prices and information: a simple framework for understanding economics

PRICES AND INFORMATION A SIMPLE FRAMEWORK FOR UNDERSTANDING

ECONOMICS by

W. Robert Reed and Max Schanzenbach

© 1996 W. Robert Reed and Max Schanzenbach

TABLE OF CONTENTS

PART I: Prices and Information

CHAPTER 1: Why You Should Read This Book CHAPTER 2: What is the Purpose of an Economy? CHAPTER 3: How Can You Measure Happiness? CHAPTER 4: If You Don't Like It, Give 'Em Money CHAPTER 5: The Incredible Information Contained in Prices: Part I CHAPTER 6: The Incredible Information Contained in Prices: Part II CHAPTER 7: The Incredible Information Contained in Prices: Part III CHAPTER 8: Information and the Fundamental Problem in Economics CHAPTER 9: The Rest of the (Output Price) Story CHAPTER 10: The Information Contained in Input Prices CHAPTER 11: A Ton of Copper Versus A Ton of Steel CHAPTER 12: A Ton of Ph.D.'s Versus a Ton of High School Dropouts

PART II: A Simple Framework for Analyzing Public Policy

CHAPTER 13: The Big Picture CHAPTER 14: The Amazing Story of Profits CHAPTER 15: Profits and the Invisible Hand CHAPTER 16: Price Controls and Other Disasters CHAPTER 17: Does Recycling Waste Resources? CHAPTER 18: Job Destruction and Economic Growth CHAPTER 19: A Simple Framework for Analyzing Public Policy--Part I CHAPTER 20: A Simple Framework for Analyzing Public Policy--Part II CHAPTER 21: A Simple Framework for Analyzing Public Policy--Part III

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CHAPTER 22: Can We Afford to Let the Maritime Industry Sink? CHAPTER 23: Job Training--Ticket to Prosperity? CHAPTER 24: Making Ourselves Poorer by Trying to Make Ourselves Richer CHAPTER 25: These Quotas Don't Amount to Peanuts CHAPTER 26: Who Will Protect Workers and Consumers? CHAPTER 27: OSHA--We're From the Government and We're Here to Help You CHAPTER 28: Unintended Consequences of Consumer Safety Regulation? CHAPTER 29: A Game Called Hot 'N Cold

PART III: Extensions of the Simple Framework

CHAPTER 30: Moving to Greener Pastures CHAPTER 31: That Loud Sucking Sound CHAPTER 32: But Where Will the Jobs Come From? CHAPTER 33: Who Gains From Trade? CHAPTER 34: How to Spite Our Collective Face by Cutting Off Our Collective Noses CHAPTER 35: Are Trade Deficits Bad? CHAPTER 36: Trade Wins, and Losses CHAPTER 37: The Information Contained in Interest Rates CHAPTER 38: Who Watches Out for Our Children's Children? CHAPTER 39: The Great Timber Famine CHAPTER 40: A Little Bit of Heaven on Earth CHAPTER 41: All for One and One for All? CHAPTER 42: What's the Catch?

PART IV: Market Imperfections and the Public Sector

CHAPTER 43: Market Imperfection I: Monopolies CHAPTER 44: A Government Price Fix CHAPTER 45: Regulating a Monopolist CHAPTER 46: Market Imperfection II: Externalities CHAPTER 47: Environmental Regulation CHAPTER 48: Market Imperfection III: Public Goods CHAPTER 49: Public Goods and Free Riders CHAPTER 50: Voting on Public Goods: All in Favor, Say "Aye" CHAPTER 51: Free Riders Versus Forced Riders CHAPTER 52: Exploiting Fellow Citizens for Fun and Profit CHAPTER 53: Why Economists Disagree CHAPTER 54: Closing Thoughts



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CHAPTER 1 Why You Should Read This Book

Have you ever wanted to comment, with clarity and assurance, on government programs, education, the environment, and the appropriate level of national defense? Do you want members of the opposite sex to swoon at your incredibly thoughtful manner of looking at political, social, and economic issues? In short, do you want to be a hit at cocktail parties? If these are your desires, then look no further than this book. Skip over all those dry textbooks with their graphs and complicated mathematics. Scrap all those weighty tomes written by famous politicians. We promise you a revolutionary way of looking at the world. We promise to teach you the ECONOMIC WAY OF THINKING.

Now maybe this was starting to sound really good until we mentioned the word "economics." After all, economics doesn't enjoy the best of reputations. In what other field can two people be awarded Nobel Prizes for saying the opposite things? George Bernard Shaw proclaimed, with characteristic wit, that "if you placed all the economists in the world from end to end they wouldn't reach a conclusion." Economists are frequently the butt of derisive jokes and clever putdowns. (Our personal favorite: "Economists are people who didn't have the personality to be accountants.") Well, what can we say? Economics does have a bad reputation, and economists haven't always helped.

And that's too bad. Because few would deny the importance of economics. Look at the front page of your daily newspaper. Economic growth, federal spending, international trade, unemployment, and environmental issues consistently fill up the column inches. On every issue there is a cacophony of arguments that try and explain why one policy is good and another is bad. The person who is able to understand economics is in a unique position to sift through these arguments and objectively evaluate the merits of conflicting policy positions.

But perhaps economics has always been a subject that put you to sleep. There is a general perception that economics is about things like economic efficiency, benefit-cost analysis, capital investment, and marginal tax rates. Don't be fooled. Economics is a much broader subject than the dry statistics and complicated terms that those bland talking-heads on television would lead you to believe. You see, economics is bigger than interest rates. Its bigger than the money supply. Its bigger than the GDP (the gross domestic product). It's even bigger than the federal deficit! As important as these are, they are not the main issues. They are the potatoes, not the meat.

First and foremost, economics is about the quality of life experienced by ordinary people. It is about having a society that produces things like multimedia personal computers, blockbuster movies, hot dance clubs, and enough leisure time to be able to enjoy these things. It is about having health care, education, and a warm bed to sleep in at night. It's about having enough prosperity so that parents can provide the basic necessities for their children, and still have enough left over for a family vacation. In short, it is about the ability of the citizens of a nation to enjoy the highest quality of life that is humanly possible given

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the technology and resources at their disposal. The person who understands economics understands more than the latest news story on unemployment or corporate earnings. The person who understands economics has insight into the process of wealth creation that makes it possible for us to afford all those things that make our lives enjoyable and satisfying.

It might surprise you to know that there is a simple formula, a single recipe if you will, for understanding economics. We would be lying if we said that it didn't require some exercising of the brain. But it's not rocket science. Free trade, the balanced budget amendment, the spotted owl, child care, and military spending--believe it or not, all of these seemingly different issues can be understood using one, straightforward framework. We like to think of it as the unifying field theory of economics. Only there is no need for any higher level mathematics, algebra, or even graphical analysis. That is what you will learn from this book. By the time you finish reading this you will be a bona fide expert on all economic topics imaginable. And it will not be because you are smart (though you might be), or because you have done a lot of research (because you probably don't have time). It is because you will have mastered an incredibly fruitful way of thinking.

You are probably thinking this is too good to be true. How can we promise to teach you a simple system of economic thinking when so many people disagree about economics? This leads us to a great insight about the nature of economics itself. While it is true that economics is relatively easy to understand, it also relatively easy to screw up. Of course, there are legitimate reasons why well-informed, reasonable people disagree about economic policies. You will learn these reasons in this book. Nevertheless, it is our judgement that most disagreements about economic policies have their source in incorrect economic thinking.

Henry Hazlitt began his classic work on economics by writing "Economics is haunted by more fallacies than any other study known to man."1 Those words were penned in the 1940s. They are just as true today. Economics does seem to attract a disproportionate number of bad ideas. Fortunately, these bad ideas often stem from common errors that are easily identified...and corrected. In this book we will not only discuss how to think correctly about economics, we will also point out some fundamental mistakes that cause people to get tripped up when they think about economic subjects.

One thing you should know before you read any further. There are times when this book will infuriate you. You will become frustrated with our simplistic analysis and feel as if we have ignored some obvious criticisms. Let us encourage you...hang in there! While our framework ends up being a simple one, it does require a lot of separate pieces to make it work. In particular, before we can address the major objections to the "free market" approach to organizing economies, we need to fully understand what makes unregulated markets so attractive. Only then will we be in a position to appreciate the relevant criticisms. So please be patient with us. The last section of this book is specifically designed to address the major criticisms of unregulated markets. It is our experience that most people find that their objections get addressed in this section, if not earlier.



Why should you read this book? Because this book will teach you the economic way of thinking. You will be amazed by how different the world looks once you learn to view it through "economic glasses." By understanding the principles in this book, you will be able to confront and deflate a vast array of economic fallacies. You will be able to point out the economic blunders of your favorite, nightly newsperson. You will dazzle your friends and associates with your insightful comments on current events. You will be a hit at cocktail parties.

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Notes

1 Henry Hazlitt. Economics In One Lesson. New York: Crown Publishers, Inc., 1979, page 9.



CHAPTER 2 What is the Purpose of an Economy?

Most economics texts are very clear about what economies do. Strangely enough, they often fail to identify the goal of that economic activity. Although we certainly want to discuss what economies do, we believe the much more important question is, what is the purpose of economic activity? In other words, in order for us to determine whether our economy is doing a good job, we need to know what the economy is supposed to be doing.

What economies do is allocate resources, where by "resources" we mean all those things that play a role in producing goods and services for consumption. This is the tie that binds all the economies of the world. The economies of capitalistic Hong Kong or communist North Korea both go about the business of directing resources between competing options. Obviously, each society has a very different way to allocate resources (a different economic system). Hong Kong generally relies on prices to allocate resources. In contrast, North Korea generally relies on government planners to allocate resources. Whether by private decisions or government mandates, the bottom line is that resources are allocated to specific uses.

Whether an economy does a good job of allocating resources is another question. In fact, it is the key question. How should an economy allocate resources? How many resources should be directed towards home building, bread baking, food growing, movie making, and clothes producing? How will we know when an economy is doing a good job or a bad job? To answer these questions we need to know what an economy ought to do; what its goal ought to be.

If you'd ask the average politician what the purpose of an economy is, you'd probably get one of three responses. Response Number One: "The purpose of the economy is to create jobs." This is a bad answer. To see why, ask yourself, why do people work? Here's a little thought experiment to help you answer that question. Suppose that starting tomorrow, everybody's wages, salary, and pay went to zero. Who would show up for work? Most people work not because of the intrinsic joy they receive from working, but because they get paid for it. (Economists have a word for jobs that people would do without pay. They call it play.) People want jobs because those jobs give them money, and that money allows them to go out and buy the things they want. People work so they can consume more. Thus, creating jobs is a means to an end. It is not the end itself.

This leads us to Response Number Two: "The purpose of the economy is to increase wages." This is an even worse answer than responding that an economy should create jobs. Suppose that the government outlawed all private sector jobs and placed everybody in jobs producing dumb stuff--things that nobody wanted. However, it compensated them by paying all workers a wage of $1000 an hour (plus paid vacation and time and a half on holidays). That's $40,000 a week! Would this be the kind of economy you'd want to live in? Think about it. While it might be nice to look at your monthly pay check and see that you are making approximately as much money as your favorite professional athlete, you'd have a



rude awakening when you went to the local WalMart. There would be nothing there but dumb stuff to buy. Wages are also a means an end--the end of having nice things to buy--and not the end itself.

Response Number Three states, "The purpose of an economy is to increase production." By now you should be able to explain why increasing production is also the wrong purpose for an economy. We care about production only because it is necessary for consumption. Think of it in these terms: if we produced cars, stereos, and hamburgers, but didn't let anybody consume them, society would be no better off. Likewise, if we produced left-handed smoke shifters, square wheels, and Ringo Starr solo albums--i.e., goods that nobody wanted--society would again be no better off. In fact, in both cases we would be worse off because we expended valuable resources to make goods from which no one was able to derive pleasure. It would be like slaving away in the kitchen all day making a pot roast and then discovering your dinner guests were vegetarians. You just wasted a pot roast as well as your time and energy.

We are now ready to state what we think most people, after some thought, would choose as the overriding purpose of an economy. THE PURPOSE OF THE ECONOMY IS TO ALLOCATE RESOURCES IN A WAY WHICH MAXIMIZES SOCIETY'S HAPPINESS. This response probably makes the most sense to you, but we bet you haven't thought about it this way before. The other goals of more jobs, or higher wages, or more production are merely means to an end. The end is greater happiness for consumers.

If we have two economies with the same set of resources, and the citizens of one economy are all miserable, and the citizens of the other economy are all deliriously happy, we can state that the second economy must be doing a better job. Or if people are generally happy now, but resources get reallocated so that people become even happier, then we say that the second allocation is better than the first, and the economy has improved. If any lingering doubts remain about the purpose of an economy, ask yourself this question: If economies don't exist to make people happier, then what good are they?

There's another way of stating the purpose of an economy that will help to show us to how to proceed: THE PURPOSE OF THE ECONOMY IS TO ALLOCATE RESOURCES TO THEIR HIGHEST VALUED USE. If a resource does not go to its most highly valued use, it is wasted and society is made "poorer." Imagine a society in which no one liked liver and onions, but everyone liked burgers and fries. Suppose that initially resources like pots, pans, cattle, and cooks were all directed towards making liver and opinions. Ugggh! What a loss! Think of how much better off that society would be if these resources were reallocated towards producing burgers and fries. While it is true that we would have fewer livers and onions (a lower valued use), we would be more than compensated by additional burgers and fries (a higher valued use). By giving up something we like less in order to gain something we like more, we make ourselves happier, and we do this simply by reallocating resources.

Clearly, if resources are directed to their highest valued use--i.e., the use that produces the most happiness--then society's happiness must be maximized given the resources available.



But how is one to know a resource's highest valued use? How can one determine whether the members of a given society will be happier with more shirts and less pants, more public subway systems and fewer private automobiles? How can we ever measure happiness?

These are difficult questions that will lead us to the heart of what economics is all about. But before we proceed, let us recognize one thing. If we have no way of measuring happiness, no way of deciding whether one allocation makes people better off than another, then we have no system for guiding how society should proceed (not to mention that we'd also have a very short book!). To put it bleakly, if we can find no acceptable way of measuring happiness, then economics has nothing to say about how resources should be allocated. We must agree on a standard for comparing different allocations of resources before we can determine whether economies are successfully doing their jobs.


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CHAPTER 3 How Can You Measure Happiness?

Up to this point, we only have determined that we want our economy to direct resources to their highest valued use for the purpose of maximizing society's happiness. But how can we determine the "highest valued use" of a resource? Consider the problem facing an economic planner in Cuba or the former Soviet Union. If a Soviet planner was trying to decide exactly where to build a new apartment complex, he might take several things into consideration. For example, he might do a study of housing conditions in various sections of Moscow. Based on that study, he might come to the opinion that new housing should be located in the most crowded part of the city or perhaps close to where a new factory is going to be built.

However the dilemma is not resolved when the location is decided. Next come questions such as: What kind of housing? Should the planner build family units or singles? Luxury apartments or just the basics? How big should the unit be? As you can see, this is a tremendously difficult decision--and an important one. From our previous discussion we decided that society is poorer if resources are not directed to their most valued use. If the planner directs bulldozers, architects, concrete and other construction resources to a part of Moscow where new housing is valued less than in another part of the city, he has done more than just made a mistake. He has hurt society. There is less happiness than what was possible. With all these difficult questions to answer, it is clear that the planner faces an overwhelming task.

Imagine how much more difficult the problem becomes when all of the resources of a country are considered. How many cars should the nation build? How many office buildings should be constructed? Should the farmers produce more vegetables, or the ranchers more beef? For the economic planner, there is simply no objective way to determine how best to use the resources that are available.

Does an objective way to measure "highest valued use" even exist? Let us consider this question in the context of an example. Let us suppose that a very wealthy, very eccentric old man meets his demise. In his will the old man directs the executor of the estate to divide his possessions among his relatives in the way that generates the most happiness. However, a codicil in his will dictates that the estate cannot be sold. Additionally, his relatives may not sell their inheritance. Whoever receives a particular allocation from this inheritance is restricted from trading or otherwise exchanging that allocation for other goods. What approach could the executor of the estate use to ensure that the maximum happiness was generated?

Consider first the approach of the planner. The executor could attempt to learn the relatives' preferences by undertaking a study. Based upon the results of his study, he would make a judgement about which relative would receive the greatest happiness from any given item. For example, in deciding who would benefit the most from having the old man's Mercedes, the executor would investigate which relatives have cars, how many cars they have, how old their cars are, etc. Suppose the results of his study showed that Uncle Morton already has


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three, very expensive luxury automobiles, while Cousin Ralph has no car and rides a bicycle to work every day. Then the executor could safely conclude that Cousin Ralph would get more happiness from the Mercedes than Uncle Morton. Or could he?

Maybe Cousin Ralph rides a bike to work each day because he enjoys the exercise. Or maybe he is a card-carrying member of Save the Planet!, and believes automobiles spoil the environment. In any case, if he received the Mercedes he would rarely use it. On the other hand, maybe Uncle Morton already has three luxury automobiles because he derives intense pleasure from luxury automobiles. Perhaps he has seven teenage sons who are always borrowing his cars. Either way, a fourth automobile would give him great joy. With lots of relatives and myriad goods, the informational requirements of his study would soon become overwhelming.

Consider another approach. Perhaps the executor says to himself, "These people know what they want. Rather than having me try to figure out their preferences, I'll just let them decide among themselves how to allocate the goods." Here he runs into another problem. How can the relatives compare their respective desires? Suppose the widow of the deceased says to the daughter-in-law, "You say you value the Mercedes a little, but I value it a lot. Therefore, I think I should get the car." What does "value a little" mean? What does "value a lot" mean? So the executor goes back to the drawing board, knowing that he must figure out some way of ranking preferences across relatives.

Then he gets a brainstorm. He decides to develop a questionnaire. Each relative would have to answer questions like: "On a scale from 1 to 10, how much do you value the Mercedes Benz?" "On a scale from 1 to 10, how much do you value the Louis XIV dining room table set?" The relative giving the highest rating would receive the item. The problem here is that it probably wouldn't take long for the relatives to realize that it pays to exaggerate on a questionnaire like this. There is no cost to lying about one's valuation. Even if a relative only believed a given item was worth a "7," he would always be better writing down a "10."

Consider a more sophisticated version of this questionnaire. Suppose the executor asks each relative to assign a rank to each item. Given a thousand items in the estate, each relative would rank order every item from their most preferred to their least preferred. While this represents an improvement on the previous approach, it also some obvious flaws. For example, what should the executor do when there are ties? Suppose an aunt, two nephews and a niece all put down the 3-D, virtual reality, home computer gaming system as their top choice? How does the executor decide which one gets it? And what does he do for the other three relatives? Does he give them their second choice instead? Suppose their second choice is somebody else's first choice?

Can you think of a better approach? It is our experience that, by now, most people come up with an alternative procedure that (i) utilizes all the information that is relevant for deciding the value of each item, (ii) allows the executor to compare preferences across individuals, and (iii) encourages truthful revelation by the relatives. And that procedure is an auction. The executor would allot each relative an equal number of tickets or coupons. Each relative



would be free to bid as much or as little as they wanted, with items going to the highest bidder. In this way, each of the dearly departed's possessions would be allocated across the respective relatives. Note the attractiveness of this approach. The heirs are encouraged to think carefully about how much they value the goods, valuations can be compared across individuals, and no relative has an incentive to exaggerate.

Suppose Heir Number One outbids everyone else by bidding ten coupons for the Mercedes, with Heir Number Two being the next highest bidder at nine. The fact that Heir Number One has to give up ten of his coupons to obtain the car means that he has to think carefully about his valuation of the car. He has no incentive to bid more than it's really worth to him, because winning the bid means he loses the opportunity to purchase other goods. Further, because Heir Number One is willing to sacrifice more of other goods than Heir Number Two, we can say with some confidence that Heir Number One anticipates getting more happiness from the car. In other words, if the car goes to Heir Number One, we can be fairly confident that the most happiness possible will be generated.

We call this method of allocation the "willingness to pay" approach. Let's replace coupons now with dollars, rubles, pesos, etc., and let's CALL THE MAXIMUM AMOUNT OF MONEY A PERSON WOULD BE WILLING TO BID FOR A GOOD THEIR WILLINGNESS TO PAY FOR THAT GOOD. By allocating goods to those who are willing to pay the most, we allow individuals to reveal just how badly they want something. People who would receive only a little happiness from consuming a particular good would not be willing to pay very much for that good. In contrast, those who would receive a lot of happiness also would be willing to pay a lot. Thus willingness to pay provides one way to measure happiness.

The Soviet planner's dilemma is solved! To decide where resources would provide the most happiness, he just needs to discover how much money people would be willing to pay to enjoy those resources. If people in one section of Moscow are willing to pay more for housing than people in another section of Moscow, the planner's decision is now an easy one. But is willingness to pay really the best way to allocate resources? In the next chapter we consider this approach in greater detail.



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CHAPTER 4 If You Don't Like It, Give 'Em Money

So far we have suggested that WILLINGNESS TO PAY provides a way of measuring how much happiness individuals receive from the allocation of resources. The obvious problem with this approach is that income--the "coupons" underlying the bidding procedure--is unequally distributed across society. In 1991, before taxes and transfers, the average income of the poorest 20 percent of households in the United States was $7,272, compared to $88,101 for the richest 20 percent.1 In some countries, the difference between the top and bottom is even greater. Simply put, there are very poor people and there are very rich people and this causes problems when we use the willingness to pay approach to determine valuations.

If some of the old man's heirs from the previous chapter were provided with 1000 coupons, while other heirs were provided with only 100, the "richer" heirs would be able to bid away most of the estate for themselves. The poorer heirs would have a difficult time getting the estate's goods even when they anticipated receiving more happiness from their consumption than the rich heirs.

Let's take an even more direct example. Suppose an extremely wealthy man owns a fleet of Rolls Royces. His butler, however, has no car and must use smelly, crowded public transportation. The wealthy man decides that he wants a new Rolls Royce because he always rather liked the ones with the mauve interior. The butler wants a car so badly that he would be overjoyed if he could just have a Ford Pinto. But alas, he cannot afford even an awful car. According to the willingness to pay procedure, who gets the car? It goes to the fabulously wealthy man who already has a Rolls for every day of the week. The poor butler gets nothing.

In this case, resources are directed to the wealthy man, but are they directed to the use that produces the most happiness? The answer is probably not, though we cannot be certain. It is possible that the butler hates driving and likes using public transportation, and it is possible that the rich man receives intense pleasure from the mauve Rolls Royce. But we are willing to concede that in this case using the willingness to pay procedure to divide up resources probably did not maximize happiness. More generally, we are willing to acknowledge that a billionaire probably values an extra dollar's worth of goods less than a poor person.

If this is an objection which you have with the willingness to pay approach--and we emphasize that it is a perfectly reasonable objection--we have a solution. Simply GIVE POOR PEOPLE MORE MONEY. If we distribute money more evenly, then we are back to something like our previous example of auctioning off the dead man's estate to generate maximum happiness--an approach that had much to recommend it.2

Now don't misunderstand us. We do not personally advocate equalizing incomes or possessions as a policy prescription. The redistribution of income is a messy and difficult



procedure, even when everybody is in agreement that this is the thing to do. And it has negative side-effects that many believe outweigh its benefits. However, we want to emphasize that determining the highest valued use of a resource is a different issue than determining the best initial distribution of incomes.3 If this problem with the willingness to pay approach really bothers you, then let's reallocate incomes so that there's a fairer distribution of "coupons" in society. With redistribution, we would still have a way of measuring happiness. And without some way of measuring happiness, we'd be in the dark about how to direct resources to increase society's happiness.

What about the alternatives? Aren't there some other ways of measuring happiness? We've already seen that surveys and questionnaires have major flaws in their ability to measure happiness. One possibility that we haven't considered yet is voting. Allocating resources by majority vote has the attraction that everyone gets one vote. This solves the unequal distribution of income problem. On the other hand, voting suffers from some pretty serious problems of its own. For example, how are the voters supposed to know whether June Smith of Mobile, Alabama or Ralph Diminico of New Haven, Connecticut will get the most pleasure from a new Plymouth Voyager with air conditioning, front-wheel suspension, and cruise control? We'll talk about voting later on in this book, and we'll see that there are some instances in which voting can serve as a reasonable measure of societal happiness. But when it comes to allocating most of the goods of society, voters are no better able to determine the highest valued use of a good than was the estate executor in the last chapter.

Well...maybe we don't really need a measure of happiness. Aren't there other ways of directing goods and services that don't require a measure of happiness? Indeed there are. For example, one alternative is to ration goods so that everyone receives an equal share. That eliminates the problem of trying to determine highest valued use. But why should a person who prefers meat receive the same amount of sugar every year as someone with a sweet tooth, who in turn receives too much meat and not enough sugar? And ration economies generally aren't very successful in getting producers to produce enough goods for everyone to have a reasonable share. In fact, history has demonstrated that economies which don't concern themselves with the question of highest valued use tend not to do very well over the long haul. There's a reason, you know, why we call it the former Soviet Union.

Clearly, willingness to pay isn't a perfect measure of happiness. Is it better than all the other alternatives? Ultimately, that's a question you have to decide for yourself. If you think that willingness to pay does not provide an adequate measure of the happiness that poor people receive from goods and services, then our advice is to give poor people more money--but preserve the approach. If you reject the willingness to pay approach, then you need to come up with something better. What do YOU suggest? It is our judgement that no better measure exists.





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Notes

1 Edgar K. Browning and Jacquelene M. Browning, Public Finance and the Price System. New York: MacMillan Publishing Company, 1994, page 259.

2 Even if everyone has an equal amount of money, we still cannot be certain that resources go to their highest valued use. We do not know if two people who hold the same amount of money value goods and services the same. Is it not possible that $20,000 worth of goods and services provides less happiness to you than it may to someone else? Maybe you are not materialistic at all, and you value a walk in the fresh air as much as you value a new car. Right now a new car isn't even an option because you don't have the $20,000 to purchase a new car. Somebody else who has $40,000 might receive intense pleasure from having two cars (maybe that's why he worked so hard to earn his $40,000). Suppose we equalize incomes by taking $20,000 from this other person and give it to you. You who do not value a car very much can now purchase one. The guy who intensely valued two cars can now only buy one because we took some of his money away. By redistributing this income, we have taken a car away from somebody who valued it more and given it to somebody who valued it less. Society is made worse off, even though money is equally distributed.

3 While the allocation of resources is a different issue than the distribution of income, the two issues are related. For example, if incomes are taxed to provide money for poor people, both rich and poor will have a smaller reward for work. This will likely have effects on the allocation of time between work and other activities.



CHAPTER 5 The Incredible Information Contained in Prices: Part I

Up to this point we have spent most of our time arguing that willingness to pay represents our best hope for guiding resources to their highest valued use. This might strike you as somewhat strange since our only concrete example of this approach--a bidding or auction market--would surely be a grossly impractical way to distribute the hundreds of millions of goods and services that must be allocated every day in a large economy. However, there is another way to distribute goods and services with which you are already very familiar. It incorporates the best features of the willingness to pay approach with a minimum of administrative maintenance. It is the organizing principle behind the allocation of resources in free market/capitalistic economies. It is currently on display at your local supermarket, laundromat, and music retailer. It is the price system. In this chapter we will begin to explain the connection between the price system and the willingness to pay approach.

We defined willingness to pay as the most you would be willing to spend to obtain a good. We also could have said that your willingness to pay for an item is the happiness, measured in dollars, that you expect to receive from the item. This definition may sound a bit strange to you, but it is really just a restatement of our previous definition, and you probably use it every day.

Each time you purchase (or do not purchase) a good, you compare your willingness to pay to its price. Say you eat a fine meal at the best restaurant in town. After eating broiled cod, crab legs, a T-bone steak, stuffed mushrooms, and a Caesar's salad, you find yourself a tad full. When the waiter brings around a tray of tempting desserts, you refuse. Though the French chocolate silk pie looks quite delicious, you decide that your $4.75 can be better spent elsewhere. NOTE: In this case, the price of the pie exceeds your willingness to pay. After dinner, you join your friends at the mall and purchase a new pair of designer jeans for $31 because your old pair suddenly was feeling a little bit tight. (You suspect they were shrunk in the dryer again.) NOTE: In this case, you decided that the $31 for the jeans could not be better spent elsewhere. Your willingness to pay exceeded the price of the jeans. We take this sentiment one step further by declaring that your willingness to pay for a good (the absolute most you would spend on it) is the happiness, measured in dollars, that you expect to receive from consuming it. At some price level, you would refuse to buy a pair of designer jeans. This price level is your willingness to pay, or the amount of happiness you expect to receive from your purchase.

Max, one of the authors, is no slave to fashion and would at most be willing to pay $30 for a pair of designer jeans. When Max goes to The Gap and discovers that jeans are $31 per pair, he decides that spending his money on other goods would be more pleasing, so he buys a pair of cheap slacks at Target. Bob, the other author, loves being a snappy dresser. He would be willing to pay up to $100 for the same jeans. At $31 a pair, he thinks that he is getting a great deal. From our previous work with willingness to pay, we know that Bob expects to receive more pleasure from the jeans than Max because he is willing to pay more. In fact, Bob expects to receive $100 in pleasure from a pair of designer jeans, while Max expects to



receive only $30 in pleasure from them. Notice that even though Bob paid $31 for his jeans, he receives $100 in happiness (his willingness to pay) from them. Armed with this knowledge of willingness to pay, we can begin to draw an amazing insight.

Unfortunately, we cannot take credit for this amazing insight. It goes back at least as far as Adam Smith. It is the fundamental insight of economics, the foundational building block of the science of resource allocation. Here it is: PRICES CONTAIN INFORMATION ABOUT WHERE RESOURCES WILL PRODUCE THE GREATEST AMOUNT OF HAPPINESS IN SOCIETY. To understand this point is going to take a little bit of concentration on your part, but stick with it because this insight is worth working for. Here we go.

Let's suppose we have five consumers. Being the creative people that we are, let's call them Consumers A, B, C, D, and E, respectively. Let's also suppose that we have some "inside" information on each consumer. Literally. We are going to imagine that we could look deep into the heart and soul of each and know exactly how much that consumer would be willing to pay for one more T-shirt. Not how much the consumer thinks he will have to pay it. Not how much it's "worth" to them according to some nebulous standard of worth. When we say "willing to pay" we mean the maximum amount of their own money they would really be willing to give up in order to consume the good. If we think back to our auction example, each consumer's willingness to pay value represents the maximum amount they would be willing to bid in order to win that T-shirt in an auction. In other words, we are going to imagine that we know how much happiness--as measured by willingness to pay--an extra T-shirt would generate for each of our consumers.

