Sowell_Thomas_-_Basic_Economics_-_5th_Edition_2014

Personal bias is another fundamental question that has long been raisedabout economics and its claim to scientific status. J.A. Schumpeter, whose massiveHistory of Economic Analysis remains unequalled for its combination of breadthand depth, dealt with the much-discussed question of the effect of personal biason economic analysis. He found ideological bias common among economists,ranging from Adam Smith to Karl Marx—but what he also concluded was howlittle effect these biases had on these economists’ analytical work, which can beseparated out from their ideological comments or advocacies. In a scholarly journal as well, Schumpeter singled out Adam Smith inparticular: “In Adam Smith’s case the interesting thing is not indeed the absencebut the harmlessness of ideological bias.”{1020} Smith’s unrelievedly negative picture of businessmen was, to Schumpeter,an ideological bias deriving from Smith’s background in a family which “did notbelong to the business class” and his intellectual immersion in the work of“similarly conditioned” intellectuals. But “all this ideology, however strongly held,really did not much harm to his scientific achievement” in producing “soundfactual and analytic teaching.”{1021} Similarly with Karl Marx, whose ideologicalvision of social processes was formed before he began to study economics, but “ashis analytic work matured, Marx not only elaborated many pieces of scientificanalysis that were neutral to that vision but also some that did not agree with itwell,” even though Marx continued to use “vituperative phraseology that does notaffect the scientific elements in an argument.”{1022} Ironically, Marx’s view ofbusinessmen was not quite as totally negative as that of Adam Smith. {xlviii} According to Schumpeter, “in itself scientific performance does not requireus to divest ourselves of our value judgments or to renounce the calling of anadvocate of some particular interest.” More bluntly, he said, “advocacy does notimply lying,”{1023} though sometimes ideologies “crystallize” into “creeds” that are“impervious to argument.”{1024} But among the hallmarks of a scientific field are“rules of procedure” which can “crush out ideologically conditioned error” from ananalysis.{1025} Moreover, having “something to formulate, to defend, to attack”

provides an impetus for factual and analytical work, even if ideology sometimes interferes with it. Therefore “though we proceed slowly because of our ideologies, we might not proceed at all without them.”{1026}Events and Ideas Does economics influence events and do events influence economics? The short answer to both questions is “yes” but the only meaningful question is—to what extent and in what particular ways? John Maynard Keynes’ answer to the first question was this: . . .the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.{1027} In other words, it was not by direct influence over those who hold power at a particular point in time that economists influence the course of events, according to Keynes. It was by generating certain general beliefs and attitudes which provide the context within which opinion-makers think and politicians act. In that sense, the mercantilists are still an influence on beliefs and attitudes in the world today, centuries after they were refuted decisively within the economics profession by Adam Smith. The question whether economics is shaped by events is more controversial. At one time, it was widely believed that ideas are shaped by surrounding circumstances and events, and that economic ideas were no exception. No doubt something in the real world starts people thinking about economic ideas, as is no doubt true of ideas in other fields, including science and mathematics. Trigonometry was given an impetus, in ancient times, by the need to re-survey

land in Egypt after recurring floods along the Nile wiped out boundaries betweendifferent people’s properties. That is one kind of influence. A more immediate and direct influence hasbeen assumed by those who believed that the Great Depression of the 1930sspawned Keynesian economics. But even if the Great Depression inspired Keynes’thinking and the widespread acceptance of that thinking among economistsaround the world, how typical was that of the way that economics has evolvedhistorically, much less how ideas in other fields have evolved historically? Were more things falling down, or was their falling creating more socialproblems, when Newton developed his theory of gravity? Certainly there were notmore free markets when Adam Smith wrote The Wealth of Nations, whichadvocated freer markets precisely because of his dissatisfaction with the effects ofvarious kinds of government intervention that were pervasive at the time. {xlix} Thegreat shift within nineteenth century economics from a theory of pricedetermined by production costs to a theory of price determined by consumerdemand was not in response to changes in either production costs or consumerdemand. It was simply the unpredictable emergence of a new intellectual insightas a way of resolving ambiguities and inconsistencies in existing economic theory.As for depressions, there had been depressions before the 1930s withoutproducing a Keynes. Nobel Prize-winning economist George Stigler pointed out that momentousevents in the real world may have no intellectual consequences: “A war mayravage a continent or destroy a generation without posing new theoreticalquestions,” he said.{1028} The tragic reality is that wars have spread ruination anddevastation across continents many times over the centuries, so that there needbe no new issue to confront intellectually, even in the midst of an overwhelmingcatastrophe. Whatever its origins or its ability to influence or be influenced by externalevents, economics is ultimately a study of an enduring part of the humancondition. Its value depends on its contribution to our understanding of a

