Sowell Basic Economics A Citizen's Guide to the Economy

powerful enough to kill a dozen people in California will kill hundreds of people in some less affluent country and thousands in a Third World nation. Greater wealth enables California buildings, bridges, and other structures to be built to withstand far greater stresses than similar structures can withstand in poorer countries. Those injured in an earthquake in California can be rushed far more quickly to far more elaborately equipped hospitals with larger numbers of more highly trained medical personnel. This is just one of innumerable ways in which wealth saves lives. There have been various calculations of how much of a rise in national income saves how many lives. Whatever the correct figure may be-X million dollars to save one life-anything that prevents national income from rising that much has, in effect, cost a life. If some particular safety law, policy, or device costs 5X million dollars, either directly or in its inhibiting effect on economic growth, then it can no longer be said to be worth it "if it saves just one human life" because it does so at the cost of 5 other human lives. There is no escaping trade-offs, so long as resources are scarce and have alternative uses.

"UNMET NEEDS"

One of the most common-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 or 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 heaven? 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 in 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 forgo opportunities for which they have willingly paid vast amounts is a cost that may far outweigh the savings from 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 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 Paul worse off, and now wants to help him 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 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, 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 urgent needs remain needs 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 at particular times and places and in particular amounts. Unfortunately, most laws and government policies apply categorically, if only because of the dangers in leaving every 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.

WHAT IS "WASTE"?

Although efficiency is what economics is all about, there are many false notions as to what constitutes "efficiency." Some think that it can be reduced to output per man-hour or to more miles per gallon or larger crops per acre. It cannot.

Efficiency is inescapably bound up with what people want-and at what cost. Even an apparently scientific question like the efficiency of an automobile engine rests ultimately on what you want the car to do. Otherwise, all automobile engines are 100 percent efficient, in the sense that all the energy they get from gasoline is used, whether in moving the car forward, overcoming internal friction in the engine, shaking the car body randomly, generating heat that is radiated out into the air, etc. It is only after you define what you want as moving the car forward that the efficiency of different engines can be compared in terms of what percentage of their power is used for that particular purpose.

When a third party defines efficiency for other people, that often conflicts with what those other people prefer in their own individually differing circumstances. For example, there have been many laments about Americans using gasoline in "wasteful" ways during the 1980s and 1990s, as contrasted with their more "fuel-efficient" behavior in the 1970s. But the reason for the change was that the real price of gasoline was lower in the 1980s and 1990s, reflecting large increases in both the immediate supply and the known reserves of petroleum in the world. Consumers were responding to the changing realities conveyed by prices, rather than to the fashionable but unsubstantiated alarms conveyed by words in the media and in politics.

During the 1970s, an international oil cartel-the Organization of Petroleum Exporting Countries (OPEC)-deliberately cut back on petroleum production, disrupting economies around the world. In the United States, government price controls turned a minor adjustment into a major shortage.

By the 1990s, new discoveries of petroleum deposits and the weakening of the OPEC cartel had the world awash in oil, with the real price of gasoline hitting an all-time low.

It is not wasteful to increase one's use of resources that have become more abundant. That is precisely what is supposed to happen in a price-coordinated economy because that is the most efficient behavior, with efficiency being defined as the most effective way of satisfying people's desires. Waste is no more objectively definable than its opposite, efficiency. The arbitrary assumption that it is serves only to let third parties impose their definitions on other people, who obviously would not be doing the things that observers define as wasteful if they themselves did not see matters differently.

Chapter 23

Myths About Markets

There are so many myths about markets that only a sample can be presented here. Because the underlying logic of these misconceptions is seldom spelled out, making that logic plain can seem like an exercise in satire.

For example, many people argue as if businesses can set prices by an act of will, as if economic activity is a zero-sum process, in which what is gained by some is lost by others, and as if those who favor free market competition are probusiness. All these are demonstrably false beliefs. So is the so-called "trickle down theory." There is also much confusion about morality and markets.