Of course, in real life this information is known only by the consumer. Nobody can know just how much somebody else is willing to pay for something. But we are going to pretend we know this information in order to see something we otherwise would miss. The table below reports each consumer's personal willingness to pay value for the T-shirt.

Willingness to Pay Values for the Five Consumers

Suppose these five consumers each walked into a town where the going price of T-shirts was $10. At a price of $10, only two consumers would choose to buy T-shirts (Consumers B and C). Consumers B and C each anticipate receiving more than $10 of happiness from owning the T-shirt. Purchasing the T-shirt clearly makes them better off. The other three consumers would not choose to buy a T-shirt (Consumers A, D, and E). While they each would receive some happiness from the T-shirt, the amount of happiness they anticipate receiving is less than $10.

Let's stop for a moment to see if we really understand what's going on here. Answer the following one-question, multiple-choice exam.

Consumer A Consumer B Consumer C Consumer D Consumer E $3.50 $11.75 $13.15 $5.60 $7.90



QUESTION: Assuming that his expectations are correct, how much happiness will Consumer B gain from owning the T-shirt?

a. $10.00. b. $1.75 ($11.75 minus the $10 purchase price). c. $11.75. d. None of the above. e. All of the above. f. (d) and (e).

The answer is not (a). While it is true that Consumer B paid $10 for the T-shirt, this only tells us that he anticipated receiving at least $10 of happiness from the T-shirt. Consumer C also paid $10 for the T-shirt. But his greater willingness to pay value indicates that he anticipated receiving greater happiness from the T-shirt than Consumer B.

How about answer (b)? In purchasing the T-shirt, Consumer B gained something from which he anticipated receiving $11.75 of happiness. In return, he gave up $10.00. Doesn't that trade make him better off by $1.75? Yes it does. But that's not the question. The question isn't how much better off Consumer B feels he is as a result of purchasing the T-shirt. The question is, how much happiness will Consumer B receive from owning the T-shirt. That's an important distinction. And one that is difficult to keep straight at times.

We will say this many times over in the course of this book: people get happiness from the consumption of goods and services, not from money itself. Money is merely the means that enables consumers to get goods and services. In evaluating the happiness that society receives from consuming goods and services, it is important that we remember to keep our eyes on the goods and services, and not the money. Forgetting this simple truth is the source of a great many economic fallacies, as we shall see later on.

So what's the answer to our question? The answer is (c), $11.75. The consumer's willingness to pay value tells us how much happiness he expects to receive from owning the particular good or service. With this firmly in mind, we can continue with our discussion of the "incredible information contained in prices."



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CHAPTER 6 The Incredible Information Contained in Prices: Part II

In this chapter we will demonstrate that THE MARKET PRICE OF A GOOD TELLS US THE WILLINGNESS TO PAY VALUE OF THE MARGINAL CONSUMER. By "market price" we mean the prevailing price of a good in a given city, town, or market. By "marginal consumer" we mean the consumer who would end up with a good if one more unit of that good were distributed to that market. In the context of our T-shirt example, if the price of T-shirts in a given market is $10, that means that if one more T-shirt were shipped to that market, the consumer who would end up with that T-shirt would have a willingness to pay for T-shirts right around $10.

Recall from the previous chapter that at a price of $10, Consumers B and C would choose to purchase the T-shirt, while Consumers A, D, and E would not. Let's assume that once a consumer buys a good, their willingness to pay falls to zero. That is, once they have the good, they wouldn't get any pleasure from having another unit of that good. (This is what we call a simplifying assumption. It's not necessary to get our result, but it greatly simplifies the analysis of the problem.) Now our table of willingness to pay values looks like this.

Willingness to Pay Values for the Five Consumers

Suppose we were to distribute one more T-shirt. What would be the willingness to pay value of the person who would receive it? Clearly, the answer to that question depends on who gets the additional T-shirt. If Consumer A was given the T-shirt, then the answer to the question would be $3.50. Alternatively, if Consumer E received the T-shirt, then the willingness to pay value of the person who receives the extra T-shirt would be $7.90. To get us over this hurdle we will make the assumption that a market guided by the price system will tend to direct goods to those who value them most. In a little bit we will explain this. For right now you have to take it on faith.

Of the three consumers who would not buy T-shirts at the price of $10 (A, D, and E), clearly Consumer E would derive the greatest happiness from having one. Assuming the market would direct this additional T-shirt to the one who valued it most, Consumer E would end up with it. Consumer E is then the "marginal consumer." Using the information from the table, we see that the willingness to pay value of the marginal consumer is thus $7.90.

Hold on here! Didn't we just get done saying that the price of a good tells us the willingness to pay of the marginal consumer? We did. But isn't the price of the good $10, while the willingness to pay value of the marginal consumer is only $7.90? That's true, but we aren't done yet.

Consumer A Consumer B Consumer C Consumer D Consumer E $3.50 0 0 $5.60 $7.90



Let's add five more consumers to our market and repeat the analysis from above. These new consumers have the willingness to pay values reported in the table below.

Willingness to Pay Values for the Ten Consumers-Before

At a price of $10 per T-shirt, how many T-shirts get bought and who buys them? There are now six consumers who decide to buy T-shirts (B, C, F, H, I, and J) and four who decide not to buy a T-shirt (A, D, E, and G). After the six buy T-shirts, and assuming that they have no interest in another T-shirt, we get the following table of willingness to pay values.

Willingness to Pay Values for the Ten Consumers-After

What would be the willingness to pay value of the marginal consumer if we were to distribute an extra (seventh) T-shirt? Once again we assume that the extra T-shirt will go to the consumer who values it most (we really will explain this later). Since Consumer G values it more than A, D, and E, he becomes the marginal consumer to whom the market directs the extra T-shirt. Thus, with ten consumers in our society and a T-shirt price of $10, we can say that the marginal consumer has a willingness to pay value of $8.90.

Now we know that $8.90 is still not $10, but consider what just happened as the number of consumers in the market increased. When there were 5 consumers, the willingness to pay value of the marginal consumer was $7.90. When there were 10 consumers in the market, the marginal consumer's willingness to pay value was $8.90. What do you think would happen if there were 50 consumers in the market? 500 consumers? 500,000? Don't you see as there are more and more consumers in the market, there is a greater likelihood that one of those consumers will have a willingness to pay value a little less--but very close--to the market price of the good. Thus, the marginal consumer's willingness to pay value approaches the market price as the size of the market increases.



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A B C D E F G H I J

$3.50 $11.75 $13.15 $5.60 $7.90 $12.80 $8.90 $10.50 $11.10 $12.25

A B C D E F G H I J

$3.50 0 0 $5.60 $7.90 0 $8.90 0 0 0




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CHAPTER 7 The Incredible Information Contained in Prices: Part III

Up to now, we just assumed that the market had a way of directing an extra unit of the good to the person whose willingness to pay was less than--but closest to--the market price of the good. We're now ready to explain this. Let's imagine ourselves observing the buying and selling of T-shirts in a large city. Suppose that a million T-shirts get sent to this city in a given year. Suppose further that the consumers in this city are free to purchase as many or as few T-shirts as they want, and that the retailers in this city are free to set any price they want. Finally, suppose the going price for T-shirts in this city is around $10.

What would happen if a million-and-one T-shirts were sent to this city rather than a million? Obviously, there would be somebody--one person--who would end up with a T-shirt if a million and one were sent, who would have not gotten a T-shirt if only a million had been sent. This is the marginal consumer. What do we know about this person's willingness to pay for a T-shirt?

The marginal consumer is not somebody whose willingness to pay is more than $10. Somebody who is willing to pay more than $10 for a T-shirt would buy one whether a million or a million-and-one were sent to that city. For example, if a consumer anticipated getting $25 of happiness from a T-shirt and its price was only $10, one would expect this consumer to be sure to go to the store and purchase a T-shirt. And he would do that even if only a million T-shirts were sent. But that means he can't be the "marginal consumer" because the marginal consumer doesn't buy a T-shirt if only a million get shipped to the city. The same logic holds for anybody with a willingness to pay for a T-shirt that is more than $10. Therefore we conclude that our marginal consumer does not have a willingness to pay larger than $10.

This is the situation that was represented in the previous chapters by the "Willingness to Pay--After" tables. Recall that after every consumer that wanted to buy a T-shirt at a price of $10 did so--and before we distributed an extra T shirt--only those consumers with willingness to pay values less than $10 were in the market. Thus the marginal consumer couldn't be somebody who had a willingness to pay greater than $10.

A similar logic leads us to the conclusion that the marginal consumer doesn't have a willingness to pay much less than $10. After all, an increase in the supply of T-shirts by one unit will exert only a minimally downward pressure on the price of T-shirts. As a result, the market price of T shirts will still be very close to $10. But if a consumer anticipated receiving much less than $10 of happiness from the T-shirt, he wouldn't be willing to shell out the $10 needed to buy it. Since we know the marginal consumer does end up purchasing a T-shirt, this must mean that his willingness to pay can't be much less than $10.

The careful reader will have noticed that the market mechanism which directs the good to the consumer with the highest willingness to pay is precisely the price system. When an extra unit of the good is sent to the market, the price drops just enough to induce one more



person to buy the good. That is, the price drops just low enough until the consumer with the highest willingness to pay value finds it attractive to buy the good. When that happens, the price decrease stops, and all the other consumers find themselves still unwilling to buy the good. This is our basis for assuming that the market has a way of directing an extra unit of the good to the person whose willingness to pay is less than--but closest to--the market price of the good. If the market is reasonably large, this willingness to pay value is likely to be very close to the market price of $10.

Now it's time to put all of this together. If the marginal consumer is not somebody whose willingness to pay for a T-shirt is more than $10, and he is not somebody whose willingness to pay is much less than $10, then we are left with only one possibility: The person who ends up with the million-and-oneth T-shirt is somebody whose willingness to pay value for a T-shirt is right around $10. That is, if an extra T-shirt were sent to this city, it would go to somebody who would receive about $10 of happiness from the extra T-shirt.

Anybody here got a problem with this story?! We can think of some. For example, in real life, T-shirts aren't sold for exactly the same price in every store. They might be $9.97 at WalMart, $8.97 at Target, and $12.47 at Sears. Furthermore, not everybody who values a T-shirt at more than $10 is going to run down to the store this second and buy one at that price. Perhaps you can think of some other objections to our story. That's okay. We're willing to loosen up our story a little bit, because we know that in real life things aren't always so nice and clean as they are in theory.

Rather than saying that the marginal consumer can't have a willingness to pay more than $10, let's just say that the marginal consumer is probably somebody whose willingness to pay isn't much larger than $10. In real life it might be $11, or $12. But most likely not $20. Likewise, the marginal consumer is never likely to be somebody with a willingness to pay much less than $10. People with willingness to pay values of $5 just aren't going to be willing to dish out $10 for a T-shirt. So, as we translate our theory to the real world, recognizing that it's something of an approximation, we still end up with the same conclusion. THE PERSON WHO ENDS UP WITH THE MILLION-AND-ONETH T-SHIRT IS SOMEBODY WHOSE WILLINGNESS TO PAY VALUE FOR A T-SHIRT IS RIGHT AROUND $10, NOT A LOT MORE, NOT A LOT LESS.

At this point you might be tempted to be a little unimpressed by this amazing insight. However, recall that willingness to pay is a measure of happiness. So when we say that the marginal consumer has a willingness to pay right around the market price, what we are really saying is this: The price of a good tells us the approximate amount of happiness--measured in dollars--that society would receive from having one more unit of that good.

If the market price of T-shirts is around $10, then if one more T-shirt gets sent to that market, it will go to a consumer who will receive approximately $10 of happiness from that T-shirt. Of course, we have no idea who that person is. We do not know what they look like. We don't know where they live. We don't even know why they want the T-shirt, if they plan to wear it under a sweater by Ralph Lauren or if they plan to tie-dye it. But we do know this:



if the market price of T-shirts is $10, and if one more T-shirt were shipped to that market, somebody is going to be made better off by about $10.

This is incredible information! It shouldn't be too difficult to see that this is the key to helping society know where to direct resources. For example, if the price of T-shirts is $10 and the price of Spam is $4 a can, we know that society will receive more happiness from an extra T-shirt than from a can of Spam. (You probably suspected this all along!) The beauty of the price system is that it provides an objective way to compare the happiness generated by two unlike goods. Still unimpressed? Then read the next chapter.



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CHAPTER 8 Information and the Fundamental Problem in Economics

It is commonly stated in economics textbooks that the fundamental problem in economics is scarcity. We beg to differ. The fact that resources are finite, or scarce, isn't a problem--it's just a fact of life. When allocating resources, choices must be made among competing options. Economics can no more solve the problem of scarcity than it can invent a perpetual motion machine. Rather, THE FUNDAMENTAL PROBLEM IN ECONOMICS IS A LACK OF KNOWLEDGE. Not just any kind of knowledge, but the knowledge of where resources have their highest valued use. This is the primary obstacle that keeps an economy from achieving its purpose of maximizing social wealth. This is the fundamental problem that economics, and economies, must attempt to solve.

Another way of looking at this knowledge problem is to note that people are heterogeneous, that is, they have different preferences. To see the connection between this and the knowledge problem, suppose all people were alike. They liked the same foods, fashions, music, cars, etc. Then the economic planner wouldn't have to look any further than himself to know what people wanted. All he would have to do is ask himself what would give himthe most happiness. In answering the question for himself, he would be answering it for all of society, since his preferences were representative of everybody else's.

Of course, people are not all alike. For example, it is incomprehensible to us why some people don't like economics. We love economics, and we're reasonable people. So how it can be that there are people out there who don't like this stuff? Go figure! People have different likes and dislikes--a fact that becomes painfully obvious to most of us at Christmas time. Indeed, anybody who has had to shop for a Christmas present for a distant relative is fully aware of how difficult it is to buy what others want. Imagine going Christmas shopping for the entire economy! Millions of people whom you've never met. Should you give Rodney Smith of Peoria, Illinois Def Leppard's new CD? Gee, what if he already has it? What if he doesn't like Deff Leppard? (Is that possible?) Maybe he only likes classical music. Maybe he doesn't have a CD player!

Different preferences are merely a nuisance at Christmas. They are a fundamental problem when allocating society's resources across millions of consumers. A person who doesn't think that lack of knowledge about people's preferences is a serious problem is a person who thinks that people have essentially the same preferences. On the other hand, if people do have significantly different preferences, then the information produced by the price system is incredibly important. Thus, the appreciation one has for the information produced in prices is directly proportional to how different one thinks people are.

Let's return to the Soviet planner of Chapter 3 who was trying to decide where and what kind of apartment complex to build. He could do a fine job of allocating resources if everyone was like him. The contractor would just have to decide what he wanted, and then order the same thing for everyone else. Of course, if the economic planners' preferences are different from his consumers' preferences, and the consumers have differing preferences



amongst themselves, then the planner faces an impossible task. Should he order an extra apartment complex to be built in Moscow or St. Petersburg? Should he build family units or singles? Luxury apartments or efficiencies? He can only make these decisions correctly (i.e. in a way that maximizes happiness) if he knows how much each consumer in his market values housing. Some of his consumers might prefer more automobiles or trips abroad instead of luxury apartments. If they get luxury apartments instead of their heart's desire of a trip to Disneyland, society is made worse off.

In contrast, let's consider how a private building contractor answers these questions in a free market or capitalistic society. It seems safe to assume that the private contractor doesn't spend much time thinking about directing resources to their highest valued use. He does, however, care about the prices of the goods and services which he sells. When examining where to build a new apartment complex, his first consideration is the price of housing. If the market price for apartments is $300 per month in Tulsa, Oklahoma, but $500 per month in Kansas City, Missouri, the contractor will decide to build new apartments in Kansas City (assuming that costs are the same in each city). And this is precisely what we would want the contractor to do if we wanted him to maximize happiness! Consumers in Kansas City would get around $500 a month in extra happiness from having a new apartment in their city, while consumers in Tulsa would derive only about $300 per month in happiness.1

How can we say this without first doing a study on where an apartment complex is most "needed?" And how can we compare the happiness of consumers in Tulsa and consumers in Kansas City? We can, if we adopt the willingness to pay approach to measuring happiness--and recognize the incredible information contained in prices. Thus, an apartment complex in Kansas City, Missouri would generate a greater increase in society's happiness than one in Tulsa, Oklahoma. The planner's dilemma is solved--almost.

OPTIONAL SECTION FOR ECONOMISTS: It has been our experience that when students with prior econom ics training are f irst exposed to the ideas in this book , their im m ediate reaction is " W here did these g uy s g et this stuf f f rom ? ! " W e want to dem onstrate that there is nothing in this book that is " new. " T he ideas in the preceding chapters--and in the chapters to com e--are al l im pl ied by standard m icroeconom ic theory . F or exam pl e, consider a standard dem and and suppl y g raph. G eneral l y , the dem and curv e is interpreted " horiz ontal l y . " T hat is, hol ding price constant, the dem and curv e reports the m axim um q uantity of the g ood that consum ers in the m ark et woul d purchase at that price. H owev er, one can al so interpret the dem and curv e " v ertical l y . " S pecif ical l y , hol ding q uantity constant, the dem and curv e reports the m axim um am ount of m oney that the m arg inal consum er woul d be wil l ing to pay f or a unit of the g ood if exactl y that q uantity were suppl ied to the m ark et. In other words, the wil l ing ness to pay v al ue of the m arg inal consum er f or ev ery g iv en l ev el of q uantity is indicated by the heig ht of the dem and curv e. 2



T he g raph abov e represents the T -shirt exam pl e we hav e been discussing f or the past three chapters. A t a price of $ 1 0 . 0 0 , the eq uil ibrium q uantity of T -shirts sol d in the m ark et is Q0 = 1 , 0 0 0 , 0 0 0 . A l l of the consum ers who hav e wil l ing ness to pay v al ues g reater than $ 1 0 . 0 0 are represented on the horiz ontal axis as l y ing to the l ef t of q uantity Q0 . In contrast, those consum ers with wil l ing ness to pay v al ues l ess than $ 1 0 . 0 0 are represented as l y ing to the rig ht of q uantity Q0 . If one m ore T -shirt is suppl ied to the m ark et, the price drops neg l ig ibl y --f rom $ 1 0 . 0 0 to $ 9 . 9 9 --and the consum er who ends up with this T -shirt is one who has a wil l ing ness to pay v al ue between $ 1 0 . 0 0 and $ 9 . 9 9 , or " rig ht around $ 1 0 . " H ow about our statem ent that wil l ing ness to pay m easures happiness? E conom ists do not g eneral l y use the term " happiness. " Instead, they use a word cal l ed " util ity . " H owev er, if y ou ask y our econom ics instructor what she m eans by " util ity , " m ost of ten the response y ou' l l hear is " happiness, " or " pl easure. "



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Notes

1 Of course, the relative costs to building in each of these cities also plays into the contractor's decision and is just as important economically, but we leave the exploration of this topic for a later chapter.

2 That the height of the demand curve represents the amount of money the consumer is willing to pay in order to get one more unit of the good is easily derived from standard microeconomic theory. For an easy-to-understand, graphical derivation, see Figure 3-4 on page 74 in Edgar K. Browning and Jacquelene M. Browning, Microeconomic Theory and Applications, Second Edition, Boston: Little, Brown and Company, 1986.



CHAPTER 9 The Rest of the (Output) Story

The previous chapters have established that the price of a good tells us the willingness to pay of the marginal consumer. Since willingness to pay is a measure of anticipated happiness, and since the marginal consumer is the one who would purchase an additional unit of the good if it were supplied, we can restate our finding as follows: The market price of a good tells us the approximate gain in happiness--measured in dollars--that society expects to receive from the consumption of one more unit of that product. So far so good. There is however, more to this story, and as they say, the plot thickens.

It is straightforward to demonstrate that the market price of a good also tells us the approximate expected loss in society's happiness--measured in dollars--from consuming one less unit of that product. We encourage you to go back to Chapters 5 through 7 and repeat the analysis for T-shirts with a market price of $10. This time however, ask yourself what would happen if 999,999 T-shirts were sent to the city rather than 1,000,000. Obviously, there would be somebody--one person--who would end up with a T-shirt if a million were sent, who would not get one if only 999,999 are sent. What do we know about this person?

The person who ends up not getting a T-shirt when only 999,999 are sent is somebody whose willingness to pay value for a T-shirt is right around $10 (not a lot more, not a lot less--how do we know this?). Since that is how much pleasure he would have gotten from the T-shirt, not getting a T-shirt means that he's out about $10 in happiness. That is, having one less T-shirt lowers society happiness by about $10. (From here on out, we drop the drop the distinction between "expected happiness" and "happiness." While consumers will sometimes be disappointed--or pleasantly surprised--by the amount of happiness they receive from the consumption of a good, we would expect their expectations to be reasonably accurate on average.)

Perhaps by now you've noticed something that bothers you about our story. While it's true that somebody is out a T-shirt if one less gets sent, don't they still have their ten dollars? Can't they spend those ten dollars on something else? Then how can we say that society has just lost $10 in happiness? DANGER...DANGER...ECONOMIC FALLACY IN THE MAKING! While the objection appears reasonable on the face of it, it leads to economic error. The fallacy arises when "we take our eyes off the ball." In this context, the "ball" is the happiness gained from consumption. When we focus our attention on dollars, we are bound to get into an error. While we all push, shove, kick, and scratch to get them, dollars themselves don't give pleasure. They're just little, green pieces of paper, incapable of producing any happiness on their own. It is the goods and services that dollars buy that yield happiness.

Suppose a tough punk walks up to a consumer who just bought a T-shirt for $10. Suppose this consumer's willingness to pay for a T-shirt was right around $10. Now suppose that punk rips the T-shirt off this consumer and completely shreds it to pieces so that it is now good for nothing. But then--consumed by guilt--the punk reaches into his pocket and gives



the consumer a $10 bill to compensate him (we're supposing he's a tough, sensitive punk). Let's do a social accounting of this transaction.

The consumer views himself as being largely unaffected by this chain of events. While it is true that the consumer lost something that he valued at around $10 (the T-shirt), he also received $10 in compensation. Thus, from the individual consumer's perspective, the transaction is a wash. However, it is not a wash from society's perspective. The undeniable fact is that there is now one less T-shirt available for enjoyment. This T-shirt would have brought about $10 in happiness. Hence, the absence of this T-shirt now means that society has lost $10 in happiness.

How do we reconcile the individual's ambivalence against society's loss? When the consumer takes his $10 in compensation and buys something else with it, that's one less good that some other guy gets to consume. We can do all kinds of things to try and disguise this fact. We can put out more green pieces of paper (dollars) to try and hide the loss. We can shuffle goods between different consumers to try and compensate the victim. But there's no changing the reality that there is now one less T-shirt in the world. This T-shirt would have produced about $10 in pleasure. Thus having one less T-shirt has cost society $10 in happiness.

The recognition that the price of a good tells both the gain in society's happiness of having one more unit of the good and the loss in happiness of having one less unit of the good allows us to see some astounding things. For example, suppose a Nissan car dealer has show lots in both Dallas, Texas and Albuquerque, New Mexico. Suppose further that a Sentra, four-door sedan with the basic amenities sells for around $11,000 in Dallas, but fetches $16,000 in Albuquerque. Lastly, just to make it interesting, suppose this car dealership is owned by Mother Theresa, and her sole purpose in life is to increase society's happiness. Would she make society better off by taking one of her Sentras in Dallas and sending it to her lot in Albuquerque, or by transferring a Sentra from Albuquerque to Dallas?

The Answer is...moving one of her Sentras from Dallas to Albuquerque. The explanation is simple. Sentras are selling for a higher price in Albuquerque. Price provides a measure of happiness. If Sentras are selling for around $11,000 in Dallas, then there is a loss of $11,000 in happiness from having one less Sentra in the Dallas area. However, if the same car is selling for $16,000 in Albuquerque, there is a gain of $16,000 in happiness from having one more Sentra in the Albuquerque area. Thus, transferring a Sentra from Dallas to Albuquerque increases society's happiness by $5000.

Isn't that amazing? We didn't have to know anything about the car markets in the two respective areas. We didn't have to do any research on why the price of a care is higher in Albuquerque. All we need to know is the price of the car in the two cities. Once we have that nailed down, we used our knowledge of the information contained in prices to draw our conclusion: Society's happiness would be increased by transferring a car from the low price city to the high price city. With that knowledge, Mother Theresa can proceed accordingly.



But there's something else you should have noticed. Suppose the car dealership wasn't owned by Mother Theresa? Suppose it was owned by Ebenezer Scrooge, a money-grubbing, filthy rich, dirty capitalist whose sole purpose in life is to make himself the richest man in the world. How would Ebenezer Scrooge have behaved had he been the owner of the car dealership? Do you see that he also would have transferred a car from Dallas to Albuquerque? That is, he would have done the very thing that the economy would have wanted him to do to help it achieve its goal of allocating resources to their highest valued use. Ebenezer Scrooge would have acted just like Mother Theresa. Very interesting. As we'll see several chapters from now, this is more than just a mere coincidence.

Up to this point, the story we have told concerns the information contained in the prices of output goods and services. Output goods and services are consumables that yield direct pleasure. In contrast, input goods and services are factors used in the production of output goods and services. They aren't consumed directly by consumers and they don't yield pleasure by themselves. Output goods and services are things like hot dogs, roller coaster rides, Ford Tauruses, and personal home computers. Input goods and services are things like delivery trucks, electronic circuit boards, steam-powered generators, accountants, and downtown office buildings. Properly understood, all goods can be classified as either output or input goods. In fact, some things, like labor, can be both an "input" (work) or an "output" (leisure). Whether a good or service is an output or an input simply depends on how it is used.

To recap then, we have demonstrated that prices contain information that is absolutely crucial for deciding where resources have their highest valued use. In particular, THE PRICE OF AN OUTPUT GOOD IDENTIFIES THE GAIN IN HAPPINESS--MEASURED IN DOLLARS--THAT SOCIETY RECEIVES FROM CONSUMING ONE MORE UNIT OF THAT GOOD. ALTERNATELY, THE PRICE OF AN OUTPUT GOOD IDENTIFIES THE LOSS IN HAPPINESS--MEASURED IN DOLLARS--THAT SOCIETY SUFFERS FROM CONSUMING ONE LESS UNIT OF THAT GOOD.

But what about the prices of input goods. There's some good news and some bad news. The good news is that the information contained in input prices is very similar to that contained in output prices. Specifically, the prices of input goods identify the gain in happiness that society receives from employing one more unit of the input good. Alternatively, they identify the loss in happiness from employing one less unit of the input good. The bad news is that the demonstration of this truth is considerably more complicated. But don't worry, it's not anything that you can't handle. Even so, we'll save it for the next chapter.



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CHAPTER 10 The Information Contained in Input Prices

Consider the problem facing Reginald Buford, an aspiring kumquat farmer. From 6 in the morning to 2 in the afternoon Reginald delivers mail for the U.S. Postal Service in Lodi, California. Reginald is an ambitious kind of guy, and he hears there's money to be made growing kumquats. He figures he could grow a 1000 bushels of kumquats a year on an acre of land working afternoons and evenings after delivering his mail. From reading the Wall Street Journal that he delivers to one of the houses on his route, Reginald learns that kumquats are selling for about $43/bushel. How much would he be willing to pay to rent an acre of land for a year?

Let's assume that all it takes to grow kumquats is an acre of land and Mr. Buford's good labor--nothing else. At $43/bushel and 1000 bushels a year, Reginald calculates he can make $43,000 a year. Since the only inputs to producing kumquats are land and labor, and the labor is "free," you might be tempted to say Reginald Buford would be willing to pay up to $43,000 to rent an acre of land on which to grow kumquats. But since you're smarter than the average reader, you realize that it isn't quite this simple. While Reginald's labor does not cost him anything, it's not as though he doesn't have anything better to do with his time. If he wasn't raising kumquats, Reginald would be sipping margaritas on the deck of his backyard, above-ground pool, working on his tan and keeping an appreciative eye on his next door neighbor, Bambi Vavoom (but that's another story).

In fact, Reginald's labor does cost him something. It costs him the happiness he would receive from what he would be doing if he wasn't raising kumquats. As a result, Reginald figures that he needs to make at least $20,000 a year in income from his kumquat venture. Anything less than that wouldn't be enough to compensate him for the time he is giving up. As a result, Reginald Buford is willing to pay up to $23,000 a year for his acre of land. ($43,000 in revenue from kumquats minus $20,000 for Reginald's lost leisure time yields a $23,000 willingness to pay valuation of the land. In other words, if the land costs $23,000 to rent, the $43,000 of revenue will just cover rent and the dollar value of Reginald's lost leisure time.)

What would happen if Reginald paid more than $23,000 a year for the land? Suppose he paid $30,000? Then, at the end of the year--after he grew and sold his 1000 bushels of kumquats--he would gross $43,000 in income. From this he would have to pay $30,000 in costs for his acre of land, leaving Reginald with just $13,000 in net income. Now $13,000 might sound like plenty of money to you, but it's not enough for Reginald Buford of Lodi, California. He would have to make at least $20,000 to get him to give up his current lifestyle and go into kumquat farming. That is why he wouldn't be willing to pay $30,000 a year for the land. Indeed, that is why he wouldn't be willing to pay anything more than $23,000 a year for his acre of land.

The world is full of Reginald Bufords. Some want to go into kumquat farming. Others want to raise oranges, peaches, squash, and kiwi fruit. Others want to expand their current scales



of production. For example, just a mile down the road from Mr. Buford is Sally Raisin, of the California Raisins. Sally currently owns a 100 acres of farmland on which she grows grapes. She is thinking of renting an additional acre in order to increase her grape production. Let's assume that all it takes to grow grapes is an acre of land and Sally's good labor--nothing else (remember, this is not a textbook on how to farm!). Further, let's say that the market price of grapes is $38/bushel, and that Sally Raisin could grow 1000 bushels of grapes on an acre of land in a year. How much would Mrs. Raisin be willing to pay for this land?

Once again, we have to consider the value of her time. Having an extra acre of land means more work for Sally Raisin, and less time at home with her husband and kids. As a result, Sally figures she'd have to make at least $15,000 a year in take-home income to compensate her for the extra hours she'd be spending away from her family. Subtracting this from the $38,000 in sales revenue that she would make from the extra 1000 bushels of grapes she would grow, Sally Raisin calculates that she also would willing to pay up to $23,000 a year for the acre of land.

Of course, the fact that Reginald Buford and Sally Raisin both are willing to pay the same amount for an acre of land is a coincidence. Other farmers, and aspiring farmers, will have different willingness to pay values: $13,000 an acre; $29,000 an acre; $18,000; etc. In fact, there are thousands of farmers out there, each with their own particular willingness to pay value. In this respect, input goods are just like the output goods we discussed earlier.

