled with
those of other people. Too often a false contrast is made between the
impersonal marketplace and the supposedly compassionate policies
of various government programs. But both systems face the same
scarcity of resources and both systems make choices within the
constraints of that scarcity. The difference is that one system involves
each individual making choices for himself or herself, while the other
system involves a small number of people making choices for millions
of others.

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

SCARCITY AND COMPETITION

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

One of the incidental benefits of competing and sharing through
prices is that different people are not as likely to think of themselves as
rivals, nor to develop the kinds of hostility that rivalry can breed. For
example, much the same labor and construction material needed to
build a Protestant church could be used to build a Catholic church. But,
if a Protestant congregation is raising money to build a church for
themselves, they are likely to be preoccupied with how much money

they can raise and how much is needed for the kind of church they
want. Construction prices may cause them to scale back some of their
more elaborate plans, in order to fit within the limits of what they can
afford. But they are unlikely to blame Catholics, even though the
competition of Catholics for the same construction materials makes
their prices higher than otherwise.

If, instead, the government were in the business of building
churches and giving them to different religious groups, Protestants
and Catholics would be explicit rivals for this largess and neither
would have any financial incentive to cut back on their building plans
to accommodate the other. Instead, each would have an incentive to
make the case, as strongly as possible, for the full extent of their
desires, to mobilize their followers politically to insist on getting what
they want, and to resent any suggestion that they scale back their
plans. The inherent scarcity of materials and labor would still limit
what could be built, but that limit would now be imposed politically
and would be seen by each as due to the rivalry of the other.

The Constitution of the United States of course prevents the
American government from building churches for religious groups, no
doubt in order to prevent just such political rivalries and the
bitterness, and sometimes bloodshed, to which such rivalries have led
in other countries and in other times.

The same economic principle, however, applies to groups that are
not based on religion but on 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 own
pocketbook is very different from seeing your desires for government

benefits thwarted directly by the rival clainns of sonne 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 own 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 amount of each
individual's claims on the output of others to what that individual's
own productivity has created for others, and thereby earned as
income. What price controls, subsidies, or other substitutes for price
allocation do is reduce the incentives for self-rationing. That is why
people with minor ailments go to doctors when medical care is either
free or heavily subsidized by the government, and why farmers
receiving government-subsidized water from 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.

Society as a whole always has to pay the full costs, regardless of
what prices are or are not charged to individuals. When price controls
make goods artificially cheaper, that allows greater self-indulgence by
some, which means that less is left for others. Thus many apartments
occupied by Just one person under rent control means that others
have trouble finding a place to stay, even when they are perfectly
willing and able to pay the current rent. Moreover, since rationing
must take place with or without prices, this means that some form of
non-price rationing becomes a substitute.

Simply waiting until what you want becomes available has been a
common form of non-price rationing. This can mean waiting in long
lines at stores, as was common in the Soviet economy, or being put on

a waiting list for surgery, as patients often are in countries where
government-provided medical care is either free or heavily subsidized.

Luck and corruption are other substitutes for price rationing.
Whoever happens to be in a store when a new shipment of some
product in short supply arrives can get the first opportunity to buy it,
while people who happen to learn about it much later can find the
coveted product all gone by the time they get there. In other cases,
personal or political favoritism or bribery takes the place of luck in
gaining preferential access, or formal rationing systems may replace
favoritism with some one-size-fits-all policy administered by
government agencies. However it is done, the rationing that is done by
prices in market economies cannot be gotten rid of by getting rid of
prices or by the government's lowering the level of prices.

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 believe that health is more important than
entertainment but, however reasonable that may sound as a general
principle, no one really believes that having a twenty-year's supply of
Band-Aids in the closet is more important than having to give up all
music in order to pay for it. A price-coordinated economy facilitates
incremental substitution, but political decision-making tends toward
categorical priorities —that is, declaring one thing absolutely more
important than another and creating laws and policies accordingly.

When some political figure says that we need to "set national
priorities" about one thing or another, what that amounts to is making

A categorically more important than B. 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 on the
changing amount of ^ that we are willing to give up in order to get
more B.

This variation in the relative values of things can be so great as to
convert something that is beneficial into something that is
detrimental, or vice versa. For example, human beings cannot live
without salt, fat and cholesterol, but most Americans get so much of
all three that their lifespan is reduced. Conversely, despite the many
problems caused by alcohol, from fatal automobile accidents to
deaths from cirrhosis of the liver, studies show that very modest
amounts of alcohol have health benefits that can be life-saving.^’"'*
Alcohol is not categorically good or bad.

Whenever there are two things which each have some value, one
cannot be categorically more valuable than another. A diamond may
be worth much more than a penny, but enough pennies will be worth
more than any diamond. That is why incremental trade-offs tend to
produce better results than categorical priorities.

There are chronic complaints about government red tape in
countries around the world, but the creation of red tape is
understandable in view of the incentives facing those who create
government forms, rules, and requirements for innumerable activities
that require official approval. Nothing is easier than thinking of
additional requirements that might be useful in some way or other, at
some time or other, and nothing is harder than remembering to ask
the crucial incremental question: At wAiat cost?

People who are spending their own money are confronted with

those costs at every turn, but people who are spending the taxpayers'
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 to 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. Red tape grows as a result.

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 whether the incremental
benefit exceeds the incremental costs. There are no incentives for
them to look at things that way. Nor are the media likely to. A New
York Times article, for example, argued that there were few, if any,
"useless" regulations^^°^*—as if that was the relevant criterion. But
neither individuals nor businesses are willing or able to pay for
everything that is not useless, when they are spending their own
money.

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

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

But there's so much more. Once you hire employee 11, you must
submit an annual self-assessment to the national authorities outlining
every possible health and safety hazard to which your employees might

be subject. These include stress that is work-related or caused by age,
gender and racial differences. You must also note all precautionary and
individual measures to prevent risks, procedures to carry them out, the
names of employees in charge of safety, as well as the physician whose
presence is required for the assessment.

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

As of the time that this description of Italian labor laws appeared
in the Wall Street Journal, the unemployment rate in Italy was 10
percent and the Italian economy was contracting, rather than
growingj^°^*

Subsidies and Taxes

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

Prices charged to the consumers of such specially taxed or
specially subsidized goods and services do not convey the real costs of
producing them and therefore do not lead to the same trade-offs as if
they did. Yet there is always a political temptation to subsidize "good"
things and tax "bad" things. However, when neither good things nor
bad things are good or bad categorically, this prevents our finding out
just how good or how bad any of these things is by letting people

choose freely, uninfluenced by politically changed prices. People who
want special taxes or subsidies for particular things seem not to
understand that what they are really asking for is for the prices to
misstate the relative scarcities of things and the relative values that
the users of these things put on them.

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

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

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

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

However much economic efficiency would be promoted by
letting resource prices be unchanged by taxes or subsidies, from a
political standpoint politicians win votes by doing special favors for
special interests or putting special taxes on whomever or whatever
might be unpopular at the moment. The free market may work best
when there is a level playing field, but politicians win more votes by
tilting the playing field to favor particular groups. Often this process is
rationalized politically in terms of a need to help the less fortunate
but, once the power and the practice are established, they provide the

means of subsidizing all sorts of groups who are not the least bit
unfortunate. For example, the l/l/d//Street^ourna/ reported:

A chunk of the federal taxes and fees paid by airline passengers are
awarded to small airports used mainly by private pilots and globe¬
trotting corporate executives.^^^^*

The Meaning of "Costs"

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

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

addressed by politicians. What politicians mean by bringing down the
cost of medical care is reducing the price of medicines and reducing
the fees charged by doctors or hospitals.

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

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

Despite how obvious all this might seem, there are never-ending
streams of political schemes designed to escape the realities being
conveyed by prices—whether through direct price controls or by
making this or that "affordable" with subsidies or by having the
government itself supply various goods and services free, as a "right."

There may be more ill-conceived economic policies based on treating
prices as just nuisances to get around than on any other single fallacy.
What all these schemes have in common is that they exempt some
things from the process of weighing costs and benefits against one
another^’'"*—a process essential to maximizing the benefits from scarce
resources which have alternative uses.

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

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

Because knowledge is one of the scarcest of all resources, prices

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

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

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

international study of free markets in 2012 found the world's freest
market to be in Hong Kong^"'^’—in a country with a communist
government.

PART II:

INDUSTRY AND COMMERCE

Chapters

THE RISE AND FALL
OF BUSINESSES

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

Fo rXunemagazine^^ ^

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. Nor is it only new
businesses that lose money. Businesses that have lasted for
generations—sometimes more than a century—have eventually been
forced by red ink on the bottom line to close down. More important,
from the standpoint of economics, is not what money the business
owner hopes to make or whether that hope is fulfilled, but how all this
affects the use of scarce resources which have alternative uses—and

therefore how it affects the economic well-being of millions of other
people in the society at large.

ADJUSTING TO CHANGES

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

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

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

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

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

Longer run changes in the relative rankings of firms in an industry
can be dramatic. For example, United States Steel was founded in 1901
as the largest steel producer in the world. It made the steel for the
Panama Canal, the Empire State Building, and more than 150 million
automobiles.^^^^’ Yet, by 2011, U.S. Steel had fallen to 13th place in the
industry, losing $53 million that year and $124 million the following
yearji23} Boeing, producer of the famous B-17 "flying fortress" bombers
in World War II and since then the largest producer of commercial
airliners such as the 747, was in 1998 selling more than twice as many
such aircraft as its nearest rival, the French firm Airbus. But, in 2003,
Airbus passed Boeing as the number one producer of commercial
aircraft in the world and had a far larger number of back orders for
planes to be delivered in the future.^^^"^’ Yet Airbus too faltered and, in
2006, its top managers were fired for falling behind schedule in the
development of new aircraft, while Boeing regained the lead in sales
of planes.^^^^*

In short, 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 with economic
enterprises in every kind of economic system and in 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 quicker to respond. Sometimes the changes are
technological, as in the computer industry, and sometimes these
changes are social or economic.

Social Changes

The A & P grocery chain was for decades a connpany superbly
adapted to social and economic conditions in the United States. It was
by far the leading grocery chain in the country, renowned for its high
quality and low prices. During the 1920s the A & P chain was making a
phenomenal rate of profit on its investment—never less than 20
percent per year,^^^^* about double the national average—and it
continued to prosper on through the decades of the 1930s, 1940s and
1950s. But all this began to change drastically in the 1970s, when A & P
lost more than $50 million in one 52-week period.^^^^’ A few years later,
it lost $157 million over the same span of time.^^^®’ Its decline had
begun and, in the years that followed, many thousands of A & P stores
were forced to close, as the chain shrank to become a mere shadow of
its former self.

A & P's fate, both when it prospered and when it lost out to rival
grocery chains, illustrates the dynamic nature of a price-coordinated
economy and the role of profits and losses. When A & P was prospering
up through the 1950s, it did so by charging lower prices than
competing grocery stores. It could do this because its exceptional
efficiency kept its costs lower than those of most other grocery stores
and chains, and the resulting lower prices attracted vast numbers of
customers. Later, when A & P began to lose customers to other grocery
chains, this was because these other chains now had lower costs than
A & P, and could therefore sell for lower prices. Changing conditions in
the surrounding society brought this about—together with
differences in the speed with which different companies spotted these
changes, realized their implications and adjusted accordingly.

What were these changes? In the years following the end of World
War II, suburbanization and the American public's rising prosperity

gave huge supermarkets in shopping malls with vast parking lots
decisive advantages over neighborhood stores—such as those of A &
P—located along the streets in the central cities. As the ownership of
automobiles, refrigerators and freezers became far more widespread,
this completely changed the economics of the grocery industry.

The automobile, which made suburbanization possible, also
made possible greater economies of scale for both customers and
supermarkets. Shoppers could now buy far more groceries at one time
than they could have carried home in their arms from an urban
neighborhood store before the war. That was the crucial role of the
automobile. Moreover, the far more widespread ownership of
refrigerators and freezers now made it possible to stock up on
perishable items like meat and dairy products. This led to fewer trips to
grocery stores, with larger purchases each time.

What this meant to the supermarket itself was a larger volume of
sales at a given location, which could now draw customers in
automobiles from miles around, whereas a neighborhood store in the
central city was unlikely to draw customers on foot from ten blocks
away. High volume meant savings in delivery costs from the producers
to the supermarket, as compared to the cost of delivering the same
total amount of groceries in smaller individual lots to many scattered
and smaller neighborhood stores, whose total sales would add up to
what one supermarket sold. This also meant savings in the cost of
selling within the supermarket, because it did not take as long to
check out one customer buying $100 worth of groceries at a
supermarket as it did to checkout ten customers buying $10 worth of
groceries each at a neighborhood store. Because of these and other
differences in the costs of doing business, supermarkets could be very

profitable while charging prices lower than those in neighborhood
stores that were struggling to survive.

All this not only lowered the costs of delivering groceries to the
consumer, it changed the relative economic advantages and
disadvantages of different locations for stores. Some supermarket
chains, such as Safeway, responded to these radically new conditions
faster and better than A & P did. The A & P stores lingered in the central
cities longer and also did not follow the shifts of population to
California and other sunbelt regions.

A & P was also reluctant to sign long leases or pay high prices for
new locations where the customers and their money were now
moving. As a result, after years of being the lowest-price major grocery
chain, A & P suddenly found itself being undersold by rivals with even
lower costs of doing business.

Lower costs reflected in lower prices is what made A & P the
world's leading retail chain in the first half of the twentieth century.
Similarly, lower costs reflected in lower prices is what enabled other
supermarket chains to take A & P's customers away in the second half
of the twentieth century. While A & P succeeded in one era and failed
in another, what is far more important is that the economy as a whole
succeeded in both eras in getting its groceries at the lowest prices
possible at the time—from whichever company happened to have the
lowest prices. Such displacements of industry leaders continued in the
early twenty-first century, when general merchandiser Wal-Mart
moved to the top of the grocery industry, with nearly double the
number of stores selling groceries as Safeway had.

Many other corporations that once dominated their fields have
likewise fallen behind in the face of changes or have even gone

bankrupt. Pan American Airways, which pioneered in commercial
flights across the Atlantic and the Pacific in the first half of the
twentieth century, went out of business in the late twentieth 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 a major 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 percent between 1947 and 1998.^^^°’
The Herald-Tribune was one of many local newspapers across the
country to go out of business with the rise of television. The New York
Daily Mirror, with a circulation of more than a million readers in 1949,
went out of business in 1963.^^^^’

By 2004, the only American newspapers with daily circulations of
a million or more were newspapers sold nationwide— USA Today, the
Wall Street Journal and the New York TimesP^^ Back in 1949, New York
City alone had two local newspapers that each sold more than a
million copies daily—the Daily Mirror at 1,020,879 and the Daily News
at 2,254,644.^^^^* The decline was still continuing in the twenty-first
century, as newspaper circulation nationwide fell nearly an additional
4 million between 2000 and 2006.^^^"^*

Other great industrial and commercial firms that have declined or
become extinct are likewise a monument to the unrelenting pressures
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
which have alternative uses. The key roles in all of this are played not
only by prices 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.

Knowledge is one of the scarcest of all resources in any economy,
and the insight distilled from knowledge is even more scarce. An
economy based on prices, profits, and losses gives decisive advantages
to those with greater knowledge and insight.

Put differently, knowledge and insight can guide the allocation of
resources, even if most people, including the country's political
leaders, do not share that knowledge or do not have the insight to
understand what is happening. Clearly this is not true in the kind of
economic system where political leaders control economic decisions,
for then the necessarily limited knowledge and insights of those
leaders become decisive barriers to the progress of the whole
economy. Even when leaders have more knowledge and insight than
the average member of the society, they are unlikely to have nearly as
much knowledge and insight as exists scattered among the millions of
people subject to their governance.

Knowledge and insight need not be technological or scientific for
it to be economically valuable and decisive for the material well-being
of the society as a whole. Something as mundane as retailing changed
radically during the course of the twentieth century, revolutionizing
both department stores and grocery stores—and raising the standard

of living of nnillions of people by lowering the costs of delivering goods
to them.

Individual businesses are forced to make drastic changes
internally over time, in order to survive. For example, names like Sears
and Wards came to mean department store chains to most Americans
by the late twentieth century. However, neither of these enterprises
began as department store chains. Montgomery Ward—the original
name of Wards department stores—began as a mail order house in
the nineteenth century. Under the conditions of that time, before
there were automobiles or trucks, and with most Americans living in
small rural communities, the high costs of delivering consumer goods
to small and widely-scattered local stores was reflected in the prices
that were charged. These prices, in turn, meant that ordinary people
could seldom afford many of the things that we today regard as basic.

Montgomery Ward cut delivery costs by operating as a mail order
house, selling directly to consumers all over the country from its huge
warehouse in Chicago. Using the existing railway freight shipping
services, and later the post office, allowed Montgomery Ward to
deliver its products to customers at lower costs that were reflected in
lower prices than those charged by local stores in rural areas. Under
these conditions, Montgomery Ward became the world's largest
retailer in the late nineteenth century.

During that same era, a young railroad agent named Richard
Sears began selling watches on the side, and ended up creating a rival
mail order house that grew over the years to eventually become
several times the size of Montgomery Ward. Moreover, the Sears retail
empire outlasted the demise of its rival in 2001, when the latter closed
its doors for the last time under its more recent name. Wards

department stores. One indication of the size of these two retail giants
in their heyday as mail order houses was that each had railroad tracks
running through its Chicago warehouse. That was one of the ways
they cut delivery costs, allowing them to charge lower prices than
those charged by local retail stores in what was still a predominantly
rural country in the early twentieth century. In 1903, the Chicago Daily
Tribune reported that mail order houses were driving rural stores out
of business.^^^^*

More important than the fates of these two businesses was the
fact that millions of people were able to afford a higher standard of
living than if they had to be supplied with goods through costlier
channels. Meanwhile, there were changes over the years in American
society, with more and more people beginning to live in urban
communities. This was not a secret, but not everyone noticed such
gradual changes and even fewer had the insight to understand their
implications for retail selling. It was 1920 before the census showed
that, for the first time in the country's history, there were more
Americans living in urban areas than in rural areas.

One man who liked to pore over such statistics was Robert Wood,
an executive at Montgomery Ward. Now, he realized, selling
merchandise through a chain of urban department stores would be
more efficient and more profitable than selling exclusively by mail
order. Not only were his insights not shared by the head of
Montgomery Ward, Wood was fired for trying to change company
policy.

Meanwhile, a man named James Cash Penney had the same
insight and was already setting up his own chain of department stores.
From very modest beginnings, the J.C. Penney chain grew to almost

300 stores by 1920 and more than a thousand by the end of the
decadeJ^^^* Their greater efficiency in delivering goods to urban
consumers was a boon to those consumers—and Penney's
competition became a big economic problem for the mail order giants
Sears and Montgomery Ward, both of which began losing money as
department stores began taking customers away from mail order
housesj^^^* The fired Robert Wood went to work for Sears and was
more successful there in convincing their top management to begin
building department stores of their own. After they did, Montgomery
Ward had no choice but to do the same belatedly, though it was never
able to catch up to Sears again.

Rather than get lost in the details of the histories of particular
businesses, we need to look at this from the standpoint of the
economy as a whole and the standard of living of the people as a
whole. One of the biggest advantages of an economy coordinated by
prices and operating under the incentives created by profit and loss is
that it can tap scarce knowledge and insights, even when most of the
people—or even their intellectual and political elites—do not have
such knowledge or insights.

The competitive advantages of those who are right can
overwhelm the numerical, or even financial, advantages of those who
are wrong. James Cash Penney did not start with a lot of money. He
was in fact raised in poverty and began his retail career as just a one-
third partner in a store in a little town in Wyoming, at a time when
Sears and Montgomery Ward were unchallenged giants of nationwide
retailing. Yet his insights into the changing conditions of retailing
eventually forced these giants into doing things his way, on pain of
extinction.

In a later era, a clerk in a J.C. Penney store named Sam Walton
would learn retailing from the ground up, and then put his knowledge
and insights to work in his own store, which would eventually expand
to become the Wal-Mart chain, with sales larger than those of Sears
and J.C. Penney combined.

One of the great handicaps of economies run by political
authorities, whether under medieval mercantilism or modern
communism, is that insights which arise among the masses have no
such powerful leverage as to force those in authority to change the
way they do things. Under any form of 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 is very different from what they are used
to. The big advantage of a 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 test of what works best.

Imagine a system in which James Cash Penney had to verbally
convince the heads of Sears and Montgomery Ward to expand beyond
mail order retailing and build a nationwide chain of stores. Their
response might well have been: "Who is this guy Penney—a part-
owner of some little store in a hick town nobody ever heard of—to tell
us how to run the largest retail companies in the world?"

In a market economy, Penney did not have to convince anybody
of anything. All he had to do was deliver the merchandise to the
consumers at lower prices. His success, and the millions of dollars in
losses suffered by Sears and Montgomery Ward as a result, left these
corporate giants no choice but to imitate this upstart, in order to
become profitable again. Although J.C. Penney grew up in worse

poverty than most people who are on welfare today, his ideas and
insights prevailed against some of the richest men of his time, who
eventually realized that they would not remain rich much longer if
Penney and others kept taking away their customers, leaving their
companies with millions of dollars in losses each year.

Economic Changes

Economic changes include not only changes in the economy but
also changes within the managements of firms, especially in their
responses 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. Even something as widely used today as
bank credit cards were initially resisted. When BankAmericard and
Master Charge (later MasterCard) first appeared in the 1960s, leading
New York department stores such as Macy's and Bloomingdale's said
that they had no intention of accepting bank credit cards as payments
for purchases in their stores, even though there were already millions
of people with such cards in the New York metropolitan area.^^^®*

Only after the success of these credit cards in smaller stores did
the big department stores finally relent and begin accepting credit
cards. In 2003, for the first time, more purchases were made by credit
cards or debit cards than by cash.^^^^’ That same year. Fortune
magazine reported that a number of companies made more money
from their own credit card business, with its interest charges, than
from selling goods and services. Sears made more than half its profits
from its credit cards and Circuit City made all of its profits from its
credit cards, while losing $17 million on its sales of electronic

merchandiseJ^'^°*

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.

Some individual executives are very successful during one era in
the country's evolution, or during one period in their own lives, and
very ineffective at a later time. Sewell Avery, for example, was for many
years during the twentieth century a highly successful and widely
praised leader of U.S. Gypsum and later of Montgomery Ward. Yet his
last years were marked by public criticism and controversy over the
way he ran Montgomery Ward, and by a bitter fight for control of the
company that he was regarded as mismanaging. When Avery resigned
as chief executive officer, the value of Montgomery Ward's stock rose
immediately. Under his leadership, Montgomery Ward had put aside
so many millions of dollars, as a cushion against an economic
downturn, that Fortune magazine called it "a bank with a store
front."^^'^^* Meanwhile, rivals like Sears were using their money to
expand into new markets.

What is important is not the success or failure of particular
individuals or companies, but the success of particular knowledge and
insights 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 insights have such
decisive advantages in the competition of the marketplace is an
economy which 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 is a society which has thrown
away much of the knowledge, insights, and talents of most of its own
people. A society in which such decisions can only be made by males
has thrown away half of its knowledge, talents, and insights.

Contrast societies with such restricted sources of decision¬
making ability with a society in which a farm boy who walked eight
miles to Detroit to look for a job could end up creating the Ford Motor
Company and changing the face of America with mass-produced
automobiles—or a society in which a couple of young bicycle
mechanics could invent the airplane and change the whole world.
Neither a lack of pedigree, nor a lack of academic degrees, nor even a
lack of money could stop ideas that worked, for investment money is
always looking for a winner to back and cash in on. A society which can
tap all kinds of talents from all segments of its population has obvious
advantages over societies in which only the talents of a preselected
few are allowed to determine its destiny.

No economic system can depend on the continuing wisdom of its
current leaders. A price-coordinated economy with competition in the
marketplace does not have to, because those leaders can be forced to
change course—or be replaced—whether because of red ink, irate
stockholders, outside investors ready to move in and take over, or
because of bankruptcy. Given such economic pressures, it is hardly
surprising that economies under the thumbs of kings or commissars
have seldom matched the track record of economies based on
competition and prices.

Technological Changes

For decades during the twentieth century, television sets were
built around a cathode ray tube, in which an image was projected
from the small back end of the tube to the larger front screen, where
the picture was viewed. But a new century saw this technology
replaced by new technologies that produced a thinner and flatter
screen, with sharper images. By 2006, only 21 percent of the television
sets sold in the United States had picture tube technology, while 49
percent of all television sets sold had liquid crystal display (LCD)
screens and another 10 percent had plasma screens.^^"^^*

For more than a century, Eastman Kodakcompany was the largest
photographic company in the world. In 1976, Kodak sold 90 percent of
all the film sold in the United States and 85 percent of all the cameras.

But new technology created new competitors. At the end of the
twentieth century and the beginning of the twenty-first century,
digital cameras began to be produced not only by such traditional
manufacturers of cameras for film as Nikon, Canon, and Minolta, but
also by producers of other computerized products such as Sony and
Samsung. Moreover, "smart phones" could now take pictures,
providing easy substitutes for the kinds of small, simple and
inexpensive cameras that Kodak manufactured.

Film sales began falling for the first time after 2000, and digital
camera sales surpassed the sales of film cameras for the first time
three years later. This sudden change left Kodak scrambling to convert
from film photography to digital photography, while companies
specializing in digital photography took away Kodak's customers. The
ultimate irony in all this was that the digital camera was invented by
Kodak.^^'^'^’ But apparently other companies saw its potential earlier and

developed the technology better.

By the third quarter of 2011, Eastnnan Kodak reported a $222
million loss, its ninth quarterly loss in three years. Both the price of its
stock and the number of its employees fell to less than one-tenth of
what they had once been.^^"^^* In January 2012, Eastman Kodak filed for
bankruptcy.^^"^^’ Meanwhile, its biggest competitor in the business, the
Japanese firm Fuji, which produced both film and cameras, diversified
into other fields, including cosmetics and flat-screen television.^^"^^’

Similar technological revolutions have occurred in other
industries and in other times. Clocks and watches for centuries
depended on springs and gears to keep time and move the hour and
minute hands. The Swiss became renowned for the high quality of the
internal watch mechanisms they produced, and the leading American
watch company in the mid-twentieth century—Bulova—used
mechanisms made in Switzerland for its best-selling watches.
However, the appearance of quartz time-keeping technology in the
early 1970s, which was more accurate and had lower costs, led to a
dramatic fall in the sales of Bulova watches, and vanishing profits for
the company that made them. As the l/l/la//Street^ourna/ reported:

For 1975, the firm reported a $21 million loss on $55 million in sales. That
year, the company was reported to have 8% of domestic U.S. watch sales,
one-tenth of what it claimed at its zenith in the early 1 960s.^^^®*

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—
Just as people do in every other walk of life. Therefore the companies

they lead likewise differ in the efficiency with which they perform their
work. Moreover, these differences change over time.