MORALITY AND MARKETS

The market is as moral or immoral as the people in it. So is the government.

The fact that we call one set of people "the market" and another set of people "society" does not mean that the moral or other imperfections of first set of people automatically justify having the second set of imperfect people overruling their decisions. Like economics, the market is not some separate entity with its own values. It is people making their own individual choices and their mutual accommodations.

Once it was fashionable to contrast the selfishness of the isolated individual in a market economy with cooperative actions among people with a more communal spirit under various forms of socialism. One reason such rhetorical or ideological fashions no longer have the same effectiveness is the actual track record of socialist systems in practice. What also needs to be considered is the track record of market economies in creating widespread cooperation among people through individual incentives. Such cooperation does not even stop at national borders.

The Indian software company Wipro creates and maintains computer systems for the American hardware chain Home Depot and, through the magic of the electronic revolution, telephone calls made by British customers to Harrod's department store in London are answered by Indians living near Delhi. Fires in the oil fields of the Middle East have been put out by a company in Texas that specializes in putting out oil fires. More than half the life insurance on people in the Philippines, Malaysia and Singapore is provided by insurance companies in other countries. Britain's hot-selling automobile, the Mini Cooper, is made with engines from Brazil, sheet metal from Germany and various other parts manufactured in Czechoslovakia. In the international diamond center in Antwerp, Hasidic Jews and Jains from India dominate the industry and interact socially as well. As the Wall Street Journal reported:

In Antwerp, Jews and Indians have come to be so embedded in each other's lives that many of the Indian dealers speak Hebrew and Yiddish. Most traditional Indian weddings have a special kosher section. After a devastating earthquake in the Indian state of Gujarat in 2001, Jewish diamond traders raised thousands of dollars for humanitarian aid.

Is cooperation any less because the incentives behind it are the individual benefits of the participants?

Despite the painful facts of history, the idea persists in many places that political decisions are more moral than decisions made through the marketplace. Writers for the San Francisco Chronicle referred to "how amoral the marketplace can be" when explaining why the water supply owned by the city of Stockton could not be entrusted to private enterprise. "Water is too life-sustaining a commodity to go into the marketplace with," they quoted the mayor of Stockton as saying. Yet, every day, life-sustaining food is supplied through private enterprises, as are many life-saving medicines. The net result is that people in most market economies are less likely to suffer from malnutrition than from obesity-just the opposite of what happens in countries where political authorities control food-and most new life-saving medicines are developed in market economies, notably that of the United States. As for privately run water systems, they already exist in Argentina.

The Economist reported on the results of privatization:

Connections to the water and sewerage networks rose, especially among poorer households: most richer households were already hooked up . . . Before privatization really got under way, in 1995, child mortality rate were falling at much the same pace in municipalities that eventually privatized and those that did not.

After 1995, the fall accelerated in privatizing municipalities. . . The fall was concentrated in deaths from infectious and parasitic diseases, the sort most likely to be affected by water quality and availability. Death from other causes did not decline.

In Britain as well, the privatized water supply in England has lower water bills, higher quality drinking water, less leakage, and a sewage disposal system that complies with environmental regulations a higher percentage of the time than those in Scotland, where the government runs the water system.

Empirical consequences, however, often matter less than deeply ingrained beliefs and attitudes. Whether in urgent or less urgent matters, many believe that those with political power are better qualified to make moral decisions than are the private parties directly concerned. Such attitudes are international. An entrepreneur in India reported his experience with a government minister there:

I had argued that lowering the excise duty would lower consumer prices of shampoos, skin creams, and other toiletries, which in turn would raise their demand. The tax revenues would thus rise, although the tax rate might be lower.

Indian women did not need lipsticks and face creams, felt the minister. I replied that all women wanted to look pretty.