Now suppose we had some way of producing an additional acre of farmland in northern California's Napa Valley--say, by reclaiming land that had previously been wiped out in a mud slide, or brush fire, or earthquake (take your pick). Suppose further that the market rental price of an acre of farmland in the Napa Valley was $23,000. Some farmer is going to end up with an acre of land that he wouldn't have had if this extra acre of land had not become available. This is the marginal farmer. What do we know about the willingness to pay value of the marginal farmer?

Is the marginal farmers' willingness to pay value going to be a lot larger than $23,000? By no means. Why not? A farmer who valued an acre of land a lot more than $23,000 would be sure to get an acre of land whether or not an extra acre was supplied to the market (does this sound familiar?). Is the marginal farmer's willingness to pay value going to be a lot less than $23,000? Of course not. Even with an extra acre of land, the market price of land in the Napa Valley will still be about $23,000. That means the marginal farmer will have to shell out around $23,000 in cold, hard cash to get this acre for a year. He certainly would not be willing to do this if he had a willingness to pay value that was much less than $23,000. Thus, the farmer who ends up with the extra acre of land must have a willingness to pay value for land right around $23,000-- not a lot more, not a lot less. Just as in the case of output goods, the marginal purchaser of the land has a willingness to pay value right around the price.

What has happened to society's happiness now that an extra acre of land has become available? The correct answer is...we can't say! We can't say at this point because--note--the



farmer who uses the land does not get any direct pleasure from it. The farmland is an input. It is being used to produce other things that provide happiness, but it doesn't provide happiness on its own. Thus, we can't just assume that the farmer's willingness to pay provides a measure of happiness. This will turn out to be the case, but we have to prove it first.

To trace out the effect on society's happiness, we have to follow through all the consequences of employing the farmland that impact society's happiness--remembering that society only gets pleasure from output goods. Let's return to our aspiring kumquat farmer, Reginald Buford. Suppose as a result of having an extra acre of land in the Napa Valley, Mr. Buford is the marginal farmer who ends up having an acre of land which he would not have had otherwise. On this acre of land, Mr. Buford grows 1000 bushels of kumquats, and kumquats sell for about $43 a bushel How much happiness has Mr. Buford produced by growing kumquats? $43,000. Kumquats are an output good. If the price of kumquats is $43/bushel, we know from our previous analysis that an extra bushel of kumquats would yield about $43 in happiness. An extra 1000 bushels would yield about $43,000 in happiness. Thus, having an extra acre of land has caused society to have $43,000 in happiness from eating kumquats that it would not have had otherwise.

But there is a downside to all this happiness. In order to produce these kumquats, Reginald Buford had to give up those leisurely times of sipping margaritas, working on his tan, and admiring the handsome Bambi Vavoom. This loss in leisure means that Reginald missed out on $20,000 in happiness over the course of a year. A social accounting shows that society gained $43,000 from the kumquats (an output good), but lost $20,000 from Reginald's leisure time (also an output good). As a result, employing the extra acre of land resulted in a net gain to society's happiness of $23,000. Not coincidentally, $23,000 also happened to be Reginald Buford's willingness to pay for the land...and the price. This demonstrates our claim: THE PRICE OF AN INPUT GOOD IDENTIFIES THE GAIN IN HAPPINESS--MEASURED IN DOLLARS--THAT SOCIETY RECEIVES FROM EMPLOYING ONE MORE UNIT OF THE INPUT GOOD.

By now you should have no problem telling the story in reverse, about the loss in society's happiness from having one less unit of the input good. That is, you should be able to easily demonstrate that THE PRICE OF AN INPUT GOOD ALSO IDENTIFIES THE LOSS IN HAPPINESS--MEASURED IN DOLLARS--THAT SOCIETY RECEIVES FROM EMPLOYING ONE LESS UNIT OF THE INPUT GOOD.

This is important stuff. If we know that the rental price of land is $23,000 an acre for a year, and if some reason society were to lose the use of this land, society would suffer a loss in happiness of approximately $23,000. We can say this without even knowing what that land was going to be used for. Maybe Reginald Buford would have used it to farm kumquats. Maybe Sally Raisin would have grown grapes on it. Maybe some developer would have built luxury condominiums on it. Perhaps the land will be used for a new factory. It doesn't matter what is done with the land. All the information that we need to know is right there in the price. And while we've told this input story about an acre of farmland, it should be clear



that the story is valid for any of the innumerable different types of inputs that are used to produce output goods: a ton of steel, a truck, a gallon of water, a shovel, an office personal computer, a kilowatt of electricity, a 5000 square foot warehouse.



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CHAPTER 11 A Ton of Copper Versus a Ton of Steel

We are now ready to apply our knowledge about the information contained in input prices. Let's take Mother Theresa out of the car business and put her in charge of production at a large industrial plant. Once again, we're going to assume that Mother Theresa's one abiding passion is to increase society's happiness, and forget about the capitalistic dogs that run American industry. The plant that she runs produces pens. To be more specific, it produces those little metal clips that can be used to attach pens to the shirt pockets of their owners. Let's give this company a name, say Pen, Inc. Right now the production accountants for Pen, Inc. are trying to decide whether to use copper or steel in producing those little metal clips. The price of copper is $1000 a ton. The price of steel is $750 a ton. It looks like a no-brainer to the accountants: use the cheaper input and keep costs down.

But the CEO at Pen, Inc. isn't interested in keeping costs down. She wants to choose the input that will result in the greatest happiness for society. Market surveys have showed convincingly that consumers don't care whether the clips are made out of copper or steel. Either works equally well. Thus, the choice of copper or steel has no impact on the happiness of Pen, Inc.'s customers.

Who, then, will it affect? Think carefully now. If Pen, Inc. uses a ton of steel to produce the metal clips for their pens, that means there will be one less ton of steel available for other uses. One less of ton of steel to produce skyscrapers, Tonka Toys, Ford Rangers, steel-belted radial tires, steel cleats for soccer shoes, etc. How much happiness will be lost because there is now one less ton of steel available for these uses? How can we possibly answer this question? All we know about steel is its price. The market price of steel is $750 a ton. The beauty of it is, that's all we have to know.

If the market price of steel is $750 a ton, then we know that society will lose approximately $750 in happiness if that steel is withdrawn from the market to make metal clips for pens. We can't say for sure what that steel would have been used for if it wasn't used to make clips. To be truthful, we don't have a clue. However, we do know this. Somebody somewhere is going to not consume certain goods and services that they would have been able to enjoy if Pen, Inc. hadn't used up all that steel in making their metal clips. Probably a lot of somebody's somewhere are going to be doing with less. We don't know who they are. Those other goods and services will never be made, and so nobody knows who would have ended up with them. But here's what we do know: the price of steel tells us that having one less ton of steel means society loses the $750 of happiness that steel would have contributed. And the price of copper tells us that having one less ton of copper means society loses $1000 in happiness.

If Pen, Inc. has already decided to produce the metal clips and the only question is copper versus steel, then SOCIETY WANTS THE FIRM TO USE THE INPUT THAT WILL RESULT IN THE SMALLEST LOSS OF HAPPINESS ELSEWHERE IN THE ECONOMY. But THIS MEANS USING THE INPUT WITH THE LOWEST PRICE. And



so, Mother Theresa makes her choice. Without a thought about the bottom line--concerned only about the happiness of the masses--she calls the Purchasing Department and tells them to place an order for a ton of steel. She sits back in her director's chair, filled with quiet satisfaction from the knowledge that because of her choice, the world is going to be a (slightly) happier place. The only thing disturbing her reverie is a memo on her desk from the firm's accountants. It recommends the very course of action she chose herself. Isn't that strange?



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CHAPTER 12 A Ton of Ph.D.'s Versus a Ton of High School Dropouts

Armed with the knowledge that the price of inputs contains incredible information, we can now consider a choice between two labor inputs. Suppose that an electronics firm has an opening for an entry level janitor. While the job does require the employee to have a good work attitude, it doesn't require formal skills. Two applicants show up for the position. One is a high school dropout. The other is a Ph.D. in electrical engineering. Each of the candidates has made it clear that he will take the job only if he is paid his market wage. The market wage for high school dropouts is about $15,000 a year. The market wage for Ph.D.'s in electrical engineering is about $70,000 a year. Which applicant should the firm hire? Once again, when we say "should" we aren't interested in what may or may not be good for the firm. We are interested in the overriding goal of maximizing society's happiness.

Of course, the firm should hire the high school dropout. You don't see a lot of Ph.D.'s in electrical engineering sweeping floors, and we personally think that is a good thing. Why? Because Ph.D.'s in electrical engineering are extremely valuable elsewhere in the economy. They can design new computer chips that allow home computers to play games that have more brilliant special effects. They can be used to build stereo systems that have more realistic sound quality. They can design circuit boards that allow better transmission and reception of telephone calls. In short, it seems like an absolute waste to put somebody with all this valuable training to use sweeping floors.

While we hate to say it like this, Ph.D.'s in electrical engineering are more valuable than high school dropouts. (If it's any consolation, we also have to acknowledge that they are more valuable than Ph.D.'s in economics.) The trick here is to know what we mean when we say "valuable." Ph.D.'s in electrical engineering--by virtue of their training--are in a position to produce more happiness for consumers than high school dropouts. They may not be nicer. You might not want to travel cross country on your Harley with one. But in terms of what they can do for the happiness of consumers, Ph.D's in electrical engineering are more valuable.

In our particular case, if the firm hires a high school dropout, that dropout won't be available to do other things. Consumers elsewhere in the economy will be missing out on some goods and services--such as washed cars, mowed lawns, and grocery bags packed--that they would have received if this high school dropout had not been removed from the labor market to produce clean floors for this firm. The fact that this worker expected to make around $15,000 a year doing something else means that the loss to consumers of not having him do those other things will be about $15,000. And that's too bad.

However, it's not nearly as bad as what would happen if the firm had hired the Ph.D. in electrical engineering. His market wage of $70,000 a year tells us that because there is one less electrical engineering Ph.D. out there in the world producing whatever he might have produced had he taken an electrical engineering job, consumers will be out about $70,000 in happiness. Let's save that Ph.D. for something more happiness-producing for consumers



than a clean floor!

Up to this point, our analysis has considered what happens when a firm chooses to employ a new resource. However, the same tools can be applied when a firm chooses to let go of an old resource. Suppose our electronics firm already employs a Ph.D. in electrical engineering, but it doesn't use him to clean floors. It employs him in its product development department. Recently, a new software package became available that greatly simplifies the work that the Ph.D. was doing at this firm.1 In fact, this software now makes the job so simple that, after a short training session, any high-school dropout could perform this work as well as this Ph.D. Question: Do we want the firm to replace its Ph.D. with a high school dropout?

The answer is a resounding YES. The Ph.D.'s market wage of $70,000 a year tells us that after he is laid off, he will contribute about $70,000 of happiness to society in another use.2

In contrast, when the high school dropout is hired on, his market wage of $15,000 tells us that society is deprived of $15,000 of happiness someplace else. After one weighs out the respective gains and losses, the net effect is an increase in society's happiness of $55,000!

The fact that the price of an input tells us information about the happiness the input produces is really pretty reasonable once you start to think about it: Ph.D.'s in electrical engineering make more money than high school dropouts because consumers are willing to pay more for the things that Ph.D.'s produce--compared to the things that high school dropouts produce. To look at this issue from another angle, suppose an input had no gainful employments. That is, suppose nobody could figure how to produce anything useful with this input. In that case, we would expect the price of that input to be zero. Ultimately, it is the amount of happiness that an extra unit of an input is expected to produce that supports the price of that input.

Copper and steel, Ph.D.s and high school dropouts. They seem so different. Yet the common bond between them is that they are all inputs in the production of goods and services. In this very important respect they are alike. As a result, the information contained in the relative prices of copper and steel is the same information that is contained in the relative prices of Ph.D.s and high school dropouts. Their prices tell us the comparative value of those resources to society. They provide a crucial piece of information for helping society to allocate resources to their highest valued use.



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Notes

1 To keep the problem uncomplicated, we assume that while the software simplifies the work of the Ph.D. at this firm, it doesn't affect his productivity at other firms. Thus, the market wage of the Ph.D. stays at $70,000.

2 You may question how we can be so certain that the Ph.D. will be readily reemployed. We will address this issue in Chapter 32.



CHAPTER 13 The Big Picture

It's about time that we start to put some of these pieces together. To do that, we have to focus on the BIG PICTURE. The big picture is reproduced below, reduced in size so that we can still fit it on the page.

At the top of the picture we have our millions of consumers. Each of our consumers is characterized by a unique set of preferences known only to himself. Some like red cars, some like white; some like to spend their vacations roughing it in the wilderness, others like to sip gin and tonics slowly through a straw while playing the slot machines in Las Vegas; some like pizza pies with anchovies, some don't.

At the bottom of the picture we have our millions of resources, where a resource is defined as anything that has the potential to produce happiness. Coal, plumbing, spring water, and steel are merely resources that are waiting to be turned into something useful, like electricity, housing, bottled water, and automobiles. All resources are like that---sitting out there somewhere, capable of producing pleasure for consumers, only needing someone to direct and organize them into something fit for consumption. There are literally billions--no, trillions--of ways to allocate these resources across the millions of consumers hungry for pleasure. It is the economy's job to manage these resources so that the happiness of society is maximized. What a gargantuan task! What a superhuman endeavor! Who possibly can be entrusted with such an awesome responsibility?

Let's reconsider some of the possibilities. There really aren't very many. One possibility is that we have an economic dictator. It makes little difference whether the dictator is a single individual ("Hi, my name is Joe...Joe Stalin" ) or a national economic planning board, say



the Committee to Review Every Existing Possibility for Insuring Exceptional Satisfaction (CREEPIES). Either way, the problem remains the same. How will the economic dictator know where to direct resources so as to maximize society's happiness? Of course, we visited this problem in Chapter 3 when we considered the Soviet planner's dilemma about allocating resources to housing and how best to distribute the deceased rich man's estate. Short of operating a national auction that would allow the millions of society's consumers to place bids, it's difficult to imagine how the dictator(s) would know what items consumers wanted and how many of them to make. In addition, there is the sticky problem of what to do if the dictator doesn't prove up to the task. ("Hey, Joe, I think you're losing touch with the proletariat, have you thought about stepping down and giving someone else a go at it?...Siberia, no I've never been there, why do you ask?")

Another possibility that seems to be quite popular today is that we let democracy do it--that is, let the people vote. Direct or indirect elections to determine the allocation of resources is an intriguing idea. The one person, one vote convention seems a particularly fair way to allow people to express their views about how society's resources should be allocated. Indeed, in many so called "capitalistic" economies, much or most of the economy is directed by this mechanism. For example, in the United States, approximately 40 cents of every dollar spent in the economy is spent by some level of government: local, state, or federal. These levels of government are led by representatives who are directly elected by voters (a.k.a consumers). Thus, voters already control--indirectly--the allocation of over forty percent of the U.S.'s resources. If democracy seems like a good way to decide how many soldiers to train and how many nuclear missiles to build, why not use it to decide what kinds of cars we should drive and what brands of breakfast cereal we should eat? While this would make for some very interesting political campaigns ("If elected, I promise you that I will put more raisins in every box of Toasted Raisin Bran Crunchies"), there are some serious drawbacks to this way of allocating resources. For one thing, the last time we checked, politicians enjoyed approval ratings just below used car salesmen and not much higher than convicted drug felons. We may not want to place even greater control of our resources in the hands of politicians. Further, the astute reader might ask, how does the one person-one vote rule relate to a consumer's willingness to pay? The answer is: not well. This is an important topic and one that we will return to later on in the book.

For now we want to focus our attention on a third possibility. In an economy organized by the market, the agents that carry out the awesome task of allocating resources across consumers are none other than those everyday, humdrum organizations we call FIRMS. For our purposes, we think of firms as nothing more than resource owners. They range in size from General Motors, which has sales upwards of $130 billion a year; to a roadside produce stand which has sales of $500 and operates for just a week. Some firms are singly owned, others have hundreds of thousands of shareholders. No matter. In fact, the laborer who "owns" his or her time and skills can also be thought of as a "firm." Firms all share the common characteristic that as resource owners, they make the decisions that result in the allocation of resources across the economy's consumers.

Maybe this isn't exactly comforting. After all, what guarantee do we have that firms will



carry out their task in a socially responsible fashion? Somehow, the thought that men like John D. Rockefeller, J. P. Morgan, Donald Trump, and Bill Gates should be entrusted with the job of deciding the happiness of millions of consumers is--shall we say--a little disconcerting. Before you get too discouraged, however, let's first think of how we would like our firms to behave in an ideal world. Then we'll compare our idealized firms to those that exist in the real world.



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CHAPTER 14 The Amazing Story of Profits

Earlier (in Chapter 7) we saw how the price system could be used to signal where a new building would produce the greatest social happiness. If 2000 square foot homes are selling for $160,000 in suburban Detroit and $120,000 in Ann Arbor, Michigan, then greater happiness would be produced if a new home were built in Detroit rather than Ann Arbor. Note, however, that we have never said whether or not a new home should be built; we have only stated where the new home generates the most happiness. Deciding if society should build a new home is somewhat more complex.

Building a new home diverts a lot of valuable resources from other happiness-producing activities. The cement that will be poured to lay the new home's foundation could have been used to build swimming pools in suburban Atlanta. The carpet used to line the floors of the new home could have been used for a new apartment complex in Duluth, Minnesota. The wiring and electrical materials that will be employed in the walls of the new home could have been used for building electrical components in the dashboards of new Chevy pickups. How can we know that the private contractor (the firm) will make the right decisions in taking these resources away from these other activities and diverting them towards the production of a new home?

Let's first think of how we would want firms to behave in an ideal world. If we could fill out a job description for our firms, we would put down "maximize society's happiness." This is admittedly a little vague, so we'll try to be more specific. Since firms are resource owners, we'd like them to DIRECT RESOURCES FROM LOW-VALUED USES TOWARD HIGH-VALUED USES.

Just our luck! The firms in the real world don't give any thought to doing what is best for society. In a free market economy, firms are interested in only one thing...PROFITS. Making more money, maximizing their incomes, that is what interests firms. But is profit lust a good thing? Shouldn't people come before profits? Before answering these questions, let's examine this thing called profits. While we promised that we would not resort to fancy formulas and high-level mathematics, here's one equation that will prove absolutely crucial for appreciating what firms do.

Profits are the difference between revenues and costs. Now think. How are a firm's revenues determined?

PROFITS = REVENUES - COSTS

REVENUES = (Output Price) X (Number of Output Units Sold)



Or, more simply, a firm's revenue is its total dollar income. What information is contained in a firm's revenues? We already know the information contained in the price of output goods. The price of an output good tells us the gain in happiness that society receives from having one more unit of the output good. If we multiply this by the number of output units sold, we see that REVENUES PROVIDE A MEASURE OF HOW MUCH TOTAL HAPPINESS THE FIRM CREATES FOR SOCIETY THROUGH ITS PRODUCTION OF GOODS AND SERVICES.1

To complete the story, compare revenues with the cost side of the firm's accounting sheet.

In our example of Reginald Buford the kumquat farmer, total costs equalled the price of the land ($23,000), plus Reginald's own cost for his labor, ($20,000), for a total cost of $43,000. Of course, this was a simplistic example. A more realistic description of costs would include kilowatts of electricity, hours of secretarial assistance, tons of cement, and many other types of inputs.

Consider the information contained in a firm's COSTS. We know from our previous hard work that the price of an input good tells us the loss in happiness that society suffers from having one less unit of the input good. When a firm chooses to employ a given input, say a ton of cement, it deprives the rest of the economy of the use of that input. For example, if the price of cement is $600 per ton, we know that consumers will be foregoing approximately $600 in happiness because that cement will no longer be available to produce alternative goods such as swimming pools and shuffleboard courts. If 150 tons of cement are required to build ten new homes, then the firm's cement costs will be $90,000 ($600 X 150). The economic interpretation of those costs is that building those two homes has resulted in $90,000 less happiness elsewhere in the economy because that cement is no longer available to produce other things. Applying this logic to all the firm's costs, we see that COSTS PROVIDE A MEASURE OF THE TOTAL LOSS IN HAPPINESS THE FIRM CAUSES FOR SOCIETY BY WITHDRAWING RESOURCES FROM OTHER USES.2

And now, for the pièce de résistance...(drum roll, please). Look what happens when we put revenues and costs together to obtain profits. If revenues tell us the gain in happiness from the goods and services supplied by the firm, and costs tell us the loss in happiness caused by using up resources to produce those goods and services, then PROFITS PROVIDE A MEASURE OF SOCIETY'S NET GAIN IN HAPPINESS GENERATED BY THE FIRM AS IT TRANSFERS RESOURCES FROM OTHER USES TO THE PRODUCTION OF ITS OWN GOODS AND SERVICES. Incredibly, profits provide the ultimate measure of whether a given firm is making society better or worse off.

Meditate for a moment on the human drama that is represented by the following home builder's income statement.

COSTS = How much the firm paid for the resources to make its output



Most people would just look at this income statement and see a bunch of numbers and not realize the amazing story that it represents. But we know better. These numbers represent a chapter in the saga of humanity's never ceasing struggle to carve out a better life from an inhospitable world. It is the story of a firm that made the world a happier place. By redirecting resources such as cement, labor, wood, etc. away from LOWER VALUED USES, and using them instead for the HIGHER VALUED USE of building homes, this--dare we say, heroic?--firm produced an increase in society's happiness of $100,000. Once we understand what's going on, reading firms' income statements becomes a moving, emotional experience. It almost makes us want to run out and become accountants (if only we had the personality for it!).

OPTIONAL SECTION FOR ECONOMISTS: R e a d e r s f a m i l i a r w i t h e l e m e n t a r y e c o n o m i c t h e o r y w i l l r e c o g n i z e t h a t w h a t w e a r e c a l l i n g " t h e n e t g a i n s i n h a p p i n e s s f r o m a r e s o u r c e t r a n s f e r " i s n o t h i n g m o r e t h a n w h a t i s c o m m o n l y i d e n t i f i e d a s t h e " w e l f a r e g a i n s f r o m t r a d e " i n s t a n d a r d e c o n o m i c s t e x t b o o k s . T h e s u p p l y c u r v e r e p r e s e n t s t h e h o r i z o n t a l s u m m a t i o n o f e a c h f i r m ' s m a r g i n a l c o s t c u r v e s . A s s u c h , t h e h e i g h t o f t h e s u p p l y c u r v e a t a n y g i v e n q u a n t i t y r e p r e s e n t s t h e m a r g i n a l c o s t o f p r o d u c i n g t h a t p a r t i c u l a r u n i t . A s d i s c u s s e d p r e v i o u s l y , t h e h e i g h t o f t h e d e m a n d c u r v e r e p r e s e n t s t h e w i l l i n g n e s s t o p a y o f t h e m a r g i n a l c o n s u m e r f o r t h a t p a r t i c u l a r u n i t . T h u s , t h e d i s t a n c e b e t w e e n t h e d e m a n d a n d s u p p l y c u r v e r e p r e s e n t s t h e d i f f e r e n c e b e t w e e n t h e m a r g i n a l c o n s u m e r ' s w i l l i n g n e s s t o p a y a n d t h e m a r g i n a l c o s t s o f p r o d u c t i o n f o r t h a t p a r t i c u l a r u n i t o f t h e g o o d . W h e n s u m m e d o v e r a l l t h e u n i t s o f t h e g o o d p r o d u c e d i n t h e m a r k e t , o n e o b t a i n s t h e a r e a i n t h e g r a p h b e l o w , w h i c h s h o u l d b e f a m i l i a r a s t h e " w e l f a r e g a i n " a s s o c i a t e d w i t h t h e m a r k e t , o t h e r w i s e i d e n t i f i e d a s t h e s u m o f " c o n s u m e r s ' a n d p r o d u c e r s ' s u r p l u s . "

Amount Description

REVENUES: $1,000,000 Sold 10 homes

COSTS: $900,000

Itemized costs: Cement: $90,000; Labor: $320,000; Wood: $270,000; Plumbing: $60,000; Sheet rock: $10,000; Carpeting: $90,000; Miscellaneous: $60,000.

PROFITS: $100,000



T h e c l a i m i n t h i s c h a p t e r i s t h a t a f i r m ' s p r o f i t s m e a s u r e t h e n e t g a i n s i n h a p p i n e s s f r o m a g i v e n r e s o u r c e t r a n s f e r . T h e k e y a s s u m p t i o n n e e d e d t o j u s t i f y t h i s c l a i m i s t h a t t h e w i l l i n g n e s s t o p a y o f t h e m a r g i n a l c o n s u m e r s a s s o c i a t e d w i t h t h e f i r m ' s o u t p u t m u s t b e e q u a l t o t h e p r i c e o f t h e g o o d . H o w e v e r , a s l o n g a s t h e f i r m c o m p r i s e s a s m a l l c o m p o n e n t o f t h e m a r k e t , t h e n i t i s a " p r i c e t a k e r , " w h i c h m e a n s t h a t t h e d e m a n d c u r v e f a c i n g t h e f i r m i s h o r i z o n t a l a t t h e m a r k e t p r i c e . T h i s i s t h e s i t u a t i o n r e p r e s e n t e d i n t h e g r a p h b e l o w .



T h e s h a d e d a r e a - - t h a t i s , t h e a r e a b e t w e e n t h e f i r m ' s d e m a n d c u r v e , r e p r e s e n t i n g t h e w i l l i n g n e s s t o p a y o f i t s c o n s u m e r s , a n d t h e f i r m ' s m a r g i n a l c o s t c u r v e - - i d e n t i f i e s t h e f i r m ' s p r o f i t s f r o m p r o d u c t i o n . I t a l s o i d e n t i f i e s t h e w e l f a r e g a i n s r e c e i v e d b y s o c i e t y f r o m t h e m a r g i n a l f i r m ' s p r o d u c t i o n . O n c e o n e r e c o g n i z e s t h a t e v e r y u n i t o f p r o d u c t i o n r e p r e s e n t s a " r e s o u r c e t r a n s f e r , " t h e n i t s h o u l d b e s e e n t h a t t h e c l a i m o f t h i s c h a p t e r i s a s t r a i g h t f o r w a r d d e d u c t i o n o f c o n v e n t i o n a l w e l f a r e t h e o r y . S t u d e n t s s o m e t i m e s r a i s e t h e o b j e c t i o n t h a t s i n c e a l l f i r m s a r e s u p p o s e d t o e a r n z e r o e c o n o m i c p r o f i t s i n l o n g r u n e q u i l i b r i u m , t h i s m u s t i m p l y t h a t f i r m s a d d n o t h i n g t o s o c i e t y ' s h a p p i n e s s . T h e r e a r e t w o s o u r c e s o f c o n f u s i o n r e p r e s e n t e d b y t h i s o b j e c t i o n . F i r s t , f i r m s c a n e a r n e c o n o m i c p r o f i t s i n t h e s h o r t r u n . I n f a c t , t h e " l o n g r u n , " a s i t i s u s e d i n e c o n o m i c s , r e p r e s e n t s a t h e o r e t i c a l i d e a l t h a t i s n e v e r r e a l i z e d . S e c o n d , t h e r e i s a n i m p o r t a n t d i s t i n c t i o n b e t w e e n m a r g i n a l a n d t o t a l . P r o f i t s m e a s u r e t h e m a r g i n a l c o n t r i b u t i o n o f t h e f i r m t o s o c i e t y ' s h a p p i n e s s . Marginal c o nt rib u t io n m e a n s t h a t w e h o l d t h e p r o d u c t i o n o f o t h e r f i r m s c o n s t a n t . A s s u m i n g t h e c l a s s i c a l m i c r o e c o n o m i c d e f i n i t i o n o f l o n g r u n e q u i l i b r i u m , t h e n a n y p a r t i c u l a r f i r m i n l o n g r u n e q u i l i b r i u m c o n t r i b u t e s z e r o g a i n t o s o c i e t y ' s h a p p i n e s s a t t h e m a r g i n . T h i s i s d i f f e r e n t f r o m s a y i n g t h a t t h e t o t a l o u t p u t p r o d u c e d b y a l l f i r m s i n a n i n d u s t r y a d d s n o t h i n g t o s o c i e t y ' s h a p p i n e s s .



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Notes

1 This interpretation of the information contained in the firm's total revenues does assume that the firm's output represents a relatively small portion of the entire quantity of goods supplied to the market. That is, we are assuming that the firm does not have significant market power in influencing the price of the output good. Chapter 43 considers the implications for our analysis when a firm possesses market power.

2 This interpretation assumes that the firm does not have market power in input markets. That is, we assume that the firm is not able to influence the price of input goods by altering the quantity of inputs it employs



CHAPTER 15 Profits and the Invisible Hand

The simple equation Profits = Revenues - Costs represents the unifying field theory of economics. If this strikes you as pathetically simplistic, we're sympathetic (maybe that's why they call economics a soft science). Nevertheless, this simple equation represents a remarkably powerful framework for analyzing all economic activities. After all, ECONOMICS IS ALL ABOUT RESOURCE TRANSFERS, taking resources away from one possible use and redirecting them towards something else. Health care, job training, child care, workplace safety, environmental cleanup--properly understood, these things are nothing more than resource transfers. If we direct more resources to child care, we have less resources for other things. If we want to provide better health care to more people, we cannot help but deprive consumers of other goods and services that would have produced happiness. The key question is--always is--which use of a resource provides the greatest happiness?

To better visualize how profits help us to answer this question, let's return to the BIG PICTURE.

For example, building a house means taking resources away from some consumers and directing these resources to others. When we say that the building contractor "takes away" resources from consumers, we don't mean that he drives through town in his half-ton pickup truck with his gang of carpenters snatching cement, sheet rock, and carpeting out of the hands of unsuspecting consumers. It is all done in a very pleasant and neighborly sort of way, with the contractor exchanging green pieces of paper for the right to employ these resources. But don't let those pleasantries prevent you from seeing what is really going on. Resources are being taken from one activity and put to use in another. To determine whether this resource transfer makes society better off, we need to compare the loss in happiness that arises from not having those resources available for alternative uses, with the gain in happiness received from the activity those resources have been redirected to.

Under the right circumstances--we'll talk more about this later--profits provide a measure of



the net gains in happiness from resource transfers, with revenues measuring the gains and costs the losses. If profits are positive, the firm has generated an increase in society's happiness. If profits are negative, the production activities of the firm have served to decrease society's happiness.

IN A FREE-MARKET ECONOMY, PROFIT-MAXIMIZING FIRMS ARE AN UNWITTING ACCOMPLICE IN THE GREAT SOCIETAL TASK OF MAXIMIZING HAPPINESS. This is a powerful insight. Take the greediest, most selfish, money-grubbing, heartless capitalist you can imagine. In his never-ending lust to maximize his own profits, a startling thing occurs. The greedy capitalist becomes indistinguishable from the zealous altruist who works untiringly for the improvement of the masses. It is as if the capitalist woke up each morning and asked himself, "How can I improve the lot of my fellow citizens today?" Ebenezer Scrooge becomes Mother Theresa, or at least her economic equivalent.