The automobile industry is just one example. According to Forbes
business magazine in 2003, "other automakers can't come close to
Toyota on how much it costs to build cars" and this shows up on the
bottom line. "Toyota earned $1,800 for every vehicle sold, GM made
$300 and Ford lost $240," Forbes reported.^^^^* Toyota "makes a net
profit far bigger than the combined total for Detroit's Big three,"
according to The Economist magazine in 2005.^^^°’ But, by 2010
Detroit's big three automakers were earning more profits per vehicle
than the average of Toyota and Honda.^^^^* By 2012, the Ford Motor
Company's annual profit was $5.7 billion, while General Motors earned
$4.9 billion and Toyota earned $3.45 billion.^^^^’

Toyota's lead in the quality of its cars was likewise not permanent.
BusinessWeek in 2003 reported that, although Toyota spent fewer
hours manufacturing each automobile, its cars had fewer defects than
those of any of the American big three automakers.^^^^’ High rankings
for quality by Consumer Reports magazine during the 1970s and 1980s
have been credited with helping Toyota's automobiles gain
widespread acceptance in the American market and, though Honda
and Subaru overtook Toyota in the Consumer Reports rankings in
2007, Toyota continued to outrank any American automobile
manufacturer in quality at that time.^^^'^’ Over the years, however,
competition from Japanese automakers brought marked
improvements in American-made cars, "closing the quality gap with
Asian auto makers," according to the Wall Street Journal However,
in 2012, Consumer Reports reported that "a perfect storm of reliability
problems" dropped the Ford Motor Company out of the top ten, while

Toyota "swept the top spots."^^^^*

Although Toyota surpassed General Motors as the world's largest
autonnobile nnanufacturer, in 2010 it had to stop production and recall
more than 8 million cars because of problems with their acceleration.
{157} Neither quality leadership, nor any other kind of leadership, is
permanent in a market economy.

What matters far more than the fate of any given business is how
much its efficiency can benefit consumers. As BusinessWeek said of
the Wal-Mart retail chain:

At Wal-Mart, "everyday low prices" is more than a slogan; it is the
fundamental tenet of a cult masquerading as a company... New England
Consulting estimates that Wal-Mart saved its U.S. customers $20 billion
last yearalone.^^^®’

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
lines of the companies involved, the bottom line for the economy as a
whole is the standard of living of the people who buy the products and
services that these companies produce.

Although we measure the amount of petroleum in barrels, which
is how it was once shipped in the nineteenth century, today it is
actually shipped in railroad tank cars or tanker trucks on land or in
gigantic oil tankers at sea. The most famous fortune in American
history, that of John D. Rockefeller, was made by revolutionizing the
way oil was refined and distributed, drastically lowering the cost of
delivering its various finished products to the consumer. When

Rockefeller entered the oil business in the 1860s, there were no
automobiles, so the principal use of petroleum was to produce
kerosene for lamps, since there were no electric lights then either.
When petroleum was refined to produce kerosene, the gasoline that
was a by-product was so little valued that some oil companies simply
poured it into a river to get rid of it.^^^^’

In an industry where many investors and businesses went
bankrupt. Rockefeller made the world's largest fortune by
revolutionizing the industry. Shipping his oil in railroad tank cars,
rather than in barrels like his competitors, was just one of the cost¬
saving innovations that made Rockefeller's Standard Oil Company the
biggest and most profitable enterprise in the petroleum industry. He
also hired scientists to create numerous new products from
petroleum, ranging from paints to paraffin to anesthetics to vaseline
—and they used gasoline for fuel in the production process, instead of
letting it go to waste. Kerosene was still the principal product of
petroleum but, because Standard Oil did not have to recover all its
production costs from the sale of kerosene, it was able to sell the
kerosene more cheaply. The net result, from a business standpoint,
was that Standard Oil ended up selling about 90 percent of the
kerosene in the country.^^“*

From the standpoint of the consumers, the results were even
more striking. Kerosene was literally the difference between light and
darkness for most people at night. As the price of kerosene fell from 58
cents a gallon in 1865 to 26 cents a gallon in 1870, and then to 8 cents
a gallon during the 1870s, ^^^^Tar more people were able to have light
after sundown. As a distinguished historian put it:

Before 1870, only the rich could afford whale oil and candles. The rest had

to go to bed early to save money. By the 1870s, with the drop in the price
of kerosene, middle and working class people all over the nation could
afford the one cent an hour that it cost to light their homes at night.
Working and reading became after-dark activities new to most Americans
inthe 1870 s.^^^2*

The later rise of the automobile created a vast new market for
gasoline, just as Standard Oil's more efficient production of petroleum
products facilitated the growth of the automobile industry.

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 really key is the role of knowledge and insights 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 the
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 completely if
operating alone.

Ray Kroc, founder of the McDonald's chain, was a genius at
operating details and may well have known more about hamburgers,
milk shakes, and French fries than any other human being—and there
is a lot to know—but he was out of his depth in complex financial
operations. These matters were handled by Harry Sonneborn, who was
a financial genius whose improvisations rescued the company from
the brink of bankruptcy more than once during its rocky early years.
But Sonneborn didn't even eat hamburgers, much less have any
interest in how they were made or marketed. However, as a team, Kroc
and Sonneborn made McDonald's one of the leading corporations in

the world.

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 burst 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 the fast food segment of the market. Even when Howard Johnson
set up imitations of the new fast food restaurants under the name
"Howard Johnson Jr.," these imitations were unable to compete
successfully, because they carried over into the fast food business
approaches and practices that were successful in conventional
restaurants, but 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.

Selecting managers can be as chancy as any other aspect of a
business. Only by trial and error did the new McDonald's franchise
chain discover back in the 1950s what kinds of people were most
successful at running their restaurants. The first few franchisees were
people with business experience, who nevertheless did very poorly.
The first two really successful McDonald's franchisees—who were very
successful—were a working class married couple who drained their
life's savings in order to go into business for themselves. They were so
financially strained at the beginning that they even had trouble
coming up with the $100 needed to put into the cash register on their
opening day, so as to be able to make change.^^^^’ But they ended up
millionaires.

Other working class people who put everything they owned on

the line to open a McDonald's restaurant also succeeded on a grand
scale, even when they had no experience in running a restaurant or
managing a business. When McDonald's set up its own company-
owned restaurants, these restaurants did not succeed nearly as well as
restaurants owned by people whose life's savings were at stake. But
there was no way to know that in advance.

The importance of the personal factor in the performance of
corporate management was suggested in another way by a study of
chief executive officers in Denmark. A death in the family of a Danish
CEO led, on average, to a 9 percent decline in the profitability of the
corporation. If it was the death of a spouse, the decline was 15 percent
and, if it was a child who died, 21 percent.^^^'^’ According to the Wall
Street Journal, "The drop was sharper when the child was under 18,
and greater still if it was the death of an only child."^^^^’ Although
corporations are often spoken of as impersonal institutions operating
in an impersonal market, both the market and the corporations reflect
the personal priorities and performances of people.

Market economies must rely not only on price competition
between various producers to allow the most successful to continue
and expand, 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 to the standards of its
competitors or is producing a product that has been superseded by
some other product.

Before reaching that point, however, losses can force a firm to
make internal reassessments of its policies and personnel. These
include the chief executive, who can be replaced by irate stockholders

who are not receiving the dividends they expected.

A poorly managed company is more valuable to outside investors
than to its existing owners, when these outside investors are
convinced that they can improve its performance. Outside investors
can therefore offer existing stockholders more for their stock than it is
currently worth, and still make a profit, if that stock's value later rises
to the level expected when existing management is replaced by more
efficient managers. For example, if the stock is selling in the market for
$50 a share under inefficient management, outside investors can start
buying it up at $60 a share until they own a controlling interest in the
corporation.

After using that control to fire existing managers and replace
them with a more efficient management team, the value of the stock
may then rise to $100 a share. While this profit is what motivates the
investors, from the standpoint of the economy as a whole what
matters is that such a rise in stock prices usually means that either the
business is now serving more customers, or offering them better
quality or lower prices, or is operating at lower cost—or some
combination of these things.

Like so many other things, running a business looks easy from the
outside. On the eve of the Bolshevik revolution the leader of the
Communist movement, V.l. Lenin, declared that "accounting and
control" were the key factors in running an enterprise, and that
capitalism had already "reduced" the administration of businesses to
"extraordinarily simple operations" that "any literate person can
perform"—that is, "supervising and recording, knowledge of the four
rules of arithmetic, and issuing appropriate receipts."^^^^’ Such
"exceedingly simple operations of registration, filing and checking"

could, according to Lenin, "easily be performed" by people receiving
ordinary workmen's wagesJ^^^’

After just a few years in power as ruler of the Soviet Union,
however, Lenin confronted a very different—and very bitter—reality.
He himself wrote of a "fuel crisis" which "threatens to disrupt all Soviet
work,"^^^®’ of economic "ruin, starvation and devastation"^^^^* in the
country and even admitted that peasant uprisings had become "a
common occurrence"^^^°* under Communist rule. In short, the
economic functions which had seemed so easy and simple before
having to perform them now seemed almost overwhelmingly difficult.

Belatedly, Lenin saw a need for people "who are versed in the art
of administration" and admitted that "there is nowhere we can turn to
for such people except the old class"—that is, the capitalist
businessmen. In his address to the 1920 Communist Party Congress,
Lenin warned his comrades; "Opinions on corporate management are
all too frequently imbued with a spirit of sheer ignorance, an
antiexpert spirit."^^^^* The apparent simplicities of Just three years
earlier now required experts. Thus began Lenin's New Economic Policy,
which allowed more market activity, and under which the economy
began to revive.

Nearly a hundred years later, with the Russian economy growing
at less than two percent annually, the same lesson was learned anew
by another Russian leader. A front-page story in the New York Times in
2013 reported how, "with the Russian economy languishing. President
Vladimir V. Putin has devised a plan for turning things around: offer
amnesty to some of the imprisoned business people."^^^^*

Chapter 6

THE ROLE OF PROFITS
—AND LOSSES

Rockefeller got rich selling oil... He found cheaper
ways to get oil from the ground to the gas pump.

John Stossef^^^

To those who run businesses, profits are obviously desirable and
losses deplorable. But economics is not business administration. From
the standpoint of the economy as a whole, and from 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 standards 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 really knowing just why people are buying one thing here
and something else there and yet 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 to 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. Therefore electricity, machines
or cement cannot be used in the same careless way that caused far
more of such inputs to be used per unit of output in the Soviet
economy than in the German or Japanese economy. From the
standpoint of the economy as a whole, and the well-being of the
consuming public, the threat of losses is just as important as the
prospect of profits.

When one business enterprise in a market economy finds ways to
lower its costs, competing enterprises have no choice but to scramble
to try to do the same. After the general merchandising chain Wal-Mart
began selling groceries in 1988, it moved up over the years to become
the nation's largest grocery seller by the early twenty-first century. Its
lower costs benefitted not only its own customers, but those of other
grocers as well. As the Wall Street Journal reported:

When two Wal-Mart Supercenters and a rival regional grocery opened
near a Kroger Co. supermarket in Houston last year, the Kroger's sales
dropped 10%. Store manager Ben Bustos moved quickly to slash some
prices and cut labor costs, for example, by buying ready-made cakes
instead of baking them in-house, and ordering precut salad-bar items
from suppliers. His employees used to stack displays by hand: Now, fruit
and vegetables arrive stacked and gleaming for display.

Such moves have helped Mr. Bustos cut worker-hours by 30% to 40%
from when the store opened four years ago, and lower the prices of
staples such as cereal, bread, milk, eggs and disposable diapers. Earlier
this year, sales at the Kroger finally edged up over the year before.^^^'^*

In short, the economy operated more efficiently, to the benefit of
the consumers, not only because of Wal-Mart's ability to cut its own
costs and thereby lower prices, but also because this forced Kroger to
find ways to do the same. This is a microcosm of what happens
throughout a free market economy. "When Wal-Mart begins selling
groceries in a community," a study showed, "the average price of
groceries in that community falls by 6 to 12 percent."^^^^* Similar
competition by low-cost sellers in other industries tends to produce
similar results in those industries. It is no accident that people in such
economies tend to have higher standards of living.

PROFITS

Profits may be the most misconceived subject in economics.
Socialists have long regarded profits as simply "overcharge," as Fabian
socialist George Bernard Shaw called it, or a "surplus value" as Karl
Marx called it. "Never talk to me about profit," India's first prime
minister, Jawaharlal Nehru, warned his country's leading industrialist,
"It is a dirty word."^^^^’ Philosopher John Dewey demanded that
"production for profit be subordinated to production for use."^^^^’

From all these men's perspectives, profits were simply
unnecessary charges added on to the inherent costs of producing
goods and services, driving up the cost to consumers. One of the great
appeals of socialism, especially back when it was simply an idealistic
theory without any concrete examples in the real world, was that it
sought to eliminate these supposedly unnecessary charges, making

things generally more affordable, especially for people with lower
incomes. Only after socialism went from being a theory to being an
actual economic system in various countries around the world did the
fact become painfully apparent that people in socialist countries had a
harder time trying to afford things that most people in capitalist
countries could afford with ease and took for granted.

With profits eliminated, 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

Let us go back to square one. The hope for profits and the threat
of losses is what forces a business owner in a capitalist economy to
produce at the lowest 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 to be 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.

It was a Soviet premier, Leonid Brezhnev, who said that his
country's enterprise managers shied away from innovation "as the
devil shies away from incense."^^^®* But, given the incentives of
government-owned and government-controlled enterprises, why
should those managers have stuck their necks out by trying new
methods or new products, when they stood to gain little or nothing if
innovation succeeded and might have lost their jobs (or worse) if it
failed? Under Stalin, failure was often equated with sabotage, and was

punished accordingly.

Even under the milder conditions of democratic socialism, as in
India for decades after its independence, innovation was by no means
necessary for protected enterprises, such as automobile
manufacturing. Until the freeing up of markets that began in India in
1991, the country's most popular car was the Hindustan Ambassador
—an unabashed copy of the British Morris Oxford. Moreover, even in
the 1990s, The Economist referred to the Ambassador as "a barely
upgraded version of a 1950s Morris Oxford."^^^^’ A London newspaper.
The Independent, reported: "Ambassadors have for years been
notorious in India for their poor finish, heavy handling and proneness
to alarming accidents."^^®°’ Nevertheless, there was a waiting list for the
Ambassador—with waits lasting for months and sometimes years—
since foreign cars were not allowed to be imported to compete with it.

Under free market capitalism, the incentives work in the opposite
direction. Even the most profitable business can lose its market if it
doesn't keep innovating, in order to avoid being overtaken by its
competitors. For example, IBM pioneered in creating computers,
including one 1944 model occupying 3,000 cubic feet. But, in the 1970s,
Intel created a computer chip smaller than a fingernail that could do
the same things as that computer.^^®^* Yet Intel itself was then
constantly forced to improve its chips at an exponential rate, as rivals
like Advanced Micro Devices (AMD), Cyrix, and others began catching
up with them technologically. More than once, Intel poured such huge
sums of money into the development of improved chips as to risk the
financial survival of the company itself.^^®^’ But the alternative was to
allow itself to be overtaken by rivals, which would have been an even
bigger riskto Intel's survival.

Although Intel continued as the leading seller of computer chips
in the world, continuing competition from Advanced Micro Devices
spurred both companies to feverish innovation, as The Economist
reported in 2007:

For a while it seemed that AMD had pulled ahead of Intel in chip design. It
devised a clever way to enable chips to handle data in both 32-bit and 64-
bit chunks, which Intel reluctantly adopted in 2004. And in 2005 AMD
launched a new processor that split the number-crunching between two
"cores" the brains of a chip, thus boosting performance and reducing
energy-consumption. But Intel came back strongly with its own dual-core
designs... Next year it will launch new chips with eight cores on a single
slice of silicon, at least a year ahead of AMD.^^®^*

Although this technological rivalry was very beneficial to
computer users, it has had large and often painful economic
consequences for both Intel and AMD. The latter had losses of more
than a billion dollars in 2002 and its stock lost four-fifths of its value.^^®"^*
But, four years later, the price of Intel stock fell by 20 percent in just
three months,^^®^* and Intel announced that it would lay off 1,000
managers,^^®®* as its profits fell by 57 percent while the profits of AMD
rose by 53 percent.^^®^* All this feverish competition took place in an
industry where Intel sells more than 80 percent of all the computer
chips in the world. ^^®®*

In short, even among corporate giants, competition in innovation
can become desperate in a free market, as the see-saw battle for
market share in microchips indicates. The dean of the Yale School of
Management described the computer chip industry as "an industry in
constant turmoil" and the Chief Executive Officer of Intel wrote a book
titled Only the Paranoid Survive}^^^^

The fate of AMD and Intel is not the issue. The issue is how the

consumers benefit from both technological advances and lower prices
as a result of these companies' fierce competition to gain profits and
avoid losses. Nor is this industry unique. In 2011,45 of the Fortune 500
companies reported losses, totaling in the aggregate more than $50
billion.^^^°* Such losses play a vital role in the economy, forcing
corporate giants to change what they are doing, under penalty of
extinction, since no one can sustain losses of that magnitude
indefinitely.

Inertia may be a common tendency among human beings around
the world—whether in business, government or other walks of life—
but businesses operating in a competitive market are forced by red ink
on the bottom line to realize that they cannot keep drifting along like
the Hindustan Motor Corporation, protected from competition by the
Indian government.

Even in India, the freeing of markets toward the end of the
twentieth century created competition in cars, forcing Hindustan
Motors to invest in improvements, producing new Ambassadors that
were now "much more reliable than their predecessors," according to
The Independent newspaper,^^^^’ and now even had "perceptible
acceleration" according to The Economist magazine.^^^^* Nevertheless,
the Hindustan Ambassador lost its long-standing position of the
number one car in sales in India to a Japanese car manufactured in
India, the Maruti. In 1997, 80 percent of the cars sold in India were
Marutis.^^^^’ Moreover, in the now more competitive automobile
market in India, "Marutis too are improving, in anticipation of the next
invaders," according to The Economist As General Motors,
Volkswagen and Toyota began investing in new factories in India, the
market share of Maruti dropped to 38 percent by 201 2.^^^^*

There was a similar pattern in India's wrist watch industry. In 1985,
the worldwide production of electronic watches was more than
double the production of mechanical watches. But, in India the HMT
watch company produced the vast majority of the country's watches,
and more than 90 percent of its watches were still mechanical. By
1989, more than four-fifths of the watches produced in the world were
electronic but, in India, more than 90 percent of the watches produced
by HMT were still the obsolete mechanical watches. However, after
government restrictions on the economy were greatly reduced,
electronic watches quickly became a majority of all watches produced
in India by 1993-1994, and other watch companies displaced HMT,
whose market share fell to 14 percent.^^^^’

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. Clearly the greater efficiency must
outweigh the profit or else socialism would in fact have had the more
affordable prices and greater prosperity that its theorists expected,
but which failed to materialize in the real world.

If in fact the cost of profits exceeded the value of the efficiency
they promote, then 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. Yet that seldom, if ever, happens, while the opposite
happens increasingly—that is, private profit-making companies taking
over various functions formerly performed by government agencies or

by non-profit organizations such as colleges and universities/’''''’

While capitalists have been conceived of as people who make
profits, what a business owner really gets is legal ownership of
whatever residual is left over after the costs 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 that business. This is what puts unrelenting
pressure on the owner to monitor everything that is happening in the
business and everything that is happening in the market for the
business' products or services.

In contrast to the layers of authorities monitoring the actions of
those under them in a government-run enterprise, the business owner
is essentially an unmonitored monitor as far as the economic
efficiency of the business is concerned. Self-interest takes the place of
external monitors, and forces far closer attention to details and far
more expenditure of time and energy at work than any set of rules or
authorities is likely to be able to do. That simple fact gives capitalism
an enormous advantage. More important, it gives the people living in
price-coordinated market economies visibly higher standards of living.

It is not just ignorant people, but also highly educated and highly
intellectual people like George Bernard Shaw, Karl Marx, Jawaharlal
Nehru and John Dewey who have misconceived profits as arbitrary
charges added on to the inherent costs of producing goods and
services. To many people, even today, high profits are often attributed

to high prices charged by those motivated by "greed" In reality, most
of the great fortunes in American history have resulted from
someone's figuring out how to reduce costs, so as to be able to charge
lower prices and therefore gain a mass market for the product. Henry
Ford did this with automobiles. Rockefeller with oil, Carnegie with
steel, and Sears, Penney, Walton and other department store chain
founders with a variety of products.

A supermarket chain in a capitalist economy can be very
successful charging prices that allow about a penny of clear profit on
each dollar of sales. Because several cash registers are usually bringing
in money simultaneously all day long in a big supermarket, those
pennies can add up to a very substantial annual rate of return on the
supermarket chain's investment, while adding very little to what the
customer pays. If the entire contents of a store get sold out in about
two weeks, then that penny on a dollar becomes more like a quarter
on the dollar over the course of a year, when that same dollar comes
back to be re-used 25 more times. Under socialism, that penny on each
dollar would be eliminated, but so too would be all the economic
pressures on the management to keep costs down. Instead of prices
falling to 99 cents, they might well rise above a dollar, after the
enterprise managers lose the incentives and pressures to keep
production costs down.

Profit Rates

When most people are asked how high they think the average
rate of profit is, they usually suggest some number 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 percent to a low of 4.1 percent,
before taxes. After taxes, the rate of profit ranged from a high of 7.8
percent to a low of 2.2 percent.^^^^* 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 that 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 widgets for $10 each and sells them for $15 each,
some might say that it makes $5 in profits on each widget that it sells.
But, of course, the store has to pay the people who work there, the
company that supplies electricity to the store, as well as other
suppliers of other goods and services needed to keep the business
running. What is left over after all these people have been paid is the
net profit, usually a lot less than the gross profit. But that is still not the
same as profit on investment. It is simply net profits on sales, which
still ignores the cost of the investments which built the store in the
first place.

It is the profit on the whole investment that matters to the
investor. When someone invests $10,000, what that person wants to
know is what annual rate of return it will bring, whether it is invested
in stores, real estate, or stocks and bonds. Profits on particular sales are
not what matter most. It is the profit on the total capital that has been
invested in the business that matters. That profit matters not Just to
those who receive it, but to the economy as a whole, because
differences in profit rates in different sectors of the economy are what
cause investments to flow into and out of these various sectors, until
profit rates are equalized, like water seeking its own level. Changing

rates of profit allocate resources in a nnarket econonny—when these
are rates of profit on investment.

Profits on sales are 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 store 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. A store that sells
pianos undoubtedly makes a higher percentage profit on each sale
than a supermarket makes selling bread. But a piano sits in the store
for a much longer time waiting to be sold than a loaf of bread does.
Bread would go stale and moldy waiting for as long as a piano to be
sold. When a supermarket chain buys $10,000 worth of bread, it gets its
money back much faster than when a piano dealer buys $10,000 worth
of pianos. Therefore the piano dealer must charge a higher percentage
mark-up on the sale of each piano than a supermarket charges on
each loaf of bread, if the piano dealer is to make the same annual
percentage rate of return on a $10,000 investment.

Competition among those seeking money from investors makes
profit rates tend to equalize, even when that requires different mark¬
ups to compensate for different turnover rates among different
products. Piano stores can continue to exist only when their higher
mark-ups in prices compensate for slower turnover in sales. Otherwise
investors would put their money elsewhere and piano stores would
start disappearing.

When the supermarket gets its money back in a shorter period of
time, it can turn right around and re-invest it, buying more bread or
other grocery items. In the course of a year, the same money turns
over many times in a supermarket, earning a profit each time, so that a

penny of profit on the dollar can produce a total profit rate for the year
on the initial investment equal to what a piano dealer makes charging
a much higher percentage mark-up on an investment that turns over
much more slowly.

Even firms in the same business may have different turnover
rates. For example, Wal-Mart's inventory turns over more times per
year than the inventory at Target stores.^^^®* In the United States in
2008, an automobile spent an average of three months on a dealer's
lot before being sold, compared to two months the previous year.
However, in 2008 Volkswagens sold in about two months in the U.S.
while Chryslers took more than four months.^^^^* Although
supermarkets tend to have especially low rates of profit on sales,
because of their high rates of turnover, other businesses' profit rates
on sales are also usually lower than what many people imagine.
Companies that made the Fortune magazine list of the 500 largest
companies in America averaged "a return on revenues [sales] of a
penny on the dollar" in 2002, compared to "6 cents in 2000, the peak
profit year."^^°°*

Profits on sales and profits on investment are not merely different
concepts. They can move in opposite directions. One of the keys to the
rise to dominance of the A & P grocery chain in the 1920s was a
conscious decision by the company management to cut profit margins
on sales, in order to increase the profit rate on investment. With the
new and lower prices made possible by selling with lower profits per
item, A & P was able to attract greatly increased numbers of
customers, making far more total profit because of the increased
volume of sales. Making a profit of only a few cents on the dollar on
sales, but with the inventory turning over nearly 30 times a year, A &

P's profit rate on investnnent soared. This low price and high volume
strategy set a pattern that spread to other grocery chains and to other
kinds of enterprises as well. Consumers benefitted from lower prices
while A & P benefitted from higher profits on their investment—
further evidence that economic transactions are not a zero-sum
process.

In a later era, huge supermarkets were able to shave the profit
margin on sales still thinner, because of even higher volumes of sales,
enabling them to displace A & P from industry leadership by charging
still lower prices.

Conversely, a study of prices in low-income neighborhoods found
that there were larger than usual mark-ups in prices charged their
customers but, at the same time, there were lower than usual rates of
profit on investment.^^°^* Higher profits on sales helped compensate for
the higher costs of doing business in low-income neighborhoods but
apparently not completely, as indicated by the avoidance of such
neighborhoods by many businesses, including supermarket chains.