particular set of conditions involving the allocation of scarce resources which havealternative uses. Unfortunately, little of the knowledge and understanding withinthe economics profession has reached the average citizen and voter, leavingpoliticians free to do things that would never be tolerated if most peopleunderstood economics as well as Alfred Marshall understood it a century ago orDavid Ricardo two centuries ago. As for what economists today can offer, there have been some very differentassessments within the profession. Economics had long been christened “thedismal science” by those unhappy with all the promising-sounding social theoriesand policy proposals that economists punctured as counterproductive. However,in the wake of John Maynard Keynes’ economic theories, which proposed usefulroles for government intervention, there was in many quarters a sense thateconomists could do much more than provide insights on particular problems orissue warnings against more ambitious but unsound policies. By the 1960s, therewere Keynesian economists who spoke of their ability to “fine-tune” the economy.One of these was Walter Heller, Chairman of the Council of Economic Advisorsunder President John F. Kennedy: Economics has come of age in the 1960’s. . . . the Federal government has an overarching responsibility for the nation’s economic stability and growth. And we have at last unleashed fiscal and monetary policy for the aggressive pursuit of those objectives. . . .Interwoven with the growing Presidential reliance on economists has been a growing political and popular belief that modern economics can, after all, deliver the goods.{1029} The simultaneous rise of unemployment and inflation during the 1970s dealta blow to Keynesian economics in general and to the idea that the governmentcould fine-tune the economy in particular. Milton Friedman expressed a view thatwas the direct opposite of that expressed earlier by Walter Heller: A major problem of our time is that people have come to expect policies to produce results that they are incapable of producing. . . . we economists in recent years have

done vast harm—to society at large and to our profession in particular—by claimingmore than we can deliver. We have thereby encouraged politicians to makeextravagant promises, inculcate unrealistic expectations in the public at large, andpromote discontent with reasonably satisfactory results because they fall short of theeconomists’ promised land.{1030}

Chapter 27

PARTING THOUGHTS We shall not grow wiser before we learn that much that we have done was very foolish. F. A. Hayek{1031} Sometimes the whole is greater than the sum of its parts. In addition towhatever you may have learned in the course of this book about particular thingssuch as prices, investment, or international trade, you may also have acquired amore general skepticism about many of the glittering words and fuzzy phrasesthat are mass produced by the media, by politicians and by others. You may no longer be as ready to uncritically accept statements andstatistics about “the rich” and “the poor.” Nor should you find it mysterious that somany places with rent control laws have also had housing shortages, or thatattempts to control the price of food have often led to hunger or even starvation. However, no listing of economic fallacies can be complete, because thefertility of the human imagination is virtually unlimited. New fallacies are beingconceived, or misconceived, while the old ones are still being refuted. The mostthat can be hoped for is to reveal some of the more common fallacies andpromote both skepticism and an analytical approach that goes beyond theemotional appeals which sustain so many harmful and even dangerous economic