In fact, one could say that it is as if an INVISIBLE HAND guided the firm unknowingly to do what was good for society. Invisible hand indeed. Just so you don't labor under the misconception that any of this is particularly new, consider the words of Adam Smith, taken from his book The Wealth of Nations, first published in 1776:

ONE IMPLICATION OF THIS IS THAT WE SHOULD BE SUSPICIOUS OF POLICIES THAT PROPOSE RESOURCE TRANSFERS WHICH PROFIT-MAXIMIZING FIRMS ARE NOT WILLING TO UNDERTAKE. If more child care would really improve society's happiness, we should expect profit-maximizing firms to be able to make good money operating day care centers. If providing more health care really is a good thing, for-profit hospitals will rise up to meet the need. Likewise, if redirecting resources to produce better trained workers would make society better off, then we should see firms opening up "worker education" centers, training workers for a profit. And we should cast a wary glance at politicians who talk about the need for government job-training programs to help America "grow stronger" in the world economy.

Does this mean that every activity that loses money decreases society's happiness? And anyactivity that makes money increases society's happiness? No, it does not. Recall that at this point in our analysis we are operating in a world without market imperfections. As we shall see, the presence of market imperfections will cause profits to distort the impact of resource transfers on society's happiness. Our point here is merely that one should be "suspicious" of

"As every individual, therefore, endeavors as much as he can...to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of the society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it....he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand [italics added] to promote an end which was no part of his intention."1



calls for society to undertake resource transfers which profit-maximizing firms are unwilling to undertake. That is, we should ask ourselves: if this activity is so good for society, how come profit-maximizing firms aren't doing it?

Maybe you're skeptical that our "unifying field theory" is complete enough to analyze the complicated issues we promised to discuss in the first chapter. Good. We plan to spend a lot of time addressing these and other issues in greater detail. In the meantime, keep your skepticism.



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Notes

1 Adam Smith, An Inquiry Into the Nature and Causes of the Wealth of Nations, Indianapolis: Liberty Classics, 1976, page 456.



CHAPTER 16 Price Controls and Other Disasters

We've all seen newspaper stories like the real-life story quoted above. Earthquakes, floods, tornadoes, hurricanes leave a path of billions of dollars of property damage in their wake. Families are left homeless. Food, clothing, and shelter are suddenly in short supply. And how does the free-market economy react to all this pain and suffering? It generally responds by causing the prices of these necessities to go through the roof, assuming the roof is still there. Funny way to increase society's happiness! After all, when was the last time you went to the store, saw a higher price, and were happier as a result? Indeed, we suspect that most people share the sentiments of Florida's attorney general, who accused the lumber companies of being "no better than looters." Such a statement is usually followed by a recommendation that it should be illegal for businesses to raise their prices beyond a certain point. This is called a price control. But let's think about this. Would we really be better off if the government prohibited lumber companies from raising the price of plywood following a natural disaster like Hurricane Andrew?

Suppose that prior to Hurricane Andrew, the price of plywood was fairly uniform over the continental United States. Say plywood initially cost $300 per thousand board feet in North Carolina and Florida. Now Hurricane Andrew devastates Florida, causing the price of plywood to rise to $400 in that state (assume the price remains at $300 in North Carolina). What happens next?

The owners of plywood in states like North Carolina realize that they can make a buck by shipping their lumber stocks to Florida. Assuming that the shipping costs of a thousand board feet are less than $100, these owners can make a quick profit by raiding their warehouses and putting their available plywood on the first train going south. This is good...and bad. It's good because the people in Florida now have more wood to rebuild their devastated cities and homes. It's bad because the people in North Carolina now have less wood for building tree houses and redecorating their family rooms. Who can say whether the gains of the consumers in Florida outweigh the losses of the consumers in North Carolina? The answer is: anyone who understands the Unifying Field Theory of Economics (Profits=Revenues-Costs).

Shipping a thousand board feet of plywood out of North Carolina means that consumers

"STORM DRIVES LUMBER PRICES TO RECORD HIGHS. Seattle (Reuter)--Hurricane Andrew has spiked cash lumber prices to record levels and sent futures soaring as investors speculate on the billions of dollars that will be spent to repair some 85,000 homes in Florida and Louisiana...Florida's attorney general has begun investigating recent retail price increases for plywood, alleging that the companies were no better than looters."



there will miss out on about $300 in happiness which they would have received from that wood. But sending another thousand board feet to Florida causes an increase in happiness of $400 there. Taking plywood resources out of the hands of North Carolina consumers and putting it into the hands of Florida consumers has created a net increase in society's happiness. This increase in happiness has occurred only because of the high price of plywood in Florida. It wouldn't have happened if government regulators had refused to allow the price of lumber to rise as a result of the natural disaster.

In fact, HIGH PRICES ARE A DISTRESS CALL THAT GOES OUT TO THE REST OF THE ECONOMY. "Mayday, Mayday...Please send food, clothing, and the resources to rebuild homes...Over and out...P.S. Hurry Up!" This SOS call is picked up by thousands of "rescue organizations" across the economy that respond with a great outpouring of relief to the disaster victims. These "rescue organizations" have names like the Georgia-Pacific Lumber Company, the Kroger Corporation food company, the Sears and Roebuck clothing company, etc. Shipments of food, clothing, and plywood all start arriving in great quantities. Oh sure, maybe the intentions of these "rescue organizations" isn't what it ought to be in an ideal world. Maybe they should be more concerned about the pain and suffering of the disaster victims and less concerned about their own interests. But that's not an argument against the price system. On the contrary! It's a tremendous argument in favor of the price system. Even though the owners of these resources may not have a whit of sympathy for the poor consumers afflicted by this disaster, they're doing everything they can to help them in their hour of need.1

The key to seeing all of this is to recognize that PRICES CONTAIN INFORMATION. The fact that the price of lumber is higher in Florida means that an extra 1000 board feet of lumber is more valued there than elsewhere. Price controls keep this information from getting out. In fact, one can think of price controls as a form of censorship. They keep the SOS call from being sent. And without this vital information, the free-market economy cannot transfer resources where they are most needed.2

That's all fine and good you say, but don't higher prices hurt people as well? Well, higher prices surely impose a burden on everybody. But note that the real problem here isn't the higher prices. The real problem here is that Hurricane Andrew (or whatever disaster we're dealing with) has wiped out the resources available to consumers. There's not enough food, clothing, and shelter to accommodate the past consumption behavior of consumers--this is the source of the real burden from the natural disaster, not the higher prices. Higher prices aren't causing there to be less food, clothing, and shelter. They are merely reflecting the fact that there's less of these things to go around. Price controls can't alter this stark reality.

In fact, artificially lowering prices makes things worse. Since the real problem here is the lack of necessities, the only way to make things better is to somehow get more of these things in the hands of consumers. High prices attract these goods from other parts of the country. Perhaps we can draw some consolation from the fact that the high prices which follow natural disasters are temporary. Thanks in large part to the tremendous desire of for-profit organizations to capitalize on this disaster, a flood of valuable resources will soon be



sent to the devastated communities. As food and clothing quickly fill the shelves of stores throughout the area, prices will come tumbling down. Thus, the spike of high prices following a natural disaster contains the seed of its own demise. It unleashes forces that will soon cause prices to return to their pre-disaster levels.

You may be thinking, "That's great, but don't higher prices disproportionately hurt the poor? After all, they're the ones least able to pay. Shouldn't we help them if they can't afford necessities?" We certainly agree with this sentiment, but consider the following. Price controls do not just lower prices for poor people. They lower prices for rich people as well. If we are really concerned about putting more food and clothing in the hands of poor people, there is no guarantee that price controls will do the job. At the lower prices, rich people will want to buy more of these goods than they would otherwise. If they do, there will be less of them available for poor people. How's this for a perverse result: ARTIFICIALLY LOWERING PRICES TO HELP POOR PEOPLE MAY IN FACT DISPROPORTIONATELY HURT POOR PEOPLE.

All of this leads us to the following conclusion. If you don't like the allocations that arise under the price system, don't kill the messenger. The price system isn't the problem. On the contrary, since the price system directs resources to a devastated area, it is the solution. The real problem is one we touched on when we first discussed the willingness to pay approach: poor people don't have enough money to adequately express their desire for goods and services. So give poor people more money. Price controls can't be counted on to help the poor because there's no guarantee that more goods and services will actually go to them. At least when we give poor people more money, there is no doubt they are going to be able to get more of the things they really need. And we can take comfort in the knowledge that we haven't compounded the original, natural disaster with the man-made disaster of price controls.

OPTIONAL SECTION FOR ECONOMISTS : T h e a r g u m e n t i n t h i s c h a p t e r i s t h a t a p r i c e c o n t r o l - -s p e c i f i c a l l y , a p r i c e c e i l i n g - - l o w e r s s o c i e t y ' s h a p p i n e s s . S t u d e n t s f a m i l i a r w i t h t h e u s e o f d e m a n d a n d s u p p l y g r a p h s t o m e a s u r e w e l f a r e g a i n s w i l l r e c o g n i z e t h i s a r g u m e n t i n t h e g r a p h b e l o w . T h i s g r a p h d e p i c t s t h e i m p o s i t i o n o f a p r i c e c e i l i n g o f P c . T h e b i n d i n g p r i c e c o n t r o l r e d u c e s t h e e q u i l i b r i u m q u a n t i t y s u p p l i e d t o Q c . T h e s h a d e d a r e a r e p r e s e n t s o n e s o u r c e o f w e l f a r e l o s s e s a s s o c i a t e d w i t h t h e l o s t o u t p u t c a u s e d b y t h e p r i c e c o n t r o l .





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Notes

1 Food for thought: Is it possible that these self-seeking, for-profit organizations do more to help the disaster victims than all the charitable efforts of the non-profit, humanitarian organizations?

2 In addition to causing too little of the good to be supplied, price controls also cause shortages. These shortages generate another source of lost happiness for society, because the lumber that does get supplied will not necessarily go to those who value it most. For example, suppose a price ceiling of $300 per thousand board feet is imposed on the lumber market and a shortage arises. This shortage means that not everybody who is willing to pay $300 for a thousand board feet will be able to buy it. Let Consumer



A be someone who is willing to pay $450 for lumber, and Consumer B somebody who is willing to pay only $350. Assuming that there is not enough lumber for both of these consumers, it is possible that Consumer B is able to find a supplier who will sell him lumber, while Consumer A does not. If that happened, the lumber would not go to the person who values it most. In other words, we could increase society's happiness by taking the lumber away from Consumer B and giving it to Consumer A.



CHAPTER 17 Does Recycling Waste Resources?

This is an exciting story. Recycling finally seems to have moved into the mainstream of American society. Everywhere you go--in offices, in schools, in all kinds of public places--it is almost impossible to avoid seeing a recycling container for cans and paper products. Many communities require their residents to separate their trash into paper, plastic, and glass. Some even go further, mandating that glass refuse be separated into brown, green, and clear glass. People proudly boast that they take the time to recycle. And what parent hasn't felt a touch of pride at seeing one of their children fish a tossed can out of the garbage pail and then say, "Daddy, we can't throw these cans away with the other trash. We need to recycle this to help save our planet." Everywhere, dedicated men and women, sparked by idealism and a desire to leave this world a little better than how they found it, work to save our precious resources. And yet...

Our first indication that all is not right comes with the recognition that recycling is often a money-losing proposition. IT EARNS NEGATIVE PROFITS. Somewhere in that statement is a story about how recycling affects society's happiness. Let's consider the two components of the profit equation. First is revenues. Despite the hoopla about the precious resources being saved, in reality recycled products generally sell at a relatively low price. Consider the following statement by the recycling coordinator of New York University (quoted later in the same article), "The revenue from recycling doesn't offset any of the costs of recycling, because right now the market price for materials is at an all-time low." Hmmm. Prices are low. What does that tell us? It can only mean one thing. Society is not getting much happiness from the recycled goods it produces as a result of all this effort.

Okay. But think of all the resources we're saving. We are saving resources, aren't we? This statement is a half truth. We are saving some resources. But in the course of doing that, we're also using up other resources. It takes resources to save resources. It takes labor to collect and sort the telephone books, newspapers, Pepsi cans, plastic milk cartons, and brown glass, green glass, and clear glass that are recycled. Labor is a resource. It takes machines to transform discarded newspapers into a pulpy mush that can be reprocessed into usable paper products. Machines are a resource. It take energy to operate those machines. Energy is a resource. Each of these resources has alternative uses. They could be used to

"SCHOOLS COLLECT TRASH BUT NO CASH. Universities across the country are going into the red to be green. Each month, 228 tons of paper are collected and recycled from the U. of California, Los Angeles campus. But UCLA recycling director E.J. Kirby said the money earned from recycling is not enough to pay for the expense of the recycling program. 'Our goal is not to make money,' Kirby said. 'We are trying to reduce the amount of trash that is taken to landfills, regardless of the cost.'"1



produce happiness elsewhere in the economy. When we tie up these resources in order to make recycled products, we deny consumers in our economy the other goods and services that they could have received from these resources.

Seen from the perspective of our unifying field theory, recycling is just another resource transfer. There are gains and losses. The trick is to compare the size of the gains against the size of the losses. But that is exactly what profits do for us. If recycling loses money, it means that the resources used to generate recycled goods would produce more happiness if they were used for something else. In other words, recycling takes resources away from higher valued uses and directs them to lower valued uses. Is it possible to state this a little more clearly? How about the following statement: RECYCLING CAUSES THE DESTRUCTION OF RESOURCES THAT ARE MORE VALUABLE THAN THE RESOURCES RECYCLING SAVES.

If the resources that were being saved were really valuable, one would expect recycled products to sell for more. For example, suppose trees were becoming scarce. Then the price of trees, and hence the price of paper, would be high. Faced with high prices for paper products, consumers would be willing to spend a lot of money for substitute, recycled paper products. But paper isn't expensive, it's cheap. (In fact the reason there is so much waste paper is precisely because paper is cheap. If it were expensive, people wouldn't "waste" it.) And because paper is cheap, consumers aren't willing to pay very much for recycled paper products. That is, consumers don't value additional paper products--recycled or otherwise--precisely because trees are not scarce. Trees are abundant. As a result, trees are not a particularly valuable resource, at least when compared to other, less plentiful resources. Thus recycling paper to save trees doesn't make a lot of sense, unless you get a kick out of cluttering up your garage with newspapers to haul down to the recycling site.

How about the landfill argument: "Recycling is good because it keeps trash from piling up in landfills." This argument is based on the premise that landfill space is scarce. Let's see...how would we know whether landfill space is scarce? That would make the price of landfill high. (If we're starting to sound a little repetitive, all we can say is that's the beauty of our "unifying field theory" of economics. The same argument works for everything.) If the price of landfill was high, then businesses, universities, cities and towns would all have to pay a lot of money for the right to deposit their trash on somebody's land. In that case nobody would have to force them to recycle. They would do it voluntarily because it was in their own financial interest to do so.

And that really is the point of this discussion on recycling. We're not saying that recycling is inherently bad. All we're saying is that if recycling were good--that is, if it would increase society's happiness--then self-interested firms and consumers would choose to recycle voluntarily. Not because it was good for Mother Earth, but because it was in their own interests to do so. In fact, for commodities such as aluminum and steel, recycling has been the norm for a long time, without any encouragement from government. In these cases, recycling is good for society. But oftentimes universities, communities, and private firms recycle because they think they're helping society, even though they're losing money doing



it. When this happens, we conclude that recycling wastes more valuable resources than it saves, and ends up lowering society's happiness.

OPTIONAL SECTION FOR ECONOMISTS: The graph below illustrates the welfare loss associated with an ex cise subsidy . The subsidy causes the m ark et supply curv e to shift down , resultin g in an in crease in eq uilibrium q uan tity from Q 0 to Q 1 . The shaded area in the graph represen ts the correspon din g welfare loss for the m ark et.



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1 U. The National College Magazine, Fall 1992.



CHAPTER 18 Job Destruction and Economic Growth

Suppose a company finds that at the end of a given year of production its revenues are $21 million, but its costs are $25 million. It has made negative profits. Maybe we feel bad for the owners who lost all this money (probably not). However, we shouldn't lose sight of the important story here. The important story concerns what has happened to society's happiness. This firm has taken resources that would have produced $25 million of happiness elsewhere in the economy, and misdirected them to the production of goods and services that generated only $21 million in happiness. Negative profits are the economy's way of telling the company to be sure and not make that mistake again ("Nothing personal, but we're going to have to penalize you $4 million for making this world a little less happy. Please don't do that again.") Suppose this company stubbornly continues to rack up losses. From the perspective of maximizing society's happiness, what do we want to see happen?

Let's be blunt. We've got to stop this company before it hurts any more people. ("Alright you guys, put your hands up in the air and give up those resources...and no funny stuff!"). In a free-market, capitalistic economy, this is accomplished by having the firm go bankrupt. And this is good, because we want the firm to shut down and quit producing. Actually, that's an awful way of saying it. What we really want the company to do is shut down and start releasing. Having firms go belly up is just the economy's way of getting resources released. IN ORDER TO MAXIMIZE SOCIETY'S HAPPINESS, WE MUST FREE UP RESOURCES WHICH ARE IN LOWER VALUED USES AND ALLOW THEM TO GO TO HIGHER VALUED USES.

This is such an obvious point, and yet failure to see it leads to one of the most common of economic fallacies. Consider the case of plant closings. Generally, plant closings are covered in the news media in much the same way as earthquakes, floods, tornadoes, and other horrible disasters. We don't mean to belittle the pain and suffering that communities and workers go through every time a major employer closes down. But let's consider this carefully. The plant is closing down because costs exceed revenue. If the plant is earning low revenues, then the firm must be producing something that consumers don't value very much. On the other hand, the high costs mean that other firms are anxious to get their hands on these inputs (after all, if no other firms were willing to buy those inputs, then why are

"PROFITS FIRST AND PEOPLE LAST. Too many companies have their priorities all mixed up. Their motto is, 'Profit first, people last.' They just want to make an extra penny without worrying about the damage to the people they are stepping all over....In my opinion, there should be more laws concerning plant closing and the responsibilities of plants to their employees. They shouldn't be able to just move away and close down, leaving their faithful employees empty-handed."1



they so expensive?). And the reason other firms are anxious to get their hands on them is because these inputs can be used to produce goods and services that consumers are willing to pay high prices for. Thus, plant closings are a desirable thing. They are good. They are good because they result in an increase in society's happiness. The last thing we want to do is create impediments that will discourage plants from closing down.

In fact, if consumer groups and labor unions were really serious about wanting to improve public welfare, they wouldn't picket firms that were closing plants. On the contrary. They would demonstrate in front of firms that were trying to stay open despite all indications that they weren't going to turn profitable. They would carry placards which said things like "LET OUR RESOURCES GO" and shout slogans like "REVENUES LOW, COSTS ARE HIGH, GUESS ITS TIME TO SAY GOODBYE." In fact, if the media were really doing their jobs, they would cover the human tragedy of firms that were continuing to stay open despite losing money ("Hi, this is Dan Rather and we are going live to the XYZ Corporation where executives continue to hold valuable inputs hostage"..."And now to Connie Chung, who will tell us of one American family's continuing struggle to survive without the other goods and services these resources could have produced.")

Consider the hypothetical example of a movie company that made only really bad movies. Let's call this company Adud, Unlimited. Let's suppose that Adud negotiates with Dustin Hoffman to make three new movies: "Ishtar II," "Ishtar III," and "Ishtar IV: This Time It's Personal." Movie fans will remember that the first Ishtar, in which Hoffman starred, was widely regarded as one of the worst movies of all time. It lost tens of millions of dollars. Few would dispute that Ishtar significantly decreased the happiness of moviegoers. Nevertheless, armed with three new scripts, Adud plunges forward--and downward. Three movies--and thousands of blistering movie reviews--later, Adud goes out of business. Prop men, cameramen, make-up artists, and Dustin Hoffman are all thrown out of work.

We bet you'll agree that movie companies that only make movies no one wants to see--like Adud--should close their doors and release their resources. After all, Dustin Hoffman has alternative uses, such as Rain Man. An actor of his prodigious talents should not be stuck in dumb movies, and neither should the other people who work for the company. When people lose jobs in unprofitable industries, they are released to work for industries which produce more highly valued goods and services. They proceed to their alternative uses, and thank heavens they do.

If you're still feeling uncomfortable with the idea that the destruction of jobs in unprofitable industries can be good for the economy, think about this. In 1900, there were 11,680,000 workers employed in agriculture (approximately 40 percent of the entire labor force). In 1993, there were only 3,074,000 workers employed in agriculture (less than 3 percent of the labor force). What caused this massive exodus from agriculture? Increases in agricultural productivity caused huge increases in agricultural output. This, in turn, dramatically lowered prices and made farming unprofitable. Most of the people who left farms did so because they could no longer make a living at it.



It was the release of these valuable resources (labor) which allowed the manufacturing sector to grow and stimulated America's transition to an industrial economy.2 Now think of what would have happened if we had imposed "plant closing laws" (pardon the pun) in 1900? What if the government had tried to stem this exodus out of agriculture by passing "bankruptcy forgiveness laws" that encouraged bankrupt farmers to continue tilling their fields? Very simply, America would not have grown. While it was painful for the farmers at the time, these economic forces worked to shift resources out of a lower valued use (agriculture) into a higher valued use (manufacturing). As a result of this massive resource transfer, the living standards of the American worker rose dramatically. While we admit it goes contrary to conventional wisdom, it is an indisputable fact that job destruction plays a vital role in economic growth.



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Notes

1 Solidarity, June 1994.

2 We recognize that unemployment and labor market transitions can be emotional subjects. Perhaps you think that we are a little too sure that workers will find new jobs. If these issues bother you, we understand. We will address them in greater detail later on.



CHAPTER 19 A Simple Framework for Analyzing Public Policies--Part I

Having walked up to the water, it's now time for us to take a big drink. In this and the next two chapters, we develop a simple framework for analyzing public policies. How can one, single framework be so useful for analyzing so many different topics? Most every public policy that we can think of involves resource transfers. But resource transfers is what our Grand Unifying Theory of Economics is all about. So buckle up and get ready for an intellectual ride that will turn you into an economic analyst extraordinaire and the absolute hit of any cocktail party. In the previous chapters you learned the pieces of the puzzle. The last three chapters previewed the value of our simple framework by putting those pieces together in a way that allowed us to gain some unconventional insights. Now we tidy things up a bit and present the whole system as an easy, do-it-yourself policy kit.

A large assortment of public policies can be summarized as either SUBSIDY or TAX policies. Let's first consider the effect of a government subsidy program. A subsidy is simply a government payment for production. For whatever reason, governments love to subsidize agricultural products. Honey, milk, wheat, cheese, wool, wine, tobacco--these are just a few of the products that governments pay billions of dollars each year to encourage farmers to produce more than they would on their own. (This then causes such huge increases in production that government then has to pay billions of dollars more each year to encourage farmers to not grow so much, but that's another story). To be concrete, let's consider the effect of a government program to subsidize the production of watermelons.

Suppose Ima Hogg is a pig farmer who happens to have a good patch of unused land behind her house. Early in the spring, Ima gave some thought to raising watermelons in that patch. She figured she could raise 1,000 watermelons a year back there. At a market price of $5 a watermelon, she'd earn revenues of $5,000. Unfortunately, Ima figured that it would cost her $5,500 to grow those watermelons. After mulling it over for some time, Ima decided against going into the watermelon business. That would have been the end of it, except for a chance encounter.

One day while Ima was down at the seed store, she happened to bump into the local agricultural extension agent. He told Ima about a new government program to help watermelon farmers defray their costs. For every watermelon she raised, the government would now pay her $2. That lowers the costs of growing 1,000 watermelons by $2,000. This was wonderful news! Ima quickly figured that with the government subsidy, her watermelon business would now be profitable. Being a woman of action, she got right on it. By the end of the summer, Ima had some of the best looking watermelons in the valley. Thanks to her hard work and the government subsidy program, Ima made a profit of $1,500 on her watermelon business. And society enjoyed 1,000 watermelons that otherwise would not have been available.

Here is a great American success story. The farmer's happy (she made money), the extension agent's happy (he was able to help a friend), watermelon consumers are happy ("Sure been a



lot of good watermelons this year."), and the government's happy (the new program seems to be working--more watermelons are being produced). With so many happy people, how could such a program not be good?

Let's analyze this subsidy program with the help of the PROFIT TABLE below.

Before the watermelon subsidy program, raising watermelons was going to result in a loss of $500. After the program, Ima found she could make a profit of $1,500. Since Ima is making a profit now, and profits are good for society, doesn't the watermelon subsidy program increase society's happiness? DANGER...DANGER...ECONOMIC FALLACY IN THE MAKING!

The fallacy arises because Ima's profits were generated by government intervention (the subsidy), not by consumers buying her goods. Our previous statement that profits measure society's happiness assumed that revenues and costs reported the correct information about the gains and losses in happiness from producing watermelons. In the Before Subsidy column, Ima's costs are the same as society's costs--$5,500. In the After Subsidy column, Ima's costs are now less than society's costs--$3,500 compared with $5,500. As a result of the subsidy, Ima is no longer forced to consider all of the happiness that the inputs could have produced in some other activity.1 The costs she sees on her balance sheet are, from society's perspective, horrible lies. Through no fault of her own, Ima is destroying happiness.

Another way to approach this problem is to ask yourself, what are the only two numbers in the table which represent the gains and losses to society from transferring resources to watermelon production? The answer is: $5,000 and $5,500. In reality, this resource transfer has given consumers $5,000 in additional pleasure from consuming Ima's watermelons. However, other consumers have lost about $5,500 in happiness because Ima withdrew fertilizer, tools, water, etc. from other pleasure-generating activities. So the net effect is a $500 loss in society's happiness. The fact that the government now has kicked in $2,000 doesn't change this reality. It just disguises the real gains and losses from this resource transfer. In this sense, subsidies (and taxes as we shall see), can be thought of as INFORMATION POLLUTION. The bottom line is that the government subsidy "tricked" our firm (Ima Hogg) into transferring resources from a higher valued use to a lower valued one, making society poorer in the process.

Before Subsidy After Subsidy

REVENUES:

COSTS:

PROFITS:

$5,000

$5,500

-$500

$5,000

$5,500 - $2,000 = $3,500

+$1,500



But haven't we forgotten something here? Didn't Ima get a check for $2,000? Didn't that make her $2,000 better off? Once again, we make mistakes when we take our eye off the ball, and the ball is always the real gains and losses in consumption that result from any resource transfer. The government handed Ima a check for $2,000, but the government had to take that $2000 from other taxpayers in order to give it to Ima. The government's gift to Ima of $2000 was completely offset by the loss of $2000 suffered by taxpayers who were forced to contribute to the Ima Hogg Watermelon Relief Fund. This is nothing more than a WEALTH TRANSFER. Wealth transfers are always a wash for society.2 While you may think that wealth transfers are unfair or unwise, from the perspective of our simple framework, they make no difference in the overall happiness of society.

OPTIONAL SECTION FOR ECONOMISTS: T h e g r a p h b e l o w s h o w s a s i m p l i f i e d r e p r e s e n t a t i o n o f t h e w e l f a r e l o s s e s r e p r e s e n t e d i n t h e P r o f i t T a b l e . T h e s u b s i d y l o w e r s I m a H o g g ' s m a r g i n a l c o s t s b y $ 2 p e r w a t e r m e l o n . N o w t h a t h e r c o s t s h a v e b e e n s u b s i d i z e d , s h e f i n d s i t p r o f i t a b l e t o p r o d u c e 1 0 0 0 w a t e r m e l o n s . H o w e v e r , i n t h e a b s e n c e o f t h e s u b s i d y , m a r g i n a l c o s t s w e r e a b o v e p r i c e , w h i c h i s e q u a l t o c o n s u m e r s ' w i l l i n g n e s s t o p a y . 3 T h a t i s , t h e o p p o r t u n i t y c o s t s o f t h e r e s o u r c e s u s e d t o p r o d u c e t h e w a t e r m e l o n s w a s g r e a t e r t h a n t h e w i l l i n g n e s s t o p a y o f t h e c o n s u m e r s r e c e i v i n g t h e w a t e r m e l o n s . T h e s h a d e d a r e a r e p r e s e n t s t h e $ 5 0 0 l o s s i n w e l f a r e a s s o c i a t e d w i t h I m a H o g g ' s p r o d u c t i o n o f 1 0 0 0 w a t e r m e l o n s ( n o t e t h a t w e h a v e m a d e t h e s i m p l i f y i n g a s s u m p t i o n t h a t t h e f i x e d c o s t s o f p r o d u c t i o n a r e z e r o ) .





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Notes

1 Note that we could just as easily have added the subsidy to the farmer's Revenues. This would have given us exactly the same result.

2 Barring administrative costs to transferring wealth and possible incentive distortions.

3 The observant reader will note that we have ignored the feedback effect of the subsidy on the market price. That is, the subsidy shifts out the market supply curve, lowering the equilibrium price of watermelons. Including this feedback effect would complicate the analysis without changing any of our conclusions. Accordingly, we disregard this effect so as to avoid unduly complicating our analysis.



CHAPTER 20 A Simple Framework for Analyzing Public Policies--Part II

As it turns out, Ima Hogg has a sister, Ura, who is already a successful watermelon farmer.1

We want to address the following question, "If a farmer is already making a profit, would a subsidy still lower society's happiness?" Let's take a closer look at Ura's business affairs to get an answer to this question.

Before the watermelon subsidy program went into effect, Ura Hogg was making a nice little profit on her watermelon operation. Like Ima, she had a patch of land behind her house on which she too could grow a 1,000 watermelons. At a market price of $5 per watermelon, this gave her $5,000 in revenues. But Ura is a better shopper than Ima. By buying her materials from low-cost suppliers, Ura finds that she could grow 1,000 watermelons for a total cost of only $4,000. As a result of her hard work and smart business sense, Ura earns $1,000 in profits before receiving any subsidies.

Now consider the effect of the watermelon subsidy program. As the table clearly shows, with an extra $2 per watermelon in subsidies, Ura's profits increase to $3,000. What has happened to social happiness? Absolutely nothing. The subsidy hasn't affected social happiness in this case because the subsidy hasn't altered Ura's management of society's resources. Before the subsidy, Ura transferred $4,000 of resources from other activities to the production of 1,000 watermelons. After the subsidy, Ura still transfers $4,000 of resources from other activities to the production of 1,000 watermelons. Resources are allocated the same way before and after the subsidy. SINCE THERE IS NO CHANGE IN THE ALLOCATION OF RESOURCES, THERE IS NO CHANGE IN SOCIETY'S HAPPINESS.