A limiting factor in how high stores in low-income neighborhoods
can raise their prices to compensate for higher costs is the fact that
many low-income residents already shop in stores in higher-income
neighborhoods, where the prices are lower, even though this may
entail paying bus fare or taxi fare. The higher the prices rise in low-
income neighborhoods, the more people are likely to shop elsewhere.
Thus stores in such neighborhoods are limited in the extent to which
they can offset higher costs and slower turnover with higher prices,
often leaving them in a precarious financial position, even while they
are being denounced for "exploiting" their customers with high prices.

It should also be noted that, where there are higher costs of doing

business in low-income neighborhoods when there are higher rates of
crime and vandalism, such additional costs can easily overwhelm the
profit margin and make many businesses unsustainable in such
neighborhoods. If a store clears a penny of profit on an item that costs
a quarter, then if just one out of every 25 of these items gets stolen by
shoplifters, that can make it unprofitable to sell in that neighborhood.
The majority of people in the neighborhood may be honest consumers
who pay for what they get at the store, but it takes only a fraction as
many who are shoplifters (or robbers or vandals) to make it
uneconomic for stores to locate there.

COSTS 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 production 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. Henry Ford proved long ago that the cost of
producing an automobile was very different when you produced 100
cars a year than when you produced 100,000. He became the leading
automobile manufacturer in the early twentieth century by pioneering
mass production methods in his factories, revolutionizing not only his

own connpany but businesses throughout the economy, which
followed the mass production principles that he introduced. The time
required to produce a Ford Model T chassis shrank from 12 man-hours
to an hour and a half.^^°^’ With a mass market for automobiles, it paid to
invest in expensive but labor-saving mass production machinery,
whose cost per car would turn out to be modest when spread out over
a huge number of automobiles. But, if there were only half as many
cars sold as expected, then the cost of that machinery per car would
be twice as much.

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

It has been estimated that the minimum amount of automobile
production required to achieve the fullest economies of scale today
runs into the hundreds of thousands of cars per year.^^°^* Back at the
beginning of the twentieth century, the largest automobile
manufacturer in the United States produced just six cars a day.^^°^* At
that level of output, the cost of production was so high that only the
truly rich could afford to buy a car. But Henry Ford's mass production
methods brought the cost of producing cars down within the price
range of ordinary Americans. Moreover, he continued to improve the
efficiency of his factories. The price of a Model T Ford was cut in half
between 1910 and 1916.^^°^*

Similar principles apply in other industries. It does not cost as
much to deliver a hundred cartons of milk to one supermarket as it
does to deliver ten cartons of milk to each of ten different
neighborhood stores scattered around town. Economies in beer

production include advertising. Although Anheuser-Busch spends
millions of dollars a year advertising Budweiser and its other beers, its
huge volume of sales means that its advertising cost per barrel of beer
is less than that of its competitors Coors and Miller.^^”^* Such savings
add up, permitting larger enterprises to have either lower prices or
larger profits, or both. Small retail stores have long had difficulty
surviving in competition with large chain stores charging lower prices,
whether A & P in the first half of the twentieth century. Sears in the
second half, or Wal-Mart in the twenty-first century. The higher costs
per unit in the smaller stores will not permit them to charge prices as
low as the big chain stores' prices.

Advertising has sometimes been depicted as simply another cost
added on to the cost of producing goods and services. However, in so
far as advertising causes more of the advertised product to be sold,
economies of scale can reduce production costs, so that the same
product may cost less when it is advertised, rather than more.
Advertising itself of course has costs, both in the financial sense and in
the sense of using resources. But it is an empirical question, rather
than a foregone conclusion, whether the costs of advertising are
greater or less than the reductions of production costs made possible
by the economies of scale which it promotes. This can obviously vary
from one firm or industry to another.

Diseconomies ofScaie

Economies of scale are only half the story. If economies of scale
were the whole story, the question would then have to be asked: Why
not produce cars in even more gigantic enterprises? If General Motors,
Ford, and Chrysler all merged together, would they not be able to

produce cars even nnore cheaply and thereby make more sales and
profit than when they produce separately?

Probably not. There comes a point, in every business, beyond
which the cost of producing a unit of output no longer declines as the
amount of production increases. In fact, costs per unit actually 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.^’"'''* Back in the 1960s, when the American Telephone &
Telegraph Company was the largest corporation in the world, its own
chief executive officer put it this way: "A.T. &T. is so big that, if you gave
it a kick in the behind today, it would be two years before the head said
'ouch.'"

In a survey of banks around the world in 2006, The Economist
magazine reported their tendency to keep growing larger and the
implications of this for lower levels of efficiency:

Management will find it harder and harder to aggregate and summarise
everything that is going on in the bank, opening the way to the
duplication of expense, the neglect of concealed risks and the failure of
internal controlsJ^°^*

In other words, the risks inherent in banking may be well under
control, as far as the top management is aware, but somewhere in
their sprawling financial empire there may be transactions being
made that expose the bank to risks that the top management is
unaware of. Unknown to the top management at an international
bank's New York headquarters, some bank official at a branch in
Singapore may be making transactions that create not only financial
risks but risks of criminal prosecution. This is not a problem peculiar to
banks or to the United States. As a professor at the London Business

School put it, some organizations have "reached a scale and
complexity that made risk-management errors almost inevitable,
while others had become so bureaucratic and top-heavy that they had
lost the capacity to respond to changing market demands."^^°®* Smaller
rivals may be able to respond faster because their decision-makers do
not have to go through so many layers of bureaucracy to get approval
for their actions.

During General Motors' long tenure as the largest manufacturer
of motor vehicles in the world, its cost of production per car was
estimated to be hundreds of dollars more than the costs of Ford,
Chrysler, or leading Japanese manufacturers.^^°^* Problems associated
with size can affect quality as well as price. Among hospitals, for
example, surveys suggest that smaller and more specialized hospitals
are usually safer for patients than large hospitals treating a wide range
of maladies.^^^°’

Economies of scale and diseconomies of scale can exist
simultaneously in the same business at various levels of output. That
is, there may be some things that a given company could do better if it
were larger and other things that it could do better if it were smaller.
As an entrepreneur in India put it, "What small companies give up in
terms of financial clout, technological resources, and staying power,
they gain in flexibility, lack of bureaucracy, and speed of decision
making."^^"* People in charge of a company's operations in Calcutta
may decide what needs to be done to improve business in that city
but, if they then have to also convince the top management at the
company's headquarters in New Delhi, their decisions cannot be put
into operation as quickly, or perhaps as fully, and sometimes the
people in New Delhi may not understand the situation in Calcutta well

enough to approve a decision that makes sense to people who live
there.

With increasing size, eventually the diseconomies begin to
outweigh the economies, so it does not pay a firm to expand beyond
that point. That is why industries usually consist of a number of firms,
instead of one giant, super-efficient monopoly.

In the Soviet Union, where there was a fascination with
economies of scale and a disregard of diseconomies of scale, both its
industrial and agricultural enterprises were the largest in the world.
The average Soviet farm, for example, was ten times the size of the
average American farm and employed more than ten times as many
workers.^^^^’ But Soviet farms were notoriously inefficient. Among the
reasons for this inefficiency cited by Soviet economists was "deficient
coordination." One example may illustrate a general problem:

In the vast common fields, fleets of tractors fanned out to begin the
plowing. Plan fulfillment was calculated on the basis of hectares worked,
and so it was to the drivers' advantage to cover as much territory as
quickly as possible. The drivers started by cutting deep furrows around
the edge of the fields. As they moved deeper into the fields, however,
they began to lift the blade of the plow and race the tractor, and the
furrows became progressively shallower. The first furrows were nine to
ten inches deep. A little farther from the road, they were five to six inches
deep, and in the center of the field, where the tractor drivers were certain
that no one would check on them, the furrows were as little as two inches
deep. Usually, no one discovered that the furrows were so shallow in the
middle of the field until it became obvious that something was wrong
from the stunted nature of the crop.^^^^*

Once again, counterproductive behavior from the standpoint of
the economy was not irrational behavior from the standpoint of the
person engaging in it. Clearly, the tractor drivers understood that their

work could be more easily monitored at the edge of a field than in the
center, and they adjusted the kind and quality of work they did
accordingly, so as to maximize their own pay, based on how much land
they plowed. By not plowing as deeply into the ground where they
could not be easily monitored by farm officials, tractor drivers were
able to go faster and cover more ground in a given amount of time,
even if they covered it less effectively.

No such behavior would be likely by a farmer plowing his own
land in a market economy, because his actions would be controlled by
the incentive of profit, rather than by external monitors.

The point at which the disadvantages of size begin to outweigh
the advantages differs from one industry to another. That is why
restaurants are smaller than steel mills. A well-run restaurant usually
requires the presence of an owner with sufficient incentives to
continuously monitor the many things necessary for successful
operation, in a field where failures are all too common. Not only must
the food be prepared to suit the tastes of the restaurant's clientele, the
waiters and waitresses must do their Jobs in a way that encourages
people to come back for another pleasant experience, and the
furnishings of the restaurant must also be such as to meet the desires
of the particular clientele that it serves.

These are not problems that can be solved once and for all. Food
suppliers must be continuously monitored to see that they are still
sending the kind and quality of produce, fish, meats, and other
ingredients needed to satisfy the customers. Cooks and chefs must
also be monitored to see that they are continuing to meet existing
standards—as well as adding to their repertoires, as new foods and
drinks become popular and old ones are ordered less often by the

customers. The normal turnover of employees also requires the owner
to be able to select, train, and monitor new people on an on-going
basis. Moreover, changes outside the restaurant—in the kind of
neighborhood around it, for example—can make or break its business.
All these factors, and more, must be kept in mind, weighed by the
owner and continuously adjusted to, if the business is to survive, much
less be profitable.

Such a spectrum of details, requiring direct personal knowledge
and control by someone on the scene and with incentives going
beyond a fixed salary, limits the size of restaurants, as compared to the
size of steel mills, automobile factories, or mining companies. Even
where there are nationwide restaurant chains, often these are run by
individual owners operating with franchises from some national
organization that supplies such things as advertising and general
guidance and standards, leaving the numerous on-site monitoring
tasks to local owners. Howard Johnson pioneered in restaurant
franchising in the 1930s, supplying half the capital, with the local
manager supplying the other half.^^^"^’ This gave the local franchisee a
vested interest in the restaurant's profitability, rather than simply a
fixed salary for his time.

Costs and Capacity

Costs vary not only with the volume of output, and to varying
degrees from one industry to another, 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 the tinnes 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 its passengers to
cover not only such current costs as paying the crew, buying food and
using fuel, 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.

To handle twice as many passengers on a given cruise at the peak
season may require buying another ship, as well as hiring another crew
and buying twice as much food and fuel. However, if the number of
passengers in the off season is only one-third of what it is at the peak,
then a doubling of the number of off-season passengers need not
require buying another ship. Existing ships can simply sail with fewer
empty cabins. Therefore, it pays the cruise line to try to attract
economy-minded passengers by offering much reduced fares during
the off season. Groups of retired people, for example, can usually
schedule their cruises at any time of the year, not being tied down to
the vacation schedules of jobs and usually not having young children
whose school schedules would limit their flexibility. It is common for
seniors to get large discounts in off-season travel, both on land and at
sea. Businesses in general can afford to do this because their costs are
lower in the off season—and each particular business is forced to do it
because its competitors will take customers away otherwise.

Excess capacity can also result from over-optimistic building.
Because of what the Wall Street Journal called "an ill-timed building
frenzy in luxury ships," luxury cruise lines added more than 4,000 new
berths in a little over a year during the early twenty-first century. When
they found that there was no such demand as to fill all the additional

cabins at their existing prices, the net result was that Crystal Cruises,
for example, offered their usual $2,995 cruise through the Panama
Canal for $1,695 and Seabourn Cruise Line cut the price of its
Caribbean cruise from $4,495 to $1,999^^^^* They would hardly have
done this unless the pressures of competition left them no choice—
and unless their incremental costs, when they had excess capacity,
were lower than their reduced prices.

Unutilized capacity can cause price anomalies in many sectors of
the economy. In Cancun, Mexico, the cheapest room available at the
modest Best Western hotel there was $180 a night in mid-2001, while
the more luxurious Ritz-Carlton nearby was renting rooms for $169 a
night. The Best Western happened to be filled up and the Ritz-Carlton
happened to have vacancies. Nor was this peculiar to Mexico. A four-
star hotel in Manhattan was renting rooms for less than a two-star
hotel nearby, and the posh Phoenician in Phoenix was renting rooms
for less than the Holiday Inn in the same city.^^^^*

Why were normally very expensive hotels renting rooms for less
than hotels that were usually much lower in price? Again, the key was
the utilization of capacity. Tourists going to popular resorts on limited
budgets had made reservations at the low-cost hotels well in advance,
in order to be sure of finding something affordable. This meant that
fluctuations in the number of tourists would be absorbed by the
higher-priced hotels. A general decline in tourism in 2001 thus led to
vacancies at the luxury hotels, which then had no choice but to cut
prices in order to attract more people to fill their rooms. Thus the
luxurious Boca Raton Resort & Spa in Florida gave guests their third
night free and tourists were able to get last-minute bargains on
luxurious beachfront villas at Hilton Head, South Carolina, where

reservations usually had to be nnade six nnonths in advanceJ^^^*

Conversely, a rise in tourism would also have more effect on
luxury hotels, which could raise their prices even more than usual.
After three consecutive years of declining profits, hotels in 2004 began
"yanking the discounts," as the Wall Street Journal put it, when
increased travel brought more guests. The luxury hotels' reactions
took the form of both price increases—$545 a night for the smallest
and cheapest room at the Four Seasons Hotel in New York—and
elimination of various free extras:

It's already tougher this year for families to find the offers of free
breakfasts and other perks that business hotels have been freely
distributing for the past three years in an effort to fill empty beds.^^^®*

Because prices can vary so widely for the same room in the same
hotel, according to whether or not there is excess capacity, auxiliary
businesses have been created to direct travelers where they can get
the best deals on a given day—Priceline and Travelocity being
examples of such businesses that have sprung up to match bargain-
hunters with hotels that have unexpected vacancies.

Since all these responses to excess capacity are due to incentives
created by the prospect of profits and the threat of losses in a market
economy, the same principles do not apply where the government
provides a good or service and charges for it. There are few incentives
for government officials to match prices with costs—and sometimes
they charge more to those who create the least cost.

When a bridge, for example, is built or its capacity is expanded,
the costs created are essentially the cost of building the capacity to
handle rush-hour traffic. The cars that drive across the bridge between

the morning and evening rush hours cost almost nothing because the
bridge has idle capacity during those hours. Yet, when tolls are
charged, often there are books of tickets or electronic passes available
at lower prices per trip than the prices charged to those who drive
across the bridge only occasionally during off-peak hours.

Although it is the regular rush-hour users who create the huge
costs of building or expanding a bridge's capacity, they pay less
because it is they who are more numerous voters and whose greater
stake in toll policies makes them more likely to react politically to toll
charges. What may seem like economic folly can be political prudence
on the part of politically appointed officials operating the bridges and
trying to protect their own jobs. The net economic result is that there
is more bridge traffic during rush hours than if different tolls reflected
costs at different times of day. Higher rush hour tolls would provide
incentives for some drivers to cross the bridge either earlier or later
than the rush hours. In turn, that would mean that the amount of
capacity required to handle rush hour traffic would be less, reducing
costs in both money terms and in terms of the use of scarce resources
which have alternative uses.

"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 come 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 in

lower prices to the consumers.

The idea that sellers can charge whatever price they want is
seldom expressed explicitly, but the implication that they can often
lurks in the background of such questions as what they will pass on to
their customers. But the passing on of 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 cost increases or decreases.

If you are running a gold mining company in South Africa and the
government there increases the tax on gold by $10 an ounce, you
cannot pass that on in higher prices to buyers of gold in the world
market because gold producers in other countries do not have to pay
that extra $10. To buyers around the world, gold is gold, wherever it is
produced. There is no way that these buyers are going to pay $10 an
ounce more for your gold than for somebody else's gold. Under these
circumstances, a $10 tax on your gold means that your profits on gold
sales in the world market will simply decline by $10an ounce.

The same principle applies when there are rising costs of
transportation. If you ship your product to market by railroad and the
railroads raise their freight charges, you can pass that on to the buyers
only to the extent that your competitors also ship their product by rail.
But, if your competitors are shipping by truck or by barge, while your
location will not allow you to do the same, then raising your prices to
cover the additional rail charges will simply allow your competitors,
with lower costs, to take away some of your customers by charging
lower prices. On the other hand, if all your competitors ship by rail and
for similar distances, then all of you can pass on the higher railroad
freight charges to all your customers. But if you ship your output an

average of 100 miles and your competitors ship their output an
average of only 10 miles, then you can only raise your prices to cover
the additional cost of rail charges for 10 miles and take a reduction in
profit by the cost of the other 90 miles.

Similar principles apply when it comes to passing on savings to
customers. If you alone introduce a new technology that cuts your
production costs 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—and this is what
has often happened—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. Many of the great
American fortunes—by Rockefeller, Carnegie, and others—came from
finding lower cost ways of producing and delivering the product to the
customer, and then charging lower prices than their higher-cost
competitors could meet, thus luring away their customers.

Over a period of time, competitors usually begin to use similar
technological or organizational advances to cut costs and reduce
prices, but fortunes can be made by pioneering innovators in the
meantime. That provides incentives for enterprises in profit-seeking
market economies to be on the lookout for new ways of doing things,
in contrast to enterprises in either government-run economies like
those in the days of the Soviet Union or in economies where laws
protect private businesses from domestic or international
competition, as in India before they began to open their economy to
competition in the world market.

SPECIALIZATION AND DISTRIBUTION

A business firnn is linnited, not only in its over-all size, but also in
the range of functions that it can perform efficiently. General Motors
makes millions of automobiles, but not a single tire. Instead, it buys its
tires from Goodyear, Michelin and other tire manufacturers, who can
produce this part of the car more efficiently than General Motors can.
Nor do automobile manufacturers own their own automobile
dealerships across the country. Typically, automobile producers sell
cars to local people who in turn sell to the public. There is no way that
General Motors can keep track of all the local conditions across the
length and breadth of the United States, which determine how much
it will cost to buy or lease land on which to locate an automobile
dealership, or which locations are best in a given community, much
less evaluate the condition of local customers' used cars that are being
traded in on new ones.

No one can sit in an automobile company's headquarters and
decide how much trade-in value to allow on a particular Chevrolet in
Seattle with some dents and scratches, or a particular used Honda in
mint condition in Miami. And if the kind of salesmanship that works in
Los Angeles does not work in Boston, those on the scene are likely to
know that better than any automobile executive in Michigan can. In
short, the automobile manufacturer specializes in manufacturing
automobiles, leaving other functions to people who develop different
knowledge and different skills needed to specialize in those particular
functions.

Middlemen

The perennial desire to "eliminate the middleman" is perennially
thwarted by economic reality. The range of human knowledge and
expertise is limited for any given person or for 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, there are
other people with different skills and experience who can perform the
next step in the sequence more cheaply or more effectively—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. Furniture manufacturers usually do not own or operate
furniture stores, and most authors do not do their own publishing,
much less own their own bookstores.

Prices play a crucial role in all of this, as in other aspects of a
market economy. Any economy must not only allocate scarce
resources which have alternative uses, it must 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 own bottom line, but this
bottom line is itself determined by what others can do and at what
cost.

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 for the owner's own sake. However, the end result

is a more efficient economy, where goods move to those who value
them most. Despite 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.

Third World countries have tended to have more middlemen than
more industrialized nations have, a fact much lamented by observers
who have not considered the economics of the situation. Farm
produce tends to pass through more hands between the African
farmer who grows peanuts, for example, to the company that
processes it into peanut butter than would be the case in the United
States. A similar pattern was found with consumer goods moving in
the opposite direction. Boxes of matches may pass through more
hands between the manufacturer of matches and the African
consumer who ultimately buys them. A British economist in mid¬
twentieth century West Africa described and explained such situations
there:

West African agricultural exports are produced by tens of thousands of
Africans operating on a very small scale and often widely dispersed. They
almost entirely lack suitable storage facilities, and they have no, or only
very small, cash reserves. . . The large number and the long line of
intermediaries in the purchase of export produce essentially derive from
the economies to be obtained from bulking very large numbers of small
parcels. . . In produce marketing the first link in the chain may be the
purchase, hundreds of miles from Kano, of a few pounds of groundnuts,
which after several stages of bulking arrive there as part of a wagon or
lorry load of several tons.^^^^*

Instead often farmers in a given area all taking time off from their

farming to carry their individually small amounts of produce to a
distant town for sale, one middleman can collect the produce of the
many farmers and drive it all to a produce buyer at one time, allowing
these farmers to apply their scarce resources—time and labor—to the
alternative uses of those resources for growing more produce. Society
as a whole thus saves on the amount of resources required to move
produce from the farm to the next buyer, as well as saving on the
number of individual negotiations required at the final points of sale.
This saving of time is especially important during the harvest season,
when some of the crop may become over-ripe before it is picked or
spoil afterwards if it is not picked promptly and then gotten into a
storage or processing facility quickly.

In a wealthier country, each farm would have more produce, and
motorized transport on modern highways would reduce the time
required to get it to the next point of sale, so that the time lost per ton
of crop would be less and fewer middlemen would be required to
move it. Moreover, modern farmers in prosperous countries would be
more likely to have their own storage facilities, harvesting machinery,
and other aids. What is and is not efficient—either from the standpoint
of the individual farmer or of society as a whole—depends on the
circumstances. Since these circumstances can differ radically between
rich and poor countries, very different methods may be efficient in
each country and no given method need be right for both.

For similar reasons, there are often more intermediaries between
the industrial manufacturer and the ultimate consumer in poor
countries. However, the profits earned by each of these intermediaries
is not just so much waste, as often assumed by third-party observers,
especially observers from a different society. Here the limiting factor is

the poverty of the consumer, which restricts how much can be bought
at one time. Again, West Africa in the mid-twentieth century provided
especially clear examples:

Imported merchandise arrives in very large consignments and needs to
be distributed over large areas to the final consumer who, in West Africa,
has to buy in extremely small quantities because of his poverty. . . The
organization of retail selling in Ibadan (and elsewhere) exemplifies the
services rendered by petty traders both to suppliers and to consumers.
Here there is no convenient central market, and it is usual to see petty
traders sitting with their wares at the entrances to the stores of the
European merchant firms. The petty traders sell largely the same
commodities as the stores, but in much smaller quantities.^^^°*

This might seem to be the ideal situation in which to "eliminate
the middleman," since the petty traders were camped right outside
stores selling the same merchandise, and the consumers could simply
walk right on past them to buy the same goods inside at lower prices
per unit. But these traders would sell in such tiny quantities as ten
matches or half a cigarette, while it would be wasteful for people in
the stores behind them to spend their time breaking down their
packaged goods that much, in view of the better paying alternative
uses of their labor and capital.

The alternatives available to the African petty traders were
seldom as remunerative, so it made sense for these traders to do what
it would not make sense for the European merchant to do. Moreover, it
made sense for the very poor African consumer to buy from the local
traders, even if the latter's additional profit raised the price of the
commodity, because the consumer often could not afford to buy the
commodity in the quantities sold by the European merchants.

Obvious as all this may seem, it has been misunderstood by

renowned writers and—worse yet—by both colonial and post-colonial
governments hostile to middlemen and prone to creating laws and
policies expressing that hostility.

Socialist Economies

As in other cases, one of the best ways of understanding the role
of prices, profits, and losses is to see what happens in their absence.
Socialist economies not only lack the kinds of incentives which force
individual enterprises toward efficiency and innovation, 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 own
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.

In the Soviet Union, for example, many enterprises produced their
own components, even though specialized producers of such
components existed and could manufacture them at lower costs. Two
Soviet economists estimated that the costs of components needed for
a machine-building enterprise in the U.S.S.R. were two to three times
as great as the costs of producing those same components in
specialized enterprises.^^^^* But why would cost matter to the individual
enterprise making these decisions in a system where profits and losses
were not decisive? What was decisive was fulfilling the monthly
production quotas set by government authorities, and that could be

assured most readily by an enterprise making its own components,
since it could not depend on timely deliveries from other enterprises
that lacked the profit-and-loss incentives of a supplier in a market
economy.

This was not peculiar to machine-building enterprises. According
to the same Soviet economists, "the idea of self-sufficiency in supply
penetrates all the tiers of the economic administrative pyramid, from
top to bottom."^^^^* Just over half the bricks in the U.S.S.R. were
produced by enterprises that were not set up for that purpose, but
which made their own bricks in order to build whatever needed
building to house their main economic activity. That was because
these Soviet enterprises could not rely on deliveries from the Ministry
of the Industry of Construction Materials, which had no financial
incentives to be reliable in delivering bricks on time or of the quality
required.

For similar reasons, far more Soviet enterprises were producing
machine tools than were specifically set up to do so. Meanwhile,
specialized plants set up for that purpose worked below their capacity
—which is to say, at higher production costs per unit than if their
overhead had been spread out over more units of output—because so
many other enterprises were producing these machine tools for
themselves.^^^"^’ Capitalist producers of bricks or machine tools have no
choice but to produce what is wanted by the customer, and to be
reliable in delivering it, if they intend to keep those customers in
competition with other producers of bricks or machine tools. That,
however, is not the case when there is one nationwide monopoly of a
particular product under government control, as was the situation in
the Soviet Union.

In China's economy as well, when it was government-planned for
decades after the Communists took over in 1949, many enterprises
supplied their own transportation for the goods they produced, unlike
most companies in the United States that pay trucking firms or rail or
air freight carriers to transport their products. As the Far Eastern
Economic Review put it: "Through decades of state-planned
development, nearly all big Chinese firms transported their own
goods, however inefficiently."^^^^* Although theoretically firms
specializing in transportation might operate more efficiently, the
absence of financial incentives for a government monopoly enterprise
to satisfy their customers made specialized transport enterprises too
unreliable, both as to times of delivery and as to the care—or lack of
care—when handling goods in transit. A company manufacturing
television sets in China might not be as efficient in transporting those
sets as a specialized transport enterprise would be, but at least they
were less likely to damage their own TV sets by handling them roughly
in transit.

One of the other side effects of unreliable deliveries has been that
Chinese firms have had to keep more goods in inventory, foregoing
the advantages of "just in time" delivery practices in Japan, which
reduce the Japanese firms' costs of maintaining inventories. Dell
Computers in the United States likewise operates with very small
inventories, relative to their sales, but this is possible only because
there are shipping firms like Federal Express or UPS that Dell can rely
on to get components to them and computers to their customers
quickly and safely.