fallacies in politics and in the media. This should include a more careful use and definition of words, so thatstatements about how countries with high wages cannot compete in internationaltrade with countries which have low wages do not escape scrutiny because ofconfusing high wage rates per unit of time with high labor costs per unit ofoutput. Similar confusion between tax rates per dollar of income and total taxrevenues received by the government has often made rational discussion of taxpolicies virtually impossible. Many economic fallacies depend upon (1) thinking of the economy as a setof zero-sum transactions, (2) ignoring the role of competition in the marketplace,or (3) not thinking beyond the initial consequences of particular policies. If economic transactions could benefit one party to those transactions only atthe expense of the other party, then it would be understandable to believe thatgovernment intervention to change the transactions terms would produce a netbenefit to a particular party, such as tenants or employees. But, if economictransactions benefit both parties, then changing the transactions terms to favorone side tends to reduce the number of transactions that the other side is willingto engage in. In a world of positive-sum transactions, it is understandable whyrent control laws lead to housing shortages and minimum wage laws increaseunemployment. Few people are likely to explicitly say that economic transactionsbenefit only one party to those transactions, but many fallacies persist because ofimplicit assumptions that people do not bother to spell out, even to themselves. Seldom do people think things through foolishly. More often, they do notbother to think things through at all, so that even highly intelligent individualscan reach untenable conclusions because their brainpower means little if it is notdeployed and applied. The central role that competition plays in free market economies often getsoverlooked by those who do not spell out their assumptions. One of theattractions of central planning, especially before it was put into operation and itsconsequences experienced, was that the alternative seemed to be a chaos of

uncoordinated activity in an uncontrolled market. Many have also believed that labor unions can increase labor’s share of anindustry’s income simply by reducing the share going to investors in that industry.But this ignores the competition for investment, which is attracted to industrieswhere the returns are higher and repelled from industries where it is lower,thereby changing employment prospects in both places. Where there iscompetition between unionized and non-union companies in the same industry,as in American automobile manufacturing, it is hardly surprising to see GeneralMotors drastically reducing the number of workers on its payroll while Toyota isincreasing its hiring in the United States. Not thinking beyond the initial consequences of economic decisions,including government policies, is a special example of not bothering to thinkthings through. Restricting the importation of foreign steel into the United Statesdid indeed save jobs in the domestic steel industry, but its repercussions on theprices and sales of other domestic products made with higher-priced domesticsteel cost far more jobs than those that were saved in the steel industry. None ofthis is rocket science but it does require stopping to think. The particular exampleshere or elsewhere in this book are not nearly as important as keeping in mind theeconomic principles they illustrate. Much confusion comes from judging economic policies by the goals theyproclaim rather than the incentives they create. In wartime, for example, whenmilitary forces absorb many resources that would normally go into producingcivilian products, there is often an understandable desire to ensure that such basicthings as food continue to be available to the civilian population, especially thosewith low incomes. Thus price controls may be imposed on bread and butter, butnot on champagne and caviar. However right this might seem, when you lookonly at the goal or the initial consequences, the picture changes drastically whenyou follow the subsequent repercussions from the incentives created. If the prices of bread and butter are kept lower than they would be ifdetermined by supply and demand in a free market, then producers of bread and

butter tend to end up with lower rates of profit than producers of champagne andcaviar, who remain free to charge “whatever the traffic will bear,” since no oneregards these things as essential. However, because all producers compete forlabor and other scarce resources, this means that the higher profits fromchampagne and caviar enable their producers to bid away more resources, at theexpense of producers of bread and butter, than they would have been able to in afree market without price controls. Shifting resources from the production ofbread and butter to the production of champagne and caviar is one of therepercussions that escapes notice when we fail to think beyond the initial stage ofconsequences of economic policies. For similar reasons, rent control tends to shiftresources from the production of ordinary housing for moderate-income peopletoward the building of luxury housing for the affluent and wealthy. The importance of economic principles extends beyond things that mostpeople think of as economics. For example, those who worry about theexhaustion of petroleum, iron ore, or other natural resources often assume thatthey are discussing the amount of physical stuff on the planet. But thatassumption changes radically when you realize that statistics on “known reserves”of these resources may tell us more about costs of exploration, and about theinterest rate on the money that finances this exploration, than about how much ofthe resource remains on Earth. Nor is the amount of physical stuff necessarily whatmatters, without knowing how much of it can be extracted and processed at whatcosts. Many other decisions that are not usually thought of as economic, may infact have serious economic repercussions. For example, some communities maydecide to restrict how tall local buildings will be allowed to be built, without anythought that this has economic implications which can result in much higher rentsbeing charged. {l} These are just some of a whole range of problems and issueswhich, on the surface, might not seem to be economic matters, but whichnevertheless look very different after understanding basic economic principlesand applying them.

