Basic Economics

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

Steven E. Landsburg{1}

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 written permission except in the case of brief quotations embodied in critical articles and reviews. For information, address Basic Books, 250 West 57th Street, 15th Floor, New York, NY 10107.

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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,{i} 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 or a nationalist, a churchman or a heathen, it is useful to know the causes and consequences of economic phenomena.

George J. Stigler{2}

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 think of 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.”{3}

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 producing that output from scarce resources in the first place—turning inputs into output.

In other words, economics studies the consequences of decisions that are made about the use of land, labor, capital and other resources that go into producing the volume of output 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.{4}

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.{5} 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.{6} 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.{7} 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,{8} 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 Easterly{9}

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.{10}

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.{11} China’s per capita consumption of dairy products nearly doubled in just five years.{12} A study estimated that one-fourth of the adults in China were overweight{13}—not a good thing in itself, but a heartening development in a country once afflicted with recurring famines.

ECONOMIC DECISION-MAKING