"A face cream won't do anything for an ugly face. These are luxuries of the rich," he said. I protested that even a village girl used a paste of haldi so that she could look pretty.

"No, it's best to leave a face to nature," he said impatiently.

"Sir," I pleaded, "how can you decide what she wants? After all, it is her hard earned money." "Yes, and I don't want her wasting it. Let her buy food. I don't want multinational companies getting rich selling face cream to poor Indians."

The idea that third party observers can impose morally better decisions often includes the idea that they can define what are "luxuries of the rich," when it is precisely the progress of free market economies which has turned luxuries of the rich into common amenities of people in general, including the poor. Within the twentieth century, automobiles, telephones, refrigerators, television sets, air-conditioners, and personal computers all went from being luxuries of the rich

to being common items across the spectrum of Americans and among millions of people in many other market economies.

In the nineteenth century, a President of the United States was criticized for spending the government's money to install such a luxury item as a bathtub in the White House. In past centuries, even such things as oranges, sugar, and cocoa were luxuries of the rich in Europe. Not only do third party definitions of what is a luxury of the rich fail to account for such changes, the stifling of free markets by third parties enables such things to remain exclusive luxuries longer than they would otherwise.

PRICES

There seem to be almost as many myths about prices as there are prices. For example, it is common to hear that the same thing is sold at very different prices by different sellers. While this can happen, usually this involves defining things as being "the same" when in fact they are not. Other myths include the notion that "greedy" sellers are responsible for rising prices or that "predatory" businesses destroy competition by selling below cost and bankrupting their rivals, so that they can then raise prices to monopolistic levels afterward. While these are only a small sample, looking at them closely may illustrate how easy it is to create a plausible-sounding myth and get it accepted by many otherwise intelligent people, who simply do not bother to scrutinize the logic or the evidence.

Different Prices for the "Same" Thing

Physically identical things are often sold for different prices, usually because of accompanying conditions that are quite different. As noted in Chapter 6, two airline passengers sitting side by side in the same plane may have paid very different fares because one bought a guaranteed reservation, while the other was a standby who got on board when there happened to be space available. What they really bought were two very different probabilities of getting on board that plane. Only in retrospect did they end up with the same thing-but people do not act in retrospect. As of the time they acted, they bought very different things. Similarly, someone who wins an automobile with a $20 lottery ticket can end up with the same car for which someone else paid $20,000. But one bought a low probability of getting a car and the other bought a virtual certainty. The car they ended up with may be the same but what they bought was not the same.

Goods sold in attractively decorated stores with polished and sophisticated sales staffs, as well as easy return policies, are likely to cost more than the physically identical products sold in a stark warehouse store with a no refund policy. Christmas cards can usually be bought for much lower prices on December 26th than on December 24th, even though the cards are physically identical to what they were when they were in great demand before Christmas.

A consumer magazine in northern California compared the total cost of buying the identical

set of food items of the same brands in various stores in their area. These total costs ranged from $80 in the least expensive store to $125 in the most expensive. Indeed, they ranged from $98 to $103 at three different Safeway supermarkets.

Part of the reason for the variations in price was the variation in the cost of real estate in the different communities-the store with the lowest prices being located in less expensive Fremont and the one with the highest prices being located in San Francisco, which has had the highest real estate prices of any major city in the country. The cost of the land on which the stores sat was different and these costs had to be recovered from the prices charged the stores' customers.

Another reason is the cost of inventory. The cheapest store had only 49 percent of the items in stock at a given time, while all three Safeway stores had more than three-quarters of the items in stock. In other words, going to different stores meant having different probabilities of finding what you wanted. It was like the difference between buying reserved seats on an airplane versus being a standby. Cost differences reflected differences in availability, which is to say, differences in the costs of maintaining inventory, even when the particular commodities were physically the same. It also meant differences in the costs measured in the time that customer would have to spend going from store to store to find all the items on a grocery shopping list.