The importance of the distinction between policy goals versus theincentives created by those policies extends beyond the particular thingsdiscussed in this book—and, indeed, beyond economics. Nothing is easier than toproclaim a wonderful goal. The “Law to Relieve the Distress of the People andReich” during the Great Depression of the 1930s gave dictatorial powers to AdolfHitler, leading to World War II, which created more distress and disaster than theGerman people—and many other peoples—had ever experienced before. What must be asked about any goal is: What specific things are going to bedone in the name of that goal? What does the particular legislation or policyreward and what does it punish? What constraints does it impose? Looking to thefuture, what are the likely consequences of such incentives and constraints?Looking back at the past, what have been the consequences of similar incentivesand constraints in other times and places? As the distinguished British historianPaul Johnson put it: The study of history is a powerful antidote to contemporary arrogance. It is humbling to discover how many of our glib assumptions, which seem to us novel and plausible, have been tested before, not once but many times and in innumerable guises; and discovered to be, at great human cost, wholly false.{1032} We have seen some of those great human costs—people going hungry inRussia, despite some of the richest farmland on the continent of Europe, peoplesleeping on cold sidewalks during winter nights in New York, despite far moreboarded-up housing units in the city than it would take to shelter them all. Some of the economic policies which have led to counterproductive or evencatastrophic consequences in various countries and in various periods of historymight suggest that there was unbelievable stupidity on the part of those makingthese decisions—which, in democratic countries, might also imply unbelievablestupidity on the part of those who voted for them. But this is not necessarily so.While the economic analysis required to understand these issues may not beparticularly difficult to grasp, one must first stop and think about the issues in an

economic framework. When people do not stop and think through the issues, itdoes not matter whether those people are geniuses or morons, because thequality of the thinking that they would have done is a moot point. In addition to the role of incentives and constraints, one of our other centralthemes has been the role of knowledge. In free market economies, we have seengiant multi-billion-dollar corporations fall from their pinnacles, some all the wayto bankruptcy and extinction, because their knowledge of changingcircumstances, and the implications of those changes, lagged behind that ofupstart rivals. While facts are important, understanding the implications of those facts iseven more important, and that is what an understanding of economics seeks toprovide. For example, the Eastman Kodak Company was the international colossusof the photographic industry for more than a century—and yet it was devastatedeconomically by the rise of digital cameras, which destroyed the market for manyKodak products built around the now obsolete technology of film. Yet what Kodaklacked was not knowledge of digital cameras, which were invented by Kodak, buta failure to see the implications of this radically new technology as well as othercompanies which developed the potentialities of this technology to the pointwhere Eastman Kodak was forced into bankruptcy. These other companiesincluded not only traditional camera makers like Nikon and Canon but alsocompanies outside the photographic industry, like Sony and Samsung, whichbegan producing digital cameras. What is important is not that particular companies succumbed to competingcompanies, whether in the photographic industry or elsewhere, but thatknowledge and insights proved decisive in market competition. The publicbenefitted because some business decisions were based on a clearerunderstanding of the economic realities of the times and circumstances—andthese were the businesses that survived to use scarce resources that hadalternative uses. In centrally planned economies, we have seen the planners overwhelmed by