The net result of habits and patterns of behavior left over from
the days of a government-run economy is that China spends about

twice as high a share of its national income on transportation as the
United States does, even though the U.S. has a larger territory,
including two states separated by more than a thousand miles from
the other 48 states.

Contrasts in the size—and therefore costs—of inventories can be
extreme from one country to another. Japan carries the smallest
inventories, while the Soviet Union carried the largest, with the United
States in between. As two Soviet economists pointed out:

Spare parts are literally used right "off the truck": in Japan producers
commonly deliver supplies to their ordering companies three to four
times a day. At Toyota the volume of warehoused inventories is calculated
for only an hour of work, while at Ford the inventories are for up to three
weeks.

In the Soviet Union, these economists said, "we have in
inventories almost as much as we create in a year."^^^^’ In other words,
most of the people who work in Soviet industry "could take a year's
paid vacation"^^^®* and the economy could live on its inventories. This is
not an advantage but a handicap because inventories cost money—
and don't earn any. From the standpoint of the economy as a whole,
the production of inventory uses up resources without adding
anything to the standard of living of the public. As the Soviet
economists put it, "our economy is always burdened by the heavy
weight of inventories, much heavier than those that weigh on a
capitalist economy during the most destructive recessions."^^^^*

Yet the decisions to maintain huge inventories were not irrational
decisions, given the circumstances of the Soviet economy and the
incentives and constraints inherent in those circumstances. Soviet
enterprises had no real choice but to maintain these costly inventories.

The less reliable the suppliers, the more inventory it pays to keep, so as
not to run out of vital components/’"''* Nevertheless, inventories add to
the costs of production, which add to the price, which in turn reduces
the public's purchasing power and therefore its standard of living.

Geography can also increase the amount of inventory required. As
a result of severe geographical handicaps that limit transportation in
parts of sub-Saharan Africa,*’"'''* large inventories of both agricultural
produce and industrial output have had to be maintained there
because regions heavily dependent on rivers and streams for
transportation can be cut off if those rivers and streams fall too low to
be navigable because the rainy season is either delayed or ends
prematurely.*^^”* In short, geographic handicaps to land transportation
and drastic differences in rainfall at different times of the year add
huge inventory costs in sub-Saharan Africa, contributing to that
region's painfully low standard of living. In Africa, as elsewhere,
maintaining large inventories means using up scarce resources
without a corresponding addition to the consumers' standard of living.

The reason General Motors can produce automobiles, without
producing any tires to go on them, is because it can rely on Goodyear,
Michelin, and whoever else supplies their tires to have those tires
waiting to go on the cars as they move down off the production lines.
If those suppliers failed to deliver, it would of course be a disaster for
General Motors. But it would be even more catastrophic for the tire
companies themselves. To leave General Motors high and dry, with no
tires to go on its Cadillacs or Chevrolets, would be financially suicidal
for a tire company, since it would lose a customer for millions of tires
each year, quite aside from the billions of dollars in damages from
lawsuits over breach of contract. Under these circumstances, it is

hardly surprising that General Motors does not have to produce all its
own components, as many Soviet enterprises did.

Absurd as it might seem to imagine Cadillacs rolling off the
assembly lines and finding no tires to go on them, back in the days of
the Soviet Union one of that country's own high officials complained
that "hundreds of thousands of motor vehicles stand idle without
tires."^^^^* The fact that complex coordination takes place so seemingly
automatically in one economic system that people hardly even think
about it does not mean that coordination will be similarly automatic
in another economic system operating on different principles.^’"''''*
Ironically, it is precisely where there is no one controlling the whole
economy that it is automatically coordinated by price movements,
while in deliberately planned economies a similar level of
coordination has repeatedly turned out to be virtually impossible to
achieve.

Reliability is an inherent accompaniment of the physical product
when keeping customers is a matter of economic life and death under
capitalism, whether at the manufacturing level or the retail level. Back
in the early 1930s, when refrigerators were just beginning to become
widely used in the United States, there were many technological and
production problems with the first mass-produced refrigerators sold
by Sears. The company had no choice but to honor its money-back
guarantee by taking back 30,000 refrigerators, at a time when Sears
could ill afford to do so, in the depths of the Great Depression, when
businesses were as short of money as their customers were. This
situation put enormous financial pressure on Sears to either stop
selling refrigerators (which is what some of its executives and many of
its store managers wanted) or else greatly improve their reliability.

What they eventually did was innprove the reliability of their
refrigerators, thereby becoming one of the leading sellers of
refrigerators in the countryj^^^*

Chapter 7

THE ECONOMICS OF
BIG BUSINESS

Competition always has been and always will be
troublesome to those who have to meet it.

Frederic BastiaF^^^^

Big businesses can be big in different ways. They can be big
absolutely, like Wal-Mart—with billions of dollars in sales annually,
making it the biggest business in the nation—without selling more
than a modest percentage of the total merchandise in its industry as a
whole. Other businesses can be big in the sense of making a high
percentage of all the sales in their industries, as Microsoft does with
sales of operating systems for personal computers around the world.
There are major economic differences between bigness in these two
senses. 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 fronn those in a market where one company enjoys a
monopoly, and such differences lead to different behavior with
different consequences for the economy as a whole. Markets
controlled by monopolies, oligopolies or cartels require a separate
analysis. But, before turning to such analysis, let us consider big
businesses in general, whether big absolutely or big relative to the
market for their industry's products. One of the general characteristics
of big businesses has already been noted in Chapter 6—economies of
scale and diseconomies of scale, which together determine the actual
scale of production of companies that are likely to survive and prosper
in a given industry. Another of the general characteristics of big
businesses is that they typically take the form of a corporation, rather
than being owned by a given individual, family, or partnership. The
reasons for this particular kind of organization and its consequences
require examination.

CORPORATIONS

Corporations are not all businesses. The first corporation in
America was the Harvard Corporation, formed in the seventeenth
century to govern America's first college. Corporations are different
from enterprises 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 organizations do
not happen to have enough money on hand to pay their 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
that the individual owners of the corporation are not personally liable
for its financial obligations. The corporation's legal liability is limited to
its own corporate assets—hence the abbreviation "Ltd." (for limited
liability) after the names of British corporations, serving the same
purpose as "Inc." (incorporated) after the names of American
corporations.

This limited liability is more than a convenient privilege for
corporate stockholders. It has major implications for the economy as a
whole. Huge companies, doing billions of dollars' worth of business
annually, can seldom be created or maintained by money from a few
rich investors. There are not nearly enough rich people for that to
happen, and even those who are rich would seldom risk their entire
fortune in one enterprise. Instead, gigantic corporations are usually
owned by thousands, or even millions, of stockholders. These include
not only people who directly own shares of corporate stocks, but also
many other people who may never think of themselves as
stockholders, but whose money paid into pension funds has been used
by those funds to purchase corporate stock. Directly or indirectly,
about half of the American population are investors in corporate
stocks.

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, Herbert Hoover organized a
philanthropic 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 growing 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.

The importance of limited liability to those particular individuals
creating or investing in corporations is obvious. But the limited
liability of stockholders is of even greater importance to the larger
society, including people who do not own any corporate stock nor
have any other affiliation with a corporation. What limited liability
does for the economy and for 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.

The economies of scale, and the lower prices which large
corporations can achieve as a result, and the correspondingly higher
standards of living resulting from these economies of scale, enable
vast numbers of consumers to be able to afford many goods and
services that could otherwise be beyond their financial means. In
short, the significance of the corporation in the economy at large
extends far beyond those people who own, manage, or work for
corporations.

What of creditors, who can collect the debts that corporations
owe them only to the extent of the corporation's own assets, and who

cannot recover any losses beyond that from those who own the
corporation? The "Ltd." or "Inc." after a corporation's name warns
creditors in advance, so that they can limit their lending accordingly
and charge interest rates adjusted to the risk.

Corporate Governance

Unlike other kinds of businesses, where those who own the
enterprise also manage it, a major corporation has far too many
stockholders for them to be able to direct its operations. Executives
are put in charge of corporate management, hired and if need be fired
by a board of directors who hold the ultimate authority in a
corporation. This arrangement applies beyond business enterprises.
Colleges and universities are usually also managed by administrators
who are hired and fired by a board of trustees, who hold the ultimate
legal authority but who do not manage day-to-day operations in the
classrooms or in academic administration.

Like limited liability, the separation of ownership and
management is a key characteristic of corporations. It is also a key
target of critics of corporations. Many have argued that a "separation
of ownership and control" permits corporate managements to run
these enterprises in their own interests, at the expense of the interests
of the stockholders. Certainly the massive and highly publicized
corporate scandals of the early twenty-first century confirm the
potential for fraud and abuse. However, since fraud and abuse have
also occurred in non-corporate enterprises, including both democratic
and totalitarian governments, as well as in the United Nations and in
non-profit charities, it is not clear whether the limited liability
corporation is any more prone to such things than other kinds of

organizations, or any less subject to the detection and punishment of
those who commit crimes.

Complaints about the separation of ownership and control often
overlook the fact that owners of a corporation's stock do not
necessarily want the time-consuming responsibilities that go with
control. Many people want the rewards of investing without the
headaches of managing. This is especially obvious in the case of large
stockholders, whose investments would be sufficient for them to start
their own businesses, if they wanted management responsibilities. The
corporate form enables those who simply want to invest their money,
without taking on the burdens of running a business, to have
institutions which permit them to do that, leaving the task of
monitoring the honesty of existing management to regulatory and
law enforcement institutions, and the monitoring of management
efficiency to the competition of the marketplace.

Outside investment specialists are always on the lookout for
companies whose management efficiency they expect to be able to
improve by buying enough stock to take over these corporations and
run them differently. This threat has been sufficiently felt by many
managements to get them to lobby state governments to pass laws
impeding this process. But these outside investors have both the
incentives and the expertise available to evaluate a corporation's
efficiency better than most of the rank-and-file stockholders can.

Complaints that corporations are "undemocratic" miss the point
that stockholders may not want them to be democratic and neither
may consumers, despite the efforts of people who call themselves
"consumer advocates" to promote laws that would force corporations
to cede management controls to either stockholders or to outsiders

who proclaim themselves representatives of the public interest. The
very reason for the existence of any business enterprise is that those
who run such enterprises know how to perform the functions
necessary to the organization's survival and well-being better than
outsiders with no financial stake—and with no expertise being
required for calling themselves "consumer advocates" or "public
interest" organizations. Significantly, attempts by various activists to
create greater stockholder input into such things as the compensation
of chief executive officers have been opposed by mutual funds holding
corporate stock.^^^'^* These mutual funds do not want their huge
investments in corporations jeopardized by people whose track
record, skills and agendas are unlikely to serve the purposes of
corporations.

The economic fate of a corporation, like that of other business
enterprises, is ultimately controlled by innumerable individual
consumers. But most consumers may be no more interested in taking
on management responsibility than stockholders are. Nor is it enough
that those consumers who don't want to be bothered don't have to be.
The very existence of enhanced powers for non-management
individuals to have a say in the running of a corporation would force
other consumers and stockholders to either take time to represent
their own views and interests in this process or risk having people with
other agendas over-ride their interests and interfere with the
management of the enterprise, without these outsiders having to pay
any price for being wrong.

Different countries have different laws regarding the legal rights
of corporate stockholders—and very different results. According to a
professor of law who has specialized in the study of business

organizations, writing in the Wall Street Journal:

American corporate law severely limits shareholders' rights. So does
Japanese, German and French corporate law. In contrast, the United
Kingdom seems a paradise for shareholders. In the U.K., shareholders can
call a meeting to remove the board of directors at any time. They can pass
resolutions telling boards to take certain actions, they are entitled to vote
on dividends and CEO pay, and they can force a board to accept a hostile
takeover bid the board would prefer to reject.^^^^*

How does the economic performance of British corporations
compare with that of corporations in other countries? According to
the British magazine The Economist, 13 of the world's 30 largest
corporations are American, 6 are Japanese, and 3 each are German and
French. Only one is British and another is half owned by Britons. Even a
small country like the Netherlands has a larger share of the world's
largest corporations.^^^^* Whatever the psychic benefits of stockholder
participation in corporate decisions in Britain, its track record of
business benefits is unimpressive.

Questions about the role of corporations, as such, are very
different from questions about what particular corporations do in
particular circumstances. The people who manage corporations run
the gamut, from the wisest to the most foolish and from the most
honest to the most dishonest, as do people in other institutions and
activities—including people who choose to call themselves "consumer
advocates" or members of "public interest" organizations or advocates
of "shareholder democracy."

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 20^0P''^ While that 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.

Some critics have claimed that corporate executives, and
especially chief executive officers (CEOs), have been overly generously
rewarded by boards of directors carelessly spending the stockholders'
money. However, this belief can be tested by comparing the pay of
CEOs of public corporations, owned by many stockholders, with the
pay of CEOs of corporations owned by a small number of large
financial institutions. In the latter case, financiers with their own
money at stake set the salaries of CEOs—and it is precisely these kinds
of corporations which set the highest salaries for CEOs.^^^®* Since it is
their own money, financiers have no incentive to over-pay, but neither
do they have any reason to be penny-wise and pound-foolish when
hiring someone to manage a corporation in which they have billions
of dollars at stake. Nor do they need to fear the adverse reactions of
numerous stockholders who may be susceptible to complaints in the
media that corporate executives are paid too much.

What has provoked special outcries are the severance packages in
the millions of dollars for executives who are let go because of their
own failures. However, no one finds it strange that some divorces cost
much more than the original wedding cost or that one spouse or the
other can end up being rewarded for being impossible to live with. In
the corporate world, it is especially important to end a relationship
quickly, even at a cost of millions of dollars for a "golden parachute,"
because keeping a failing CEO on can cost a company billions through
the bad decisions that the CEO can continue to make. Delays over the

firing of a CEO, whether these are delays within the company or within
the courts, can easily cost far more than the golden parachute.

MONOPOLIES AND CARTELS

Although much of the discussion in previous chapters has been
about the way free competitive markets function, competitive free
markets are not the only kinds of markets, nor are government-
imposed price controls or central planning the only interferences 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 literally one seller. However, a small number
of sellers—an "oligopoly," as economists call it—may cooperate with
one another, either explicitly or tacitly, in setting prices and so produce
results similar to those of a monopoly. Where there is a formal
organization in an industry to set prices and output—a cartel—its
results can also be somewhat like those of a monopoly, even though
there may be numerous sellers in the cartel. 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,
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. For many years, each local
telephone company in the United States was a monopoly in its region
of the country and that remains true in some other countries. For
about half a century before World War II, the Aluminum Company of
America (Alcoa) produced all the virgin ingot aluminum in the United
States. Such situations are unusual, but they are important enough to
deserve some serious attention.

Most big businesses are not monopolies and not all monopolies
are big business. In the days before the automobile and the railroad, a
general store in an isolated rural community could easily be the only
store for miles around, and was as much of a monopoly as any
corporation on the Fortune 500 list, even though the general store was
usually an enterprise of very modest size. Conversely, today even
multi-billion-dollar nationwide grocery chains like Safeway or Kroger
have too many competitors to be able to set prices on the goods they
sell the way a monopolist would set prices on those goods.

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 competition 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 it and distributing it, including a return on
investment sufficient to keep those investments being made? After all,
most people do not grow apples, much less process them into Juice
and then bottle the Juice, transport and store it, so they have no idea
how much any or all of this costs. Competition in the marketplace
makes it unnecessary to know. Those few people who do know such
things, and who are in the business of making investments, have every
incentive to invest wherever 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 competition 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.

Only then will the in-flow of investments from other sectors of the
economy stop, with the incentives for these in-flows now being gone.
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
monopolist 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 object to the fact that a monopolist can charge
higher prices than a competitive business could. But the ability to
transfer money from other members of the society to itself is not the
sole harm done by a monopoly. From the standpoint of the economy
as a whole, these internal transfers do not change the total wealth of
the society, even though such transfers redistribute wealth in a
manner that may be considered objectionable. What adversely affects
the total wealth in the economy as a whole is the effect of a monopoly
on the allocation of scarce resources which have alternative uses.

When a monopoly charges a higher price than it could charge if it
had competition, consumers tend to buy less of the product than they
would at a lower competitive price. In short, a monopolist produces
less output than a competitive industry would produce with the same
available resources, technology and cost conditions. The monopolist
stops short at a point where consumers are still willing to pay enough
to cover the cost of production (including a normal rate of profit) of
more output.

In terms of the allocation of resources which have alternative
uses, the net result is that some resources which could have been used
to produce more apple Juice instead go 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 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 the monopolistic 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 competition caused by that flood of
investment. It is like water seeking its own level. But, just as dams can
prevent water from finding its own level, so government intervention
can prevent a monopoly's profit rate from being reduced by
competition.

In centuries past, government permission was required to open
businesses in many parts of the economy, especially in Europe and
Asia, and monopoly rights were granted to various business owners,
who either paid the government directly for these rights or bribed
officials who had the power to grant such rights, or both. However, by
the end of the eighteenth century, the development of economics had
reached the point where increasingly large numbers of people
understood how this was detrimental to society as a whole and
counter-pressures developed toward freeing the economy from
monopolies and government control. Monopolies have therefore
become much rarer, at least at the national level, though restrictions
on competition remain common in many cities where restrictive
licensing laws limit how many taxis are allowed to operate, causing
fares to be artificially higher than necessary and cabs less available
than they would be in a free market.

Again, the loss is not simply that of the individual consumers. The
economy as a whole loses when people who are perfectly willing to
drive taxis at fares that consumers are willing to pay are nevertheless
prevented from doing so by artificial restrictions on the number of taxi
licenses issued, and thus either do some other work of lesser value or

remain unemployed. If the alternative work were of greater value, and
were compensated accordingly, then such people would never have
been potential taxi drivers in the first place.

From the standpoint of the economy as a whole, monopolistic
pricing means that consumers of a monopolist's product are foregoing
the use of scarce resources which would have a higher value to them
than in alternative uses. That is the inefficiency which causes the
economy as a whole to have less wealth under monopoly than it
would have under free competition. It is sometimes said that a
monopolist "restricts output," but this is not the intent, nor is the
monopolist the one who restricts output. The monopolist would love
to have the consumers buy more at its inflated price, but the
consumers stop short of the amount that they would buy at a lower
price under free competition. It is the monopolist's higher price which
causes the consumers to restrict their own purchases and therefore
causes the monopolist to restrict production to what can be sold. But
the monopolist may be advertising heavily to try to persuade
consumers to buy more.

Similar principles apply to a cartel—that is, a group of businesses
which agree among themselves to charge higher prices or otherwise
avoid competing with one another. In theory, a cartel could operate
collectively the same as a monopoly. In practice, however, individual
members of cartels tend to cheat on one another secretly—lowering
the cartel price to some customers, in order to take business away
from other members of the cartel. When this practice becomes
widespread, the cartel becomes irrelevant, whether or not it formally
ceases to exist.

When railroads were formed in the nineteenth century, they often

had competing lines between major cities, such as Chicago and New
York. These were called "trunk lines," as distinguished from "branch
lines" leading from the trunk lines to smaller communities that might
be served by only one railroad each. This led to monopoly prices on the
branch lines and prices so competitive on the trunk lines that the cost
of shipping freight a long distance on a trunk line was often cheaper
than shipping it a shorter distance on a branch line. More important,
from the railroads' point of view, the trunk line prices were so low as to
Jeopardize profits. In order to deal with this problem, the railroads got
together to form a cartel:

These cartels kept breaking down... The cost of sending a train from here
to there is largely independent of how much freight it carries. Therefore,
above a break-even point, each additional ton of freight yields nearly
pure profit. Sooner or later, the temptation to offer secret rebates to
shippers in order to capture this profitable-at-any-price traffic would
become irresistible. Once the secret rebates started, price wars soon
followed and the cartel would collapse.^^^^*

For very similar reasons, the steamboat companies had
attempted to form a cartel before the railroads did—and for similar
reasons those cartels collapsed, as many other cartels have since then.
A successful cartel requires not only an agreement among the
companies involved but also some method by which they can check
up on each other, to make sure all the cartel members are living up to
the agreement, and also some way to prevent competition from other
companies outside the cartel. All these things are easier said than
done. One of the most successful cartels, that in the American steel
industry, was based on a pricing system that made it easy for the
companies to check up on one another,^’"'''''* but that system was

eventually outlawed by the courts under the anti-trust laws.

Governmental and Market Responses

Because some kinds of huge business organizations were once
known as "trusts," legislation designed to outlaw monopolies and
cartels became known as "anti-trust laws." However, such laws are not
the only way of fighting monopolies and cartels. Private businesses
that are not part of the cartel have incentives to fight them in the
marketplace. Moreover, private businesses can take action much faster
than the years required for the government to bring a major anti-trust
case to a successful conclusion.

Back in the heyday of American trusts, Montgomery Ward was
one of their biggest opponents. Whether the trust involved
agricultural machinery, bicycles, sugar, nails or twine, Montgomery
Ward would seek out manufacturers that were not part of the trust
and buy from them below the cartel price, reselling to the general
public below the retail price of the goods produced by members of the
cartel. Since Montgomery Ward was the number one retailer in the
country at that time, it was also big enough to set up its own factories
and make the product itself, if need be. The later rise of other huge
retailers like Sears and the A & P grocery chain likewise confronted the
big producers with corporate giants able to either produce their own
competing products to sell in their own stores or able to buy enough
from some small enterprise outside the cartel, enabling that
enterprise to grow into a big competitor.

Sears did both. It produced stoves, shoes, guns, and wallpaper,
among other things, in addition to subcontracting the production of
other products. A & P imported and roasted its own coffee, canned its

own salmon, and baked half a billion loaves of bread a year for sale in
its storesj^"^”* While giant firms like Sears, Montgomery Ward and A & P
were unique in being able to compete against a number of cartels
simultaneously, smaller companies could also take away sales from
cartels in their respective industries. Their incentive was the same as
that of the cartel—profit. Where a monopoly or cartel maintains prices
that produce higher than normal profits, other businesses are
attracted to the industry. This additional competition then tends to
force prices and profits down. In order for a monopoly or cartel to
continue to succeed in maintaining profits above the competitive
level, it must find ways to prevent others from entering the industry.

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.

For much of the late twentieth century, the government of India
not only decided which companies it would license to produce which
products, it imposed limits on how much each company could
produce. Thus an Indian manufacturer of scooters was hauled before a
government commission because he had produced more scooters
than he was allowed to and a producer of medicine for colds was
fearful that the public had bought "too much" of his product during a
flu epidemic in India. Lawyers for the cold medicine manufacturer

spent nnonths preparing a legal defense for having produced and sold
more than they were allowed to, in case they were called before the
same commissionj^"^^’ All this costly legal work had to be paid for by
someone and that someone was ultimately the consumer.

In the absence of government prohibition against entry into
particular industries, various clever schemes can be used privately to
try to erect barriers to keep out competitors and protect monopoly
profits. But other businesses have incentives to be just as clever at
circumventing these barriers. Accordingly, the effectiveness of barriers
to entry has varied from industry to industry and from one era to
another in the same industry. The computer industry was once difficult
to enter, back in the days when a computer was a huge machine taking
up thousands of cubic feet of space, and the cost of manufacturing
such machines was likewise huge. But the development of microchips
meant that smaller computers could do the same work and chips were
now inexpensive enough to produce that they could be manufactured
by smaller companies. These include companies located around the
world, so that even a nationwide monopoly does not preclude
competition in an industry. Although the United States pioneered in
the creation of computers, the actual manufacturing of computers
spread quickly to East Asia, which supplied much of the American
market with computers, even when those computers carried American
brand names.

Chapters

REGULATION AND
ANTI-TRUST LAWS

Competition is not easily suppressed even when there
are only a few independent firms... competition is a
tough weed, not a delicate flower.

George J. Stigler^^"^^^

In the late nineteenth century, the American government began
to respond to monopolies and cartels by both directly regulating the
prices which monopolies and cartels were allowed to charge and by
taking punitive legal action against these monopolies and cartels
under the Sherman Anti-Trust Act of 1890 and other later anti-trust
legislation. Complaints about the high prices charged by railroads in
places where they had a monopoly led to the creation of the Interstate
Commerce Commission in 1887, the first of many federal regulatory
commissions created to control the prices charged by monopolists.

During the era when local telephone companies were
monopolies in their respective regions and their parent company—

the American Telephone and Telegraph Company—had a monopoly of
long-distance service, the Federal Communications Commission
controlled the prices charged by A.T.&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 against various practices, such as price discrimination,
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 task is far more complex and,
in some respects, impossible. Moreover, the political climate in which
regulatory commissions operate often leads to policies and results
directly the opposite of what was expected by those who created such
commissions.

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. Only the actual
functioning of a market itself could reveal such prices, with the less
efficient firms being eliminated by bankruptcy and only the most
efficient surviving, and their lower prices now being the market prices.

No outside observers can know what the most efficient ways of
operating a given firm or industry are. Indeed, many managements
within an industry discover the hard way that what they thought was
the most efficient way to do things was not efficient enough to meet
the competition, and have ended up losing customers as a result. The
most that a regulatory agency can do is accept what appear 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.
As noted in Chapter 6, there may be no such thing as "the" cost of
production. The cost of generating electricity, for example, can vary
enormously, depending on when and where it is generated. When you
wake up in the middle of the night and turn on a light, that electricity
costs practically nothing to supply, because the electricity-generating
system must be kept operating around the clock, so it has much
unused capacity in the middle of the night, when most people are
asleep. But, when you turn on your air conditioner on a hot summer
afternoon, when millions of other homes and offices already have
their air conditioners on, that may help strain the system to its limit
and necessitate turning on costly standby generators, in order to avoid
blackouts.

It has been estimated that the cost of supplying the electricity
required to run a dishwasher, for example, at a time of peak electricity
usage, can be 100 times greater than the cost of running that same
dishwasher at a time when there is a low demand for electricity.^^"^^’
Turning on your dishwasher in the middle of the night, like turning on
a light in the middle of the night, costs the electricity-generating
system practically nothing, since the electricity has to be generated

around the clock in any case.