How about the fact that Ura Hogg now makes more money? Again, the transfer of $2,000 in subsidies to Ura Hogg is exactly counterbalanced by the transfer of $2,000 away from other taxpayers who had to foot the bill for this program. It represents a pure wealth transfer that results in no change in society's total happiness.

You should now see that when it comes to subsidies, there are two kinds of watermelons in the world. There are those watermelons that would have been produced before the subsidy, and still get produced after the subsidy (like Ura Hogg's watermelons). And there are those

Before After

REVENUES:

COSTS:

PROFITS:

$5,000

$4,000

+$1,000

$5,000

$4,000 - $2,000 = $2,000

+$3,000



watermelons that would not have been produced before the subsidy, but now get produced because of the subsidy (like Ima Hogg's watermelons). Only the production of the latter kind of watermelons causes a change in society's happiness.

Thus, in analyzing the effect of a particular public policy on society's happiness, we follow the following three-step procedure.

Step 1. We begin by determining how the policy will change the allocation of society's resources. In particular, we ask whether the policy will increase or decrease the quantity of the good directly impacted by the public policy. For example, subsidies lower costs, so production increases. In contrast, taxes increase costs and hence decrease production.

Step 2. Once we determine whether more or less of the good will be produced, we focus on a specific resource transfer that is changed by the public policy. For example, in the case of watermelon subsidies, we look only at those watermelons that would not been produced before the subsidy, but get produced after the subsidy. Further, we don't look at all the affected watermelons. We just choose a representative case. We focus on a typical resource transfer that is altered by the policy.

Step 3. We then construct numbers using the PROFIT TABLE to illustrate how society's happiness is impacted in this particular case.

Having shown it for the representative case, we're finished. For while the numbers might be different for other resource transfers impacted by the policy, the conclusion will always be the same. Thus, our simplistic Profit Table will lead us to the correct conclusion every time. ("Look out cocktail parties, here we come!") The next chapter shows how to use this simple, three-step framework for analyzing public policies involving taxes.

OPTIONAL SECTION FOR ECONOMISTS: Perhaps one can obtain a better idea of this three step procedu re by referring to the fig u re bel ow . T he first step consists of determ ining w hether m ore or l ess of the g ood w il l be produ ced. I n the case of a su bsidy , the su ppl y cu rv e shifts ou t so that q u antity increases from Q 0 to Q 1 .

T he second step consists of choosing a representativ e resou rce transfer affected by the pol icy . N ote that the u nits betw een Q 0 and Q 1 are the onl y resou rce transfers affected by the pu bl ic pol icy . T hey are the u nits that w ou l dn' t hav e been produ ced before the su bsidy , bu t g et produ ced after the su bsidy . T hu s, w e focu s on one of the u nits betw een Q 0 and Q 1 , cal l it Q *

T he l ast step consists of representing the resou rce transfer Q * in the Profit T abl e. N ote that before the su bsidy , the su ppl y cu rv e l ay abov e the dem and cu rv e at the indicated q u antity . W e transl ate this into ou r Profit T abl e by show ing R ev enu es as being l ess than C osts. A fter the su bsidy , the su ppl y cu rv e l ies bel ow the dem and cu rv e at Q * . T his is refl ected in the Profit T abl e by show ing that R ev enu es are now g reater than the ( su bsidiz ed) C osts. T he Profit T abl e thu s represents a resou rce transfer w hich l ow ers society ' s happiness. B efore the su bsidy , this resou rce transfer w as u nprofitabl e, and thu s a profit-m ax im iz ing firm w ou l d nev er u ndertak e it. A fter the su bsidy ,



this resou rce transfer becom es profitabl e, so that the firm is " trick ed" into doing som ething w hich l ow ers society ' s happiness. T his captu res the essence of the w el fare l oss associated w ith the su bsidy .



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1 We should note that the names Ima Hogg and Ura Hogg are not the product of our overactive imaginations. Ima Hogg was the only daughter of James Stephen Hogg (1851-1906), a Texas politician who served as governor of that state from 1891-1895. With respect to the names Ima Hogg and Ura Hogg, the Texas historian Kenneth Hendrickson writes, "It has often been suggested that the Hoggs's behavior in naming their only daughter Ima was peculiar; however, their intent was anything but strange. The child was named after the heroine of a novel, The Fate of Marvin, written by Hogg's



beloved older brother Tom in 1873. Truly peculiar, even bizarre, is the myth that the Hoggs had a second daughter whom they named Ura. Even though no such person ever existed, there are still many people in Texas who insist that she did" (Hendrickson, The Chief Executives of Texas, College Station, Texas: Texas A&M University Press, 1995, page 130).



CHAPTER 21 The Simple Framework for Analyzing Public Policies--Part III

Many states and localities derive a special source of financing from Hotel and Motel taxes. These taxes are largely responsible for the shock most tourists experience at check out time. "I thought you quoted me a price of $50 a night?" "That is correct, Madam." "But I only stayed here two nights." "That is correct, Madam." "And your telling me that I owe you $149?" "That is correct, Madam." "But that's outrageous!" "That is correct, Madam." We know tourists are hurt by this tax, but remember...we care only about the big picture. We care only about the tax's overall effect on society's happiness.

The first question we want to ask ourselves is what effect will Hotel and Motel taxes have on the allocation of society's resources? Will more or less resources be devoted to the provision of hotel and motel accommodations after the tax? It certainly seems reasonable that these taxes will make tourists and other travelers less willing to stay in hotels and motels. That means that there will be less demand for hotels and motels. And that means that profit-maximizing firms will build fewer hotels and motels, or maybe they will build hotels and motels with fewer rooms. The bottom line is that fewer resources will be transferred from other activities to provide accommodations for travelers. The table below illustrates the effect of this tax on a representative resource transfer affected by this tax policy.

Before the adoption of the Hotel and Motel tax, a hotel would have found it profitable to provide two nights' lodging to a traveler. At $50 a night, these resources would have generated around $50 times 2, or $100 in social happiness. And that would have been great. Because the hotel figured that it only cost $75 to provide a room for two nights to a guest. Resources--say sheets, maid service, electricity, etc.--that could have generated $75 in pleasure in doing something else are withdrawn from those activities and directed towards the provision of hotel services. Here they generate $100 in happiness, resulting in a net gain of $25. Since the profit-maximizing firm can make a buck at this activity, this resource transfer goes through and society is made better off.

But look what happens after the tax. The hotel no longer finds this transaction profitable. As a result, it either goes out of business or sells off some of its facilities. And that is a shame. A resource transfer which would have increased social happiness by $25 now does not take place. Resources are withdrawn from a higher valued activity (hotel lodging) to a lower

Before Tax After Tax

REVENUES:

COSTS:

PROFITS:

$100

$75

+$25

$100

$75 + $49 = $124

-$24



valued activity (who knows what). Again, from the perspective of social happiness, the only two numbers that matter in the table are the Revenues and Costs that the hotel would have experienced before the tax was imposed. These are the numbers that reveal the gains and losses, respectively, of transferring additional resources to hotel guest services. In this case, the economy has been "tricked" into not providing additional accommodations, even though providing them would have made society better off.

The fact that taxes can make people worse off probably isn't a new insight for you. But there's an additional reason to dislike taxes here that you might not have appreciated before (just in case you needed one more reason). Suppose the government raises $10 million in tax revenues from a variety of specific taxes on goods and services. What is the total cost to taxpayers? Most people would say $10 million, the amount of the tax revenues. Since you are smarter than the average reader, you know that this isn't the full story. On top of the actual tax revenues taken away from taxpayers, there is the additional cost due to the lost happiness from misallocated resources. Economists call this the WELFARE COST OF TAXATION. It is the lost happiness that results when taxes take resources out of higher-valued uses and divert them to lower-valued uses--just like in our hotel/motel example.1

Does this mean that all taxes are bad? A full answer would require us to compare the value of government services society receives from its tax burden with the value of private consumption given up through taxation. We will examine this topic in more detail when we talk about government finances later in this book. For right now it's worth noting that if society wants to raise a given amount of revenues for a particular purpose, taxes should be set so that the disruption in the allocation of society's resources is minimized.

If a government decided to raise all of its revenues through a Hotel and Motel Tax, the size of this tax would be huge, and there would be dramatic changes in the way society allocated resources. (For example, most travelers would probably choose to pack a tent in their suitcases or just stay home.) But if a government spread the tax burden across all of the goods and services in the economy, there would be relatively little change in the way resources are allocated. Think about it. If all prices only go up by a penny, consumers will probably not alter their consumption patterns by much. This would minimize the likelihood that taxes would distort the allocation of resources by "tricking" the economy to place resources in lower-valued activities. This is why economists generally advise that taxes be broad-based (like a sales or income tax), rather than narrowly focused on a few goods (like a Hotel/Motel tax).

Now that we have developed the theory of the PROFIT TABLE to analyze government subsidy and tax policies, the next step is to learn how to apply this framework to news stories that are commonly encountered in the media. That is the goal of the next few chapters.

OPTIONAL SECTION FOR ECONOMISTS: T h e g r a p h b e l o w i l l u s t r a t e s t h e w e l f a r e l o s s r e p r e s e n t e d i n



t h e P r o f i t T a b l e . T h e t a x i n c r e a s e s t h e h o t e l c h a i n ' s m a r g i n a l c o s t s , m a k i n g s o m e o f i t s u n i t s u n p r o f i t a b l e . A s a r e s u l t , t h e c h a i n s e l l s o f f s o m e o f i t s p r o p e r t i e s , r e d u c i n g i t s n u m b e r o f r o o m s f r o m Q 0 t o Q 1 . Q * i s a r e p r e s e n t a t i v e r o o m w h i c h w o u l d h a v e b e e n p r o f i t a b l e f o r t h e c h a i n t o l e t b e f o r e t h e t a x . T h a t i s , t h e a s s o c i a t e d R e v e n u e s f r o m l e t t i n g t h e r o o m a r e g r e a t e r t h a n t h e C o s t s ( M R i s g r e a t e r t h a n M C a t Q * ) . H o w e v e r , a f t e r t h e t a x , R e v e n u e s a r e l e s s t h a n C o s t s ( M R i s l e s s t h a n M C + t a x a t Q * ) . T h e d i s t a n c e b e t w e e n t h e M R a n d M C c u r v e a t Q * r e p r e s e n t s t h e w e l f a r e l o s s c a u s e d b y Q * n o l o n g e r b e i n g " p r o d u c e d " b y t h e h o t e l c h a i n .



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Notes

1 In our example, the firm bears all of the tax burden. However, the situation is not altered if the



consumer bears some or all of the tax burden. In this case, you would subtract the tax from the Revenues column to represent that the marginal consumer now would consume more hotel accommodations only if the price were lowered to $51 (i.e., willing to pay of $100 - $49 = $51).



CHAPTER 22 Can We Afford to Let the Maritime Industry Sink?

The American shipping industry is sinking. Fast. Hit hard by environmental mandates and foreign competition, the industry has shrunk rapidly in recent years as older ships have been retired. American shipping firms have chosen not to build replacements for their aging fleets. Instead, they are choosing to run their business on foreign ships, run by foreign crews. The bottom line is not only the loss of one of the country's most important industries, but the loss of American jobs. Can we really afford to stand by and watch this economic disaster and do nothing? Subsidizing the maritime industry is an investment in the U.S. economy that will pay off in more jobs, higher wages, and an economical way for American business to ship its goods. To not financially support this industry would be a short-sighted, penny-wise/pound-foolish policy. We can't afford not to help the maritime industry!

What do you think? (We have to confess that we become suspicious the moment someone tells us that we can't afford not to spend money!) Hopefully you should be able to see past most of the candy-coated fallacies in the previous paragraph. Our task in this chapter, however, is to translate this news story into the framework of our Profit Table. This is an exercise which we will repeat throughout this book.

To do this, we need to know how subsidies to the maritime industry would work. Since we don't know anything more about this issue than what we have read in the excerpt above, we will have to use our imagination. One way the government could choose to help the maritime industry would be to subsidize the cost of new shipbuilding. While the editorial writer did not suggest a specific policy, we note that a subsidy for new shipbuilding is consistent with his concern that the size of the American fleet is shrinking. Let's consider a hypothetical decision by one of the shipping companies--say, American President Lines (APL)--to build another ship, before and after the government subsidy for new shipbuilding. Remember, we want to construct a scenario that will focus our attention on how this subsidy would alter the allocation of resources in the society.

Recalling our three-step procedure for evaluating this policy, we first ask whether this subsidy will cause more or fewer ships to be built. Having determined that the subsidy will cause more ships to be built, the second step consists of concentrating our attention on a "representative ship." Not just any ship. Rather, a ship that wouldn't have been built before

"HAULING DOWN OLD GLORY. The Clinton Administration's decision last year to end maritime operating subsidies has forced America's two largest commercial shipping companies, American President Lines and Sea-Land, to consider going foreign-flag with foreign crews. I believe that Clinton's policy represents a major threat to the American laborer, our economy and the role of the United States in an expanding global market."1



the subsidy, but gets built after the subsidy. In terms of our Profit Table, this means that the "representative ship" should show a negative profit in "Before Subsidy" column, and a positive profit in the "After Subsidy" column. The third step consists of entering numbers for Revenue, Cost, and the subsidy that are consistent with these outcomes. One possible Profit Table is given below.

The numbers in the table show that APL would never choose to build a new ship without a subsidy from the government. APL predicts that an additional cargo ship would increase revenues by $17 million. However, the costs of building such a vessel would be $25 million. Thus, the profit-seekers at APL--without a thought to the well-being of American women and children, particularly children--just say no to another ship.

Look how different this proposal appears after the government decides to come to the rescue. If the government targets $10 million to APL to help pay for the new ship--either through a direct subsidy or a special tax exemption, which is essentially the same thing--this ship now becomes profitable. Rather than losing $8 million, APL finds that it can make $2 million. So APL goes ahead and builds the ship. Let's call it the U.S.S. Subsidy. Men and women have been put to work. Profits have been made. Shareholders have been enriched. All because a spanking new ship now sails the oceans blue, a testimony to the far-sighted partnership of government and industry. (All this is starting to make us sea-sick!)

Of course, we're only looking at half of the story here. This ship didn't come out of nowhere. It was built by the employment of resources that had alternative uses. From the perspective of society's happiness, there are only two numbers in the table that matter--$17 million and $25 million. There is no denying that the additional cargo ship made society better off by $17 million. But society lost something when the resources to make that ship--the laborers, the steel, the land on which the ship was built--were taken away from other activities. Society lost $25 million in happiness. Thus, the profit-seekers at APL--without a thought to the well-being of American women and children, particularly children--did precisely the right thing for society's happiness when they first chose not to build a new ship. Society would have preferred the alternative uses of those resources. The subsidy, however, provided an incentive for APL to misallocate these resources to ship building, and society's happiness decreased.

Now let's consider some objections to this analysis. How about the objection that this is too simplistic. All these numbers are made up! We confess--this is true. We haven't done any

Before Tax After Tax

REVENUES:

COSTS:

PROFITS:

$17M

$25M

-$8M

$17M

$25M - $10M = $15M

+$2M



research on this issue. We have no idea how much a new ship would actually cost. We have no idea how much revenues a new ship might actually generate. In fact, just so there's no doubt about this--we'll just come right out and say that we are completely ignorant about the shipping industry. Before we read this editorial, we thought the Merchant Marines were a new service of the armed forces established to provide crowd control for storeowners during end-of-the-year closeout sales. How embarrassing!

However, the beauty of our simple framework is that we don't have to know anything about the maritime industry. All we have to know is that the subsidy is going to cause more ships to be built. Who can deny this? Increasing production is the whole point of a subsidy. Furthermore, we know that these ships were not profitable without the subsidy, or they would have been built. The particular numbers that we choose aren't important. After all, we're not saying that the subsidy will cause a social loss of exactly $8 million. To be honest, we don't know how much of a social loss will actually result. Our made-up numbers merely illustrate that (i) a ship will be built after the subsidy that wouldn't have been built before (that is, the subsidy will cause a different allocation of resources), and (ii) the transfer of resources represented by the building of this ship will take resources from higher valued uses and direct to them to a lower valued use. That is, the hypothetical numbers in our table illustrate the essence of the problem--subsidies to the maritime industry will decrease society's happiness.

Low revenues signal that there is only a small social benefit from additional shipping services. Note that it really doesn't make a difference why the social benefit of extra shipping services is small. In this particular instance, the reason society is not made much happier from additional shipping services is because foreign firms are already providing a lot of those shipping services for American consumers. As a result, the extra benefit from extra shipping services is small. But, again, we don't have to know. All we have to know is that society will receive relatively little benefit from having additional resources transferred to the shipping industry.

OPTIONAL SECTION FOR ECONOMISTS: T h e g r a p h b e l o w i l l u s t r a t e s t h e w e l f a r e l o s s c a u s e d b y t h e s u b s i d y . T h e s u b s i d y l o w e r s t h e m a r g i n a l c o s t s o f b u i l d i n g n e w s h i p s f o r A P L . A s a r e s u l t , A P L e m p l o y s m o r e o f s o c i e t y ' s r e s o u r c e s i n s h i p b u i l d i n g , a n d t h e i r p r o d u c t i o n o f n e w s h i p s i n c r e a s e s f r o m Q 0 t o Q 1 . Q * i s a r e p r e s e n t a t i v e s h i p t h a t w o u l d n o t h a v e b e e n b u i l t b e f o r e t h e s u b s i d y , b u t w h i c h A P L d e c i d e s t o b u i l d a f t e r t h e s u b s i d y . T h a t i s , p r i o r t o t h e s u b s i d y , t h e R e v e n u e s f r o m b u i l d i n g a s h i p w e r e l e s s t h a n t h e C o s t s ( M R i s l e s s t h a n M C a t Q * ) . H o w e v e r , a f t e r t h e t a x , R e v e n u e s a r e g r e a t e r t h a n C o s t s ( M R i s g r e a t e r t h a n M C -s u b s i d y a t Q * ) . T h e d i s t a n c e b e t w e e n t h e M R a n d M C c u r v e a t Q * r e p r e s e n t s t h e w e l f a r e l o s s c a u s e d b y A P L b u i l d i n g t h e s h i p Q * .



N O T E : T h e r e a d e r m i g h t b e c o n f u s e d b y t h e d i f f e r e n c e b e t w e e n t h i s f i g u r e a n d t h e o n e u s e d t o r e p r e s e n t t h e w e l f a r e l o s s e s c a u s e d b y s u b s i d i z i n g I m a H o g g , t h e w a t e r m e l o n f a r m e r . I n I m a H o g g ' s c a s e , t h e P r o f i t T a b l e r e p r e s e n t e d t h e p r o d u c t i o n o f 1 0 0 0 w a t e r m e l o n s . S o t h e w e l f a r e l o s s r e p r e s e n t e d t h e s u m o f t h e d i f f e r e n c e b e t w e e n M R a n d M C f o r e a c h o f t h e 1 0 0 0 u n i t s , r e s u l t i n g i n t h e i n d i c a t e d a r e a . H o w e v e r , i n t h i s s h i p b u i l d i n g e x a m p l e , t h e P r o f i t T a b l e r e p r e s e n t s t h e p r o d u c t i o n o f o n l y o n e u n i t , Q * . T h u s t h e w e l f a r e l o s s i n t h i s c a s e i s t h e d i f f e r e n c e b e t w e e n M R a n d M C o n l y a t Q * .



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Notes

1 Newsweek, August 29, 1994.



CHAPTER 23 Job Training: Ticket to Prosperity?

To listen to most politicians, job training is a win-win proposition. We take workers who have lost their jobs. We give them new skills and productive training. With the extra training they receive, not only do they produce more goods and services for society, but they also earn higher wages. Higher wages means more tax revenues, and with the stream of increased tax revenues, society gets a return on its original investment that pays off for many years to come. "We can't afford not to help workers invest in job training." (Sound familiar?)

Let's take this case one step at a time. First, we analyze the worker's decision to invest in job training before and after the government makes available job training grants. Once again, we have to use our imaginations to represent the effects of this program. How exactly might this program work? To keep it simple, let's assume the government gives each worker a job training voucher. This voucher is essentially a check, written by the government, that can only be used for purchasing work-oriented education. In this simple example, the worker is free to choose the kind of education he or she wishes. The only effect of the government grant is that it helps to pay for whatever training workers believe would best help them.

Job training grants will surely cause more workers to choose to get trained. That is, there will be workers who would not have chosen job training before the government announced this program, but who now will choose to get trained with the help of the government grant. We want to choose numbers for our table that represent this scenario. For our representative case, let's consider the situation of Rosie Riveter, who loses her job in a small, West Virginia manufacturing plant that closed down due to technological change. We explain the situation in terms of her personal profit table.

ROSIE'S PERSONAL PROFIT TABLE FOR JOB TRAINING

"DISPLACED WORKERS GET AID. Huntington, W. Va. (AP)--The U.S. Labor Department has approved $6 million in grants to help retrain 1,300 workers in four states who have lost their jobs to foreign competition, government action, or technological change...[Labor Secretary Robert Reich said,] 'With the continuing changes taking place in our economy, we must be sure affected workers have the opportunities they need to remain productive. That means necessary training, retraining, and support services.'"1

Before Training Grant After Training Grant

REVENUES: $10,000 $10,000



We can think of Rosie as a firm. In fact, Rosie is a resource owner. She is CEO, Chairman of the Board, and sole stockholder of "Rosie's Labor Services." Now that Rosie has been displaced (released) from her old job, she has a hard decision to make. She could take her current skills, somewhat antiquated though they are, and take a job that pays $5 an hour. Or she could get some training that would allow her to upgrade her job skills. This would enable her to have a job that paid $6 per hour. Rosie calculates that earning a $1 an hour more would allow her to make about $10,000 more over the course of her expected working life. This increase in her earning power is represented by "Revenues-Before" in the table above.

Before continuing, let's reflect on the information contained in this increase in Rosie's wages. In particular, can you explain how this job training will produce additional happiness for society? Why should consumers care that Rosie has better training? They care because Rosie's better training will allow her to produce more goods and services that consumers want. The higher wages she receives is a reflection of the happiness consumers get from those additional goods and services. This follows directly from the fact that the price of labor, like the price of any input, tells us the additional happiness society gets from one more unit of that input. If job training causes Rosie's market wage to increase by $10,000, the additional goods and services which she produces generate approximately $10,000 more in happiness than she could have produced without that job training.

Now let's turn to the "Costs" side of the ledger. To get her job training, Rosie would have to enroll in classes offered by a local vocational-technical school. This school employs a number of resources in order to make job training classes available to students. For example, it occupies some old storefront property in a low-rent mall in which to hold classes. It employs a staff of instructors to teach the job training classes. And there are books, audio-visual supplies, secretaries, photocopiers, and other resources that this school has brought together in order to provide job training classes. In order to pay for all these resources, the vocational-technical school charges a tuition of $6,000. Further, there is another set of costs that need to be included. Rosie will have to go to school for two years during weekday evenings in order to attend classes. She will also need time on weekends to study for her classes. She calculates that the costs to her giving up this time is about $8,000. Thus, the total costs of obtaining job training for Rosie is $14,000.

Before the government grant, Rosie decides that the training is just not worth it. But after the government institutes the grant program, Rosie finds it pays for her to be retrained. Using the same analysis as before, we find that the job training program has lowered society's happiness. It has directed resources (Rosie's time, the job trainer, classroom space) that would have produced $14,000 of pleasure doing something else, to an activity (job training) that only produces $10,000 of pleasure for society. Society's happiness is decreased by

COSTS:

PROFITS:

$14,000

-$4,000

$14,000 - $5,000 = $9,000

+$1,000



$4,000.2

This is true despite the fact that everybody directly involved in the job training activity is delighted with the government grant program. Rosie is delighted because she is made better off by the program. The vocational-technical school is pleased because the program makes it possible for its students to take classes. The job training instructor is satisfied because the school now has money to pay him to teach classes. And the government program administrator is elated because workers are getting trained and earning higher wages after they leave school (Newspaper headline: "LABOR SECRETARY DECLARES PROGRAM A SUCCESS. 'IT WORKS,' HE SAYS."). What these participants are not considering in their praise of the program is the happiness that consumers are missing because resources were taken away from higher valued uses.

Now let's consider some objections to this analysis. Are we saying that job training is bad? Of course not. Job training can be great. It makes workers more productive. With greater productivity, workers can produce more--and better--goods and services that consumers want. The problem is that job training is no different from any other resource transfer. You want the economy to produce more job training? Then resources must be transferred away from something else. The corollary to the famous statement that there is no such thing as a free lunch, is that there is no such thing as free job training (or free anything else for that matter).

Suppose we had a government program to train everybody to earn their doctorate degree. Would that be a desirable policy? Some Ph.D.'s are clearly good for the economy. But everybody having a Ph.D.? ("Hey, Honey, I'm going to the doctor's." "Don't be smart with me, Frank. Are you going to the doctor who pumps gas down at the corner service station or are you going next door to see that cute little, redheaded Ph.D. again?") Having everybody earn their doctorate would be an incredible waste of society's resources. But then, how many Ph.D.'s is the right amount? Now that's a tough question. It requires a lot of information about the value of that education and the value of the resources needed to educate those workers. That is precisely the kind of information that markets produce. Self-interested individuals will make the right choices for society so long as the information contained in their personal profit tables isn't distorted by excessive subsidies and taxes.

How about the objection that job training is an investment for society, since higher wages mean more tax revenues later on? DANGER...DANGER...ECONOMIC FALLACY IN THE MAKING. Can you catch it? The economic fallacy once again arises because we've taken our eyes off the ball. The purpose of the economy is not to maximize the amount of tax revenues we can collect from consumers (we just wish someone would tell our politicians that!). Income taxes represent WEALTH TRANSFERS from taxpayers to the recipients of government-supplied goods and services. Every dollar transferred from Rosie's future paycheck is one dollar more of goods and services for someone else, and one dollar less for her. From the perspective of society's happiness, they cancel out.3 Thus, taxes certainly shouldn't be counted as a source of social gain, and a justification for job training.4



Alright already. Maybe the reason we want to give Rosie a job training grant is because we feel sorry for her. She's poor, doesn't have much training, and we would like her to be better off. No problem. We've got a solution for that. Give her money. Just don't require her to spend it on something that will lower society's happiness.



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Notes

1 Daily Oklahoman, March 14, 1995.

2 Notice that we optimistically assume that the government training program actually works. If the government program fails to provide Rosie with better skills, then society would lose the entire $14,000 training fee, with no return on its investment.

3 We emphasize that our simple analysis assumes that (i) no resources are taken away from other uses in order to collect and distribute government tax revenues, and (ii) that there are no distortions in the allocation of society's resources other than the increase in resources directed to job training. Of course, if either of these assumptions is invalid, the case against government subsidies for job training is even stronger.

4 How about the argument that Rosie does find the job training profitable, but she doesn't have the money to pay for it? The correct response here is to note that Rosie could always borrow the money. However, the costs of borrowing (i.e, interest) must also be included on the Cost line of the Profit Table. As we shall see later on in the book, the interest on borrowed funds represents the lost happiness of borrowers who have agreed to forgo current consumption. As such, it represents a cost to society as real as the lost happiness from diverting any other resource away from alternative activities. If Rosie finds that job training is unprofitable once she takes into account borrowing costs, then society's happiness would be lowered if she proceeded to upgrade her job skills.



of 5CHAPTER 23


CHAPTER 24 Minimum Wages and Unions: Making Ourselves Poorer by

Trying to Make Ourselves Richer

A major function of unions, perhaps the major function of unions, is to see that a given firm pays its employees more than their market wage. Governments perform the same role when they impose minimum wages. In this chapter we demonstrate how our Profit Table can be used to evaluate union and government efforts to coerce firms to pay higher wages.

Many people who earn the minimum wage work in the fast food business. Accordingly, let's consider the case of a fast food restaurant trying to decide whether to employ a machine or a person for a particular job task. To avoid any legal problems, let's call our imaginary firm McBurger King. McBurger King is thinking of expanding its business by staying open later. One consequence of being open later is that there will be more trays to wash. McBurger King could hire a local teenager to wash those trays. Or it could employ a mechanical dishwasher. The human dishwasher has a market wage of $9,000 a year, while the mechanical dishwasher rents for $10,000 a year. The fast food restaurant expects to generate about $12,000 in Revenue by staying open later. (To simplify our analysis, we assume that the services of either a human or mechanical dishwasher are identical, and that this is the only extra cost of staying open later.) We can represent McBurger King's choice between a human dishwasher and a mechanical dishwasher in the Profit Tables below.

Clearly, McBurger King will hire a person to wash dishes rather than rent a machine. And

"WAGE HIKE WOULD MEAN $18 WEEKLY. New York (AP)--Raising the minimum wage by 90 cents an hour would buy an extra bag of groceries or two tickets to the movies for the estimated 4.2 million Americans who toil for the lowest allowable hourly pay...Unions say raising the minimum wage would benefit even those who make more because it raises the floor on wages. 'Everyone benefits from it,' said Lenore Miller, president of the Hotel Employees and Restaurant Employees International Union."1

Table for Employing a Teenager 5 Table for Employing a Machine

REVENUE:

COST:

PROFITS:

$12,000

$9,000

$3,000

5

REVENUE:

COST:

PROFITS:

$12,000

$10,000

$2,000



this is exactly what we want. If the restaurant employs the human dishwasher, that is one less person on the job market, one person who will not be producing $9,000 of happiness in an alternative use. If the restaurant employs a mechanical dishwasher, then there is one less machine available to generate $10,000 of happiness in its alternative use.

Now say the government decides to impose a minimum wage, raising the worker's wages to $10,400. The firm's profit tables now look like this:

After the minimum wage, McBurger King still decides to expand its hours, but now it employs a machine to wash trays instead of a human. And that is a shame. Why? Because the higher price of the machine tells us that the machine would produce more happiness elsewhere in the economy than the teenager. It is the more valuable input. As a result, society would prefer that McBurger King leave that resource alone, and instead employ the less valuable input. Hiring the machine to wash trays instead of the teenager is like hiring a Ph.D. in electrical engineering to sweep floors rather a high school dropout (remember that one?).

Not only will the artificially high wages caused by unions or minimum wages induce firms to hire the wrong inputs, it will also affect the quantity of goods available for consumption. For example, by changing a few numbers in the table (try changing Revenue to $9,500), you can see that the minimum wage may actually stop McBurger King from staying open later and offering more of its product to the public. And that is (another) shame. The fact that transferring resources to later hours was profitable before the minimum wage tells us that society wanted the restaurant to stay open later.

Lastly, on top of all these other problems, note that we are left with some unemployed workers. If the best use of a worker can only produce $9,000 of Revenue per year, while his mandated wage is $10,400 per year, you can probably guess that this worker will find himself unemployed for quite some time. And that is a (third) shame.