the task of trying to set literally millions of prices—and keep changing thoseprices in response to innumerable and often unforeseeable changes incircumstances. It was not remarkable that they failed so often. What wasremarkable was that anyone had expected them to succeed, given the vastamount of knowledge that would have had to be marshaled and mastered in oneplace by one set of people at one time, in order to make such an arrangementwork. Lenin was only one of many theorists over the centuries who imagined thatit would be easy for government officials to run economic activities—and the firstto encounter directly the economic and social catastrophes to which that beliefled, as he himself admitted, after just a few years in power. Given the decisive advantages of knowledge and insight in a marketeconomy, even when this knowledge and insight are in the minds of people bornand raised in poverty, such as J.C. Penney or F.W. Woolworth, we can see whymarket economies have so often outperformed other economies that depend onideas originating solely within a narrow elite of birth or ideology. While marketeconomies are often thought of as money economies, they are still more soknowledge economies, for money can always be found to back new insights,technologies and organizational methods that work, even when these innovationswere created by people initially lacking in money, whether Henry Ford, ThomasEdison, David Packard, or others. Capital is always available under capitalism, butknowledge and insights are rare and precious under any economic system. Knowledge should not be narrowly conceived as the kind of information inwhich intellectuals and academics specialize. We should not be like the depictionof the famous scholar Benjamin Jowett, master of Balliol College at Oxford, whoinspired this verse: My name is Benjamin Jowett. If it’s knowledge, I know it. I am the master of this college, What I don’t know isn’t knowledge.

In reality, there is much that the intelligentsia do not know that is knowledgevital to the functioning of an economy. It may be easy to disdain the kinds ofhighly specific mundane knowledge and its implications which are ofteneconomically decisive by asking, for example: “How much knowledge does it taketo fry a hamburger?” Yet McDonald’s did not become a multi-billion-dollarcorporation, with thousands of outlets around the world, for no reason—not withso many rivals trying desperately and unsuccessfully to do the same thing, andsome of them failing even to make enough money to stay in business. Anyonewho studies the history of this franchise chain {li} will be astonished at the amountof detailed knowledge, insights, organizational and technological innovation,financial improvisation, all-out efforts and desperate sacrifices that went intocreating an enormous economic success from selling just a few common foodproducts. Nor was McDonald’s unique. All sorts of businesses—from Sears to Intel andfrom Honda to the Bank of America—had to struggle upward from humblebeginnings to ultimately achieve wealth and security. In all these cases, it was theknowledge and insight that was built up over the years—the human capital—which ultimately attracted the financial capital to make ideas become a reality.The other side of this is that, in countries where the mobilization of financialresources is made difficult by unreliable property rights laws, those at the bottomhave fewer ways of getting the capital needed to back their entrepreneurialendeavors. More important, the whole society loses the benefits it could gain fromwhat these stifled entrepreneurs could have contributed to the economic rise ofthe nation. Success is only part of the story of a free market economy. Failure is at leastas important a part, though few want to talk about it and none want to experienceit. When the same resources—whether land, labor or petroleum—can be used bydifferent firms and different industries to produce different products, the only wayfor the successful ideas to become realities is to take resources away from other

uses that turn out to be unsuccessful, or which have become obsolete after havinghad their era of success. Economics is not about “win-win” options, but aboutoften painful choices in the allocation of scarce resources which have alternativeuses. Success and failure are not isolated good fortunes and misfortunes, butinseparable parts of the same process. All economies—whether capitalism, socialism, feudalism or whatever—areessentially ways of cooperating in the production and distribution of goods andservices, whether this is done efficiently or inefficiently, voluntarily orinvoluntarily. Naturally, individuals and groups want their own particularcontributions to the process to be better rewarded, but their complaints orstruggles over this are a sideshow to the main event of complementary effortswhich produce the output on which all depend. Yet invidious comparisons andinternecine struggles are the stuff of social melodrama, which in turn is thelifeblood of the media and politics, as well as portions of the intelligentsia. By portraying cooperative activities as if they were zero-sum contests—whether in employer-employee relations or in international trade or othercooperative endeavors—those with the power to impose their misconceptions onothers through words or laws can create a negative-sum contest, in which all areworse off. A young worker who is destitute of both knowledge and money wouldtoday find it virtually impossible to purchase the knowledge that was vital to afuture career by working long hours for no pay, as many did in times past—including F. W. Woolworth, who by this means rose from dire poverty to becomeone of the richest men of his era in retailing. Those with a zero-sum vision who have seen property rights as mere specialprivileges for the affluent and the rich have helped erode or destroy such rights, orhave made them practically inaccessible to the poor in Third World countries,thereby depriving the poor of one of the mechanisms by which people frombackgrounds like theirs have risen to prosperity in other times and places. However useful economics may be for understanding many issues, it is not asemotionally satisfying as more personal and melodramatic depictions of these