There are many reasons why additional electricity, beyond the
usual capacity of the system, may be many times more costly per
kilowatt hour than the usual costs when the system is functioning
within its usual capacity. The main system that supplies vast numbers
of consumers can make use of economies of scale to produce
electricity at its lowest cost, while standby generators typically
produce less electricity and therefore cannot take full advantage of
economies of scale, but must produce at higher costs per kilowatt
hour. Sometimes technological progress gives the main system lower
costs, while obsolete equipment is kept as standby equipment, rather
than being junked, and the costs of producing additional electricity
with this obsolete equipment is of course higher. Where additional
electricity has to be purchased from outside sources when the local
generating capacity is at its limit, the additional cost of transmitting
that electricity from greater distances raises the cost of the additional
electricity to much higher levels than the cost of electricity generated
closer to the consumers.

More variations in "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 all these fuels are used for other
things besides generating electricity, the fluctuating demand for these
fuels from other industries, or for use in homes or automobiles, makes
their prices unpredictable. Hydroelectric dams likewise vary in how
much electricity they can produce when rainfall varies, increasing or
reducing the amount of water that flows through the generators.
When the fixed costs of the dam are spread over differing amounts of
electricity, the cost per kilowatt hour varies accordingly.

How is a regulatory commission to set the rates to be charged
consumers of electricity, given that the cost of generating electricity
can vary so widely and unpredictably? If state regulatory commissions
set electricity rates based on "average" costs of generating electricity,
then when there is a higher demand or a shorter supply within the
state, out-of-state suppliers may be unwilling to sell electricity at
prices lower than their own costs of generating the additional
electricity from standby units. This was part of the reason for the
much-publicized blackouts in California in 2001. "Average" costs are
irrelevant when the costs of generation are far above average at a
particular time or far below average at other times.

Because the public is unlikely to be familiar with all the economic
complications involved, they are likely to be outraged at having to pay
electricity rates far higher than they are used to. In turn, this means
that politicians are tempted to step in and impose price controls based
on the old rates. And, as already noted in other contexts, price controls
create shortages— in this case, shortages of electricity that result in
blackouts. A larger quantity demanded and a smaller quantity
supplied has been a very familiar response to price controls, going
back in history long before electricity came into use. However,
politicians' success does not depend on their learning the lessons of
history or of economics. It depends far more on their going along with
what is widely believed by the public and the media, which may
include conspiracy theories or belief that higher prices are due to
"greed" or "gouging."

Halfway around the world, attempts to raise electricity rates in
India were met by street demonstrations, as they were in California. In
the Indian state of Karnataka, controlled politically by India's Congress

Party at the time, efforts to change electricity rates were opposed in
the streets by one of the opposition parties. However, in the
neighboring state of Andhra Pradesh, where the Congress Party was in
the opposition, it led similar street demonstrations against electricity
rate increases.^^"^"^’ In short, what was involved in these demonstrations
was neither ideology nor party but an opportunistic playing to the
gallery of public misconceptions.

The economic complexities involved when regulatory agencies
set prices are compounded by political complexities. Regulatory
agencies are often set up after some political crusaders have
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
powers 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 a keen interest in the activities of the
commission and to lobby the government for favorable regulations
and favorable appointments of individuals to these commissions.

The net result of these asymmetrical outside interests on these
agencies is that commissions set up to keep a given firm or industry
within bounds, for the benefit of the consumers, often metamorphose
into agencies seeking to protect the existing regulated firms from
threats arising from new firms with new technology or new
organizational methods. Thus, in the United States, the Interstate
Commerce Commission— initially created to keep railroads from
charging monopoly prices to the public— responded to the rise of the

trucking industry, whose competition in carrying freight threatened
the economic viability of the railroads, by extending the commission's
control to include trucking.

The original rationale for regulating railroads was that these
railroads were often monopolies in particular areas of the country,
where there was only one rail line. But now that trucking undermined
that monopoly, by being able to go wherever there were roads, the
response of the I.C.C. was not to say that the need for regulating
transportation was now less urgent or perhaps even unnecessary.
Instead, it sought— and received from Congress— broader authority
under the Motor Carrier Act of 1935, in order to restrict the activities of
truckers. This allowed railroads to survive under the new economic
conditions, despite truck competition that was more efficient for
various kinds of freight hauling and could therefore often charge
lower prices than the railroads charged. Trucks were now permitted to
operate across state lines only if they had a certificate from the
Interstate Commerce Commission declaring that the trucks' activities
served "public convenience and necessity" as defined by the I.C.C. This
kept truckers from driving railroads into bankruptcy by taking away as
many of their customers as they could have in an unregulated market.

In short, freight was no longer being hauled in whatever way
required the use of the least resources, as it would be under open
competition, but only by whatever way met the arbitrary
requirements of the Interstate Commerce Commission. The I.C.C.
might, for example, authorize a particular trucking company to haul
freight from New York to Washington, but not from Philadelphia to
Baltimore, even though these cities are on the way. If the certificate
did not authorize freight to be carried back from Washington to New

York, then the trucks would have to return empty, while other trucks
carried freight from D.C. to New York.

From the standpoint of the economy as a whole, enormously
greater costs were incurred than were necessary to get the work done.
But what this arrangement accomplished politically was to allow far
more companies— both truckers and railroads— to survive and make
a profit than if there were an unrestricted competitive market, where
the transportation companies would have no choice but to use the
most efficient ways of hauling freight, even if lower costs and lower
prices led to the bankruptcy of some railroads whose costs were too
high to survive in competition with trucks. The use of more resources
than necessary entailed the survival of more companies than were
necessary.

While open and unfettered competition would have been
economically beneficial to the society as a whole, such competition
would have been politically threatening to the regulatory commission.
Firms facing economic extinction because of competition would be
sure to resort to political agitation and intrigue against the survival in
office of the commissioners and against the survival of the
commission and its powers. Labor unions also had a vested interest in
keeping the status quo safe from the competition of technologies and
methods that might require fewer workers to get the job done.

After the I.C.C.'s powers to control the trucking industry were
eventually reduced by Congress in 1980, freight charges declined
substantially and customers reported a rise in the quality of the
service.^^"^^* This was made possible by greater efficiency in the industry,
as there were now fewer trucks driving around empty and more
truckers hired workers whose pay was determined by supply and

demand, rather than by union contracts. Because truck deliveries were
now more dependable in a competitive industry, businesses using
their services were able to carry smaller inventories, saving in the
aggregate tens of billions of dollars.

The inefficiencies created by regulation were indicated not only
by such savings after federal deregulation, but also by the difference
between the costs of interstate shipments and the costs of intrastate
shipments, where strict state regulation continued after federal
regulation was cut back. For example, shipping blue jeans within the
state of Texas from El Paso to Dallas cost about 40 percent more than
shipping the samejeans internationally from Taiwan to Dallas.^^"^^*

Gross inefficiencies under regulation were not peculiar to the
Interstate Commerce Commission. The same was true of the Civil
Aeronautics Board, which kept out potentially competitive airlines and
kept the prices of air fares 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, some airlines went bankrupt, but new airlines arose and 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 the billions of dollars.^^"^^’

These were not Just zero-sum changes, with airlines losing what
passengers gained. The country as a whole benefitted from
deregulation, for the industry became more efficient. Just as there
were fewer trucks driving around empty after trucking deregulation,
so airplanes began to fly with a higher percentage of their seats filled
with passengers after airline deregulation, and passengers usually had

more choices of carriers on a given route than before. Much the same
thing happened after European airlines were deregulated in 1997, as
competition from new discount airlines like Ryanair forced British
Airways, Air France and Lufthansa to lower their fares.^^"^®’

In these and other industries, the original rationale for regulation
was to keep prices from rising excessively but, over the years, this
turned into regulatory restrictions against letting prices fall to a level
that would threaten the survival of existing firms. Political crusades
are based on plausible rationales but, even when those rationales are
sincerely believed and honestly applied, their actual consequences
may be completely different from their initial goals. People make
mistakes in all fields of human endeavor but, when major mistakes are
made in a competitive economy, those who were mistaken can be
forced from the marketplace by the losses that follow. In politics,
however, those regulatory agencies often continue to survive, after
the initial rationale for their existence is gone, by doing things that
were never contemplated when their bureaucracies and their powers
were created

ANTI-TRUST LAWS

With anti-trust laws, as with regulatory commissions, a sharp
distinction must be made between their original rationales and what
they actually 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 and competitive marketplace.

In practice, nnost of the fannous anti-trust cases in the United States
have involved some business that charged lower prices than its
competitors. Often it has been complaints from these competitors
which caused the government to act.

Competition versus Competitors

The basis of many government prosecutions under the anti-trust
laws is that some company's 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.

Obviously, if it eliminates all competitors, then the surviving firm
would be a monopoly, at least until new competitors arise, and could
in the interim charge far higher prices than in a competitive market.
But that is extremely rare. However, the specter of monopoly is often
used to justify government policies of intervention where there is no
serious danger of a monopoly. For example, back when the A & P
grocery chain was the largest retail chain in the world, more than four-
fifths of all the groceries in the United States were sold by other
grocery stores. Yet the Justice Department brought an anti-trust
action against A & P, using the company's low prices, and the methods
by which it achieved those low prices, as evidence of "unfair"
competition against rival grocers and rival grocery chains.

Throughout the history of anti-trust prosecutions, there has been

an unresolved confusion between what is detrimental to competition
and what is detrimental to competitors. In the midst of this confusion,
the question of what is beneficial to the consumer has often been lost
sight of.

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
at the benefits to the consuming public. For example, fewer scarce
resources are used when products are bought and sold in carload lots,
as large chain stores are often able to do, than when the shipments are
sold and delivered in much smaller individual quantities to numerous
smaller stores. Both delivery costs and selling costs are less per unit of
product when the product is bought and sold in large enough
amounts to fill a railroad boxcar. The same principle applies when a
huge truck delivers a vast amount of merchandise to a Wal-Mart
Supercenter, as compared to delivering the same total amount of
merchandise to numerous smaller stores scattered over a wider area.

Production costs are also lower when the producer receives a
large enough order to be able to schedule production far ahead,
instead of finding it necessary to pay overtime to fill many small and
unexpected orders that happen to arrive at the same time.

Unpredictable orders also increase the likelihood of slow periods
when there is not enough work to keep all the workers employed.
Workers who have to be laid off at such times may find other jobs, and
not all of them may return when the first employer has more orders to
fill, thus making it necessary for that employer to hire new workers,
which entails training costs and lower productivity until the new
workers gain enough experience to reach peak efficiency. Moreover,
employers unable to offer steady employment may find recruiting

workers to be more difficult, unless they offer higher pay to offset the
uncertainties of the job.

In all these ways, production costs are higher when there are
unpredictable orders than when a large purchaser, such as a major
department store chain, can contract for a large amount of the
supplier's output over a considerable span of time, enabling cost
savings to be made in production, part of which go to the chain in
lower prices as well as to the producer as lower production costs that
leave more profit. Yet this process has long been represented as big
chain stores using their "power" to "force" suppliers to sell to them for
less. For example, a report in the San Francisco Chronicle said:

For decades, big-box retailers such as Target and Wal-Mart Stores have
used their extraordinary size to squeeze lower prices from suppliers,
which have a vested interest in keeping them happyJ^'^^*

But what is represented as a "squeeze" on suppliers for the sole
benefit of a retail chain with "power" is in fact a reduction in the use of
scarce resources, benefitting the economy by freeing some of those
resources for use elsewhere. Moreover, despite the use of the word
"power," chain stores have no ability to reduce the options otherwise
available to the producers. A producer of towels or toothpaste has
innumerable alternative buyers and was under no compulsion to sell
to A & P in the past or to Target or Wal-Mart today. Only if the
economies of scale make it profitable to supply a large buyer with
towels or toothpaste (or other products) will the supplier find it
advantageous to cut the price below what would otherwise be
charged. All economic transactions involve mutual accommodation
and each transactor has to make the deal a net benefit to the other

transactor, in order to have a deal at all.

Despite economies of scale, the government has repeatedly taken
anti-trust action against various companies that gave quantity
discounts that the authorities did not like or understand. There was,
for example, a well-known anti-trust action against the Morton Salt
Company in the 1940s for giving discounts to buyers who bought
carload lots of their product. Businesses that bought less than a
carload lot of salt were charged $1.60 a case, those who bought
carload lots were charged $1.50 a case, and those who bought 50,000
cases or more in a year's time were charged $1.35. Because there were
relatively few companies that could afford to buy so much salt and
many more that could not, "the competitive opportunities of certain
merchants were injured," according to the Supreme Court, which
upheld the Federal Trade Commission's actions against Morton Salt.^^^°’

The government likewise took action against the Standard Oil
Company in the 1950s for allowing discounts to those dealers who
bought oil by the tank car.^^^^* The Borden Company was similarly
brought into court in the 1960s for having charged less for milk to big
chain stores than to smaller grocers.^^^^’ In all these cases, the key point
was that such price differences were considered "discriminatory" and
"unfair" to those competing firms unable to make such large
purchases.

While the sellers were allowed to defend themselves in court by
referring to cost differences in selling to different classes of buyers, the
apparently simple concept of "cost" is by no means simple when
argued over by rival lawyers, accountants and economists. Where
neither side could prove anything conclusively about the costs—
which was common— the accused lost the case. In a fundamental

departure from the centuries-old traditions of Anglo-American law,
the government need only make a superficial or prima facie case,
based on gross numbers, to shift the burden of proof to the accused.
This same principle and procedure were to reappear, years later, in
employment discrimination cases under the civil rights laws. As with
anti-trust cases, these employment discrimination cases likewise
produced many consent decrees and large out-of-court settlements by
companies well aware of the virtual impossibility of proving their
innocence, regardless of what the facts might be.

The emphasis on protecting competitors, in the name of
protecting competition, takes many forms and has appeared in other
countries besides the United States. A European anti-trust case against
Microsoft was based on the idea that Microsoft had a duty to
accommodate competitors who might want to attach their software
products to the Microsoft operating system. Moreover, the rationale of
the European decision was defended in a New York Times editorial:

Microsoft's resounding defeat in a European antitrust case establishes
welcome principles that should be adopted in the United States as
guideposts for the future development of the information economy.

The court agreed with European regulators that Microsoft had abused
its operating system monopoly by incorporating its Media Player, which
plays music and films, into Windows. That shut out rivals, like RealPlayer.
The decision sets a sound precedent that companies may not leverage
their dominance in one market (the operating system) to extend it into
new ones (the player).

The court also agreed that Microsoft should provide rival software
companies the information they need to make their products work with
Microsoft's server software.^^^^*

The New York Times editorial seemed surprised that others saw
the principle involved in this anti-trust decision as "a mortal blow

against capitalism itself."^^^"^* But when free competition in the
marketplace is replaced by third-party intervention to force
companies to facilitate their competitors' efforts, it is hard to see that
as fostering competition, as distinguished from protecting
competitors.

The confusion between the two things is long standing. Back
when Kodachrome was the leading color film in the world, it was also
what was aptly called "the most complicated film there is to
process."^^^^’ Since Eastman Kodak had a huge stake in maintaining the
reputation of Kodachrome, it sought to protect that reputation by
processing all Kodachrome itself, so it sold the processing and the film
together, rather than risk having other processors turn out
substandard results that could be seen by consumers as deficiencies of
the film. Yet an anti-trust lawsuit forced Kodak to sell the processing
and the film separately, in order not to foreclose that market to other
film processors. The fact that all other Kodak films were sold without
processing included might suggest that Kodak was not out to
foreclose the processing market but to protect the quality and
reputation of one particular film that was especially difficult to
process. Yet the focus on protecting competitors prevailed in the
courts.

"Control" of the Market

The rarity of genuine monopolies in the American economy has
led to much legalistic creativity, in order to define various companies
as monopolistic or as potential or "incipient" monopolies. How far this
could go was illustrated when the Supreme Court in 1962 broke up a
merger between two shoe companies that would have given the new

combined company less than 7 percent of the shoe sales in the United
StatesJ^^^’ The court likewise in 1966 broke up a merger of two local
supermarket chains which, put together, sold less than 8 percent of the
groceries in the Los Angeles areaJ^^^* Similarly arbitrary categorizations
of businesses as "monopolies" were imposed in India under the
Monopolies and Restrictive Trade Practices Act of 1969, where any
enterprises with assets in excess of a given amount (about $27 million)
were declared to be monopolies and restricted from expanding their
bus! ness

A standard practice in American courts and in the literature on
anti-trust laws is to describe the percentage of sales made by a given
company as the share of the market which 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 passage of time showed that they controlled nothing, or else
they would never have allowed themselves to be forced out of
business. The severe shrinkage in size of such former giants as A & P
likewise suggests that the rhetoric of "control" bears little relationship
to reality. But such rhetoric remains effective in courts of law and in
the court of public opinion.

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. During the decades when the Aluminum Company of America
(Alcoa) was the only producer of virgin ingot aluminum in the United
States, its annual profit rate on its investment was about 10 percent
after taxes. Moreover, the price of aluminum went down over the years
to a fraction of what it had been before Alcoa was formed. Yet Alcoa

was prosecuted under the anti-trust laws and convictedj^^^*

Why were aluminum prices going down under a monopoly, when
in theory they should have been going up? Despite its "control" of the
market for aluminum, Alcoa was well aware that it could not jack up
prices at will, without risking the substitution of other materials—
steel, tin, wood, plastics— for aluminum by many users. Technological
progress lowered the costs of producing all these materials and
economic competition forced the competing firms to lower their
prices accordingly.

This raises a question which applies far beyond the aluminum
industry. 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 serve as a substitute, as
television did when it replaced many newspapers as sources 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.
Phones and cameras would be classified as being in separate
industries when calculating what percentage of the market was
"controlled" by Kodak, but the economic reality said otherwise.

In Spain, when high-speed trains began operating between
Madrid and Seville, the division of passenger traffic between rail and
air travel went from 33 percent rail and 67 percent air to 82 percent rail
and 18 percent air.^^“’ Clearly many people treated air and rail traffic as
substitute ways of traveling between these two cities. No matter how

high a percentage of the air traffic between Madrid and Seville might
be carried ("controlled") by one airline, and no matter how high a
percentage of the rail traffic might be carried by one railroad, each
would still face the competition of all air lines and all rail lines
operating between these cities.

Similarly, in earlier years, ocean liners carried a million passengers
across the Atlantic in 1954 while planes carried 600,000. But, eleven
years later, the ocean liners were carrying just 650,000 passengers
while planes now carried four million.^^^^* The fact that these were
technologically very different things did not mean that they could not
serve as economic substitutes. In twenty-first century Latin America,
airlines have even competed successfully with buses. According to the
Wall Street Journal:

The new low-cost carriers in Brazil, Mexico and Colombia are largely
avoiding competition with incumbent full-service airlines. Instead, they
are stimulating new traffic by adding cheap, no-frills flights to secondary
cities that, for many residents, had long required day-long bus rides.

Largely as a result, the number of airline passengers in these countries
has surged. The newfound mobility has opened up the flow of commerce
and drastically cut travel times in areas with poor roads, virtually no rail
service and stretches of harsh terrain.^^^^^

One low-cost airline offers flights into Mexico City for "about half
the price of the 14-hour overnight bus ride."^^^^’ In Brazil and Colombia
it is much the same story. In both these countries, new low-cost
airlines have reduced bus travel somewhat and greatly increased air
travel, as the total number of people traveling has grown. Planes and
buses are obviously very different technologically, but they can serve
the same purpose and compete against each other in the marketplace
— a crucial fact overlooked by those who compile data on how large a

share of the market some company "controls."

Those bringing anti-trust lawsuits generally seek to define the
relevant market narrowly, so as to produce high percentages of the
market "controlled" by the enterprise being prosecuted. In the famous
anti-trust case against Microsoft at the turn of the century, for
example, the market was defined as that for computer operating
systems for stand-alone personal computers using microchips of the
kind manufactured by Intel. This left out not only the operating
systems running Apple computers but also other operating systems
such as those produced by Sun Microsystems for multiple computers
or the Linux system for stand-alone computers.

In its narrowly defined market, Microsoft clearly had a "dominant"
share. The anti-trust lawsuit, however, did not accuse Microsoft of
jacking up prices unconscionably, in the classic manner of monopoly
theory. Rather, Microsoft had added an Internet browser to its
Windows operating system free of charge, undermining rival browser
producer Netscape.

The existence of all the various sources of potential competition
from outside the narrowly defined market may well have had
something to do with the fact that Microsoft did not raise prices, as it
could have gotten away with in the short run— but at the cost of
Jeopardizing its long-run sales and profits, since other operating
systems could have been substituted for Microsoft's system, if the
prices of these other operating systems were right. In 2003, the city
government of Munich in fact switched from using Microsoft Windows
in its 14,000 computers to using Linux^^^"^*— one of the systems
excluded from the definition of the market that Microsoft "controlled,"
but which was nevertheless obviously a substitute.

In 2013, the Departnnent of Justice filed an anti-trust 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 percent 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. More fundamentally, defining the relevant market as the beer
market ignored the fact that beer was Just one alcoholic beverage—
and "beer has been losing market share on this wider playing field for a
decade or more" to other alcoholic drinks, according to the Wall Street
Journal}^^^^

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. If
there is only one producer of widgets in Brazil, that producer is not a
monopoly in any economically meaningful sense if there are a dozen
widget manufacturers in neighboring Argentina and hundreds of
widget makers in countries around the world. Only if the Brazilian
government prevents widgets from being imported does the lone
manufacturer in the country become a monopoly in a sense that
would allow higher prices to be charged than would be charged in a
competitive market.

If it seems silly to arbitrarily define a market and "control" of that
market by a given firm's current sales of domestically produced
products, it was not too silly to form the basis of a landmark U.S.

Supreme Court decision in 1962, which defined the market for shoes in
terms of "domestic production of nonrubber shoes." By eliminating
sneakers, deck shoes, and imported shoes of all kinds, this definition
increased the defined market share of the firms being charged with
violating the anti-trust laws— who in this case were convicted.

Thus far, whether discussing widgets, shoes, or computer
operating systems, we have been considering markets defined by a
given product performing a given function. But often the same
function can be performed by technologically different products. Corn
and petroleum may not seem to be similar products belonging in the
same industry but producers of plastics can use the oil from either one
to manufacture goods made of plastic.

When petroleum prices soared in 2004, Cargill Dow's sales of a
resin made from corn oil rose 60 percent over the previous year, as
plastics manufacturers switched from the more expensive petroleum
oi|j 266 } vvhether or not two things are substitutes economically does
not depend on whether they look alike or are conventionally defined
as being in the same industry. No one considers corn as being in the
petroleum industry or considers either of these products when
calculating what percentage of the market is "controlled" by a given
producer of the other product. But that simply highlights the
inadequacy of "control" statistics.

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.

The fact that these other activities are functionally very different from
golf does not matter. In economic terms, when higher prices for A
cause people to buy more of B, then Aand B are substitutes, whether
or not they look alike or operate alike. But laws and government
policies seldom look at things this way, especially when defining how
much of a given market a given firm "controls."

Domestically, as well as internationally, as the area that can be
served by given producers expands, the degree of statistical
dominance or "control" by local producers in any given area means
less and less. For example, as the number of newspapers published in
given American communities declined substantially after the middle
of the twentieth century, with the rise of television, much concern was
expressed over the growing share of local markets "controlled" by the
surviving papers. In many communities, only one local newspaper
survived, making it a monopoly as defined by the share of the market
it "controlled." Yet the fact that newspapers published elsewhere
became available over wider and wider areas made such statistical
"control" less and less meaningful economically.

For example, someone living in the small community of Palo Alto,
California, 30 miles south of San Francisco, need not buy a Palo Alto
newspaper to find out what movies are playing in town, since that
information is readily available from the San Francisco Chronicle,
which is widely sold in Palo Alto, with home delivery being easy to
arrange. Still less does a Palo Alto resident have to rely on a local paper
for national or international news.

Technological advances have enabled the New York Times and
the Wall Street Journal to be printed in California as readily as in New
York, and at the same time, so that these became national

newspapers, available in communities large and small across America.
USA Today achieved the largest circulation in the country with no
local origin at all, being printed in numerous communities across the
country.

The net result of such widespread availability of newspapers
beyond the location of their headquarters has been that many local
"monopoly" newspapers had difficulties even surviving financially, in
competition with larger regional and national newspapers, much less
making any extra profits associated with monopoly. Yet anti-trust
policies based on market share statistics among locally headquartered
newspapers continued to impose restrictions on mergers of local
papers, lest such mergers leave the surviving newspapers with too
much "control" of their local market. But the market as defined by the
location of a newspaper's headquarters had become largely irrelevant
economically.

An extreme example of how misleading market share statistics
can be was the case of a local movie chain that showed 100 percent of
all the first-run movies in Las Vegas. It was prosecuted as a monopoly
but, by the time the case reached the 9th Circuit Court of Appeals,
another movie chain was showing more first-run movies in Las Vegas
than the "monopolist" that was being prosecuted. Fortunately, sanity
prevailed in this instance. Judge Alex Kozinski of the 9th Circuit Court
of Appeals pointed out that the key to monopoly is not market share—
even when it is 100 percent— but the ability to keep others out. A
company which cannot keep competitors out is not a monopoly, no
matter what percentage of the market it may have at a given moment.
That is why the Palo Alto Daily News is not a monopoly in any
economically meaningful sense, even though it is the only local daily

newspaper published in town.

Focusing on market shares at a given moment has also led to a
pattern in which the U. S. government has often prosecuted leading
firms in an industry just when they were about to lose that leadership.
In a world where it is common for particular companies to rise and fall
over time, anti-trust lawyers can take years to build a case against a
company that is at its peak— and about to head over the hill. A major
anti-trust case can take a decade or more to be brought to a final
conclusion. Markets often react much more quickly than that against
monopolies and cartels, as early twentieth century trusts found when
giant retailers like Sears, Montgomery Ward and A & P outflanked
them long before the government could make a legal case against
them.

"Predatory" Pricing

One of the remarkable theories which has become part of the
tradition of anti-trust law is "predatory pricing." According to this
theory, a big company that is out to eliminate its smaller competitors
and take over their 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 and 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. Perhaps even more
remarkable, they have not had to do so, even in courts of law, in anti¬
trust cases. Nobel Prizewinning economist Gary Becker has said: "I do
not know of any documented predatory-pricing case."^^^^*

Yet both the A & P grocery chain in the 1940s and the Microsoft
Corporation in the 1990s were accused of pursuing such a practice in
anti-trust cases, but without a single example of this process having
gone to completion. Instead, their current low prices (in the case of A &
P) and the inclusion of a free Internet browser in Windows software (in
the case of Microsoft) have been interpreted as directed toward that
end— though not with having actually achieved it.