Aren't there any winners from minimum wages? Yes there are. While some workers will lose their jobs, others will be able to keep their jobs at the higher (minimum) wage. The workers who keep their jobs are clearly better off. In fact, the benefits from union wage raising or government minimum wages are clearly evident to those who benefit. It's not hard

Table for Employing a Teenager 5 Table for Employing a Machine

REVENUE:

COST:

PROFITS:

$12,000

$10,400

$1,600

5

REVENUE:

COST:

PROFITS:

$12,000

$10,000

$2,000



for them to see that the efforts of their union officials or elected politicians have directly helped them. As a result they can be expected to support those leaders who advocate raising wages artificially.

On the other hand, the workers who lose their jobs, or who find it difficult to get employed, may not see that their misfortune is due to distortionary wage policies. They are more likely to blame the greediness of insensitive, self-seeking employers. They are not likely to see the irony that the efforts of the very people who are trying to "help" them are precisely what is keeping them from finding a job. Accordingly, union officials and elected politicians may find relatively little political resistance to plans for artificially raising workers' wages.

The bottom line is that artificially setting wages above their market level is going to cause distortions in the allocation of resources in society. By affecting the way that firms employ inputs and produce outputs, artificially high wages result in lower overall happiness for society. Still unconvinced? Alright, then, we give up. Let's raise the minimum wage. But let's not be cheap about it. If raising the wage from $4.25 per hour to $5.00 an hour is a good idea, then raising it to $5.50 or $6.00 an hour is even a better idea. Even at $6.00 an hour, a worker who puts in a 40 hour work week and works 50 weeks a year will earn only $12,000. Hardly enough money to raise a family. So let's make the minimum wage $10 an hour. No, $50 an hour...$100 an hour!

Why doesn't anybody advocate a minimum wage of $100 an hour? Because everyone knows that the end result would be an economy with a couple of $100-an-hour workers, surrounded by a great ocean of unemployed. But if raising the minimum wage from $4.25 to $100 an hour is a bad idea, why then is it a good idea when it only gets raised to $5.00 an hour? As always, the secret in economics is to keep one's eye on the ball. As a nation, we make ourselves wealthy by allocating resources to their highest valued use. This is the only real way to raise our "national wage."

In a free market/capitalistic economy, the individual efforts of society's members to make themselves richer serves to enrich all of society. This is the essence of Adam Smith's "invisible hand" insight. But there is a public sector analog to the "invisible hand." We like to call it the "invisible foot." By attempting to use laws or coercion to artificially make ourselves richer, the individual efforts of society's members can backfire, producing precisely the opposite effect from that which was intended. That is, the very efforts intended to provide prosperity can cause the economy to stumble, to trip up, just as if it was being impeded by a great "invisible foot:" making ourselves poorer by trying to make ourselves richer.



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Notes

1 Daily Oklahoman, February 4, 1995.



CHAPTER 25 These Quotas Don't Amount to Peanuts

Up to this point in our analysis, we have examined the impact of price ceilings, subsidies, and taxes on society's happiness. But a lot of government interventions belong to two additional categories: QUOTAS and MANDATES. Quotas are government-imposed restrictions on the amount of output a firm can produce. Mandates are government rules which require firms to produce more of something--like workplace safety. Quotas and mandates are easily incorporated into our Profit Table once we see their connection to taxes and subsidies respectively.

Consider peanut quotas. What is the primary impact of peanut quotas on the allocation of society's resources? You don't have to be a rocket scientist (or peanut farmer, for that matter) to realize that the primary impact of a peanut quota is to divert resources out of the peanut industry into other activities. There will be fewer peanuts grown under a quota system. Fewer peanuts means fewer peanut farmers, less farmland, fewer automated peanut-picking machines, etc., that will be directed to the peanut industry. We want to use our Profit Table to illustrate how a resource transfer that would have been profitable before the peanut quota now becomes unprofitable.

Why is it now unprofitable to harvest peanuts beyond the quota? What happens to the peanut farmer if he goes beyond his quota? Actually, we have no idea. We confess that we are woefully ignorant of the peanut industry, just as we were woefully ignorant of the shipping industry. On the other hand, reason suggests that there are only a few possibilities. The most obvious possibility is that the peanut farmer would have to pay a hefty fine if caught. Alternatively, he could lose his quota allotment entirely and have to find alternative employment. (Maybe he could join the merchant marines.) Another possibility is that he is thrown in jail. (If he tries to escape, he could be shot. Headline news story: "QUOTAS RESULT IN DEATH OF GOOBER FARMER.")

"PEANUT GROWERS QUICK TO DEFEND QUOTA SYSTEM. Caddo County [Oklahoma] has the nation's largest quota allotment for a single county, according to the Agricultural Stabilization and Conservation Service, which administers the program. Caddo County's peanut allotment this year was 80.14 million pounds. But the efficiency of the quota system is questioned by [a] study...commissioned by the...Western Peanut Growers Association and Panhandle Peanut Growers Association. [Jack] Coppedge [president of the Oklahoma Peanut Growers Association] said the two peanut grower groups involved in the study are composed mainly of farmers outside the quota system. 'They've got some quota...They want a lot more. They want to disrupt the program so they can get some (quota).'"1



For our purposes, it really doesn't matter which of these possibilities is the right one. The main point is that there is a PENALTY for exceeding the quota, and that this penalty is large enough to discourage some farmers from growing additional peanuts. Consider the following representation of the farmer's decision to grow another 1000 pounds of peanuts.

At 70 cents a pound, this farmer calculates that he could earn $700 in revenues by growing 1000 more pounds of peanuts. The costs to growing these additional peanuts are $450 (in extra land, labor, fertilizer, etc.), so the farmer decides to grow the peanuts.

Enter the Department of Agriculture. Since these peanuts would put the farmer over his peanut quota, he now needs to consider the full economic transaction. While he'll make $250 in profit, he will also incur a $5000 penalty for violating the United States' government policy on peanut production. Note that this penalty enters our Profit Table in precisely the same way as a tax. It represents the monetary value of the hurt that the farmer will experience once the feds catch him.

Once the farmer considers this penalty, those extra peanuts lose their luster. The farmer chooses not to grow additional peanuts. An economic transaction that would have increased society's happiness by $250 has been discouraged. Resources are transferred to lesser valued activities instead of the higher valued use of peanut production. Society is made a little poorer. And that is a shame.2

Of course, this numerical example illustrates the loss associated with not producing an additional thousand pounds of peanuts. How large is the total loss associated with the quota? It is close to impossible to be able to answer this question. Among other things, one would have to know how many peanuts would have been grown in the absence of the quota. That is, one would have to look into their crystal ball and see a world that doesn't exist--a world without peanut quotas. Even though we can't be certain how large the total loss will be, we can be certain of one thing. Production restrictions--quotas--reduce society's happiness by causing too few resources to flow to an industry where the government has intervened. Our next task is to examine the impact of government mandates that cause too many resources to be devoted to a particular good.


Before Penalty After Penalty

REVENUES:

COSTS:

PROFITS:

$700

$450

+$250

$700

$450 + $5000 = $5450

-$4750




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Notes

1 The Daily Oklahoman, November 30, 1994.

2 Quotas seem like an especially nonsensical policy, so you might be wondering why government would implement a quota policy. If government can get farmers to decrease their supply of peanuts, the price of peanuts will rise. At higher prices, farmers can earn greater income--at least those farmers lucky enough to have quota allotments. So a quota allows government to increase the incomes of one favored group (peanut farmers with quota allotments) at the expense of consumers and other farmers.



CHAPTER 26 Who Will Protect Workers and Consumers?

Thank goodness for unions! If it weren't for unions, work would be a living heck for most workers. Why if the unions hadn't fought for a shorter work week, surely workers today would all be forced to work 50, 60, or more hours a week. If unions hadn't fought for safer working conditions, surely industrial accidents would be a leading cause of death for working age men and women. And if unions hadn't been willing to go toe-to-toe with greedy employers, firms would never have been willing to offer shorter work weeks, pension plans, health insurance, and other fringe benefits. And while we're at it, let's give a hearty round of applause to the U.S. government which each year mandates thousands of laws on everything from job hazards to family leave. Surely, without all these diligent efforts by unions and government to protect workers and consumers from the avaricious clutches of businessmen, life would be, in the words of Thomas Hobbes, "nasty, brutish, and short." Surely?!

As you have probably guessed, we beg to differ! But just how do markets take care of the interests of workers and consumers? As anyone knows who has ever approached their boss about a raise, it's not as though employers always seem driven by a desire to protect, nurture, and otherwise cherish their employees. "Sorry to see you go, and don't let the door hit you on the way out" was the printable portion of the response that one of the author's bosses gave him when he once asked for a raise. Remarkably, the simple framework that we developed in the previous chapters can be applied to the issue of worker and consumer protection.

Likely, you feel a little hesitant about discussing an issue such as worker and consumer protection in economic terms. After all, when we discuss protection issues, especially safety, we are discussing human life, and how can we ever put a price on something like that? Well, we aren't really putting a price on a particular human life, but rather on risk to human life in general. Almost every action involves some sort of risk. One could be smacked by a rollerblader while walking in the park, one could die in an airplane crash, and one could slip and fall in the bathtub. But walks in the park, airplane rides, and bathing are good things. People get pleasure from them, yet they all involve a risk. That risk can be reduced, but it can never be eliminated. Thus, the question we are concerned with is: how much risk to life and limb is the right amount?

"UNITY DECLARATION OF UAW, IAM, & USWA. Left solely to their own devices, profit-driven multi-national corporations...can neither be trusted nor expected to look out for the well-being of their workers or the welfare of the societies in which they operate. Without the countervailing power that only organized workers can achieve, the economic freedom...that we have come to enjoy [is] in serious peril."1



If you are still uncomfortable with discussing risk in economic terms, ask yourself this question: would you ever stand for a speed limit of 25 miles per hour on the interstate? Almost everyone would find such a slow speed intolerable. Yet when you say the limit should be raised to between 55 and 75 miles per hour (which is where most people want it), you are implicitly saying that for the sake of convenience and speed, you are willing to increase the risk of an accident--to actually let more people die. While speed limits are quite different from government mandates about worker or consumer safety, they still involve an acceptance of increased risk to human life and limb--and solely for the sake of a fast and convenient system of transportation! So could it be that a particular government mandate could make us worse off, even though it makes us safer?

Let's begin with an illustration. Suppose a government study determined that a certain stamping machine, used in the steel industry, was unacceptably dangerous. Accordingly, the Occupational Safety and Health Administration (OSHA) issues an administrative decree requiring all firms who utilize this machine to switch to a more expensive, albeit safer, machine. Would this increase society's happiness? On the one hand, there would be fewer workplace injuries and fatalities. These are clear benefits that even hard-hearted, uncompassionate economists would be forced to acknowledge. On the other hand, the resources needed to satisfy this law would have to pulled away from other activities. Would the benefits be worth it? Suppose the OSHA-approved equipment cost the firm $1 billion dollars a year. Do you think it would be a good idea? How about if it cost $100 million? $1 million?

These are tough questions. Answering them requires balancing out the lost happiness that society suffers when it takes the resources used in supplying safer machines from other activities, against the gain in happiness that society will receive from having fewer injuries and fatalities. Who is in a position to balance out these gains and losses? From out of nowhere comes the most improbable hero of all--that money-grubbing, self-seeking, uncaring, capitalistic institution: the profit-maximizing firm.

The costs of supplying safer machines represent the dollar value of the happiness society would have received had the resources used to produce the machine been put to other uses. But what is the dollar gain of the benefits? If the firm supplies a safer workplace, that might make workers better off, but how does it help the firm? (Remember, we are assuming that firms don't care one whit about the well-being of their workers.) When it comes to output goods, the benefits of supplying additional goods and services are represented by their respective prices--which in turn reflects how much individuals are willing to pay for additional units of those goods and services. Could there be a similar process at work when it comes to workplace safety? Indeed, there is.

While workers don't pay for workplace safety directly, they can pay for it indirectly in their willingness to trade off wages and other financial benefits for nonwage benefits like safety. Let's suppose that each of 5 workers who have to use this stamping machine would get $40 of happiness per week from the additional safety (given 52 weeks a year, that amounts to $2,080 a year per worker, or $10,400 a year for the five workers). As a result, they would be



willing to accept a dollar less per hour in wages if somehow they could convince the owner to substitute the new, safer machine for the old, dangerous one. Thus, a firm that employed the safer machine could save $10,400 a year in wages. As long as that greedy, profit-maximizing firm could purchase that new machine for less than $10,400 a year, it would do so.

But suppose the cost of the new machine was more than $10,400 a year. Then the firm wouldn't find it profitable to replace the old, dangerous machine; and workers would suffer a higher rate of injury. Exactly. That is precisely the outcome we want. If workers don't value the resources employed in the new machine at more than its costs, then we are really saying that workers wouldn't get as much happiness from these resources as other consumers would receive from them. In that case, the happiness-maximizing strategy for society should be to allocate these resources to their higher-valued alternatives.

Now we suspect that deep in your heart, you--dear reader--are harboring a number of reservations about our conclusions that firms can be trusted to do what's best for their workers. Let's see if we can anticipate what some of them might be. Let's begin with the argument, "This is crazy, you never see workers taking wage cuts to have safer working conditions." Response Number One: Why not?

If workers really did value safer working conditions, then why wouldn't they be willing to take a pay cut in order to have a reduced probability of sustaining an injury on the job? Would you accept a dollar an hour pay cut to reduce the probability of being killed next year from 100% to 50%? From 50% to 10%? If you are like most people, the answer to these questions would be, "Of course I'll take a wage cut!" Fifty percent and 10% are upsettingly high probabilities when one is discussing death.

But how about this: would you be willing to take a dollar an hour pay cut to reduce your probability of sustaining a life-threatening accident from 0.01% to 0.001% (that is, to reduce your chance of having a fatal accident from 1 in 10,000 to 1 in 100,000)? To put this in perspective, a 1 in 10,000 chance means that the average worker could expect to work 10,000 years before having a fatal accident. A 1 in 100,000 chance lengthens this period of time to 100,000 years. Now we ask the question again, would you be willing to take a dollar an hour pay cut to reduce your probability of sustaining a life-threatening accident from 0.01% to 0.001%?

If you are like most people, you probably would answer no to this last question. Those probabilities are so small that most of us would be willing to risk the higher 1 in 10,000 chance of having a serious accident and keep the dollar per hour in higher wages. In fact, given current, workplace fatality rates for the U.S. economy, most safety improvements fit into this last category.2 Therefore, we suggest that one doesn't see many workers giving up wages to have greater job safety because most improvements make the workplace only negligibly safer. Most workers are not willing to make substantial sacrifices in wages in order to obtain marginal improvements in safety.



Response Number Two: If this story isn't true, why do we see firms characterized by dangerous working conditions paying higher wages? Consider work on oil derricks, which is notoriously dangerous. Injuries, both minor and serious, are common occurrences. Yet, workers are willing to work those dangerous jobs because firms pay a premium for that kind of work. Why do firms pay a premium for dangerous work? Because if workers had to choose between safe jobs and dangerous jobs, and both jobs paid the same wage, the choice would be what economists call a NO BRAINER. Without higher wages, workers would not be willing to do dangerous work. Even with higher wages, many workers choose not to take dangerous jobs. They would rather have safer jobs with lower pay. Said differently, these workers are willing to give up wages in order to get safer working conditions. But that's what we said all along!

The trump argument is always, "Oh yeah! Well that might be fine in theory, but that's not how it works in the real world." Response Number Three: Let's take a look at the real world. The figure below shows death rates for workers on the job during the period 1930 to 1990. Just how important has OSHA and workplace regulation been in reducing the number of employment fatalities?



Source: W. K. Viscusi, J. Vernon, and J. Harrington, Jr., E conom ics of R egul ation and A ntitrust, L ex ington, M A : D .C . Heath and C om p any , 1 9 9 2 , p age 7 1 4 .

One doesn't need to have a Ph.D. in statistics to figure out that OSHA has had no observable impact in reducing deaths on the job. Amazingly, this figure shows that workplace deaths have been steadily decreasing since 1930. Why? By now you've probably figured out our explanation for this phenomenon. Profit-maximizing firms found they could increase their profits by providing safer workplaces for their employees.

But..But..maybe it was the unions after all. They were around in the 1930's. Maybe workplace fatalities have decreased since then because unions were fighting for workers' rights. We can't dismiss this possibility. But here's the amazing thing. It isn't just that workplaces are safer now then they used to be. Everything is safer. Cars are safer. Appliances are safer. Homes are safer. Look at the figure below.

Source: W. K. Viscusi, J. Vernon, and J. Harrington, Jr., E conom ics of R egul ation and A ntitrust, L ex ington, M A : D .C . Heath and C om p any , 1 9 9 2 , p age 6 0 6 .

Now what could possibly account for the trend in decreased fatalities associated with homes and motor vehicles? Clearly unions had nothing to do with this. In contrast, we can tell exactly the same, profit-maximizing story about why firms would want to provide safer consumer products. If consumers value safety, they will pay more for safer products (anybody ever hear of Volvo automobiles?). If firms find that the greater revenues from



safer products are more than the costs of producing the increased safety, they will take the initiative to produce those goods.

Safer consumer products. Safer workplaces. It's the same story. When the gain in happiness that society receives from increased safety is greater than the loss in happiness that comes from diverting resources from other uses in order to produce that safety, profit-maximizing firms will work to protect workers and consumers. And safety is not the only good which workers trade wages to buy. Longer vacations, family leave, health insurance, fewer working hours, and other non-wage benefits can also be "purchased" by workers through lower wages. If these benefits are in society's interest, it won't take a crippling industrial strike--or an act of Congress--to force firms to provide them.



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Notes

1 Solidarity, September 1995.

2 As a point of comparison, the annual rate of workplace fatalities for the U.S. labor force is about 1 in 10,000.



CHAPTER 27 OSHA--We're From the Government and We're Here to Help

You

OSHA is a U.S. federal agency which relies almost entirely on mandates to influence firm behavior. The bottom line for the firms is that they end up employing more resources for the purpose of worker safety than they would voluntarily choose. Now lest you think otherwise, we are not members of the PRO-INJURY AND MAIMING SOCIETY. We don't get a special kind of joy every time we hear of an industrial accident. However, consider the following cost estimates of various OSHA worker safety mandates:

Source: John F. Morrall III, "A Review of the Record," Regulation, 1986, p. 30.

Columns (1) and (2) report the specific area in which OSHA intervened and the year the mandate was passed. Columns (3) and (4) report the number of lives estimated to be saved by the regulation and the estimated cost per life saved. Thus, OSHA's 1986 asbestos standards are estimated to have saved 74.7 lives per year, at an annual cost of approximately $6.7 billion (= 74.7 times $89.3 million).

We're not saying that saving 74.7 lives is bad. We think it's great. It's just that $6.7 billion could have produced an awful lot of happiness elsewhere in the economy. For example, just think how many lives that $6.7 billion could have saved if these resources had been transferred to the health industry instead of spent on asbestos removal. $6.7 billion could buy an awful lot of open heart surgeries, not to mention high blood pressure pills, mammogram examinations, drug research, and testing for an AIDS cure. It could also pay for an awful lot of additional police to patrol the streets in high crime neighborhoods.1

Let us show how our simple framework can be used to analyze OSHA mandates. Consider

Regulation Regulation

(1)

Year Year (2)

Estimated Lives Saved per Year

(3)

Estimated Cost per Life Saved (1984 dollars)

(4)

Ethylene oxide

Acrylonitrile

Coke ovens

Asbestos

Arsenic

1984

1978

1976

1986

1978

2.8

6.9

31.0

74.7

11.7

$25.6 million

$37.6 million

$61.8 million

$89.3 million

$92.5 million



the example we discussed in the previous chapter. Suppose OSHA issued an administrative decree requiring the XYZ Corporation to utilize a safer, but more expensive, stamping machine. Suppose each of the 5 workers who had to use this machine valued the additional safety at $40 per week times 52 weeks per year (equals $2,080 a year per worker, or $10,400 a year for the five workers). Thus, XYZ Corp. could save $10,400 a year in labor costs by employing the safer machine. However, the yearly rental cost of the safer machine is $20,000. Under these circumstances the firm would not have employed this machine before the OSHA mandate.

Now we're going to do something really weird. Recall from our previous discussion of peanut quotas that firms who violated government restrictions were subject to a PENALTY. We used this concept to show how a firm could be induced to not produce something that is otherwise profitable for them. We now introduce the concept of the PENALTY AVOIDANCE BENEFIT (PAB) to show how a firm can be induced to produce something (safety) that is unprofitable for them.

If the firm violates the OSHA mandate, something bad happens. What exactly will happen? Surprisingly, this time we really do know the answer to that question: OSHA imposes an administrative fine (penalty). In this instance, suppose that the firm would incur a $15,000 fine if they did not replace the old stamping machine with the newer, OSHA-mandated model. By switching to the newer machine, the XYZ Corporation avoids having to pay this tax penalty. The opportunity to avoid this penalty provides the financial incentive for the firm to obey the OSHA mandate. As a result, we can treat this penalty avoidance benefit (PAB) the same as a subsidy. (Recall that we previously treated the penalty from violating a quota the same as a tax).

Why is a PAB like a subsidy? Suppose your boss tells you he'll pay you $50 to show up for work next Saturday. As you lie in bed half asleep on Saturday morning, you consider that there is a $50 benefit for getting out of bed and going to work. Compare that to the case where your boss tells you he's going to reduce your bonus by $50 if you don't show up for work on Saturday. The benefit of getting out of bed and going to work is still $50. In the first case, your boss "subsidizes" your pay to get you to work. In the second, case he threatens you with a penalty if you don't go to work. In each case, working gives you $50 more in your pocket than not working.

It's the same thing for the XYZ Corporation. If it follows OSHA's mandate to employ the new machine, it ends up $15,000 more in its "pockets." We can now represent the XYZ Corporation's decision to buy the new machine before and after the OSHA mandate as follows.

Before Mandate After Mandate

REVENUES: $10,400 $10,400



Prior to OSHA's mandate, the XYZ Corporation would have never chosen to make the workplace safer by using the new stamping machine. And that was the right thing for them to do. The gain that the workers would have experienced from having the safer machine was only $10,400. But it would have come at the expense of $20,000 in lost happiness elsewhere in the economy. The resources that would have been used to construct the new machine would have had to be taken away from other consumers. Those other consumers would have gotten greater pleasure from those resources than the workers at the XYZ Corporation. Thus, by not employing the new stamping machine, the XYZ Corporation allows these resources to be released to go to a higher valued use.

The OSHA mandate changes all this. It causes a reallocation of resources away from other consumers to the workers of the firm. And that change in the allocation of resources lowers society's happiness by $9,600 (the difference between the gain of $10,400 in happiness by the workers of the XYZ Corporation, and the loss of $20,000 in happiness by other consumers). Of course there are other firms besides the XYZ Corporation who are impacted by OSHA's mandates. As a result, we will never know the total amount of the social loss created by these mandates. But we do know that too many resources will be allocated to the production of safer workplaces. This is the great value of our SIMPLE FRAMEWORK. It allows us both (i) to demonstrate that society's happiness will be lowered by these mandates, and (ii) to illustrate just what it is that causes this loss. All in the context of a simple table, and we need not be experts in the industry being regulated.



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Notes

1 Note also that asbestos is a fire retardant, so its purpose is to prevent death and injury. Thus, while lives are saved by removing asbestos, lives may be lost by its removal.

COSTS:

PROFITS:

$20,000

-$9,600

$20,000 - $15,000 = $5,000

+$5,400



CHAPTER 28 Unintended Consequences of Consumer Safety Regulation

The previous chapter showed how government MANDATES can lower society's happiness by forcing firms to take resources that are higher valued elsewhere, in order to produce something that is lower valued--such as safety. In doing so, we accepted the notion that at least the government was successful in getting the market to produce additional safety. Now we want to demonstrate that the government may not be successful in getting additional safety produced, even when it mandates this outcome. The reason for this has to do with the UNINTENDED CONSEQUENCES of market interventions.

The Profit Table below represents the Revenues and Costs associated with a commercial laundry firm, before and after new regulations protecting the safety of laundry workers are mandated by OSHA. Specifically, the table reports how much money Bob Guthrie's Nichols Hills Cleaners made from his business with medical accounts.

Before the new rules, Bob Guthrie made a profit of $2,000 from this business. After the new rules, two things happened. First, Mr. Guthrie had to spend a total of $6,000 to come into compliance with the new regulations. Second, he was able to lower his wage costs by a $1,000. This latter result didn't happen immediately of course. But Mr. Guthrie found that workers appreciated working in a safer environment. This meant that his employees were less willing to quit and take jobs elsewhere, and that he didn't have to give as many raises to hold on to his good workers.

"LAUNDRY RULES DRESS WORKERS LIKE DOCTORS. New federal regulations are requiring commercial laundry workers to dress like surgeons when dealing with certain clothing, and promise to cost many employers thousands of dollars annually....Bob Guthrie, manager of Nichols Hills Cleaners, has discontinued business with his few medical accounts....He said the expense of the hepatitis shots as well as the gowns, gloves and face shields was too much."1

Before Regulation

After Regulation

REVENUES:

COSTS:

PROFITS:

$10,000

$8,000

+ $2,000

$10,000

$8,000 + $6,000 - $1,000 = 13,000

- $3,000



Unfortunately, the savings in labor costs were not enough to outweigh the costs of compliance. Bob Guthrie found that the total costs of his medical laundry business had increased from $8,000 to $13,000, resulting in negative profits. As a result--and as the article states--he discontinued his medical cleaning business. We know from our previous analysis that the effect of this mandate is to decrease society's happiness by diverting resources out of the medical cleaning business. But that's not what we want to focus on now. Instead, we want to investigate the overall impact of this mandate on the level of public health in society.

The combination of higher costs and fewer laundries willing to take medical cleaning business means that hospitals will have to pay higher prices to have their laundry washed. To compensate for these higher costs, hospitals will have to cut back on some of their medical services or charge higher prices to their patients. What do people usually do when the price of something goes up? They consume less of it. Economists are so sure of this last statement that this conclusion is awarded the prestigious title of being a law of human behavior. It is called the LAW OF DEMAND. When the price of gasoline goes up, people consume less gasoline. When the price of stringbeans go up, people consume fewer stringbeans. And when the price of health care goes up, people consume less health care.

To see this clearly, let's take an extreme example. Suppose the government piles on so many new safety regulations that the average cost of treating each patient rises to $1,000,000. Who would (or could) purchase health care at this price? Virtually no one. In this case, mandating excessive safety regulations clearly lowers the public's overall health. A bit unrealistic, you say. Sure. But it does highlight the problem: IF THE DECLINE IN PUBLIC HEALTH RESULTING FROM FEWER PEOPLE PURCHASING MEDICAL CARE OUTWEIGHS THE INCREASE IN PUBLIC HEALTH RESULTING FROM THE SAFETY MANDATES, THEN GOVERNMENT REGULATION DAMAGES PUBLIC HEALTH. And it would not be the only time that regulations to improve public health have had unintended consequences.

Consider the following real-life example. Until recently, the government has had strict regulations mandating the adoption of child-resistant safety caps on products such as aspirin, prescription drugs, etc. Now what to do you think the net impact on public safety has been as a result of this regulation? Consider the following conclusion by a highly regarded economist who has carefully studied this subject:

How can this be? It's not that difficult to figure out. As anybody knows who has ever struggled with a so-called "child-resistant" safety cap, they aren't very easy for adults to open either. How do some people choose to respond to this? Let's return to the law of

"The overall implication of this analysis is that there have been 3500 additional poisonings annually of children under five that resulted from the decreased safety precautions after the advent of safety caps."2



demand. In essence, it is now more "costly" to open up a medicine bottle. When an action becomes more costly, people do it less frequently. One way to open up medicine bottles less frequently is to leave them open. That is, people don't put the tops back on. So children find more open medicine bottles to get into. The perverse result is that child-resistant safety caps have--on balance--made it easier, not harder, for children to get access to poisonous substances.

An isolated incident you say? Consider the effect of regulations governing the introduction of new drugs. The federal Food and Drug Administration places severe requirements on the ability of pharmaceutical firms to market new drugs. It takes an average of approximately three years and millions of dollars for a new drug to receive approval by the FDA.3 While the intensive testing required by the FDA no doubt reduces the number of harmful drugs available to consumers, it also has another effect. It reduces the number of beneficial drugs available to consumers. Many economists believe that the net effect of the FDA's tough approval process has been to harm more consumers than it has helped. This is how one advocate put it:

FDA regulations raise the cost of introducing new drugs. Not just ineffective or dangerous drugs, but good drugs as well.5 As a result, less drugs make it to market. But that's not the end of the story. Less drugs on the market can only mean one thing. Higher drug prices. When drug prices are higher, consumers will take fewer of them, which means that consumers will miss out on the health benefits of drugs that they would have taken in the absence of the FDA regulations. Once again, we are left with an unintended consequence: FDA regulation may lower the health of the very population that the agency is entrusted to protect.

So what's the problem with our government? Why these unintended consequences of well-intentioned regulations? Is it because government is filled with bungling idiots who either are too incompetent to know better or too insensitive to care? We don't think so. In our opinion, the fundamental problem here is one of INFORMATION.6

How much do consumers value child-resistant safety caps? How much happiness will

"...in 1981...the FDA published a press release confessing to mass murder. That was not, of course, the way in which the release was worded; it was simply an announcement that the FDA had approved the use of timolol, a Beta-blocker, to prevent recurrences of heart attacks. At the time timolol was approved, Beta-blockers had been widely used outside the U.S. for over ten years. It was estimated that the use of timolol would save from seven thousand to ten thousand lives a year in the U.S. So the FDA, by forbidding the use of Beta-blockers before 1981, was responsible for something close to a hundred thousand unnecessary deaths."4



consumers get from that new drug? Are they willing to forego other goods to get products that are safer? Or is the cost of the safety so high that consumers would rather do without the good if they are forced to pay for the extra safety? These are incredibly difficult questions to answer, but they are questions of life and death.

Note that the issue isn't whether to have safety or not. The issue is, how much safety? When government mandates safety standards, it is extremely difficult for consumers to signal their evaluations of those standards. Only markets are positioned to collect and convey the information that resource owners need to know if they are to allocate resources so as to maximize society's happiness. This is a topic we explore further in the next chapter.



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Notes

1 The Daily Oklahoman, July 27, 1992.

2 W. Kip Viscusi, John Vernon, Joseph E. Harrington, Jr. Economics of Regulation and Antitrust. Lexington, MA: D.C. Heath and Company, 1992, p. 738.

3 W. Kip Viscusi, John Vernon, Joseph E. Harrington, Jr. Economics of Regulation and Antitrust. Lexington, MA: D.C. Heath and Company, 1992, p. 732..