issues often found in the media and in politics. Dry empirical questions are seldomas exciting as political crusades or ringing moral pronouncements. But empiricalquestions are questions that must be asked, if we are truly interested in the well-being of others, rather than in excitement or a sense of moral superiority forourselves. Perhaps the most important distinction is between what sounds goodand what works. The former may be sufficient for purposes of politics or moralpreening, but not for the economic advancement of people in general or the poorin particular. For those who are willing to stop and think, basic economicsprovides some tools for evaluating policies and proposals in terms of their logicalimplications and empirical consequences. If this book has contributed to that end, then it has succeeded in its mission.

Q U E S T I O N S

Q U E S T I O N S The pages in parentheses are where answers to these questions can be found in the print edition. PART I: PRICES AND MARKETS 1. Can there be a growing scarcity without a growing shortage—or a growing shortage without a growing scarcity? Explain with examples. (pages 38, 47–48) 2. Can a decision be economic, if there is no money involved? Why or why not? (pages 6–7) 3. Can there be surplus food in a society where people are hungry? Explain why or why not. (pages 54–55) 4. When a housing shortage suddenly disappears, within a time period too short for any new housing to have been built, and yet people no longer have any trouble finding a vacant home or apartment, what has probably happened? What will probably happen in the longer run? Explain. (page 39) 5. Which of the following are—or are not—affected by price controls that limit how high the product’s price can go: (a) the quantity supplied, (b) the quantity demanded, (c) the quality of the product, (d) a black market for

the product, (e) hoarding of the product, (f) the supply of auxiliary services that usually go with the product, or (g) efficiency in the allocation of resources? Explain in each case. (a: pages 41–44; b: pages 39–41; c: pages 49–50, 51–53; d: pages 50–51, 53; e: pages 48–49; f: page 42; g: pages 52– 53, 64–65) 6. Building ordinary housing and building luxury housing involves using many of the same resources, such as bricks, pipes, and construction labor. How does the allocation of these resources between ordinary housing and luxury housing tend to change after rent control laws are passed? (pages 43, 47) 7. Are prices usually higher or lower in low–income neighborhoods? Why? Include among prices the interest rate on money borrowed and the cost of getting paychecks cashed. (pages 66–68) 8. When a government institution or program produces counterproductive results, is that necessarily a sign of irrationality or incompetence on the part of those who run that particular institution or program? Explain with examples. (pages 70–72) 9. We all consider some things more important than others. Why then can there be a problem when some official government policy establishes “national priorities”? (pages 77–78)10. We tend to think of costs as the money we pay for things. But does that mean that there would be no costs in a primitive society that did not yet use money or in a modern cooperative community, where people collectively produce the goods and services they use and do not charge each other for them? (pages 22, 28)11. How does rent control affect the average number of persons per apartment and the average amount of time that the same persons stay in the same apartment? (pages 39–41)

12. Back in the days of the Soviet Union, the government owned and operated most of the enterprises in the economy. Most prices were set by central planners, rather than by supply and demand, and the success or failure of Soviet enterprises was judged primarily by how well they met the numerical targets for production, which were set by the central planners. Specify five ways in which this arrangement produced different economic end results from those in market economies. (pages 17, 22–23, 27, 71, 73– 74) 13. How can the price of baseball bats be affected by the demand for paper or the price of catchers’ mitts be affected by the demand for cheese? (page 20) 14. Why are price controls likely to cause more of a shortage of gasoline than of strawberries? (page 49) 15. How does rent control affect the quality of housing and the average age of housing? (pages 41–42)PART II: INDUSTRY AND COMMERCE 1. Why would a big corporation pay millions of dollars in severance money to an executive who has been a complete failure, who has turned corporate profits into corporate losses? (page 145) 2. Why has Toyota manufactured cars with only enough inventory of parts to last a few hours? Why did Soviet industries have nearly enough inventory to last for a year? (page 136) 3. Why do American manufacturers of computers or television sets tend to have them transported by others while Chinese manufacturers tend to transport them themselves? (page 135) 4. How did the movement of population from rural to urban America affect