Since it is impossible to prove a negative, the accused company
cannot disprove that it was pursuing such a goal, and the issue simply
becomes a question of whether those who hear the charge choose to
believe it.

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 problematical. Whether it
can do so and escape the anti-trust laws as well is even more
problematical— 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.

As an illustration of what can happen, back in 1933 the
Washington Post went bankrupt, though not because of predatory
pricing. In any event, this bankruptcy did not cause the printing
presses, the building, or the reporters to disappear. All were acquired
by publisher Eugene Meyer, at a price that was less than one-fifth of
what he had bid unsuccessfully for the same newspaper just four years
earlier. In the decades that followed, under new ownership and
management, the Washington Post grew to become the largest
newspaper in the nation's capital. By the early twenty-first century, the
Washington Post had one of the five largest circulations in the country.

Had some competitor driven the paper into bankruptcy by
predatory pricing back in 1933, that predatory competitor would have
accomplished nothing except to enable the Post to rise again, with
Eugene Meyer now having lower production costs than the previous
owner— and therefore being a more formidable competitor.

Bankruptcy can eliminate particular owners and managers, but it
does not eliminate competition in the form of new people, who can
either take over an existing bankrupt enterprise or start their own new
business from scratch in the same industry. Destroying a particular
competitor— or even all existing competitors— does not mean
destroying competition, which can take the form of new firms being

formed. In short "predatory pricing" can be an expensive venture, with
little prospect of recouping the losses by subsequent monopoly
profits. It can hardly be surprising that predatory pricing remains a
theory without concrete examples. What is surprising is how seriously
that unsubstantiated theory is taken in anti-trust cases.

Benefits and Costs of Anti-Trust Laws

Perhaps the most clearly 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 other anti-trust laws on competition in the
marketplace is another question.

The more stringent anti-monopoly laws in India produced many
clearly 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
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, produced fiber in Thailand from pulp bought in Canada and
sent this fiber to his factory in Indonesia for converting to yarn. He
then exported the yarn to Belgium, where it would be made into
carpets.^^^®*

It is impossible to know how many other Indian businesses
invested outside of India because of the restrictions against

"monopoly." What is known is that the repeal of the Monopolies and
Restrictive Trade Practices Act in 1991 was followed by an expansion of
large-scale enterprises in India, both by Indian entrepreneurs and by
foreign entrepreneurs who now found India a better place to establish
or expand businesses. What also increased dramatically was the
country's economic growth rate, reducing the number of people in
poverty and increasing the Indian government's ability to help them,
because tax revenues rose with the rising economic activity in the
country.

Although India's Monopolies and Restrictive Trade Practices Act
was intended to rein in big business, its actual effect was to cushion
businesses from the pressures of competition, domestic and
international— and the effect of that was to reduce incentives toward
efficiency. Looking back on that era, India's leading industrialist, Ratan
Tata of Tata Industries, said of his own huge conglomerate:

The group operated in a protected environment. The less-sensitive
companies didn't worry about their competition, didn't worry about their
costs and had not looked at newer technology. Many of them didn't even
look at market shares.^^^^*

In short, cushioned capitalism produced results similar to those
under socialism. When India's economy was later opened up to
competition, at home and abroad, it was a shock. Some of the
directors of Tata Steel "held their heads in their hands" when they
learned that the company now faced an annual loss of $26 million
because freight rates had gone up. In the past, they could simply have
raised the price of steel accordingly but now, with other steel
producers free to compete, local freight charges could not simply be
passed on in higher prices to the consumers, without risking bigger

losses through a loss of customers to global competitors. Tata Steel
had no choice but to either go out of business or change the way they
did business. According to Forbes magazine:

Tata Steel has spent $2.3 billion closing decrepit factories and
modernizing mines, collieries and steelworks as well as building a new
blast furnace.. .From 1993 to 2004 productivity skyrocketed from 78 tons
of steel per worker per year to 264 tons, thanks to plant upgrades and
fewer defects.^^^°*

By 2007, the Wall Street Journal was reporting that Tata Steel's
claim to be the world's lowest-cost producer of steel had been
confirmed by analysts.^^^^* But none of these adjustments would have
been necessary if this and other companies in India had continued to
be sheltered from competition under the guise of preventing
"monopoly." India's steel industry, like its automobile industry and its
watch industry, among others, were revolutionized by competition.

Chapter 9

MARKET AND

NON-MARKET ECONOMIES

In general, "the market" Is smarter than the smartest of Its Individual

participants.

Robert L Bartle/^^^^

Although business enterprises based on profit have become one
of the most common economic institutions in modern industrialized
nations, an understanding of how businesses operate internally and
how they fit into the larger economy and society is not nearly as
common. The prevalence of business enterprises in many economies
around the world has been so taken for granted that few people ask
the question why this particular way of providing the necessities and
amenities of life has come to prevail over alternative ways of carrying
out economic functions.

Among the many economically productive endeavors at various
times and places throughout history, capitalist businesses are just one.
Human beings lived for thousands of years without businesses. Tribes

hunted and fished together. During the centuries of feudalism, neither
serfs nor nobles were businessmen. Even in more recent centuries,
millions of families in America lived on self-sufficient farms, growing
their own food, building their own houses, and making their own
clothes. Even in more recent times, there have been cooperative
groups, such as the Israeli kibbutz, where people have voluntarily
supplied one another with goods and services, without money
changing hands. In the days of the Soviet Union, a whole 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 different from those
supplied by profit-seeking businesses, others supply similar or
overlapping goods and services.

Universities publish books and stage sports events that bring in
millions of dollars in gate receipts. National Geographic magazine is
published by a non-profit organization, as are other magazines
published by the Smithsonian Institution and a number of
independent, non-profit research institutions ("think tanks") such as
the Brookings Institution, the American Enterprise Institute and the
Hoover Institution. Some functions of a Department of Motor Vehicles,
such as renewing automobile licenses, are also handled by the

American Automobile Association, a non-profit organization, which
also arranges airline and cruise ship travel, like commercial travel
agencies.

In short, the activities engaged in by 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 the passage of time.

Municipal transit, for example, was once provided by private
profit-seeking businesses in the United States before many city
governments took over trolleys, buses, and subways. Activities have
also shifted the other way in more recent times, when such
governmental functions as garbage collection and prison
management have in some places shifted to private, profit-seeking
businesses, and such functions of non-profit colleges and universities
as running campus bookstores have been turned over to companies
like Follet or Barnes & Noble. Traditional non-profit academic
institutions have also been supplemented by the creation of profit-
seeking universities such as the University of Phoenix, which not only
has more students than any of the private non-profit academic
institutions but more students than even some whole state university
systems.

The simultaneous presence of a variety of organizations doing
similar or overlapping things provides opportunities for insights into
how different ways of organizing economic activities affect the
differing incentives and constraints facing decision-makers in these
organizations, and how that in turn affects the efficiency of their
activities and the way these enterprises affect the larger economy and

society.

Misconceptions of 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. This is not just a
conclusion of free market economists. In The Communist Manifesto,
Marx and Engels said of capitalist business, "The cheap prices of its
commodities are the heavy artillery with which it batters down all
Chinese walls."^^^^* That by no means spared business from criticism,
then or later.

Since there are few, if any, people who want to return to
feudalism or to the days of self-sufficient family farms, government

enterprises are the prinnary alternative to capitalist businesses today.
These government enterprises may be either isolated phenomena or
part of a comprehensive set of organizations based on government
ownership of the means of production, namely socialism. There have
been many theories about the merits or demerits of market versus
non-market ways of producing goods and services. But the actual
track record of market and non-market producers is the real issue.

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 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.

Thus, when a hurricane, flood, or other natural disaster strikes
some part of the United States, emergency aid usually comes both
from the Federal Emergency Management Agency (FEMA) and from
numerous private insurance companies, whose customers' homes and
property have been damaged or destroyed. FEMA has been
notoriously slower and less efficient than the private insurance
companies. One insurance company cannot afford to be slower in
getting money into the hands of its policy-holders than a rival

insurance company is in getting money to the people who hold its
policies. Not only would existing customers in the disaster area be
likely to switch insurance companies if one dragged its feet in getting
money to them, while their neighbors received substantial advances
from a different insurance company to tide them over, word of any
such difference would spread like wildfire across the country, causing
millions of people elsewhere to switch billions of dollars' worth of
insurance business from the less efficient company to the more
efficient one.

A government agency, however, faces no such pressure. No
matter how much FEMA may be criticized or ridiculed for its failures to
get aid to disaster victims in a timely fashion, there is no rival
government agency that these people can turn to for the same
service. Moreover, the people who run these agencies are paid
according to fixed salary schedules, not by how quickly or how well
they serve people hit by disaster. In rare cases where a government
monopoly is forced to compete with private enterprises doing the
same thing, the results are often like that of the government postal
service in India:

When Munnbai Region Postmaster General A.R Srivastava joined the
postal system 27 years ago, mailmen routinely hired extra laborers to
help carry bulging gunnysacks of letters they took all day to deliver.

Today, private-sector couriers such as FedEx Corp. and United Parcel
Service Inc. have grabbed more than half the delivery business
nationwide. That means this city's thousands of postmen finish their
rounds before lunch. Mr. Srivastava, who can't fire excess staffers, spends
much of his time cooking up new schemes to keep his workers busy. He's
ruled out selling onions at Mumbai post offices: too perishable. Instead,
he's considering marketing hair oil and shampoo.^^^^*

India Post, which carried 16 billion pieces of mail in 1999, carried
less than 8 billion pieces by 2005, after FedEx and UPS moved inj^^^’
The fact that competition means losers as well as winners may be
obvious but that does not mean that its implications are widely
understood and accepted. A New York Times reporter in 2010 found it
a "paradox" that a highly efficient German manufacturer of museum
display cases is "making life difficult" for manufacturers of similar
products in other countries. Other German manufacturers of other
products have likewise been very successful but "some of their success
comes at the expense of countries like Greece, Spain and Portugal." His
all too familiar conclusion: "The problem that policy makers are
wrestling with is how to correct the economic imbalances that
German competitiveness creates."^^^^*

In the United States, for decades a succession of low-price
retailers have been demonized for driving higher-cost competitors out
of business. The Robinson-Patman Act of 1936 was sometimes called
"the anti-Sears, Roebuck Act" and Congressman Patman also
denounced those who ran the A & P grocery chain. In the twenty-first
century, Wal-Mart has inherited the role of villain because it too makes
it harder for higher-cost competitors to survive. Where, as in India, the
higher-cost competitor is a government agency, the rigidities of its
rules—such as not being able to fire unneeded workers—make
adjustments even harder than they would be for a private enterprise
trying to survive in the face of new competition.

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

both Sears and Montgomery Ward were reluctant to begin operating
out of stores, after decades of great success selling exclusively from
their mail order catalogs. It was only when the 1920s brought
competition from chain stores that cut into their profits and caused
red ink to start appearing on the bottom line that they had no choice
but to become chain stores themselves. In 1920, Montgomery Ward
lost nearly $10 million and Sears was $44 million in debt^^^^*—all this in
dollars many times more valuable than today. Under socialism. Sears
and Montgomery Ward could have remained mail order retailers
indefinitely, and there would have been little incentive for the
government to pay to set up rival chain stores to complicate
everyone's life.

Socialist and capitalist economies differ not only in the quantity
of output they produce but also in the quality. Everything from cars
and cameras to restaurant service and airline service were of
notoriously low quality in the Soviet Union. Nor was this a
happenstance. The incentives are radically different when the
producer has to satisfy the consumer, in order to survive financially,
than when the test of survivability is carrying out production quotas
set by the government's central planners. The consumer in a market
economy is going to look not only at quantity but quality. But a central
planning commission is too overwhelmed with the millions of
products they oversee to be able to monitor much more than gross
output.

That this low quality is a result of incentives, rather than being
due to traits peculiar to Russians, is shown by the quality deterioration
that has taken place in the United States or in Western Europe when
free market prices have been replaced by rent control or by other

forms of price controls and government allocation. Both excellent
service and terrible service can occur in the same country, when there
are different incentives, as a salesman in India found:

Every time I ate in a roadside cafe or dhaba, my rice plate would arrive in
three minutes flat. If I wanted an extra roti, it would arrive in thirty
seconds. In a saree shop, the shopkeeper showed me a hundred sarees
even if I did not buy a single one. After I left, he would go through the
laborious and thankless job of folding back each saree, one at a time, and
placing it back on the shelf In contrast, when I went to buy a railway
ticket, pay my telephone bill, or withdraw money from my nationalized
bank, I was mistreated or regarded as a nuisance, and made to wait in a
long queue. The bazaar offered outstanding service because the
shopkeeper knew that his existence depended on his customer. If he was
courteous and offered quality products at a competitive price, his
customer rewarded him. If not, his customers deserted him for the shop
next door. There was no competition in the railways, telephones, or
banks, and their employees could never place the customer in the center.

{ 278 }

London's The Economist magazine likewise pointed out that in
India one can "watch the tellers in a state-owned bank chat amongst
themselves while the line of customers stretches on to the street."^^^^*
Comparisons of government-run institutions with privately-run
institutions often overlookthe fact that ownership and control are not
the only differences between them. Government-run institutions are
almost always monopolies, while privately-run institutions usually
have competitors. Competing government institutions performing
the same function are referred to negatively as "needless duplication."
Whether the frustrated customers waiting in line at a government-run
bank would consider an alternative bank to be needless duplication is
another question. Privatization helped provide an answer to that
question in India, as the Wall Street Journal reported:

The banking sector is still dominated by the giant State Bank of India but
the country's growing middle class is taking most of its business to the
high-tech private banks, such as HDFC Bank Ltd. and ICICI Bank Ltd.
leaving the state banks with the least-profitable businesses and worst
borrowers.^^®°*

While some privately owned businesses in various countries can
and do give poor service, or cut corners on quality in a free market,
they do so at the risk of their own survival. When the processed food
industry first began in nineteenth century America, it was common for
producers to adulterate food items with less expensive fillers.
Horseradish, for example, was often sold in colored bottles, to conceal
the adulteration. But when Henry J. Heinz began selling unadulterated
horseradish in clear bottles,^^®^’ this gave him a decisive advantage
over his competitors, who fell bythe wayside while the Heinz company
went on to become one of the enduring giants of American industry,
still in business in the twenty-first century and highly successful. When
the H.J. Heinz company was sold in 2013, the price was $23 billion.^^®^*
Similarly with the British food processing company Crosse &
Blackwell, which sold quality foods not only in Britain but in the United
States as well. It too remained one of the giants of the industry
throughout the twentieth century and into the twenty first. Perfection
is not found in either market or non-market economies, nor in any
other human endeavors, but market economies exact a price from
enterprises that disappoint their customers and reward those that
fulfill their obligations to the consuming public. The great financial
success stories in American industry have often involved companies
almost fanatical about maintaining the reputation of their products,
even when these products have been quite mundane and inexpensive.

McDonald's built its reputation on a standardized hamburger and
maintained quality by having its own inspectors make unannounced
visits to its meat suppliers, even in the middle of the night, to see what
was being put into the meat it was buyingj^®^’ Colonel Sanders was
notorious for showing up unexpectedly at Kentucky Fried Chicken
restaurants. If he didn't like the way the chickens were being cooked,
he would dump them all into a garbage can, put on an apron, and
proceed to cook some chickens himself, to demonstrate how he
wanted it done. His protege Dave Thomas later followed similar
practices when he created his own chain of Wendy's hamburger
restaurants. Although Colonel Sanders and Dave Thomas could not be
everywhere in a nationwide chain, no local franchise owner could take
a chance on seeing his profits being thrown into a garbage can by the
head honcho of the chain.

In the credit card era, protecting card users' identity from theft or
misuse has become part of the quality of a credit card service.
Accordingly, companies like Visa and MasterCard "have levied fines,
sent warning letters and held seminars to pressure restaurants into
being more careful about protecting the information" about card-
users, according to the Wall Street Journal, which added: "All
companies that accept plastic must follow a complex set of security
rules put in place by Visa, MasterCard, American Express Co. and
Morgan Stanley's Discover unit."^^®'^*

Behind all of this is the basic fact that a business is selling not only
a physical product, but also the reputation which surrounds that
product. Motorists traveling in an unfamiliar part of the country are
more likely to turn into a hamburger restaurant that has a McDonald's
or Wendy's sign on it than one which does not. That reputation

translates into dollars and cents—or, in this case, billions of dollars.
People with that kind of money at stake are unlikely to be very tolerant
of anyone who would compromise their reputation. Ray Kroc, the
founder of the McDonald's chain, would explode in anger if he found a
McDonald's parking lot littered. His franchisees were expected to keep
not only their own premises free of litter, but also to see that there was
no McDonald's litter on the streets within a radius of two blocks of
their restaurants.^^®^*

When speaking of quality in this context, what matters is the kind
of quality that is relevant to the particular clientele being served.
Hamburgers and fried chicken may not be regarded by others as either
gourmet food or health food, nor can a nationwide chain mass-
producing such meals reach quality levels achievable by more
distinctive, fancier, and pricier restaurants. What the chain can do is
assure quality within the limits expected by their particular customers.
Those quality standards, however, often exceed those imposed or used
by the government. As USA Today reported:

The U.S. Department of Agriculture says the meat it buys for the
National School Lunch Program "meets or exceeds standards in
commercial products."

That isn't always the case. McDonald's, Burger King and Costco, for
instance, are far more rigorous in checking for bacteria and dangerous
pathogens. They test the ground beef they buy five to 10 times more
often than the USDA tests beef made for schools during a typical
production day.

And the limits Jack in the Box and other big retailers set for certain
bacteria in their burgers are up to 10 times more stringent than what the
USDA sets for school beef

For chicken, the USDA has supplied schools with thousands of tons of
meat from old birds that might otherwise go to compost or pet food.
Called "spent hens" because they're past their egg-laying prime, the

chickens don't pass muster with Colonel Sanders—KFC won't buy them—
and they don't pass the soup test, either. The Campbell Soup Company
says it stopped using them a decade ago based on "quality
considerations."^^®^*

While a market economy is essentially an impersonal 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
founder F.W. Woolworth's insistence on the importance of courtesy to
the customers. This came from his own 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.^^®^*

Ray Kroc's zealous insistence on maintaining McDonald's
reputation for cleanliness paid off at a crucial juncture in the early
years, when he desperately needed a loan to stay in business, for the
financier who toured McDonald's restaurants said later; "If the parking
lots had been dirty, if the help had grease stains on their aprons, and if
the food wasn't good, McDonald's never would have gotten the
loan."^ 288 } Similarly, Kroc's good relations with his suppliers—people
who sold paper cups, milk, napkins, etc., to McDonald's—had saved
him before when these suppliers agreed to lend him money to bail
him out of an earlier financial crisis.

What is called "capitalism" might more accurately be called
consumerism. It is the consumers who call the tune, and those
capitalists who want to remain capitalists have to learn to dance to it.
The twentieth century began with high hopes for replacing the
competition of the marketplace by a more efficient and more humane
economy, planned and controlled by government in the interests of
the people. However, by the end of that century, all such efforts were

so thoroughly discredited by their actual results, in countries around
the world, that even most communist nations abandoned central
planning, while socialist governments in democratic countries began
selling off government-run enterprises, whose chronic losses had been
a heavy burden to the taxpayers.

Privatization was embraced as a principle by such conservative
governments as those of Prime Minister Margaret Thatcher in Britain
and President Ronald Reagan in the United States. But the most
decisive evidence for the efficiency of the marketplace was that even
socialist and communist governments, led by people who were
philosophically opposed to capitalism, turned back towards the free
market after seeing what happens when industry and commerce
operate without the guidance of prices, profits and losses.

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
off 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 as cause and effect—and that preventing bad effects
can prevent good effects. It was not coincidental that Smith Corona
began losing millions of dollars a year on its typewriters when Dell
began making millions on its computers. Computers were replacing
typewriters. Nor was it coincidental that sales of film began declining
with the rise of digital cameras. The fact that scarce resources have
alternative uses implies that some enterprises must lose their ability
to use those resources, in order that others can gain the ability to use
them.

Smith Corona had to be prevented from using scarce resources,
including both materials and labor, to make typewriters, when those
resources could be used to produce computers that the public wanted
more. Some of the resources used for manufacturing cameras that
used film had to be redirected toward producing digital cameras. Nor
was this a matter of anyone's fault. No matter how fine the typewriters
made by Smith Corona were or how skilled and conscientious its
employees, typewriters were no longer what the public wanted after
they had the option to achieve the same end result—and more—with
computers. Some excellent cameras that used film were discontinued
when new digital cameras were created.

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

It is hard to know how industry in general could have gotten the
millions of workers that they added during the twentieth century,
whose output contributed to dramatically rising standards of living for
the public at large, without the much-lamented decline in the number
of farms and farm workers that took place during that same century.

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 themselves
are doing, if rising standards of living are to be achieved and sustained.

The financial pressures of the free market are just one of the ways
in which this can be done. Kings or commissars could instead simply
order individuals and enterprises to change from doing A to doing B.
No doubt other ways of shifting resources from one producer to
another are possible, with varying degrees of effectiveness and
efficiency. What is crucial, however, is that it must be done. Put
differently, the fact that some people, regions, or industries are being
"left behind" or are not getting their "fair share" of the general
prosperity is not necessarily a problem with a political solution, as
abundant as such proposed solutions may be, especially during
election years.

However more pleasant and uncomplicated life might be if all
sectors of the economy grew simultaneously at the same lockstep
pace, that has never been the reality in any changing economy. When
and where new technologies and new methods of organizing or
financing production will appear cannot be predicted. To know what
the new discoveries were going to be would be to make the
discoveries before the discoveries were made. It is a contradiction in
terms.

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—in other words, by impeding or
thwarting the economy's allocation of scarce resources to their most
valued uses, on which the standard of living of the whole society
depends. Moreover, since economic changes are never-ending, this
same policy of preventing resources from going to the uses most
valued by millions of people must be on-going as well, if the
government succumbs to the political temptation to intervene on
behalf of particular industries, regions or segments of the population,
sacrificing the standard of living of the population as a whole.

What can be done instead is to recognize that economic changes
have been going on for centuries and that there is no sign that this will
stop—or that the adjustments necessitated by such changes will stop.
This applies to government, to industries and to the people at large.
Neither enterprises nor individuals can spend all their current income,
as if there are no unforeseeable contingencies to prepare for. Yet many
observers continue to lament that even people who are financially
prepared are forced to make adjustments, as a New York Times
economic reporter lamented in a book about Job losses with the grim
title. The Disposable American. Among others, it described an
executive whose job at a major corporation was eliminated in a
reorganization of the company, and who consequently had to sell "two
of the three horses" she owned and also sell "$16,500 worth of Procter
stock, cutting into savings to support herself while she hunted for
work."

Although this executive had more than a million dollars in
savings and owned a seventeen-acre estate,^^®^* it was presented as

some tragic failure of society that she had to make adjustments to the
ever-changing economy which had produced such prosperity in the
first place.

PART III:
WORK AND PAY

Chapter 10

PRODUCTIVITY AND PAY

Government data, if misunderstood or improperly
used, can lead to many false conclusions.

Steven R. Cunningham^^^°^

In discussing the allocation of resources, we have so far been
concerned largely with inanimate resources. But people are a key part
of the inputs which produce output. 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, if we are to live at
all, much less enjoy the various amenities that go into our modern
standard of living. In many societies of the past, people were forced to
work, whether as serfs or slaves. In a free society, people are paid to
work. But 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 resource
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 paynnent of wages and salaries 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. If the
pay of truck drivers doubles, some taxi drivers may decide that they
would rather drive a truck. Let the income of engineers double and
some students who were thinking of majoring in math or physics may
decide to major in engineering instead. Let pay for all jobs double and
some people who are retired may decide to go back to work, at least
part-time, while others who were thinking of retiring may decide to
postpone that for a while.

How much people are paid depends on many things. Stories
about the astronomical pay of professional athletes, movie stars, or
chief executives of big corporations often cause journalists and others
to question how much this or that person is "really" worth.

Fortunately, since we know from Chapter 2 that there is no such
thing as "real" worth, we can save all the time and energy that others
put into such unanswerable questions. Instead, we can ask a more
down-to-earth question: What determines how much people get paid
for their work? To this question there is a very down-to-earth answer:
Supply and Demand. However, that is just the beginning. Why does
supply and demand cause one individual to earn more than another?

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

hired. But why does that overlap take place at a pay rate that is several
times as high for an engineer as for a messenger?

Messengers would of course like to be paid what engineers are
paid, but there is too large a supply of people capable of being
messengers to force employers to raise their pay scales to that level.
Because it takes a long time to train an engineer, and not everyone is
capable of mastering such training, there is no such abundance of
engineers relative to the demand. That is the supply side of the story.
But what determines the demand for labor? What determines the limit
of what an employer is willing to pay?

It is not merely the fact that engineers are scarce that makes
them valuable. It is what engineers can add to a company's earnings
that makes employers willing to bid for their services—and sets a
limit to how high the bids can go. An engineer who added $100,000 to
a company's earnings and asked for a $200,000 salary would obviously
not be hired. On the other hand, if the engineer added a quarter of a
million dollars to a company's earnings, that engineer would be worth
hiring at $200,000—provided that there were no other engineers who
would do the same job for a lower salary.

PRODUCTIVITY

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 a certain productivity that is inherent in that

particular worker, rather than being dependent on surrounding
circumstances as well.

A worker using the latest modern equipment can obviously
produce more output per hour than the very same worker employed
in another firm whose equipment is not quite as up-to-date or whose
management does not have production organized as efficiently. For
example, Japanese-owned cotton mills in China during the 1930s paid
higher wages than Chinese-owned cotton mills there, but the
Japanese-run mills had lower labor costs per unit of output because
they had higher output per worker. This was not due to different
equipment—they both used the same machinery—but to more
efficient management brought over from Japan.^^^^*

Similarly, in the early twenty-first century, an international
consulting firm found that American-owned manufacturing
enterprises in Britain had far higher productivity than British-owned
manufacturing enterprises. According to the British magazine The
Economist, "British industrial companies have underperformed their
American counterparts startlingly badly," so that when it comes to
"economy in the use of time and materials," fewer than 40 percent of
British manufacturers "have paid any attention to this." Moreover,
"Britain's top engineering graduates prefer to work for foreign-owned
companies."^^^^* In short, lower productivity in British-owned
companies reflected differences in management practices, even when
productivity was measured in terms of output per unit of labor.