Mistakes or miscalculations may sometimes cause the same thing to be sold for different prices under comparable conditions temporarily, but competition usually makes this a passing phenomenon. When customers go where prices are lower, those whose prices are higher have little choice but to lower their prices, if they are not offering some offsetting advantages along with the same physical product. Where there are permanently different prices for things that are truly the same, the higher-price seller usually ends up going out of business for lack of customers.

"Predatory" Pricing

One of the popular myths that 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 and forces it out of business. Then, having acquired a monopolistic position, it 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.

One of the most remarkable things about this theory is that those who advocate it seldom provide concrete examples of when it ever actually happened. Perhaps even more remarkable, they have not had to do so, even in courts of law, in anti-trust cases.

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) or 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.

But this is more than just a theory without evidence. It is something that it 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 payoff in the long run is problematical. Whether it can do so and escape the anti-trust laws is even more problematical-and these laws can lead to millions of dollars in fines and/or the dismemberment of the Company. But, even if our would-be predator manages somehow to overcome these 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 be a more dangerous rival.

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, while its rivals disappeared one by one, until it was the only major newspaper in town by 1978. By the early twenty first century, The Washington Post had one of the five largest circulations in the country.

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 without destroying competition can be an expensive endeavor, with little prospect of recouping the losses by subsequent monopoly profits.

BRAND NAMES

Brand names are often thought to be just ways of being able to charge a higher price for the same product by persuading people through advertising that there is a quality difference, when in fact there is no such difference. In other words, brand names are considered to be useless things from the standpoint of the consumer's interests. As India's Prime Minister Nehru once asked, "Why do we need nineteen brands of toothpaste?" In reality, brand names serve a number of purposes from the standpoint of the consumer. Brands are a way of economizing on scarce knowledge, and of forcing producers to compete in quality and price.

When you drive into a town you have never seen before and want to get some gasoline for your car or to eat a hamburger, you have no direct way of knowing what is in the gasoline that some stranger at the filling station is putting into your tank or what is in the hamburger that another stranger is cooking for you to eat at a roadside stand that you have never seen before.

But, if the filling station's sign says Chevron and the restaurant's sign says McDonald's, then you don't worry about it. At worst, if something terrible happens, you can sue a

multi-billion-dollar corporation. You know it, the corporation knows it, and the local dealer knows it. That is what reduces the likelihood that something terrible will happen.

On the other hand, imagine if you pull into a no-name filling station in some little town and the stranger there puts something into your tank that messes up your engine or-worse yet-if you eat a no-name hamburger that sends you to the hospital. Your chances of suing the local business owner successfully (perhaps before a jury of his friends and neighbors) may be considerably less. Moreover, even if you should win, the chances of collecting enough money to compensate you for all the trouble you have been put through is more remote.

Brand names are not guarantees. But they do reduce the range of uncertainty. If a hotel sign says Hyatt Regency, chances are you will not have to worry about whether the bed sheets in your room were changed since the last person slept there. If the camera you buy is a Nikon, it is unlikely to jam up the first time you wind the film. Even if you stop at a dingy and rundown little store in a strange town, you are not afraid to drink a soda they sell you, if it is a bottle or can of Coca Cola or Seven-Up. Imagine, however, if the owner of this unsavory little place mixed you a soda at his own soda fountain. Would you have the same confidence in drinking it?

Like everything else in the economy, brand names have both benefits and costs. A hotel with a Hyatt Regency sign out front is likely to charge you more for the same size and quality of room, and accompanying service, than you would pay in some comparable, locally-run, independent hotel if you knew where to look. Someone who regularly stops in this town on business trips might well find a locally-run hotel that is a better deal. But it is as rational for you to look for a brand name when passing through for the first time as it is for the regular traveler to go where he knows he can get the same things for less.