4 David Friedman, The Machinery of Freedom, 2nd Edition, La Salle, Illinois, Open Court, 1978.

5 It is worth noting that even with FDA regulations dangerous drugs still make it to market.

6 Another problem relates to the incentives facing government bureaucrats. Government bureaucrats don't have the incentives that firms do to weigh out the social benefits and costs of devoting more resources to safer medicine caps, electricians, drugs, etc. If a drug company procrastinates in getting a drug to market, it loses millions of dollars in potential revenues. Those revenues are a reflection of the happiness that consumers will miss out on by not having the new drug. If a bureaucrat in the FDA delays the approval of a new drug, what is the cost to him? A denied promotion? A smaller raise? In fact, there is an incentive for a bureaucrat not to approve a new drug--he would share a huge portion of the blame if the drug turned out to be dangerous. How about with respect to potentially dangerous



drugs? While pharmaceutical companies may have an incentive to bring out a drug sooner, that does not mean they will be rash. If a drug company rushes a potentially dangerous drug to the market, it will incur substantial costs if the drug harms public health. Not only is there the financial damage from lost sales and damaged reputation, but there is also the liability expenses from harmed consumers. (Juries are generally not timid in awarding damages to consumers who have been hurt by a company's products.) Thus, profit-maximizing firms are in a unique position to weigh out the social benefits and costs of new drug introductions.



CHAPTER 29 A Game Called Hot 'N Cold

When we were kids, we played a game called Hot 'N Cold. The way the game works is like this: The players agree on an object, say a quarter, that will be hidden someplace in a room. Somebody is chosen to be "it" and is led outside while the door is closed him. Back inside, the other players hide the object, maybe on the seat of a chair, in a planter, on top of the stereo system. The player who was taken outside the room is then brought back in. His job is to find the hidden object.

The only information he has to go on are the "hot" and "cold" clues of the other players. If the player who is "it" is searching the room far away from where the object is hidden, the other players say things like, "Brrrr! You're freezing and you're going to catch cold if you aren't careful," "Put a parka on, Chump", and "Frostbite! Frostbite!" As "it" gradually moves closer, the other players tell him he's "getting warmer." When he gets really close to the object, they say things like "You're starting to sweat, baby" and "Watch out! You're going to burn yourself!"

Besides being revealing about our incredibly deprived childhoods, this game serves as a beautiful picture of how a free-market economy operates (we confess that we didn't necessarily make this connection when we were kids). Think of "it" as the firm. The firm's job is to combine resources in such a way that it will make society better off. It doesn't have a clue about the best way to do that. Despite the best efforts of its production engineers and market consultants, it is led into the "room" not knowing what combination will produce the best result for society. Profits are like the "hot" and "cold" signals described above. When a firm does a poor job of combining resources to make a product--either because it is taking resources that are really valuable in other activities, or because the product it produces isn't much wanted by consumers--it earns negative profits. That's the economy's way of saying "Brrrr! You're freezing."

Alternatively, as it hits on a better combination of resources, either by improving its product or economizing on inputs, it starts to earn a reasonable rate of return on its investment. That is, the economy says, "You're getting warmer." Every now and then there is a firm that develops a new good or service, and it earns incredible profits--say McDonald's perfects the

"COMPANY GROWING MO' AND MO'. Apache, OK (AP)--It's been a year of expansion for Maury Tate, whose plan for a simple sideline business to help him cover rodeo entry fees has mushroomed into the nationally known Mo' Betta shirts....'We didn't have a clue,' Tate said about his small-town company that has bloomed into a national sensation. 'Everything that has happened has been crazy.' Crazy enough that business for the 100 employees has increased 40 to 50 percent this year alone."1



concept of fast food, or Microsoft develops an incredibly powerful operating system called MSDOS. What does the economy say then? "Hot dog! You're burning out of control, baby!"

In a world of darkness and uncertainty, profits are the consumers' way of telling firms when they get it right. There are many different ways of producing a product, many different ways of improving a product so that consumers will like it more (derive more happiness from it). And what makes this all difficult for firms is that oftentimes consumers don't know themselves what they will like before they experiment with it. Nor do consumers know how long they will like it. Pet rocks, bell bottoms, and Teenage Mutant Ninja Turtles were all "products" that produced huge profits for their inventors that were relatively short-lived. Frisbees, blue jeans, and the Beatles are products that have continued to produce happiness for consumers long after their initial introduction. Who could have guessed how much happiness these products would have produced at the time of their introduction? Or for how long consumers would continue to find pleasure in them?

But profits also play another important role. When one firm earns exceptional profits from hitting on the right combination of resources to please consumers, an inevitable reaction occurs. Other firms try to copy the winning combination. Imitation--copy catting. That is one of the great trademarks of free-market/capitalism. The rise of McDonald's sets in motion forces that spawn competitors producing like products, such as Burger King and Wendy's. Apple Corporation's menu-driven operating system gives rise to Microsoft's Windows and Windows 95. Dodge Caravan gives rise to Ford Windstar. There was a time when salad bars were only to be found in health food restaurants. Now they're everywhere.

One can picture the whole economy as an enormous room filled with firms roaming around, each trying to find where consumers have "hidden" the object that will produce the most happiness for society. When consumers tell one firm that "they're hot," a flock of other firms swarm over to where that firm is and try to copy--and improve--what that first firm is doing. It's like the whole economy is one huge game of Hot 'N Cold.

Both of these functions of profits are well-illustrated in the story of Maury Tate, the main character in the article excerpt which began this chapter. In 1987, Maury Tate was a full-time, professional rodeo rider. He had a family friend sew colorful materials into his rodeo shirts. When his fellow competitors saw Tate's shirts, they offered to buy them. Tate would literally sell the shirt off his back to another rider who liked what Tate was wearing. One thing led to another, and soon Tate found himself the owner of a company that was producing shirts for national chain stores. Tate just happened to hit upon a combination that pleased consumers. But then something else happened. Soon he found that his weren't the only shirts that offered colorful western-style looks. Everybody starting to produce them. Levi started to produce similar looking shirts. And Wrangler's. Even Sears, Wal-Mart, and Target. Each day, thousands of firms try to mimic what Maury Tate did by accident. They assemble resources, drawing them away from other parts of the economy, hoping to combine them in a way that will make them the next big success in the economy's hit parade.



This perspective of the world as being a world of "darkness and uncertainty" is a controversial perspective with far-reaching consequences. It differs with most conventional textbook presentations of how the economy operates. It is customary, for example, for economics textbooks to represent firms as being fully cognizant of the revenues and costs they would experience at every possible level of production. Armed with this knowledge, the major task of firms is merely to choose the level of output that maximizes total profits. Rarely is there a sense of the lack of information that characterizes most firm decision-making. There is little to no mention of the role of the entrepreneur.

In fact, most textbooks represent a view of the economy in which firms settle down to what is called "long-run equilibrium." That's where there is no more impetus for change in an industry. Each firm produces the same products and quantity as the year before. Further, all the firms in the industry are completely identical. Each earns zero economic profits. There are no new firms who enter this industry, and no old firms who depart.

Contrast this world with the picture of the economy that is represented by your local paper's Business section. What kind of world is this? This is the world of bankruptcies and business mergers. Of new products. Of firms that were the leader in their fields last year, but are now trying to compete with new entrants who are threatening to take away their market share this year. It is the world of Lee Iaccocca, of Bill Gates, of Robert Crandall. It is a world in which automobile corporations report record earnings one year, and multi-billion dollar losses the next. Where firms try to "redesign" themselves to fit changing business environments. It is a jungle out there! Each firm scrambling, trying to figure out what it is that consumers want this year. Nothing is certain, everything is risky. Where is this world in the standard economics textbook?

On one extreme, we have a picture of an economy in which everything is known. The most difficult task facing firms is to choose the level of output which will maximize profits. On the other extreme, we have a picture in which the economy is characterized by great uncertainty, in which firms grope and stumble in the dark trying to find out what will please consumers. It turns out that which worldview one subscribes to has important implications for public policy.

Suppose one believes that lack of information is a serious problem facing the economy. Then one is inclined to try to place as many resources as possible under the control of profit-maximizing firms. One sees the entrepreneur as the driving force of the economy, and a key agent for improving society's happiness. One supports minimizing regulations which restrict firms from pursuing profit-increasing combinations of resources. One becomes a proponent of the FREE-MARKET; one advocates leaving as many resource allocations to the price system as possible.

On the other hand, suppose one believes that lack of information is not a serious problem. In this case, the informational role played by profits is relatively unimportant. An economic planner can decide what and how much to produce, just as well as any firm. In fact, the economic planner can probably do it better. After all, he or she can produce the good



without "wasteful competition." This is the worldview which underlies much of GOVERNMENT REGULATION of consumer safety, for example. It is also the worldview of economic policy makers who believe that government spending can be used to stimulate economic growth. Here the question of what to produce is not considered a problem. It is assumed that those in charge of disbursing the funds will know what it is that consumers want--and how the rest of the economy will respond to the government's intervention. In this case, one is a proponent of an ACTIVIST GOVERNMENT, a government that tends to use planners, regulations, taxes, subsidies, and the like to direct resources to various uses.

Two very different worldviews--two very different policy positions. Which worldview is right? In the end, it's a matter of one's best judgement. That's because the fundamental element--information--is unseen. Nobody can know just how much unknown information is out there. Despite our best efforts to remain scientifically neutral and unopinionated, you've probably been able to figure out what our worldview is. How about yours? Think about it....Anybody for a game of Hot 'N Cold?



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Notes

1 The Daily Oklahoman, December 27, 1992.



CHAPTER 30 Moving to Greener Pastures

We now enter a new section of our exploration of economics. The previous chapters developed a working model of how an economy functions, how resources are directed to consumers and divided up among them. We know that a firm's revenues represent the happiness that society receives from the firm's output. We know that a firm's costs represent the happiness society could receive if those resources were freed up for their next best use. By comparing the two, we can tell whether the firm's resource transfers result in a net increase or net decrease in happiness. We also understand the tremendous problems that arise when the information that firms receive from the marketplace is distorted by subsidies and taxes. This theory represents the foundational building blocks of economics.

Our next task is to apply this framework to a number of issues that have likely been nagging at you this whole book. We begin with international trade. Is it a good thing for the economy? How do trade policies affect society's happiness? And trade deficits? Are they harbingers of doom? How can we be so sure that displaced workers will find jobs? In addition to these questions, we'll also look at how markets work to conserve natural resources for future generations. In the pages ahead we shall take a giant step toward our goal of making you an armchair economist...and a hit at cocktail parties.

While it might seem like a funny place to start, we're going to begin our study of international trade by looking at plant relocations. Let's consider the economic insights offered by the distinguished Representative from Wayne, Michigan. His big beef with the Federal Mogul Co. is that it decided to close down its plant in Detroit and open up a new plant in Alabama, not because it wasn't making money in Detroit, but because it could make more money in Alabama. We've got to admit, that does sound awfully greedy. We suspect that the owners are probably not very nice people (even the name of the company--the Federal Mogul Co.--sounds rather cold and heartless). But we're going to leave the moralizing to those who have earned the right to judge others by virtue of their own impeccable behavior--the politicians.

"My own congressional district suffered the effects of the runaway plant in 1972 when the Garwood plant in Wayne [Michigan] moved and left 600 unemployed workers behind....Mr. Speaker, the reason these firms are moving away is not economic necessity but economic greed. For instance, the Federal Mogul Co. in Detroit signed a contract in 1971 with the United Auto Workers and six months later announced it would be moving to Alabama. A spokesman for the company was quoted as saying they were moving 'not because we are not making money in Detroit, but because we can make more money in Alabama.'"1



Let's consider why the Federal Mogul Co. might want to move from Detroit to Alabama. While we can only surmise, it seems reasonable that costs may have played the primary role in the firm's decision. Many plant closings are driven by the desire to move to locations where the costs of production are lower. How can this be represented in the context of our simple Profit Table? The key is to identify the gains and losses to the firm of shutting down the plant in Detroit and opening up another plant in Alabama.

Let's suppose that the costs of production in Detroit are $32 million. By shutting down the plant there, the firm saves $32 million. Since this is what the firm stands to gain by relocating to Alabama, we report this gain on the firm's "Revenues" line of the Profit Table. (The trick is to always report the dollar value of the gain to the firm on the "Revenues" line.) What is the cost of opening up the plant in Alabama? It is the cost of production there. Supposing that costs are expected to be only $20 million in Alabama, we report this on the associated "Costs" line. Now look at our Profit Table and see if we haven't captured the essence of the firm's relocation decision.

Ignoring the costs of moving for the moment, we see that the Federal Mogul Co. could increase their profits by $12 million if they relocated from Detroit to Alabama.

In order to keep the problem simple, let's assume that the Alabama and Detroit plants produce the same quantity and quality of goods. This simplification is consistent with our initial supposition that cost considerations are the driving force behind the move. As a result of this assumption, the customers of the firm are unaffected by its decision to relocate. We are now in a position to investigate the gains and losses to society caused by the firm's relocation decision.

Note that there are two sets of resource transfers represented in the Profit Table above. When the Federal Mogul Co. shuts down in Detroit, it releases its inputs (land, labor, locally purchased materials, etc.) so that other firms can employ them. As these other firms move in to put these resources to work, additional goods and services are produced. Consumers benefit from these additional goods and services. How much happiness do these consumers receive from the additional goods and services? Don't be bashful about saying approximately $32 million of happiness. After all, that was what the Federal Mogul Co. was paying to employ those inputs. And we know that the happiness that those inputs could produce elsewhere is reflected in their market price.

A second set of resource transfers takes place when the firm opens up in Alabama. In order to begin production, the Federal Mogul Co. has to take away inputs that could have been

REVENUES (gain from shutdown):

COSTS (for a plant in Alabama):

PROFITS (from moving the factory):

$32 M

$20 M

+$12 M



used to produce other goods and services. The workers who ended up working for the good folks at Federal Mogul were bid away from alternative employers. Who knows what they might have been doing otherwise? Flipping burgers at McDonald's, washing cars at the Skweeky Kleen Kar Wash, working as a barmaid at the Suds 'N Duds Laundromat, Bar, and Grill. No matter. As a result of these workers signing on with Federal Mogul, there will now be fewer burgers flipped, fewer "kars kleened," and fewer mugs of beer while customers wait for the spin cycle to end at the Suds 'N Duds. That means lost consumer happiness. How much? Approximately $20 million, of course.

Forgetting whatever heartless motives may have lurked in the minds of the evil corporate chieftains at Federal Mogul Co., the bottom line is that relocating the plant to Alabama results in an increase in society's happiness. We can say this because we know that the ultimate reason that costs were higher in Detroit is because resources were more valuable there. By releasing the more valuable resources in Detroit, and replacing them with less valuable resources in Alabama, the Federal Mogul Co. has acted in society's best interests. Thank goodness they weren't content with the money they were making in Detroit, but wanted to make even more!

Let's come back now to some points that we glossed over earlier. Haven't we ignored moving costs? Yes we have, but including moving costs leaves our essential analysis unchanged. To see this, just add the moving costs to the "Costs" line of the Profit Table. Say moving costs are $7 million, raising total costs to $27 million. Moving costs also represent resources that the Federal Mogul Co. has taken away from consumers who could have benefitted from them. As long as moving costs are less than $12 million, the firm will still decide to relocate, and society will be better off if they do.

Suppose the moving costs are greater than $12 million? Say they're 15 million? Then the firm doesn't relocate. But again, this is exactly what we want the firm to do. If total costs are $35 million ($20 million + $15 million), then the firm would tie up resources that could have produced a total of $35 million of happiness elsewhere, while releasing resources that will produce only $32 million of happiness. If the firm relocated, it would lower society's happiness by $3 million. The bottom line is always the same. IF THE FIRM'S PROFITS ARE INCREASED BY RELOCATING, THEN WE EXPECT THAT SOCIETY'S HAPPINESS IS ALSO INCREASED. WE CAN TRUST THE FIRM TO DO WHAT IS RIGHT FOR SOCIETY, AS LONG AS IT DOES WHAT IS BEST FOR ITSELF.

One last twist. Suppose the firm found it profitable to relocate from Detroit to Dallas, Texas, instead of Alabama. Would that increase society's happiness? "Of course!" you say. Suppose the firm found it profitable to relocate from Detroit to San Antonio, Texas. Would that increase society's happiness? "Of course!" you say again. Suppose the firm found it profitable to relocate from Detroit to El Paso, Texas. Would that increase society's happiness? "Of course!" you say for the third time.

One last question. Suppose the firm found it profitable to cross that short little bridge that leads from El Paso, Texas to Juarez, Mexico--a mere 100 yards further south. Would that



increase society's happiness? "Oh no! I've been tricked!" you say. (You probably saw it coming all along.) Here's the question we want to wrestle with. If it increases society's happiness to have a plant relocate from Detroit, Michigan to El Paso, Texas, what could be so fundamentally different if we relocate that plant just 100 yards further south--in Juarez, Mexico. Shouldn't that also increase society's happiness?



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1 U.S. House of Representatives, Congressional Record, 94th Congress, 1st Session, 10 June 1974, p. 18559.



CHAPTER 31 That Loud Sucking Sound

If society's happiness increases when a plant moves from Detroit, Michigan to El Paso, Texas because costs are lower in El Paso, then what is different about the plant moving to Juarez, Mexico to take advantage of lower costs there? In fact, there is a difference. As we shall see, though, it is a difference that affects the interpretation of the numbers in the table, but not our conclusion about the impact of this move on society's happiness.

The numbers below represent the case where the firm's costs of production are $32 million in Detroit, but only $20 million in Juarez. To keep it simple, we once again assume that the $20 million plant in Juarez will produce the same quantity and quality of goods as the $32 million plant in Detroit, so that the firm's customers are unaffected by the move. We also assume that unions aren't a problem, so that the $32 million of costs in Detroit represent the amount of happiness those resources will produce in the rest of the economy when they are released.

The numbers all look the same! Indeed they do. The difference lies in their interpretation. When the plant closes down in Detroit, $32 million of resources are released to produce other goods and services for consumers elsewhere in the economy. This social "gain" from the plant closing down is the same whether the plant ends up relocating in El Paso or Juarez. But now look at the costs. When the plant opens up in El Paso, resources are pulled away from other activities that could have produced happiness for our consumers. (Remember--fewer burgers flipped, fewer "kars kleened," and fewer beers consumed at the Suds 'N Duds.) When the plant opens up in Juarez, there is no corresponding withdrawal of resources from other activities.

Oh sure, there are fewer resources available to produce happiness for MEXICAN consumers. But we don't care about Mexican consumers. That didn't sound very nice, did it? Let's put it another way: in deciding what's best for the happiness of AMERICAN society, we don't consider the effect of our trade actions on the consumers of other societies. We

"That loud sucking noise you hear is the sound of American jobs going south to Mexico"--Ross Perot, 1992 U.S. Presidential candidate, arguing against the North American Free Trade Agreement (NAFTA).

REVENUES:

COSTS:

PROFITS:

$32 M

$20 M

+$12 M



focus solely on what's good for American consumers. If this lack of concern for our international neighbors bothers you, take heart. We will demonstrate later that voluntary acts of trade between nations make both societies better off.

What then, is the nature of the costs to the U.S. society when this plant opens up in Juarez? While it's true that no American consumers are adversely impacted because there are fewer resources available to produce other goods and services, there is another cost. Do you see it?

The American firm is going to pay its Mexican workers $20 million to operate the plant in Juarez. What are the Mexican workers going to do with all that money? One option is to go shopping. Suppose they take that $20 million and go on a huge shopping spree north of the border. Let's imagine that they come back with a gigantic shopping cart full of American goods and services: cowboy boots, Coupe DeVille's, bar-b-que ribs, 10-gallon hats, and souvenir t-shirts ("My parents went to Texas and all I got was this lousy t-shirt"). How has this hurt American consumers? THESE GOODS AND SERVICES ARE NO LONGER AVAILABLE FOR AMERICAN CONSUMERS.

The Mexican shopping spree is no different than if a tornado tore through Texas destroying $20 million of goods and services. Whether they are taken away by a natural disaster or by Mexican workers purchasing them with dollars earned from their American employer, the fact is that those goods can no longer be consumed by American consumers.

If the price of a pair of snakeskin cowboy boots is $100, then having one less pair of those cowboy boots means that American consumers lose $100 in happiness. If $5000 worth of snakeskin cowboy boots (50 pairs at $100 a pair) are withdrawn from the American economy, then consumers in the U.S. will be out approximately $5000 of happiness. And so it follows that when Mexicans buy $20 million of American stuff, it imposes a loss in happiness on American consumers of approximately $20 million.

Let's go back to our Profit Table to review why relocating the plant from Detroit to Juarez, Mexico will improve (American) society's happiness. The resource transfers resulting from this plant relocation result in both gains and losses for the U.S. economy. When the plant in Detroit closes down and releases $32 million of resources, those resources are reemployed, producing approximately $32 million of happiness. When the plant opens up in Juarez and pays the workers there $20 million, those workers will take their money and buy American goods and services. When they do so, they remove goods and services worth $20 million from American stores and supermarkets. Since those goods and services can no longer be consumed by Americans, consumers in the U.S. will lose out on the approximately $20 million in happiness. When the social gains are weighed against the social losses, the net impact is a $12 million increase in society's happiness. Whether the firm relocates to El Paso or Juarez, the bottom line is the same. Only the story is somewhat different.

Are you convinced? Not really? Let's consider some common criticisms of this analysis. CRITICISM NUMBER ONE: "Your story is hopelessly unrealistic! The Mexican workers aren't going to be paid in dollars. They're going to get paid in pesos. And even if they were



paid in dollars, they wouldn't spend all their dollars in the U.S. So what does that do to your theory, buster?"

Suppose they are paid in pesos rather than dollars. In order to get pesos, the plant had to take its $20 million and trade it with someone (or some firm) who was willing to give up pesos to get dollars. But why would anyone be willing to trade their pesos for American dollars? Because they wanted those dollars to buy American goods and services. So whether the plant gives the $20 million directly to the workers, or gives it to someone else who wants to buy American goods and services, the result is the same: less stuff for consumers in the U.S.

"Not necessarily," you say. "Suppose the someone who traded pesos for dollars really didn't want to buy anything in America? Suppose instead that they used those dollars to buy things from some other foreign country, say oil from Saudi Arabia? After all, dollars are an international currency." While this still raises the question of what that person from Saudi Arabia is going to do with all those American dollars, we concede the point. Some of those dollars may not all come back to the American economy.

Let's take the worse case scenario. Suppose none of those dollars come back to the U.S. economy. Then what? Then we just made the following trade: In exchange for the goods and services produced for American consumers by hardworking Mexican laborers, we gave up...$20 million of green pieces of paper.

Doesn't that make us poorer? DANGER...DANGER...DANGER...ECONOMIC FALLACY IN THE MAKING! Once again, the fallacy comes from taking our eyes off the ball. The U.S. economy may have fewer dollar bills circulating around it, but there are now more goods for consumers to enjoy. Do you see why? Recall that our working assumption is that the $20 million plant in Juarez will produce the same quantity and quality of goods as the $32 million plant in Detroit. This means when the plant closed down in Detroit and opened up in Juarez, the firms' output of goods and services remained the same. However, when the resources released by the Detroit plant were reemployed by other firms, we gained extra goods and services that we didn't have before. And what did we have to give up in order to get these extra goods? Absolutely nothing! Just a bunch of green paper that didn't cost hardly anything to produce. The bottom line is that there are more goods and services for the same number of American consumers. That can only mean one thing: The happiness of (American) society has increased.

A second criticism that one hears frequently in discussions of international trade is the following. CRITICISM NUMBER TWO: "There's no way American workers getting paid $10 or $15 an hour can compete with cheap Mexican labor willing to work for $10 or $15 a DAY! In order to increase their profits, American firms will close down their U.S. plants and factories and move south of the border. As the quote at the beginning of this chapter says, 'That loud sucking noise you hear is the sound of American jobs going south to Mexico.'"

Stated like that, it sure does seem like cheap foreign labor poses a threat to the high standard



of living we enjoy in the U.S.1 But consider the following. If it's a bad deal for the U.S. economy when foreign workers are willing to do what American workers do for only $10 a day, then it must be an even worse deal when those foreign workers are willing to work for $5 a day. And if it's a really bad deal when foreign workers are willing to work for only $5 a day, then it must be a terrible deal for the U.S. economy when they're willing to work for $1 a day. And if it's a terrible deal when foreign workers are willing to work for only $1 a day, then that can only mean one thing. If foreign workers were willing to work for absolutely nothing--if they were willing to produce goods and services for American consumers asking nothing in return--that can only mean ECONOMIC DISASTER!

What's wrong with this argument? Suppose Mexican workers got together and took out a full page ad in the New York Times and said: "Hola, Gringos! We love you! We're willing to produce your cars, your stereos, your tv sets, anything you want, for free. Don't bother paying us. It's just our little way of saying thanks for being such a great neighbor. And hey...Have a nice day."

Economists have a word for this. They call it Christmas! When somebody gives you a gift for Christmas, what's your response? Do you whine and complain about how all these gifts are ruining your life? Or do you sit down and write a thank you note? When Mexican workers produce goods and services for American consumers for cheap, that's just like a gift to the American economy. The cheaper they work, the bigger the gift. It's just as if they wrapped up those cars, stereos, and tv sets, put them in pretty boxes with bright red bows, and wrote a note saying, "Feliz Navidad! Love, Juan (or Pedro, or Maria)." We don't know about you, but it seems to us that there's only one response when somebody is being this nice. Smile and say, "Muchas Gracias!"

Which brings us to CRITICISM NUMBER THREE: "Your whole theory depends on those American workers getting reemployed again. If they aren't reemployed, then there's no additional goods and services to produce happiness for American consumers. That loud sucking noise you hear is the sound of your theory going down the drain."

We may surprise you by saying this criticism is true. Our whole theory depends on displaced American workers finding employment. To illustrate, consider the effect on our nation's happiness if no workers were reemployed after the plant in Detroit closed down and moved to Juarez. We assumed that the factory in Mexico ships us the same quantity and quality of goods, so American consumers lose nothing in that transaction. But then we have to ship Mexican consumers $20 million worth of goods and services as payment. So now we are down $20 million in happiness. If the laid off Detroit workers don't produce anything (i.e. remain unemployed), then we have no gain in happiness. Society's revenues from this transaction are 0, while its costs are $20 million. In order for us to say free trade is a good thing, we must be confident that workers will be reemployed. That just happens to be the subject of our very next chapter.





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1 However, there must be some reason why wages in the two countries are different in the first place. The average American worker can simply produce more than the average Mexican worker because, in part, American workers are more skilled. (In economic terms, American workers are more productive than Mexican workers.) So it may be worth it to firms to stay in America and pay higher wages. Surely with completely free trade some firms, after considering the relative skills of American and Mexican workers, will take advantage of lower wages and move some jobs and factories to Mexico. It is unclear how many will do so, but this unimportant to our analysis. We can consider the extreme case and assume that Mexican workers can produce just as much as their American counterparts while receiving much lower wages.



CHAPTER 32 But Where Will the Jobs Come From?

A plant closes down in Detroit. Thousands of jobs are lost. Suddenly, workers who thought they had secure futures find themselves facing an uncertain job market and wondering how they'll be able to pay their bills and keep their families fed. And what do we have to say about all this? We say labor is a resource like any other, and when a plant closes RESOURCES ARE RELEASED TO PRODUCE HAPPINESS FOR CONSUMERS ELSEWHERE IN THE ECONOMY! Preposterous! How can we be so sure that these workers will get reemployed? We base our confidence on three reasons.

OUR FIRST REASON FOR BELIEVING THAT UNEMPLOYED WORKERS WILL BE REEMPLOYED IS THAT THE HISTORICAL RECORD SAYS THEY WILL. One of the great disservices of modern textbook presentations of the economy is that they present a picture of an economy at "equilibrium." Just the very sound of that word brings to mind comforting images of workers secure in their jobs, of firms happily producing the same goods year in and year out, of a world in which everything proceeds pretty much the same as it did yesterday, yestermonth, and yesteryear. O contraire!

This has never been the experience of the real economy. The real economy is characterized by tremendous turbulence. In 1800, approximately 80 percent of the population was involved in the production of agricultural products. In 1900, the number was close to 40 percent. In 1993, it was a little less than 3 percent. This incredible transformation of the U.S. economy over long stretches of time merely reflects the underlying turbulence that characterizes the economy--and labor markets--all the time. The table below shows the rate of job losses in the labor market from 1970 to 1993.

"JOB LOSSES EVERYWHERE, BUT SO ARE JOBS. NEW YORK (AP)--Layoffs. Layoffs. Layoffs....Just last week, Woolworth said it would slash 13,000 jobs. Two weeks before, in a single day, four companies--Martin Marietta, USAir, DuPont and Chemical Waste Management-- announced job reductions totaling 16,000. Nonetheless, beneath the appearances of a pink slip blizzard, something surprising is happening: job growth."



The occurrence of job losses isn't a recent phenomenon. It's something that happens all the time. And not just during the bad times. Even during times of overall growth for the U.S. economy, there is significant job churning; large numbers of workers are laid off and reemployed or voluntarily leaving jobs for better opportunities elsewhere. Furthermore, the process of job creation and job destruction is by no means a nice, even one. The pictograph below shows how net job creation was distributed across the United States during one particular year.



While jobs in California, Michigan, and New Jersey were declining in number, a substantial increase in new jobs was taking place in Idaho, Utah, and Texas.

But how can we know whether the process ends up creating more jobs than it destroys? Here's a simple test. Watch the candidates during the next presidential election. When the incumbent President stumps on the campaign trail to offer reasons for why the American people should vote for him or her, see if he doesn't say something like the following: "My fellow Americans, only I can offer you the hand of experience as we steer the ship of state through uncharted waters. Under my wise leadership, the U.S. economy created millions of new jobs. (INTERRUPTION AS SUPPORTERS ENTHUSIASTICALLY CHEER.) Under my careful guidance, there are now more jobs in the American economy than at any point in this great country's history. (INTERRUPTIONS AS SUPPORTERS CHEER EVEN MORE ENTHUSIASTICALLY.) And if you vote for me this coming November, I promise you that I will continue my tireless efforts to create even more jobs so that together, we can build a better, brighter future. Good night. And God bless America. (PANDEMONIUM ERUPTS AS SUPPORTERS YELL "FOUR MORE YEARS...FOUR MORE YEARS...")"

What is responsible for the creation of all these jobs year after year? The "wise leadership" and "careful guidance" of our politicians have relatively little to do with it. Historically, job creation in the U.S. economy has been practically a sure thing. If just about every President can brag at the end of his four years that there were more jobs than when he took office, then who happens to occupy the White House has relatively little to do with job creation. Instead, it has a lot to do with the dynamics of the economy itself. Why are we confident that laid off workers will get reemployed? Because historically they always have. Maybe not every worker, maybe not immediately. But it is indisputable that the U.S. economy has continued to create millions of new jobs--year in, year out--for decade after decade. The promise that the economy will continue to create new jobs in the future is a far more reliable promise than most of the promises you'll hear made on the campaign trail.