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.
Thus workers in South Africa have higher productivity than workers in
Brazil, Poland, Malaysia, or China because, as The Economist magazine

pointed out, South African firms "rely more on capital than labour"^^^^*
In other words, South African workers are not necessarily working any
harder or any more skillfully than workers in these other countries.
They just have more or better equipment to work with.

The same principle applies outside what we normally think of as
economic activities, and it applies to what we normally think of as a
purely individual feat, such as a baseball player hitting a home run. A
slugger gets more chances to hit home runs if he is batting ahead of
another slugger. But, if the batter hitting after him is not much of a
home run threat, pitchers are more likely to walk the slugger, whether
by pitching to him extra carefully or by deliberately walking him in a
tight situation, so that he may get significantly fewer opportunities to
hit home runs over the course of a season.

During Ted Williams' career, for example, he had one of the
highest percentages of home runs—in proportion to his times at bat
—in the history of baseball. Yet he had only one season in which he hit
as many as 40 homers, because he was walked as often as 162 times a
season, averaging more than one walk per game during the era of the
154-game season.

By contrast. Hank Aaron had eight seasons in which he hit 40 or
more home runs, even though his home-run percentage was not quite
as high as that of Ted Williams. Although Aaron hit 755 home runs
during his career, he was never walked as often as 100 times in any of
his 23 seasons in the major leagues. Batting behind Aaron during
much of his career was Eddie Mathews, whose home-run percentage
was nearly identical with that of Aaron, so that there was not much
point in walking Aaron to pitch to Mathews with one more man on
base. In short. Hank Aaron's productivity as a home-run hitter was

greater because he batted with Eddie Mathews in the on-deck circle.

More generally, in almost any occupation, your productivity
depends not only on your own work but also on cooperating factors,
such as the quality of the equipment, management and other workers
around you. Movie stars like to have good supporting actors, good
make-up artists and good directors, all of whom enhance the star's
performance. Scholars depend heavily on their research assistants,
and generals rely on their staffs, as well as their troops, to win battles.

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 all 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. Businesses in Third World countries without modern
highways, or efficient trains and airlines, may have to absorb higher
transportation costs. Even when they sell the same product for the
same price as businesses in more advanced economies, the net

revenue fronn that product will be less, and therefore the value of the
labor that went into producing that product will also be worth
correspondingly less.

In countries with high levels of corruption, the bribes necessary to
get bureaucrats to permit the business to operate likewise have to be
deducted from sales revenues and likewise reduce the value of the
product and of the workers who produce it, even if these workers have
the same output per hour as workers in more modern and less corrupt
economies. In reality. Third World workers more typically have lower
output per hour, and the higher costs of transportation and corruption
which must be deducted from sales revenues can leave such workers
earning a fraction of what workers earn for doing similar work in other
countries.

In short, productivity is not just a result solely of what the
individual worker does but is a result of numerous other factors as
well. To say that the demand for labor is based on the value of the
worker's productivity is not to say that pay is based on merit. Merit and
productivity are two very different things. Just as morality and
causation are two different things.

PAY DIFFERENCES

Thus far the discussion has been about things affecting the
demand for labor. What about supply? Employers seldom bid as much
as they would if they had to, because there are other individuals

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 on wages and salaries differently from the way we look on
prices paid for other inputs into the production process. Often we ask
questions that are emotionally powerful, even if they are logically
meaningless and wholly undefined. For example: Are the wages "fair"?
Are the workers "exploited"? Is this "a living wage"?

No one likes to see fellow human beings living in poverty and
squalor, and many are prepared to do something about it, as shown by
the vast billions of dollars that are donated to a wide range of charities
every year, on top of the additional billions spent by governments in
an attempt to better the condition of poor people. These socially
important activities occur alongside an economy coordinated by
prices, but the two things serve different purposes. Attempts to make
prices, including the prices of people's labor and talents, be something
other than signals to guide resources to their most valued uses make
those prices less effective for their basic purpose, on which the
prosperity of the whole society depends. Ultimately, it is economic
prosperity which makes it possible for billions of dollars to be devoted
to helping the less fortunate.

Income "Distribution"

Nothing is more straightforward and easy 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 on more
complicated Jobs that would be overwhelming for a beginner or for
someone with only limited experience or training. It is hardly
surprising that this leads to higher incomes. With the passing years,
older individuals may also become more knowledgeable about Job
opportunities, while increasing numbers of other people become
more aware of them and their individual abilities, leading to offers of
new Jobs or promotions where they are currently working. It is not
uncommon for most of the people in the top 5 percent of income-
earners to be 45 years 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," as they are often called—may be discussed as if they were
different classes of people, often they are in fact people at different
stages of their lives. Three-quarters of those American workers who
were in the bottom 20 percent in income in 1975 were also in the top
40 percent at some point over the next 16 years.^^^^’

This is not surprising. After 16 years, people usually have had 16
years more work experience, perhaps including on-the-Job training or
formal education. Those in business or the professions have had 16
years in which to build up a clientele. It would be surprising if they
were not able to earn more money as a result.

None of this is unique to the United States. A study of eleven
European countries found similar patterns.^^^^’ One-half of the people

in Greece and two-thirds of the people in Holland who were below the
poverty line in a given year had risen above that line within two years.
A study in Britain found similar patterns when following thousands of
individuals over a five-year period. At the end of five years, nearly two-
thirds of the individuals who were initially in the bottom 10 percent in
income had risen out of that bracket.^^^^’ Studies in New Zealand
likewise showed significant rises of individuals out of the bottom 20
percent of income earners in just one year and of course larger
numbers rising out of this bracket over a period of several years.^^^^’

When some people are born, live, and die in poverty, while others
are born, live, and die in luxury, that is a very different situation from
one in which young people have not yet reached the income level of
older people, such as their parents. But the kind of statistics often cited
in the media, and even in academia, typically do not distinguish these
very different situations. 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.^^^®*

Much discussion of "the rich" and "the poor"—or of the top and
bottom 10 or 20 percent—fail to say Just what kinds of incomes qualify

to be in those categories. As of 2011, a household inconne of $101,583
was enough to put those who earned it in the top 20 percent of
Americans. But a couple earning a little over $50,000 a year each are
hardly "the rich." Even to make the top 5 percent required a household
income of just over $186,000^^^^*—that is, about $93,000 apiece for a
working couple. That is a nice income, but rising to that level after
working for decades at lower levels is hardly a sign of being rich.

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. If you receive a million dollars in a year
and spend a million and a half, you are not getting rich. But many
frugal people on modest incomes have been found, after their deaths,
to have left surprisingly large amounts of wealth to their heirs.

Even among the truly rich, there is turnover. When Forbes
magazine ran its first list of the 400 richest Americans in 1982, that list
included 14 Rockefellers, 28 du Pontsand 11 Hunts. Twenty years later,
the list included 3 Rockefellers, one Hunt and no du Ponts.^^°°Uust over
one-fifth of the people on the 1982 Forbes list of the wealthiest
Americans inherited their wealth. By 2006, however, only two percent
of the people on the list had inherited their wealth.^^°^*

Although there is much talk about "income distribution," most
income is of course not distributed at all, in the sense in which
newspapers or Social Security checks are distributed from some
central place. Most income is distributed only in the figurative
statistical sense in which there is a distribution of heights in a
population—some people being 5 foot 4 inches tall, others 6 foot 2

inches, etc.—but none of these heights was sent out from some
central location. Yet it is all too common to read journalists and others
discussing how "society" distributes its income, rather than saying in
plain English that some people make more money than others.

There is no collective decision by "society" as to how much each
individual's work is worth. In a market economy, those who get the
direct benefit of an individual's goods or services decide how much
they are prepared to pay for what they receive. People who would
prefer collective decision-making on such things can argue their case
for that particular method of decision-making. But it is misleading to
suggest that today "society" distributes its income with one set of
results and should simply change to distributing its income with
different results in the future.

More is involved than a misleading metaphor. Often the very
units 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 individual 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.

For example, a detailed analysis of U.S. Census data showed that
there were 40 million people in the bottom 20 percent of households
in 2002 but 69 million people in the top 20 percent of households.^^°^*
Although the unwary might assume that these quintiles represent
dividing the country into "five equal layers," as two well-known
economists have misstated it in a popular book,^^°^’ there is nothing
equal about those layers. They represent grossly different numbers of

people.

Not only do the nunnbers of people differ considerably between
low-income households and high-income households, the proportions
of people who work also differ by very substantial amounts between
these households. In the year 2010, the top 20 percent of households
contained 20.6 million heads of households who worked, compared to
7.5 million heads of households who worked in the bottom 20 percent
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 the year-round, even the top 5 percent of
households contained more heads of households who worked full¬
time for 50 or more weeks than did the bottom 20 percent. 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 percent of households compared to the bottom 20 percent.^^°^’

At one time, back in the 1890s, people in the top 10 percent in
income worked fewer hours than people in the bottom 10 percent, but
that situation has long since reversed.^^°^’ We are no longer talking
about the idle rich versus the toiling poor. Today we are 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. Among the top 6
percent of income earners in a survey published in the Harvard
Business Review, 62 percent worked more than 50 hours a week and
35 percent worked more than 60 hours a week.^^°^*

The sizes of families and households have differed not only from
one income bracket to another at a given time, but also have differed
over time. These differences are not incidental. They radically change

the implications of trends in "income distribution" statistics. For
example, real income per American household rose only 6 percent
over the entire period from 1969 to 1996, but real per capita income
rose 51 percent over that same period.^^°^* The discrepancy is due to
the fact that the average size of families and households was declining
during those years, so that smaller households—including some with
only one person—were now earning about the same as larger
households had earned a generation earlier. Looking at a still longer
period, from 1967 to 2007, real median household income rose by 30
percent over that span, but real per capita income rose by 100 percent
over that same span.^^°®* Declining numbers of persons per household
were the key to these differences.

Rising prosperity contributed to the decline in household size. As
early as 1966, the U.S. Bureau of the Census reported that the number
of households was increasing faster than the number of people and
concluded: "The main reason for the more rapid rate of household
formation is the increased tendency, particularly among unrelated
individuals, to maintain their own homes or apartments rather than
live with relatives or move into existing households as roomers,
lodgers, and so forth."^^°^* Yet these consequences of rising prosperity
generate household income statistics that are widely used to suggest
that there has been no real economic progress.

A Washington Post writer, for example, declared "the incomes of
most American households have remained stubbornly flat over the
past three decades."^^^°’ It might be more accurate to say that some
writers have remained stubbornly blind to economic facts. When two
working people in one household today earn the same total amount
of money that three working people were earning in one household in

the past, that is a 50 percent increase in income per person—even
when household income remains the same.

Despite some confused or misleading discussions of "the rich"
and "the poor," based on people's transient positions in the income
stream, genuinely rich and genuinely poor people do exist—people
who are going to be living in luxury or in poverty all their lives—but
they are much rarer than gross income statistics would suggest. Just
as most American "poor" do not stay poor, so most rich Americans
were not born rich. Four-fifths of American millionaires earned their
fortunes within their own lifetimes, having inherited nothing.^^"*
Moreover, the genuinely rich are rare, like the genuinely poor.

Even if we take a million dollars in net worth as our criterion for
being rich, only about 3.5 percent of American households are at that
level.^^^^* This is in fact a fairly modest level, given that net worth
counts everything from household goods and clothing to the total
amount of money in an individual's pension fund. If we count as
genuinely poor that 5 percent of the population which remains in the
bottom 20 percent over a period of years, then the genuinely rich and
the genuinely poor—put together—add up to less than 10 percent of
the American population. Nevertheless, some political rhetoric might
suggest that most people are either "haves" or "have nots."

Trends over Time

If our concern is with the economic well-being of flesh-and-blood
human beings, as distinguished from statistical comparisons between
income brackets, then we need to look at real income per capita,
because people do not live on percentage shares. They live on real
income. Among those Americans who were in the bottom 20 percent

in 1975, 98 percent had higher real incomes in 1991—and two-thirds
had higher real incomes in 1991 than the average American had back
in 1975, when they were in the bottom 20 percentJ^^^*

Even when narrowly focusing on income brackets, the fact that
the share of the bottom 20 percent of households declined from 4
percent of all income in 1985 to 3.5 percent in 2001 did not prevent the
real income of the households in this bracket from rising by thousands
of dollars in absolute terms,^^^"^* quite aside from the movement of
actual people out of the bottom 20 percent between the two years.

Radically different trends are found when looking at statistics
based on comparisons of top and bottom income brackets over time,
rather than following individual income-earners over the same span of
time. For example, it is a widely publicized fact that census data show
the percentage of the national income going to those in the bottom
20 percent bracket has been declining over the years, while the
percentage going to those in the top 20 percent has been rising—and
the amount going to those in the top one percent has been rising
especially sharply. This has led to the familiar refrain that "the rich are
getting richer and the poor are getting poorer"—a notion that
provides the media with the kind of dramatic and alarming news
stories that sell newspapers and attract television audiences, as well as
being ideologically satisfying to some and politically useful to others.
The real question, however, is: Is it true?

A diametrically opposite picture is found when comparing what
happens to specific individuals over time. Unfortunately, most
statistics, including those from the U.S. Bureau of the Census, do not
follow particular individuals over time, even though the illusion that
they do may be fostered by data on income categories over time.

Among the few studies which have actually followed individual
Americans over time, one from the University of Michigan and another
from the Internal Revenue Service, show patterns similar to each other
but radically different from the often-cited patterns in data from the
Census Bureau and other sources. The University of Michigan study
followed the same individuals from 1975 through 1991 and the
Internal Revenue Service study followed individuals through their
income tax returns from 1996 through 2005.

The University of Michigan study found that, among working
Americans who were in the bottom 20 percent in income in 1975,
approximately 95 percent had risen out of that bracket by 1991 —
including 29 percent who had reached the top quintile by 1991,
compared to only 5 percent who still remained in the bottom quintile.
The largest absolute amount of increase in income between 1975 and
1991 was among those people who were initially in the bottom
quintile in 1975 and the least absolute increase in income was among
those who were initially in the top quintile in 1975.^^^^*

In other words, the incomes of people who were initially at the
bottom rose more than the incomes of people who were initially at
the top. This is the direct opposite of the picture presented by Census
data, based on following income brackets over time, instead of
following the people who are moving in and out of those brackets.

Similar patterns appeared in statistics from the Internal Revenue
Service, which also followed given individuals. The IRS found that
between 1996 and 2005 the income of individuals who had been in the
bottom 20 percent of income tax filers in 1996 had increased by 91
percent by 2005, and the income of those individuals who were in the
top one percent in 1996 had fallen by 26 percent.^^^^* It may seem

almost impossible that the data from the Bureau of the Census and
the data from the IRS and the University of Michigan can all be correct,
but they are. Studies of income brackets over time and studies of
individual people over time are measuring fundamentally different
things that are often confused with one another.

A study of individual incomes over time in Canada turned up
patterns very similar to those in the United States. During the period
from 1990 to 2009, Canadians who were initially in the bottom 20
percent had both the highest absolute increase in income and the
highest percentage increase in income. Only 13 percent of the
Canadians who were initially in the bottom quintile in 1990 were still
there in 2009, while 21 percent of them had risen all the way to the top
quintile.^^^^’

Whatever the relationship between one income bracket and
another, that is not necessarily the relationship between people,
because people are moving from one bracket to another as time goes
on. Therefore the fate of brackets and the fate of people can be very
different—and, in many cases, completely opposite. When income¬
earning Americans in the bottom income bracket have their incomes
nearly double in a decade, they end up no longer in the bottom
bracket. There is nothing mysterious about this, since most people
begin their careers in entry-level jobs and their growing experience
over the years leads to higher incomes. Nor is it surprising that people
whose incomes are at the peak of the income pyramid seem often also
to be at or near their own peak incomes and do not continue to rise as
dramatically as those who started at the bottom.

Some Americans reach the top one percent in income—
approximately $369,500 and up in 2010^^^®*—in a given year because of

some particular boost to their income during that particular year.
Someone who sells a house may have an income that year which is
some multiple of the income received in any year before or since.
Similarly for someone who receives a large inheritance in a given year,
or cashes in stock options that have been accumulating over the years.
Such spikes in income account for a substantial proportion of those
whose incomes in a given year reach the top levels. More than half the
people in the top one percent in income in 1996 were no longer at that
level in 2005. Among those in the top one-hundredth of one percent in
income in 1996, three-quarters were no longer at that level in 2005.^^^^’

Many people who never have a spike in income that would put
them in the top one percent may nevertheless end up in the top 20
percent after many years of moving up in the course of a career. They
are not "rich" in any meaningful sense, even though they may be called
that in political, media or even academic rhetoric. As already noted,
the amount of income required to reach the top 20 percent is hardly
enough to live the lifestyle of the rich and famous. Nor will being in the
top one percent, for that half of the people in that bracket who do not
remain there.

Just as there are spikes in income from time to time, so there are
troughs in income in particular years. Thus many people who are
genuinely affluent, or even rich, can have business losses or off years in
their professions or investments, so that their income in a given year
may be very low or even negative, without their being poor in any
meaningful sense. This may help explain such anomalies as hundreds
of thousands of people with incomes below $20,000 a year who are
living in homes costing $300,000 and up.^^^°’

The fundamental confusion that makes income bracket data and

individual income data seem mutually contradictory is the implicit
assumption that people in particular income brackets at a given time
are an enduring "class" at that level. If that were true, then trends over
time in comparisons between income brackets would be the same as
trends over time between individuals. Because that is not the case,
however, the two sets of statistics lead not only to different
conclusions but even to opposite conclusions that seem to contradict
each other.

The higher up the income scale people are, the more volatile are
their incomes. "During the past three recessions, the top 1% of earners
(those making $380,000 or more in 2008) experienced the largest
income shocks in percentage terms of any income group in the U.S."
the Wall Street Journal reported. When the incomes of people making
$50,000 or less fell by 2 percent between 2007 and 2009, the incomes
of people making a million dollars or more fell by nearly 50 percent.^^^^*

Conversely, when the economy grows, the incomes of the top one
percent "grow up to three times faster than the rest of the country's."
This is not really surprising, since incomes at the highest levels are less
likely to be due to salaries and more likely to be due to income from
investments or sales, both of which can vary greatly when the
economy goes up or down. Similar patterns apply to wealth as to
income. "During the 1990 and 2001 recessions, the richest 5% of
Americans (measured by net worth) experienced the largest decline in
their wealth," the Wall Street Journal reported.^^^^’

Differences in Skiiis

Among the many reasons for differences in productivity and pay
is that some people have more skills than others. No one is surprised

that engineers earn more than messengers or that experienced
shipping clerks tend to earn higher pay than inexperienced shipping
clerks—and experienced pilots tend to earn more than either.
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 exertions, but also their ability to apply mental proficiency to
their tasks. The time when "a strong back and a weak mind" were
sufficient for many Jobs is long past in most modern economies.
Obvious as this may seem, its implications are not equally obvious nor
always widely understood.

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 payor less frequent employment, or both.
A premium on physical strength likewise favored male workers over
female workers.

In some desperately poor countries living close to the edge of
subsistence, such as China in times past, the sex differential in
performing physical labor was such that it was not uncommon for the
poorest people to kill female infants. While a mother was necessary for
the family, an additional woman's productivity in arduous farm labor
on small plots of land with only primitive tools might not produce
enough food to keep her alive—and her drain on the food produced by
others would thus threaten the survival of the whole family, at a time
when malnutrition and death by starvation were ever-present
dangers. One of the many benefits of economic development has been
making such desperate and brutal choices unnecessary.

The rising importance of skills and experience relative to physical

strength has changed the relative productivities of youth compared to
age, and of women compared to men. This has been especially so in
more recent times, as the power of machines has replaced human
strength in industrial societies and as skills have become crucial in
high-tech economies. Even within a relatively short span of time, the
age at which most people receive their peak earnings has shifted
upward. In 1951, most Americans reached their peak earnings
between 35 and 44 years of age, and people in that age bracket earned
60 percent more than workers in their early twenties. By 1973,
however, people in the 35 to 44-year-old bracket earned more than
double the income of the 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
reduced 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 got their
workdone at lower costs by eliminating the male premium, equalizing
the pay of women and men to match their productivities. The most
unenlightened or prejudiced employers had higher labor costs, which
risked the elimination of their businesses by the ruthlessness of
market competition. Thus the pay of women began to equal that of
men of similar qualifications even before there were laws mandating
equal pay.

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. As already noted, there are striking differences between the
numbers and proportions of people who work and those who don't
work, as between the top income brackets and the bottom income
brackets. A simultaneous rise in rewards for work and a growing
welfare state that allows more people to live without working virtually
guarantees increasing inequality in earnings and incomes, when many
of the welfare state benefits are received in kind rather than in money,
such as subsidized housing or subsidized medical care, since these
benefits are not counted in income statistics.

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 economies grow
more technologically and economically more 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. However,

in order to deternnine whether there is discrinnination or how severe it
is, we first need to define what we mean.

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. "No
Irish Need Apply" was a stock phrase in advertisements for many
desirable Jobs in nineteenth-century and early twentieth-century
America. Before World War II, many hospitals in the United States
would not hire black doctors or Jewish doctors, and some prestigious
law firms would not hire anyone who was not a white Protestant male
from the upper classes. In other cases, people might be hired from a
number of groups, but individuals from different groups were
channeled into different kinds of Jobs.

None of this has been peculiar to the United States or to 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 as history is measured, and by no means universally
observed around the world today.

Overlapping with discrimination, and often confused with it, are
employment differences based on substantial differences in skills,
experience, work habits and behavior patterns from one group to
another. Mohawk Indians, for example, were long sought after to work
on the construction of skyscrapers in the United States, for they
walked around high up on the steel frameworks with no apparent fear
or distraction from their work. In times past, Chinese laborers on
rubber plantations in colonial Malaya were found to collect twice as

much sap from rubber trees in a given amount of time as Malay
workers did.

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 in the absence of different
beliefs about different groups, application of the same employment
criteria to different groups can result in very different proportions of
these groups being hired, fired, or promoted. Distinguishing
discrimination from differences in qualifications and performances 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 less work habits
and attitudes, to make possible comparisons 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 day care while their mothers
return to work. These 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. However, as far back as 1971,
American single women who worked continuously from high school
into their thirties earned slightly more than single men of the same
description,^^^"^’ even though women as a group earned substantially
less than men as a group.

This suggests that employers were willing to pay women of the
same experience the same as men, if only because they are forced to
by competition in the labor market, and that women with the same
experience may even outperform men and therefore earn more. But
differences in domestic responsibilities prevent the sexes from having
identical workplace experience or identical incomes based on that
experience. None of this should be surprising. If, for example, women
were paid only 75 percent of what men of the same level of
experience and performance were paid, then any employer could hire
four women instead of three men for the same money and gain a
decisive advantage in production costs over competing firms.

Put differently, any employer who discriminated against women
in this situation would be incurring unnecessarily higher costs, risking
profits, sales, and survival in a competitive industry. It is worth noting
again the distinction made in Chapter 4 between intentional and
systemic causation. Even if not a single employer consciously or
intentionally thought about the economic implications of
discriminating against women, the systemic effects of competition
would tend to weed out over time those employers who paid a sex
differential not corresponding to a difference in productivity. This
process would be hastened to the extent that women set up their own
businesses, as many increasingly do, and do not discriminate against
other women.

Substantial pay differentials between women and men are not
the same across the board, but vary between those women who
become mothers and those who do not. In one study, women without
children earned 95 percent of what men earned, while women with
children earned just 75 percent of what men earned.^^^^’ Moreover,

even those wonnen without children need not be in the same
occupations as men. The very possibility of having children makes
different occupations have different attractions to women, even
before they become mothers. Occupations like librarians or teachers,
which one can resume after a few years off to take care of small
children, are more attractive to women who anticipate becoming
mothers. But occupations such as computer engineers, where just a
few years off from work can leave you far behind in this rapidly
changing field, tend to be less attractive to many women. In short,
women and men make different occupational choices and prepare for
many of these occupations by specializing in a very different mix of
subjects while being educated.

The question as to whether or how much discrimination women
encounter in the labor market is a question about whether there are
substantial differences in pay between women and men in the same
fields with the same qualifications. The question as to whether there is
or is not income parity between the sexes is very different, since
differences in occupational choices, educational choices, and
continuous employment all affect incomes. Men also tend to work in
more hazardous occupations, which usually pay more than similar
occupations that are safer. As one study noted, "although 54 percent of
the workplace is male, men account for 92 percent of all Job-related
deaths."^'^^*

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 racial or ethnic group to differ in age from another by a decade or

more—and we have already seen how age makes a big difference in
income. While gross statistics show large income differences among
American racial and ethnic groups, finer breakdowns usually show
much smaller differences. For example, black, white, and Hispanic
males of the same age (29) and IQ (100) have all had average annual
incomes within a thousand dollars of one another.^^^^* In New Zealand,
while there are substantial income differences between the Maori
population and the white population, these differences likewise shrink
drastically when comparing Maoris with other New Zealanders of the
same age and with the same skills and literacy levels.^^^®*

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 against each other for employees as well
as competing 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, where they too 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. Clearly, that represents a loss of rent—if
this is a free market. However, if there is rent control, with a surplus of
applicants for vacant apartments, then such discrimination costs the
landlord nothing, since there will be no delay in finding a new tenant.

under these conditions.

Similar principles apply in job markets. An employer who refuses
to hire qualified individuals from the "wrong" groups risks leaving his
Jobs unfilled longer in a free market. This means that he must either
leave some work undone and some orders from customers unfilled—
or else pay overtime to existing employees to get the Job done. Either
way, this costs the employer more money. 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.

Whether these artificially higher wages are set by a labor union or
by a minimum wage law does not change the principle. Empirical
evidence strongly indicates that racial discrimination tends to be
greater when the costs are lower and lower when the costs are greater.

Even in white-ruled South Africa during the era of apartheid,
where racial discrimination against blacks was required by law, white
employers in competitive industries often hired more blacks and in
higher occupations than they were permitted to do by the
government—and were often fined when caught doing so.^^^^* This was
because it was in the employers' economic self-interest to hire blacks.
Similarly, whites who wanted homes built in Johannesburg typically
hired illegal black construction crews, often with a token white
nominally in charge to meet the requirements of the apartheid laws,
rather than pay the higher price of hiring a white construction crew as
the government wanted them to do.^^^°* White South African landlords
likewise often rented to blacks in areas where only whites were legally
allowed to live.^^^^*

The cost of discrimination to the discriminators is crucial for
understanding such behavior. Employers who are spending other
people's money—government agencies or non-profit organizations,
for example—are much less affected by the cost of discrimination. In
countries around the world, discrimination by government has been
greater than discrimination by businesses operating in private,
competitive markets. Understanding the basic economics of
discrimination makes it easier to understand why blacks were starring
on Broadway in the 1920s, at a time when they were not permitted to
enlist in the U.S. Navy and were kept out of many civilian government
jobs as well. Broadway producers were not about to lose big money
that they could make by hiring black entertainers who could attract
big audiences, but the costs of government discrimination were paid
by the taxpayers, whether they realized it or not.