Since brand names are a substitute for specific knowledge, how valuable they are depends on how much knowledge you already have about the particular product or service. Someone who is very knowledgeable about photography might be able to safely get a bargain on an off-brand camera or lens, or even a second-hand camera or lens. But that same person might be well advised to stick to well known brands of new stereo equipment, if his knowledge in that field falls far short of his expertise in photography.

Many critics of brand names argue that the main brands "are all alike." Even when that is so, the brand names still perform a valuable function. All the brands may be better than they would have to be if the product were sold under anonymous or generic labels. Both Kodak and Fuji film have to be better than they would have to be if boxes simply said "Film," without any reference to the manufacturer. But, when film is sold with brand names on the boxes, Kodak knows that it will lose millions of dollars in sales if it falls behind Fuji in quality and Fuji knows that it will lose millions if it falls behind Kodak. When United Parcel Service first began to compete with Federal Express in overnight deliveries, UPS announced that it would deliver packages by 3 PM the next day. Federal Express immediately announced that it would deliver them by 10:30 AM-which both companies subsequently did.

Brands have not always existed. They came into existence and then survived and spread for a reason. In eighteenth century England, for example, only a few luxury goods, such as Chippendale furniture, were known by their manufacturer's brand name. It was an innovation when Josiah Wedgwood put his name on chinaware that he sold and which ultimately became world famous for its quality and appearance.

In nineteenth century America, most food processors did not put brand names on the food that they sold-a situation which allowed adulteration of food to flourish. When Henry Heinz entered this business and sold unadulterated processed food, he identified his products with his

name, reaping the benefits of the reputation he established among consumers, which allowed his company to expand rapidly and an array of new processed foods bearing his name to be readily accepted by the public. In short, the rise of brands promoted better quality by allowing consumers to distinguish and choose, and forcing producers to take responsibility for what they made, reaping rewards when it was good and losing customers when it was not.

Quality standards for hamburgers, milk shakes and French fries were all revolutionized in the 1950s and 1960s by McDonald's, whose methods and machinery were later copied by some of their leading competitors. But the whole industry's standards became higher because McDonald's spent millions of dollars researching the growing, storage and processing of potatoes, in addition to making unannounced visits to its potato suppliers, as it did to its suppliers of hamburger meat, in order to ensure that its quality specifications were being followed, while its huge buying power forced dairies to supply a higher quality of milk shake mix that McDonald's demanded. After all this was done, some might say in later years that leading hamburger chains were "all alike," but they were all better because McDonald's could first reap the rewards of having its brand name identified in the public mind with higher quality products than they had previously been used to in hamburger stands.

Even when the various brands of a product are made to the same formula by law, as with aspirin, quality control is promoted when each producer of each brand of aspirin is identified than when the producer is anonymous.

Moreover, the best-known brand has the most to lose if some impurity gets into the aspirin during production and causes anyone injury or death. This is especially important with foods and medicines.

McDonald's not only has to meet the standards set by the government, it has to meet the standards set by the competition of Wendy's and Burger King. If Campbell's soup were identified on the label only as "soup"-or "Tomato Soup," "Clam Chowder," etc.-the pressures on all canned soup producers to maintain both safety and quality would be less.

In countries where there are no brand names, or where there is only one producer created or authorized by the government, the quality of the product or service tends to be notoriously low. During the days of the Soviet Union, the country's only airline, Aeroflot, became the epitome of bad service and rudeness to passengers. After the dissolution of the Soviet Union, a new privately financed airline began to have great success, in part because its passengers appreciated being treated like human beings for a change. The management of the new airline declared that its employment policy was that it would not hire anyone who had ever worked for Aeroflot.

Similarly, one of the reasons for the great success of McDonald's in Moscow-the largest McDonald's in the world, with lines of people waiting to get into it-is that it was being compared to the previous bad quality of service in Soviet restaurants, not to Wendy's or Burger King.

Competition in the marketplace affects not only price but quality. Brand names make the competitors responsible for both.

THE ROLE OF PROFITS

Business and the Market