Just as minimum wage laws reduce the cost of discrimination to
the employer, maximum wage laws increase the employer's cost of
discrimination. Among the few examples of maximum wage laws in
recent centuries were the wage and price controls imposed in the
United States during World War II. Because wages were not allowed to
rise to the level that they would reach under supply and demand,
there was a shortage of workers. Just as there is a shortage of housing
under rent control. Many employers who had not hired blacks or
women before, or who had not hired them for desirable Jobs before
the war, now began to do so. The "Rosie the Riveter" image that came
out of World War II was in part a result of wage and price controls.

CAPITAL, LABOR AND EFFICIENCY

While everything requires sonne labor for its production,
practically nothing can be produced by labor alone. Farmers need
land, taxi drivers need cars, artists need something to draw on and
something to draw with. Even a stand-up comedian needs an
inventory of jokes, which is his capital. Just as hydroelectric dams are
the capital of companies that generate electricity.

Capital complements labor in the production process, but it also
competes with labor for employment. In other words, many goods and
services can be produced either with much labor and little capital or
much capital and little labor. When transit workers' unions force bus
drivers' pay rates much above what they would be in a competitive
labor market, transit companies tend to add more capital, in order to
save on the use of the more expensive labor. Buses grow longer,
sometimes becoming essentially two buses with a flexible connection
between them, so that one driver is using twice as much capital as
before and is capable of moving twice as many passengers.

Some might think that this is more "efficient," but efficiency is not
so easily defined. If we arbitrarily define efficiency as output per unit of
labor, as some do, then it is merely circular reasoning to say that
having one bus driver moving more passengers is more efficient. It
may in fact cost more money per passenger to move them, as a result
of the additional capital needed for the expanded buses and the more
expensive labor of the drivers.

If bus drivers were not unionized and were paid no more than
was necessary to attract qualified people, then undoubtedly their
wage rates would be lower and it would then be profitable for the

transit connpanies to hire nnore of thenn and use shorter buses. Not
only would the total cost of moving passengers be less, passengers
would have less time to wait at bus stops because of the shorter and
more numerous buses. This is not a small concern to people waiting
on street corners on cold winter days or in high-crime neighborhoods
at night.

"Efficiency" cannot be meaningfully defined without regard to
human desires and preferences. Even the efficiency of an automobile
engine is not simply a matter of physics. All the energy generated by
the engine will be used in some way—either in moving the car
forward, overcoming internal friction among the engine's moving
parts, or shaking the automobile body in various ways. It is only when
we define our goal—moving the car forward—that we can regard the
percentage of the engine's power that is used for that task as
indicating its efficiency, and the other power dissipated in various
other ways as being "wasted."

Europeans long regarded American agriculture as "inefficient"
because output per acre was much lower in the United States than in
much of Europe. On the other hand, output per agricultural worker
was much higher in the United States than in Europe. The reason was
that land was far more plentiful in the U.S. and labor was more scarce.
An American farmer would 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
because of supply and demand, 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.

Similarly, Third World countries often get more use out of given
capital equipment than do wealthier and more industrialized
countries. Such tools as hammers and screwdrivers may be plentiful
enough for each worker in an American factory or shop to have his
own, but that is much less likely to be the case in a much poorer
country, where such tools are more likely to be shared, or shared more
widely, than among Americans making the same products. Looked at
from another angle, each hammer in a poor country is likely to drive
more nails per year, since it is shared among more people and has less
idle time. That does not make the poorer country more "efficient." It is
just that the relative scarcities of capital and labor are different.

Capital tends to be scarcer and hence more expensive in poorer
countries, while labor is more abundant and hence cheaper than in
richer countries. Poor countries tend to economize on the more
expensive factor. Just as richer countries economize on a different
factor that is more expensive and scarce there, namely labor. In the
richer countries, it is capital that is more plentiful and cheaper, while
labor is more scarce and more expensive.

When a freight train comes into a railroad stop, workers are
needed to unload it. When a freight train arrives in the middle of the
night, it can either be unloaded then and there, so that the train can
proceed on its way intact, or some boxcars can be detached and left on
a siding until the workers come to work the next morning to unload
them.

In a country where such capital as railroad boxcars are very scarce
and labor is more plentiful, it makes sense to have workers available
around the clock, so that they can immediately unload boxcars, and
this very scarce resource does not remain idle. But, in a country that is

rich in capital, it nnay often be more economical to detach individual
boxcars from a train, letting the train continue on its way. Thus the
detached boxcars can sit idle on a siding, waiting to be unloaded the
next morning, rather than have expensive workers sitting around idle
during the night, waiting for the next train to arrive.

This is not just a question about these particular workers'
paychecks or this particular railroad company's monetary expenses.
From the standpoint of the economy as a whole, the more
fundamental question is: What are the alternative uses of these
workers' time and the alternative uses of the railroad boxcars? In other
words, it is not Just a question of money. The money only reflects
underlying realities that would be the same in a socialist, feudal or
other non-market economy. Whether it makes sense to leave the
boxcars idle waiting for the workers to arrive or to leave the workers
idle waiting for trains to arrive depends on the relative scarcities of
labor and capital and their relative productivity in alternative uses.

During the era of the Soviet Union and its Cold War competition
with the United States, the Soviets used to boast of the fact that an
average Soviet boxcar moved more freight per year than an average
American boxcar. But, far from indicating that their economy was
more efficient, this showed that Soviet railroads lacked the abundant
capital of the American railroad industry, and that Soviet labor had
less valuable alternative uses of its time than did American labor.
Similarly, a study of West African economies in the mid-twentieth
century noted that trucks there "are in service twenty-four hours a day
for seven days a week and are generally tightly packed with
passengers and freight."^^^^’

For similar reasons, automobiles tend to have longer lives in poor

countries than in richer countries. Not only does it pay many poorer
countries to keep their own automobiles in use longer, it pays them to
buy used cars from richer countries. In just one year, 90,000 used cars
from Japan were sold to the United Arab Emirates. Dubai, one of those
emirates, has become a center for the sale of these used vehicles to
other Middle Eastern and African countries. The Wall Street Journal
reported: "Many African cities are already teeming with Toyotas, even
though very few new cars have been sold there."^^^^* In Cameroon, the
taxis "are beaten-up old Toyotas, carrying four in the back and three in
the front."^^^"^* Even cars needing repairs are sold internationally:

Japan's exporters also ship out thousands of cars that have been
dented or damaged. Mechanics in Dubai can repair vehicles for a fraction
of the price in Japan, where high labor costs make it one of the world's
most expensive places to fix a car.^^^^*

By and large, it pays richer countries to Junk their cars,
refrigerators, and other capital equipment in a shorter time than it
would pay people in poorer countries to do so. Nor is this a matter of
being able to afford "waste." It would be a waste to keep repairing this
equipment, when the same efforts elsewhere in the Japanese
economy—or the American economy or German economy—would
produce more than enough wealth to provide replacements. But it
would not make sense for poorer countries, whose alternative uses of
time are not as productive, to Junk their equipment at the same times
when richer countries Junk theirs. The fact that labor is cheaper in
Dubai than in Japan is not a happenstance. Labor is more productive in
richer countries. That is one of the reasons why these countries are
more prosperous in the first place. The sale of used equipment from
rich countries to poor countries can be an efficient way of handling the

situation for both kinds of countries.

In a modern industrial economy, many goods are mass produced,
thereby lowering their production costs, and hence prices, because of
economies of scale. But repairs on those products are still typically
done individually by hand, without the benefit of economies of scale,
and therefore relatively expensively. In such a mass production
economy, repeated repairs can in many cases quickly reach the point
where it would be cheaper to get a new, mass-produced replacement.
The number of television repair shops in the United States has
therefore not kept pace with the growing number of television sets, as
mass production has reduced television prices to the point where
many malfunctioning sets can be more cheaply replaced than
repaired.

A book by two Russian economists, back in the days of the Soviet
Union, pointed out that in the Union of Soviet Socialist Republics
"equipment is endlessly repaired and patched up," so that the "average
service life of capital stock in the U.S.S.R. is forty-seven years, as against
seventeen in the United States."^^^^’ They were not bragging. They were
complaining.

Chapter 11

MINIMUM WAGE LAWS

Supply-and-demand says that above-market prices
create unsaleable surpluses, but that has not stopped
most of Europe from regulating labor markets into
decades of depression-level unemployment.

Bryan Caplan^^^^^

Just as we can better understand the economic role of prices in
general when we see what happens when prices are not allowed to
function, so we can better understand the economic role of workers'
pay by seeing what happens when that pay is not allowed to vary with
the supply and demand for labor. Historically, political authorities set
maximum wage levels centuries before they set minimum wage levels.
Today, however, only the latter are widespread.

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
produce 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 is not, that worker
is unlikely to be employed. Yet minimum wage laws are almost always
discussed politically in terms of the benefits they confer on workers
receiving those wages. Unfortunately, the real minimum wage is
always zero, regardless of the laws, and that is the wage that many
workers receive in the wake of the creation or escalation of a
government-mandated minimum wage, because they either lose their
jobs or fail to find Jobs when they enter the labor force. The logic is
plain and an examination of the empirical evidence from various
countries around the world tends to back up that logic, as we shall see.

UNEMPLOYMENT

Because 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 laws
than in a free market.

Unemployed workers are not surplus in the sense of being useless
or in the sense that there is no work around that 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 more experienced
workers. The unemployed are made idle by wage rates artificially set
above the level of their productivity. Those who are idled in their

youth are of course delayed in acquiring the job skills and experience
which could make them more productive—and therefore higher
earners—later on. That is, they not only lose the low pay that they
could have earned in an entry-level Job, they lose the higher pay that
they could have moved on to and begun earning after gaining
experience in entry-level Jobs. Younger workers are disproportionately
represented among people with low rates of pay in countries around
the world. Only about three percent of American workers over the age
of 24 earn the minimum wage,^^^®’for example.

Although most modern industrial societies have minimum wage
laws, not all do. Switzerland has been a rare exception—and has had
very low unemployment rates. In 2003, The Economist magazine
reported: "Switzerland's unemployment neared a five-year high of
3.9% in February."^®®^* Swiss labor unions have been trying to get a
minimum wage law passed, arguing that this would prevent
"exploitation" of workers. However, the Swiss cabinet still rejected the
proposed minimum wage law in January 2013.^®'^°* Its unemployment
rate at that time was 3.1 percent.^®^^*

Singapore likewise has no minimum wage law and its
unemployment rate has likewise been 2.1 percent.^®'^^’ Back in 1991,
when Hong Kong was still a British colony, it too had no minimum
wage law, and its unemployment rate was under 2 percent.^®'^®* In the
United States, during the Coolidge administration—the last
administration before there was any federal minimum wage law—the
annual unemployment rate got as low as 1.8 percent.^®'^'^*

The explicit minimum wage rate understates the labor costs
imposed by European governments, which also mandate various
employer contributions to pension plans and health benefits, among

other things. Higher costs in the form of mandated benefits have the
same economic effect as higher costs in the form of minimum wage
laws. Europe's unemployment rates shot up when such government-
mandated benefits, to be paid for by employers, grew sharply during
the 1980s and 1990s.

In Germany, such benefits accounted for half of the average labor
cost per hour. By comparison, such benefits accounted for less than
one-fourth the average labor costs per hour in Japan and the United
States.^^'^^’ Average hourly compensation of manufacturing employees
in the European Union countries in general is higher than in the United
States or Japan.^^^^* So is unemployment.

Comparisons of Canada with the United States show similar
patterns. Over a five-year period, Canadian provinces had minimum
wage rates that were a higher percentage of output per capita than in
American states, and unemployment rates were correspondingly
higher in Canada, as was the average duration of unemployment,
while the Canadian rate of job creation lagged behind that in the
United States. Over this five-year period, three Canadian provinces had
unemployment rates in excess of 10 percent, with a high of 16.9
percent in Newfoundland, but none of the 50 American states
averaged unemployment rates in double digits over that same five-
year period.^^^^’

A belated recognition of the connection between minimum wage
laws and unemployment by government officials has caused some
countries to allow their real minimum wage levels to be eroded by
inflation, avoiding the political risks of trying to repeal these laws
explicitly, when so many voters think of these laws as being beneficial
to workers. Such laws are in fact beneficial to those workers who

continue to be employed—those who are on the inside looking out,
but at the expense of the unemployed who are on the outside looking
in.

Labor unions also benefit from minimum wage laws, and are
among the strongest proponents of such laws, even though their own
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 the unskilled and
inexperienced workers are likely to be displaced by more experienced
and higher skilled unionized workers.

Just as businesses seek to have government impose tariffs on
imported goods that compete with their own 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.

Among 3.6 million Americans earning no more than the
minimum wage in 2012, Just over half were from 16 to 24 years of age
—and 64 percent of them worked part-time.^^"^®* Yet political
campaigns to increase the minimum wage often talk in terms of
providing "a living wage" sufficient to support a family of four—such
families as most minimum wage workers do not have, and would be
ill-advised to have before they reach the point where they can feed
and clothe their children. The average family income of a minimum

wage worker is more than $44,000 a year—far more than can be
earned by someone working at minimum wages. But 42 percent of
minimum-wage workers live with parents or some other relative. In
other words, they are not supporting a family but often a family is
supporting them. Only 15 percent of minimum-wage workers are
supporting themselves and a dependent, ^^^^^the kind of person
envisioned by those who advocate a "living wage."

Nevertheless, a number of American cities have passed "living
wage" laws,^^^°’ which are essentially local minimum wage laws
specifying a higher wage rate than the national minimum wage law.
Their effects have been similar to the effects of national minimum
wage laws in the United States and other countries—that is, the
poorest people have been the ones who have most often lost jobs.

The huge financial, political, emotional, and ideological
investment of various groups in issues revolving around minimum
wage laws means that dispassionate analysis is not always the norm.
Moreover, the statistical complexities of separating out the effects of
minimum wage rates on employment from all the other ever-
changing variables which also affect employment mean that honest
differences of opinion are possible when examining empirical data.
However, when all is said and done, most empirical studies indicate
that minimum wage laws reduce employment in general,^^^^’ and
especially the employment of younger, less skilled, and minority
workers.

A majority of professional economists surveyed in Britain,
Germany, Canada, Switzerland, and the United States agreed that
minimum wage laws increase unemployment among low-skilled
workers. Economists in France and Austria did not. However, the

majority among Canadian economists was 85 percent and among
American economists was 90 percentj^^^* Dozens of studies of the
effects of minimum wages in the United States and dozens more
studies of the effects of minimum wages in various countries in
Europe, Latin America, the Caribbean, Indonesia, Canada, Australia,
and New Zealand were reviewed in 2006 by two economists at the
National Bureau of Economic Research. They concluded that, despite
the various approaches and methods used in these studies, this
literature as a whole was one "largely solidifying the conventional
view that minimum wages reduce employment among low-skilled
workers."^^^^’

Those officially responsible for administering minimum wage
laws, such as the U. S. Department of Labor and various local agencies,
prefer to claim that these laws do not create unemployment. So do
labor unions, which have a vested interest in such laws as protection
for their own members' Jobs. In South Africa, for example. The
Economist reported:

The main union body, the Congress of South African Trade Unions (Cosatu)
says joblessness has nothing to do with labour laws. The problem, it says,
is that businesses are not trying hard enough to create Jobs.^^^^*

In Britain, the Low Pay Commission, which sets the minimum
wage, has likewise resisted the idea that the wages it set were
responsible for an unemployment rate of 17.3 percent among workers
under the age of 25, at a time when the overall unemployment rate
was 7.6 percent.^^^^’

Even though most studies show that unemployment tends to
increase as minimum wages are imposed or increased, those few

studies that seem to indicate otherwise have been hailed in some
quarters as having "refuted" this "myth."^^^^* However, one common
problem with some research on the employment effects of minimum
wage laws is that surveys of employers before and after a minimum
wage increase can survey only those particular businesses which
survived in both periods. Given the high rates of business failures in
many industries, the results for the surviving businesses may be
completely different from the results for the industry as a whole.^’"'’"’
Using such research methods, you could survey people who have
played Russian roulette and "prove" from their experiences that it is a
harmless activity, since those for whom it was not harmless are
unlikely to be around to be surveyed. Thus you would have "refuted"
the "myth" that Russian roulette is dangerous.

It would be comforting to believe that the government can
simply decree 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 experience and skills.

Unemployment varies not only in its quantity as of a given time, it
varies also in how long workers remain unemployed. Like the
unemployment rate, the duration of unemployment varies
considerably from country to country. Countries which 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. In Germany,
for example, there is no national minimum wage law but government-
imposed mandates on employers, job security laws, and strong labor
unions artificially raise labor costs anyway. As of the year 2000, 51.5
percent of the unemployed in Germany were unemployed for a year or
more, while Just 6 percent of the unemployed in the United States
were unemployed that long. However, as the U.S. Congress extended
the period during which unemployment compensation would be paid,
the share of Americans who remained unemployed for a year or longer
rose to 31.3 percent in 2011, compared to 48 percent in Germany.^^^^*

Informal Minimum Wages

Sometimes a minimum wage is imposed not by law, but by
custom, 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. Although organized public pressures
for higher pay for Third World workers in Southeast Asia and Latin
America have made news in the United States in recent years, such
pressures are not new nor confined to Americans. Similar pressures
were put on companies operating in colonial West Africa in the middle
of the twentieth century.

Informal minimum wages imposed in these ways have had effects
very similar to those of explicit minimum wage laws. An economist
studying colonial West Africa in the mid-twentieth century found signs
telling Job applicants that there were "no vacancies" almost
everywhere. Nor was this peculiar to West Africa. The same economist

—P.T. Bauer of the London School of Economics—noted that it was "a
striking feature of many under-developed countries that money wages
are maintained at high levels" while "large numbers are seeking but
unable to find work"^^^®* These were of course not high levels of wages
compared to what was earned by workers in more industrialized
economies, but high wages relative to Third World workers'
productivity and high relative to their alternative earning
opportunities, such as in agriculture, domestic service, or self-
employment as street vendors and the like—that is, in sectors of the
economy not subject to external pressures to maintain an artificially
inflated wage rate.

The magnitude of the unemployment created by artificially high
wages that multinational companies felt pressured to pay in West
Africa was indicated by Professor Bauer's first-hand investigations:

I asked the manager of the tobacco factory of the Nigerian Tobacco
Company (a subsidiary of the British-American Tobacco Company) in
Ibadan whether he could expand his labour force without raising wages if
he wished to do so. He replied that his only problem would be to control
the mob of applicants. Very much the same opinion was expressed by
the Kano district agent of the firm of John Holt and Company in respect of
their tannery. In December 1949 a firm of produce buyers in Kano
dismissed two clerks and within two days received between fifty and sixty
applications for the posts without having publicized the vacancies. The
same firm proposed to erect a groundnut crushing plant. By June 1950
machinery had not yet been installed; but without having advertised a
vacancy it had already received about seven hundred letters asking for
employment. . . I learnt that the European-owned brewery and the
recently established manufacturers of stationery constantly receive
shoals of applications for employment.^^®^*

Nothing had changed fundamentally more than half a century
later, when twenty-first century Job seekers in South Africa were lined

up far in excess of the number of jobs available, as reported in the New

York Times:

When Tiger Wheels opened a wheel plant six years ago in this faded
industrial town, the crush of job seekers was so enormous that the chief
executive, Eddie Keizan, ordered a corrugated iron roof to shield them
from the midday heat.

"There were hundreds and hundreds of people outside our gate, just
sitting there, in the sun, for days and days," Mr. Keizan recalled in an
interview. "We had no more jobs, but they refused to believe us."^^^°^

Why then did wage rates not come down in response to supply
and demand, leading to more employment at a lower wage level, as
basic economic principles might lead us to expect? According to the
same report:

In other developing countries, legions of unskilled workers have kept
down labor costs. But South Africa's leaders, vowing not to let their nation
become the West's sweatshop, heeded the demands of politically
powerful labor unions for new protections and benefits.^^^^*

Such "protections and benefits" included minimum wages set at
levels higher than the productivity of many South African workers. The
net result was that when Tiger Wheels, which had made aluminum
wheels solely in South Africa for two decades, expanded its
production, it expanded by hiring more workers in Poland, where it
earned a profit, rather than in South Africa, where it could only break
even or sustain a loss.^^^^’ The misfortunes of eager but frustrated
African Job applicants throughout the South African economy were
only part of the story. The output that they could have produced, if
employed, would have made a particularly important contribution to
the economic well-being of the consuming public in a very poor

region, lacking many things that others take for granted in more
prosperous societies.

It is not at all clear that workers as a whole are benefitted by
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. The only
category of clear beneficiaries are people living in richer countries,
who can enjoy the feeling that they are helping people in poorer
countries, or Third World leaders too proud to let their workers be
hired at wage rates commensurate with their productivity.

While South African workers' productivity is twice that of workers
in Indonesia, they are paid five times as much^^^^*—when they can find
jobs at all. In short, these productive South African workers are not
"surplus" or "unemployable" in any sense other than being priced out
of the market by politicians.

As already noted in Chapter 10, South African firms use much
capital per worker. This is more efficient for the firms, but only because
South African labor laws make labor artificially more expensive, both
with minimum wage laws and with laws that make laying off workers
costly. "Labour costs are more than three-and-a-half times higher than
in the most productive areas of China and a good 75% higher than in
Malaysia or Poland," according to The Economist With such
artificially high costs of South African labor, it pays employers to use
more capital, but this is not greater efficiency for the economy as a
whole, which is worse off for having so many people unemployed.

which is to say, with so many resources idled instead of being
allocated.

South Africa is not unique. A National Bureau of Economic
Research study, comparing the employment of low-skilled workers in
Europe and the United States found that, since the 1970s, such workers
have been disproportionately displaced by machinery in European
countries where there are higher minimum wages and more benefits
mandated to be paid for by employers. The study pointed out that it
was since the 1970s that European labor markets moved toward more
control by governments and labor unions, while in the United States
the influence of government and labor unions on labor markets
became less.^^^^’

The net result has been that, despite more technological change
in the United States, the substitution of capital for labor in low-skilled
occupations has been greater in Europe. Sometimes the work of low-
skilled labor is not displaced by capital but simply dispensed with, as
the study noted:

It is close to impossible to find a parking attendant in Paris, Frankfurt or
Milan, while in New York City they are common. When you arrive even in
an average Hotel in an American city you are received by a platoon of bag
carriers, door openers etc. In a similar hotel in Europe you often have to
carry your bags on your own. These are not simply trivial traveler's
pointers, but indicate a deeper and widespread phenomenon: low skilled
jobs have been substituted away for machines in Europe, or eliminated,
much more than in the US, while technological progress at the "top" i.e. at
the high-tech sector, is faster in the US than in Europe.^^^^^

Just as a price set by 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 nnarket level tends 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.

In a free market, low-productivity workers are Just as employable
at a low wage rate as high-productivity workers are at a high wage
rate. During the long era from the late nineteenth century to the mid¬
twentieth century, when black Americans received lower quantities
and lower qualities of education than whites in the South where most
lived, the labor force participation rates of black workers were
nevertheless slightly higher than those of white workers.^^^^* For most
of that era, there were no minimum wage laws to price them out of
Jobs and, even after a nationwide minimum wage law was passed in
1938, the wartime inflation of the 1940s raised wages in the free
market above the legally prescribed minimum wage level, making the
law largely irrelevant by the late 1940s. The law was amended in 1950,
beginning a series of minimum wage escalations.

If low-wage employers make workers worse off than they would
be otherwise, then it is hard to imagine why workers would work for
them. "Because they have no alternative" may be one answer. But that
answer implies that low-wage employers provide a better option than
these particular workers have otherwise—and so are not making
them worse off. Thus the argument against low-wage employers

making workers worse off is internally self-contradictory. What would
make low-wage workers worse off would be foreclosing one of their
already limited options. This is especially harmful when considering
that low-wage workers are often young, entry-level workers for whom
work experience can be more valuable in the long run than the
immediate pay itself.

DIFFERENTIAL IMPACT

Because 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 by minimum wage laws are those who are younger, less
experienced or less skilled. This pattern has been found in New
Zealand, France, Canada, the Netherlands, and the United States, for
example. It should not be surprising that those whose productivity
falls furthest short of the minimum wage level would be the ones
most likely to be unable to find a job.^^^®*

In Australia, the lowest unemployment rate for workers under the
age of 25, during the entire period from 1978 to 2002, never fell below
10 percent, while the fi/gfiest unemployment rate for the population in
general barely reached 10 percent once during that same period.^®^^*
Australia has an unusually high minimum wage, relatively speaking,
since its minimum wage level is nearly 60 percent of that country's
median wage rate, while the minimum wage in the United States has
been less than 40 percent of the American median wage rate.^®^°*

In early twenty-first century France, the national unemployment
rate was 10 percent but, among workers under the age of twenty five,
the unemployment rate was more than 20 percentJ^^^’ In Belgium, the
unemployment rate for workers under the age of twenty five was 22
percent and in Italy 27 percentJ^^^* During the global downturn in 2009,
the unemployment rate for workers under the age of 25 was 21
percent in the European Union countries as a whole, with more than
25 percent in Italy and Ireland, and more than 40 percent in Spain

As American laws and policies moved more in the direction of
those in other modern industrial nations in the early twenty-first
century, the unemployment rate among Americans who were from 25
to 34 years old went from being lower than unemployment rates in the
same age bracket in Canada, Britain, Germany, France and Japan in
2000 to being fi/gfierthan in these same countries in 2011

Some countries in Europe set lower minimum wage rates for
teenagers than for adults, and New Zealand simply exempted
teenagers from the coverage of its minimum wage law until 1994. This
was tacit recognition of the fact that those workers less in demand
were likely to be hardest hit by unemployment created by minimum
wage laws.

Another group disproportionately affected by minimum wage
laws are 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 during the same era. Such expressions of overt racial
discrimination were both legal and socially accepted in all three