This brings us to our SECOND REASON for why we are confident that unemployed workers will be reemployed. It is no mere accident that the U.S. economy is able to continually find new ways to put to work the millions of workers who lose their jobs each year. There is a powerful dynamic--a magnet if you will--that serves to unite unemployed workers with the consumption desires of the members of society. To illustrate how this works, we're going to reveal some personal things about one of the authors of this book. (Don't worry--it's not going to be that personal.)

A little over ten years ago, one of the authors of this book (let's call him "Bob") took his first job teaching economics at a large, public university. Bob's first teaching position paid him $27,500 a year, an average wage for someone just leaving graduate school at that time. This was the first real job Bob had ever had. Now don't get the wrong impression. He had previously worked at a number of different jobs while going to school. He delivered newspapers, worked the graveyard shift at an all-night gas station, operated the night desk at an executive hotel, ran his own painting crew during summer vacations, etc. The guy wasn't lazy. But none of these jobs paid any real money. For Bob, $27,500 seemed like an



impossibly large sum. Bob just couldn't imagine how in the world he was going to spend all of that money. (Just so you don't stay in suspense, you'll be relieved to know that he did eventually get it figured out. All the money got spent just fine, thank you.)

Now let's fast-forward through Bob's life, ten years later. He makes a lot more money now. But here is the amazing thing. You would think that with all the extra money Bob is making, his desire for additional goods and services would have slacked off a little bit. Not at all. If anything, his desire for goods and services has increased--not decreased. When Bob was a single guy coming out of graduate school, he rented a little apartment. He didn't have much furniture, and his wants were pretty simple. Just give him some good economics books, leave him alone, and he was happy. Now Bob owns a home. And now that he has a home, Bob needs furniture inside the house so it doesn't look so empty. When he lived in his little apartment, his living room furniture consisted of a couple of bean bags. Now that he has a respectable home, bean bags won't do. Owning a home has created a desire for furniture that Bob never had when he rented a simple apartment.

Bob also has a lawn around his home. When Bob was living in an apartment building, he never bothered with how the outside of his place looked. But now he is concerned with keeping up with the Jones' (actually, the next door neighbor he has to keep up with are the Browns). Their lawn looks really nice. And so Bob feels pressure to make his lawn look nice. He buys trees and shrubs to keep it nicely landscaped. He hires a lawn service to keep it fertilized and growing, and he spends lots of money keeping it watered during the hot summer months. This is the same Bob who didn't care a whit about how the outside of his old rental place looked. Having a nice home in a nice neighborhood has created a desire for a nice lawn. A desire that Bob never had when he rented a simple apartment.

And it goes on and on. Bob is now married with four kids. He worries about having enough money to pay doctors' bills, glasses and braces for the kids, about having enough money so that his kids can go to college. He works hard to make sure that there's money in the bank--or at least sufficiently small balances on his credit cards--so that he can replace the refrigerator, or the cars, or the roof. And we're still not done. Because Bob also has a lot of things that he would love to do, but can't afford right now. In ten years of marriage, Bob and his family have never taken a real vacation. He'd love to go to Disneyland, he'd love to have a fancy computer system to play games on and hook up to the Internet. And he'd love to not have to work so hard so he could have more time to spend with his wife and kids.

Well, that is Bob's story. Admittedly, it is not a very exciting one. Then again, Bob is not a very exciting guy. But that's the point. His story is typical. When he was starting out in his first job, Bob couldn't figure out how he'd ever spend all the money he was making. Now he can't ever imagine making so much money that he'd run out of things to spend it on. The more he makes, the more new desires he discovers for additional goods and services. At least in this respect, Bob is not unusual. It's just human nature.

Ask yourself: Do you know anybody who complains about having too much money? Despite the fact that Americans enjoy the highest standard of living ever known in the



history of the world, there is absolutely no evidence to suggest that they have had enough. They want better computers, safer cars, improved health care, more vacation time, and the list goes on. And so we are led to this fundamental fact about consumers: CONSUMERS HAVE INFINITE DESIRES FOR ADDITIONAL GOODS AND SERVICES. They are a bottomless consumption pit. No matter how many goods and services the economy manages to dish up, consumers will always want more.

Now we come to the powerful principle which explains why we have confidence that workers will get reemployed when they lose their jobs. On the one hand, we have unemployed workers who want to work. On the other hand, we have consumers with infinite desires for additional goods and services. And in the middle are entrepreneurs who stand to gain substantial profits by bringing these two sides together. This is the ultimate explanation for why the economy creates more jobs each year. Why shouldn't we have every expectation that entrepreneurs will continue to match workers with consumers? What will keep entrepreneurs from performing this role? You tell us.

Now don't get us wrong. We do not subscribe to a fairy tale world in which all workers become instantly reemployed once they are laid off. It takes time for entrepreneurs to figure out how they can use these workers. There may be periods when the unemployment rate rises because it is not immediately clear to entrepreneurs how best to employ these idle workers. But entrepreneurs will figure it out. As long as government hasn't created barriers that make it difficult for firms to reap the rewards of matching workers to consumers--barriers like minimum wages, mandated benefits for all employees, and burdensome regulations on small businesses--entrepreneurs will continue to employ workers to satisfy consumers' demands. That is the powerful dynamic that serves as a giant magnet to bring together willing workers and hungry consumers. Thus, OUR SECOND REASON FOR BELIEVING THAT UNEMPLOYED WORKERS WILL GET REEMPLOYED IS THAT THE INFINITE DESIRES OF CONSUMERS PROVIDE AN INCENTIVE FOR ENTREPRENEURS TO HIRE UNEMPLOYED WORKERS IN ORDER TO PRODUCE ADDITIONAL GOODS AND SERVICES.

Still unconvinced? Perhaps you're thinking that all this is fine and good, but it assumes that workers can produce additional goods and service. Maybe they can't. Maybe they don't have any skills that would allow them to produce things that consumers want. As a result, no firm wants to hire them after they're laid off. Isn't that possible? Theoretically, yes. But then we have to ask ourselves another question. Why was the workers' former employer willing to pay them so much money if they didn't have any other employment opportunities?

Let's see if we have this straight. The Federal Mogul Company--a firm interested solely in increasing its own profits--was paying $32 million to workers who had no other employment opportunities? What's wrong with this picture? Why did the firm feel compelled to offer so much money to these workers to begin with? If there really were no other jobs for these workers, they would gladly have been willing to work for less. And the firm could have hired its workforce for only $30 million, or $20 million, or less. So why was it paying $32 million, and not less?



The reason is simple. The firm paid its workers $32 million because it was forced to. Anything less, and the workers would have refused to work for the Federal Mogul Co. and would have taken jobs elsewhere. To argue that these workers have no alternative employment doesn't make any sense given the large sum of money Federal Mogul Co. was paying them. Such an argument implies that Federal Mogul Co.--and other firms like it--are really bleeding heart philanthropists who pay wages far in excess of what they have to. We have heard a lot of charges made against the labor practices of corporations, but excessive generosity isn't one of them!

Okay. Let's consider one more possibility. Maybe the firm paid the lowest wages it could when it hired its workers, but that was many years ago. Now these workers are older. Not only that, but the labor market has deteriorated where the firm was located. When it laid its workers off, those workers found it a lot more difficult to find jobs than when they first went to work for the firm, many years ago. Isn't this possible?

The first thing to note is that this argument still assumes that the $32 million in labor costs is far in excess of the amount required to keep those workers from taking jobs elsewhere. But we're willing to concede that maybe this happens sometimes in the real world. After all, we're reasonable people. Maybe in the real world it does happen that workers are laid off and the only jobs that they can find are jobs that pay less than what the workers made before. Does that destroy our argument? Consider once again the Profit Table for a firm that closes down in Detroit and opens up in Juarez.

From the perspective of society's happiness, the costs represent $20 million in goods and services that will be withdrawn from the U.S. economy. The revenues represent the $32 million of happiness from the additional goods and services that get produced when these workers get reemployed. Suppose the former employees of the Federal Mogul Co. are unable to find jobs that pay the same wages they had before. Instead, suppose these workers all end up making only two-thirds of what they made at their old jobs. That means they find jobs that pay them $24 million in wages instead of $32 million. Then instead of society receiving $32 million of happiness from additional goods and services, it only gets $24 million of happiness. SOCIETY IS STILL BETTER OFF.

In return for gaining additional goods and services that produce $24 million of happiness, we have to send $20 million of goods and services south of the border. We're still ahead in the happiness department by $4 million.1 In fact, as long as these workers end up with new jobs that pay more money than what the firm is paying its Mexican workforce (more than $20 million), society as a whole ends up being better off. We can be confident that this will

REVENUES:

COSTS:

PROFITS:

$32 M

$20 M

+$12 M



happen. After all, if the next best employment opportunities of these laid off workers paid less than $20 million, they probably would have negotiated with the company for a wage which would keep the plant from shutting down.

In conclusion, OUR THIRD REASON FOR HAVING CONFIDENCE THAT THESE WORKERS WILL BE REEMPLOYED IS THE FACT THAT THEIR WAGES WERE SO HIGH TO BEGIN WITH. We emphasize that this conclusion does not require workers to get reemployed at new jobs paying wages equal to their old jobs. In order for plant relocations to increase society's happiness, American workers need only get reemployed at wages that are higher than that received by the foreign workers who replaced them. The lower the wages of their foreign substitutes, the more likely that will happen. And that loud sucking noise you hear is the sound of American households feverishly consuming the additional goods and services that foreign plant relocations make possible.



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Notes

1 If it bothers you that this increase in society's happiness was bought at the expense of these workers' personal fortunes, we have a solution. Give 'em money.



CHAPTER 33 Who Gains From Trade?

Suppose that last night, while you were sleeping, government agents came during the dark of night to blockade your house. In the morning, when you went to take out the garbage, you were greeted by the following sight: barbed wire sealed off all points of exit from your property, tanks poked their turrets from between tree limbs, Army sharpshooters patrolled the perimeter to make sure that nobody attempted to escape. What would your reaction be? ("Hey, honey, there's a lot of people outside our house. Did you forget to pay the phone bill this month?") Suppose you found out that the reason for all this activity is that the government was simply enforcing a new law: "Henceforth, each household is forbidden to engage in trade with any other household." Power and telephone lines were cut. Water lines into the home were blocked. Effective immediately, each family was responsible for providing all its own food, clothing, entertainment, and other needs. Take some time to answer the following question: What would be the effect of this new law on society's happiness?

Seems like a no brainer, right? Suppose instead, government passed a new law which mandated the following: "Henceforth, each town is forbidden to engage in trade with any other town." Now the barbed wire, tanks, and Army sharpshooters are pulled back to the city limits. This law isn't quite as severe as the previous law, because there are at least some opportunities for trade within the town. But it's still pretty bad. The good news is the local paper gets delivered to your home, since the newspaper company is located in town. The bad news is that the paper is done in crayon, because the company that produces the ink is located in a different city. The good news is that you're able to watch programming from the local cable TV company. The bad news is that instead of watching Baywatch, the only station in town is showing repeats of the production of "Goldilochs and the Three Bears" by Mrs. Smith's 5th grade class. You get the idea.

A law which discouraged trade outside a town's borders would surely lower society's happiness. Similarly, a law which discouraged trade outside a state's borders would also surely lower society's happiness. Does it not follow, then, that protectionist policies which discourage trade outside a country's borders can only have the same effect?

"It is the maxim of every prudent master of a family, never to attempt to make at home what it will cost him more to make than to buy. A taylor does not attempt to make his own shoes, but buys them of the shoemaker. The shoemaker does not attempt to make his own cloaths, but employs a taylor. The farmer attempts to make neither the one nor the other, but employs those different artificers....What is prudence in the conduct of every private family, can scarce be folly in that of a great kingdom."--Adam Smith, Wealth of Nations1



Or think of it this way. Suppose Adam and Johnny agree to a voluntary exchange of goods. Since the exchange is voluntary, Adam and Johnny must both believe that the trade has made them better off. The same thing holds true for trade between Annalisa and Josephine. And Andrew and Joanne. And Adonirah and Jack. Now let's join Adam, Annalisa, Andrew, and Adonirah together and call them a country, like "America." And let's join Johnny, Josephine, Joanne, and Jack together and call them a country, like "Japan." If these voluntary exchanges make each person better off individually, how can the same set of voluntary exchanges make the countries of "America" or "Japan" worse off? How can something be unquestionably good at the individual level, but bad when we sum up the exchanges?

International trade--that is, trade between countries--is remarkably simple to understand because, in principle, it is no different than trade within countries. That was the point that Adam Smith was making when he wrote the words that begin this chapter--over two hundred years ago. Not surprisingly then, the same, simple framework that we have used to analyze resource transfers within countries can also be applied to resource transfers between countries.

Suppose an American car dealership imports Honda Civics from Japan. The dealer pays $12,000 to Honda of Japan to import the car. It turns around and sells the Civic for $16,000. Ignoring the other costs of the dealer, we can represent this transaction in our beloved Profit Table as follows.

Profits from the Honda Civic Trade

Assuming the market price of Honda Civics is right around $16,000, the dealer's revenues represent a dollar measure of the happiness that some American consumer will receive because one more Civic was available. In exchange for this car, Americans have traded $12,000 of green pieces of paper. What will Honda of Japan do with this money? One possibility is that they will trade their dollars for yen at the foreign exchange desk at the Bank of Tokyo. But the Bank of Tokyo isn't all that interested in holding on to American dollars (the local McDonald's only takes yen), so it looks for someone who is willing to swap yen for dollars. Maybe a Japanese business office in Osaka is interested in buying American personal computers. It goes to the Bank of Tokyo and exchanges its yen for the $12,000. The business office can now buy 3 personal computers at $4,000 a piece. After a short trip abroad, those twelve thousand dollars return to the U.S. to pay for 3 personal computers that get shipped to Osaka.

REVENUES:

COSTS:

PROFITS:

$16,000

$12,000

+$4,000



From the perspective of the U.S. economy, here is the trade we just made with Japan. In exchange for one Honda Civic, American consumers gave up three personal computers. Was it a good deal? Sure. Since the personal computers were each priced at $4,000, losing three personal computers meant that American consumers missed out on $12,000 of happiness. That's a bummer. But in return they got a Honda Civic that produced $16,000 of happiness. The bottom line is that this trade has resulted in a net increase of $4,000 in (U.S.) society's happiness. (Lest we think we just pulled a fast one on the Japanese, we should remember that since the Japanese made this trade voluntarily, it must mean that they also were made better off).

Let's use this example to consider the much loathed and generally feared practice of foreign "dumping." Dumping is a practice whereby foreign countries sell their goods in American markets at prices lower than what they charge in their home markets. Why might a foreign country do this? There are a lot of reasons, but consider the one that seems to most offend Americans. Suppose the government of Japan subsidizes the export of Hondas. For every Civic that Honda ships to the U.S., the Japanese government gives Honda of Japan a large cash payment.

Now this seems really unfair. How in the world can American car manufacturers compete against the Honda Civic if the Japanese government subsidizes them? Good question. Though not necessarily the right question. We'd rather ask, how does the practice of foreign dumping affect the happiness of U.S. society? This depends on the amount of the foreign subsidy. If a small subsidy is a little offensive, then a large subsidy should be downright nauseating. So let's assume the absolutely worst case scenario. Let's assume that the Japanese government subsidizes the entire cost of the Civic. Rather than having to pay $12,000 for the Civic, the American car dealer picks up the entire car for nothing, thanks to the Japanese government. We're forced to agree, this is unfair competition at its most unfair. Let's see how this transaction gets reflected in the dealer's profit statement.

Nice looking profits! This car dealer certainly has no complaints about foreign dumping. But how has this transaction affected society's overall happiness? On the one hand American consumers get a spanking new Honda Civic. On the other hand, American consumers give up....what? What did American consumers have to give up in return for the Honda? The answer is, absolutely nothing (note that the dealer's costs are zero). Since the dealer didn't have to send $12,000 to Honda of Japan, Honda of Japan never had $12,000 to exchange with the Bank of Tokyo, which in turn didn't have $12,000 to trade with the business office in Osaka. As a result, the business office in Osaka never placed an order for three personal computers, which means that those three personal computers can now be enjoyed by

REVENUES:

COSTS:

PROFITS:

$16,000

-- 0 --

+$16,000



American consumers.

Here is the trick: the less dollars we have to send abroad to get the goods we want, the less dollars foreign countries have to make claims on our goods and services. And the less goods and services foreign countries take from us, the more we have for ourselves. Dumping? What's to complain about? Rather than taking foreign firms to court for violating anti-dumping laws, we should be doing something more productive, like writing thank you notes!

But...but...but...won't this hurt American car manufacturers? Indeed it will. If the Japanese really did ship us their cars for free, this would dramatically lower the price of cars in America. Of course, those lower prices are telling us something. With all these nice new Japanese cars over here, the extra happiness of an additional American car is pretty small. As a result, we'd like American car manufacturers to stop producing so many cars. Instead, we'd like them to devote their resources to producing other, more valuable things. And if they can't think of anything else to do with those resources, then they better release them to those who can.

How about the fairness argument? It surely isn't fair that American car manufacturers have to compete against foreign cars that are heavily subsidized by their governments. Indeed it isn't, and so we have to return to the purpose of the economy. Is the purpose of the economy to guarantee fairness to all producers? Or is it to maximize the happiness of consumers? Whose benefit are we running this economy for anyway? For Lee Iacocca's benefit? Or for you, a consumer?

From the perspective of the producer, it makes no difference if the price of cars is low because Japanese cars are subsidized by their government, or if car prices are low because Americans have a change of heart and all decide they'd rather take the bus. Wouldn't that be unfair too? ("How dare those consumers decide they don't like our cars anymore! You think they would at least have called and told us they were taking the bus before we shipped all these new cars to the showroom.") And speaking of fairness, was it fair to the horse and buggy industry when Henry Ford introduced his non-hay eating, non-manure producing form of transportation? Talk about unfair competition!

The answer to the question of what is fair is a tough one. We sure are glad we don't have to answer it. In contrast, the answer to the question, Who gains from trade? is an easy one. American consumers do. And as long as trade proceeds voluntarily, the greater the trade, the greater the increase in society's happiness. It's just that simple.



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Notes

1 Adam Smith, An Inquiry Into the Nature and Causes of the Wealth of Nations, Indianapolis: Liberty Classics, 1976, pages 456f.



CHAPTER 34 How To Spite Our Collective Face by Cutting Off Our Collective

Noses

How should we feel when our government representatives retaliate against European soybean subsidies (or South Korean shipbuilding subsidies, or Canadian wheat subsidies, etc.) by imposing punitive tariffs against the offending countries? Should we write our officials letters of support, thanking them for preventing unfair trade? Before you get out your stationary, let's do a simple analysis.

As has already been demonstrated in our analysis of dumping, when foreign countries subsidize their products, they make them cheaper for us to import. Translated, that means we don't have to give up as many of our goods and services in order to get what we want from our foreign trading partners. How could anybody argue that lower prices make consumers worse off? When you go car shopping and see a sticker price of $12,000, do you say to the salesman, "I'll give you $14,000 and not a penny less?"

But when our government tries to prevent foreign governments from subsidizing their exports, we are saying, in effect, "No Francois, you must charge us $5 for that bushel of soybeans, not $3. Oui, $5 and not a penny less!" When foreign governments subsidize their products, it is like a blue-light special at KMart. ("Attention, KMart shoppers, please direct your attention to Aisle 17 where you'll find some very special prices on European soybeans. For the next hour, you can buy two--yes, two--European soybeans for the price of one.")

It's bad enough that the American government doesn't extend an official letter of appreciation to the kindly French taxpayers when they subsidize their agricultural exports to us. (We were raised to write Thank You notes whenever someone sent us a gift.) As if rude manners weren't bad enough, our government adds injury to insult by using bad economics. Let's use our Profit Table to show the effect of a retaliatory tariff on the happiness of American consumers.

Suppose a PUNITIVE TARIFF was imposed on French white wines (which was exactly what happened in this particular case). Now consider an American importer of French wines. Prior to the tariff, this importer could buy a bottle of Chablis from a French wine

"FRENCH FARMERS PROTEST U.S. CALLS FOR SUPPORT CUTS. Paris (AP) French farmers burned an American flag and clashed with riot police in a rainstorm Wednesday near the U.S. Embassy in a protest against U.S. pressure to cut European crops subsidies. ....The...administration has threatened $300 million in punitive tariffs on European farm products unless the Europeans agree by Dec. 5 to cut subsidies to farmers for growing soybeans and other oilseeds."1



company for $18. In return, that importer could turn around and sell that wine for $25 in the U.S., generating a nifty $7 profit. Now the U.S. government slaps a $10-a-bottle tariff on all French white wines. The plan works brilliantly. Less Chablis gets shipped to the U.S. This is represented in our Profit Table by the fact that the importer can no longer make a profit on this transaction. Hence the trade does not take place.

What is the impact on America's consumers? Clearly, they have lost out on the happiness they would have received from the French wine. In this instance, that would be a loss of approximately $25 in happiness. There is, however, some corresponding gain. American consumers get to keep $18 of goods and services that would have ended up getting shipped to France. Alas, the gain does not compensate for the loss. By discouraging this trade, the punitive tariff has resulted in a $7 decrease in the happiness of American consumers.

What would happen if, instead, the $10 tariff were placed on the French firm shipping the wine, rather than the American importer? In that case the French would no longer be willing to sell their wine to us for $12. If they were forced to pay the $10 tariff, they would simply charge the American importer $10 more. This would increase the cost to the American importer from $12 to $22. Thus, the American importer would end up paying for the tariff anyway, only indirectly, by having to pay higher wine prices. And the Profit Table would end up being the same as when the American importer directly paid the tariff.2

Finally, note that we get the same result again if the government imposes an IMPORT QUOTA on French Chablis. Suppose the bottle of wine represented in the Profit Table is a bottle of wine that would have been beyond the allowable limit after the U.S. government imposed the quota. Suppose further that the penalty associated with violating the quota was $15. The result, not surprisingly, is the same.

So who exactly gets punished when punitive tariffs are imposed? It's true that the French get hurt. After all, they--like us--derive benefits from this trade. They valued the $20 in American goods and services more than the Chablis they were giving up in return. But clearly, American consumers are also punished. And it is by no means clear that the hurt suffered by Americans will be any less than that suffered by the French.

Picture the following scene. It's a beautiful Christmas morning. Outside, the freshly fallen snow glistens in the sun's early rays. Inside, the happy sounds of children playing with their new toys fills the house. A warm, crackling fire burns on the hearth. And from the living

Before Tariff After Tariff

REVENUES:

COSTS:

PROFITS:

$25

$18

+$7

$25

$18 + $10 = $28

-$3



room CD player, the Mormon Tabernacle Choir sings the holiday's favorite hymns. Suddenly, there is a knock at the door. A neighbor has arrived with another gift! The children all gather round in giddy curiosity to see what the special present is.

But before the gift can be opened, the man of the house, in a fit of furious rage, comes storming down the staircase and yells at the neighbor, "Get that gift out of my house!" The children are shocked. The neighbor says, "Merci, Monsieur! It eez a geeft! Weeth love, from me and my familee!" "You miserable bum, you no good son of a French milking maid, who said you could bring that present in this house? Get out. Get out before I throw you out." "But Daddy, Daddy," the children say, "the man was only trying to be nice."

"I'll show you nice," says the father. He reaches back and throws a walloping, roundhouse punch right to the neighbor's jaw. The neighbor reels backwards. And then the father does the craziest thing. He grabs a frying pan from the kitchen and hits himself over the head. Again, he punches the neighbor, grabs the frying pan, and hits himself over the head. Over and over this continues, until the neighbor stumbles out of the house, taking his package with him. Bruised and hurt, the father slumps to the floor. But before he slips into unconsciousness, he turns to his disbelieving children and triumphantly announces, "I guess I showed him."

An unbelievable story you say? Something that would never happen in any normal household you say? You're probably right. And yet this happens everyday in the world of international trade. It's bad enough that our government turns down gifts that could make Americans better off. But just in case one of those pesky foreign countries persists in trying to give us their goods for cheap, our government hits American consumers over the head with a figurative frying pan in its efforts to keep those gifts at bay. It's like cutting off one's nose to spite one's face!

OPTIONAL SECTION FOR ECONOMISTS: T h e f i g u r e b e l o w i d e n t i f i e s t h e w e l f a r e l o s s a s s o c i a t e d w i t h a t a r i f f o n i m p o r t s . T h e i m p o s i t i o n o f t h e t a r i f f c a u s e s t h e s u p p l y c u r v e t o s h i f t u p b y t h e a m o u n t o f t h e t a r i f f . T h i s r e d u c e s t h e q u a n t i t y o f i m p o r t s f r o m Q 0 t o Q 1. T h e s h a d e d a r e a i n d i c a t e s t h e " l o s t h a p p i n e s s , " o r w e l f a r e l o s s , c a u s e d b y t h e t a r i f f .



T h e a l e r t r e a d e r w i l l n o t e t h a t t h e a n a l y s i s a s s u m e s t h a t t h e s u p p l y c u r v e o f i m p o r t s i s p e r f e c t l y e l a s t i c . T h e g r a p h b e l o w s h o w s t h a t i f t h e s u p p l y c u r v e o f i m p o r t s i s u p w a r d s l o p i n g , t h e i m p o s i t i o n o f a t a r i f f h a s a m b i g u o u s w e l f a r e e f f e c t s . A r e a B i d e n t i f i e s t h e l o s t g a i n s f r o m t r a d e r e s u l t i n g f r o m t h e r e d u c t i o n i n i m p o r t s f r o m Q 0 t o Q 1. A r e a A r e p r e s e n t s t h e w e l f a r e g a i n r e s u l t i n g f r o m t h e f a c t t h a t A m e r i c a n c o n s u m e r s n o w p a y P 1-t a r i f f i n s t e a d o f P 0 f o r t h e q u a n t i t y Q 1. I f A r e a B i s l a r g e r t h a n A r e a A , t h e n t h e r e i s a n e t w e l f a r e l o s s a s s o c i a t e d w i t h t h e t a r i f f . I f A r e a B i s s m a l l e r t h a n A r e a A , t h e n t h e t a r i f f c a u s e s a n e t w e l f a r e g a i n .



N O T E : W h e n t h e s u p p l y c u r v e o f i m p o r t s i s u p w a r d s l o p i n g , t h e P r o f i t T a b l e i g n o r e s a s o u r c e o f w e l f a r e c h a n g e s . T h i s i s t h e f i r s t t i m e i n t h i s b o o k t h a t o u r P r o f i t T a b l e h a s n o t c a p t u r e d a n i m p o r t a n t w e l f a r e e f f e c t ! W h y d i d t h i s h a p p e n ? I n t h e p a s t , p r i c e c h a n g e s d i d n o t c o n t r i b u t e t o c h a n g e s i n s o c i a l w e l f a r e . T h e y s i m p l y m e a s u r e d w e a l t h t r a n s f e r s b e t w e e n " c o n s u m e r s " a n d " p r o d u c e r s " ( i .e ., c o n s u m e r s c u m o w n e r s o r s h a r e h o l d e r s ) . H o w e v e r , i n i n t e r n a t i o n a l t r a d e , p r o d u c e r ' s s u r p l u s r e p r e s e n t s t h e g a i n t o t h e f o r e i g n t r a d i n g p a r t n e r . T h u s , c h a n g e s i n p r o d u c e r ' s s u r p l u s c o n t r i b u t e t o A m e r i c a n s o c i a l w e l f a r e . A s a p r a c t i c a l m a t t e r , a l m o s t a l l e c o n o m i s t s a g r e e t h a t t h i s l a t t e r e f f e c t i s r e l a t i v e l y s m a l l , a n d t h a t t h e i m p o s i t i o n o f t a r i f f s c a u s e s a n e t l o s s f o r A m e r i c a n s o c i a l w e l f a r e .



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Notes

1 The Daily Oklahoman, November 19, 1992.



2 We note that this analysis does assume that the supply curve of imports is perfectly elastic. If the supply curve is upward sloping, there is a benefit to American society of imposing the tariff, that may or may not compensate for the lost gains from trade described in the Profit Table. This is described further in the "Optional Section for Economists" at the end of this chapter.



CHAPTER 35 Are Trade Deficits Bad?

Perhaps no other single topic in all of economics has been so widely misunderstood as the trade deficit. Strangely enough, the trade deficit is a remarkably simple subject. Suppose you and your neighbor Jim get to talking one Saturday morning, and the two of you decide that each has some things the other wants. So you decide to trade. Jim gives you his 15 horsepower, John Deere riding lawnmower that is still in mint condition. In exchange, you give him a rake. Jim agrees to grill steaks for your family every night for the next six months. You give him a bag of dogfood. Jim gives you his brand new Porsche. You give him a bottle cap opener. Using any reasonable accounting standard, you have just accumulated a tremendous "trade deficit:" the value of the items that you have received is greater than the value of the items you gave up. When a trade deficit occurs at the individual level, you thank your lucky stars that you were fortunate enough to live next door to a chump like Jim. ("It's just like the realtor said, honey, the three most important things in choosing a home are location, location, and location.") Why is it then, that when a trade deficit occurs at the national level, it is a source of great consternation and travail?

Let's consider trade between two countries, say America and Japan. Suppose Sony of Japan sells 10,000 camcorders to Sears, Roebuck and Company in the U.S. for $500 a piece. At this point in the transaction, this trade can be summarized as follows: The U.S. gets 10,000 camcorders, and Japan gets $5,000,000 (equals 10,000 times $500) in green pieces of paper. What can Japan do with its $5,000,000? There are THREE POSSIBILITIES.

First, JAPAN CAN SPEND ITS MONEY ON AMERICAN GOODS AND SERVICES. This was exactly the scenario described in Chapter 33 when we discussed "Who Gains From Trade?" Let's suppose the Japanese spend their money on American personal computers costing $2,000 a piece. Then America ends up trading 2,500 personal computers (2500 times $2,000 equals $5,000,000) in exchange for 10,000 Sony camcorders. If we follow the flow of goods and money in a diagram, it would like something like this.

"U.S. TRADE DEFICIT WORST IN 6-1/2 YEARS. Washington (AP) The U.S. trade deficit jumped to $9.17 billion in May as higher oil prices and a big drop in sales of commercial airliners contributed to the worst merchandise trade performance in 6-1/2 years."1



There are two things to observe in the diagram above. The first is that money and goods flow in opposite directions. If money is flowing out of the country, goods and services must be flowing into the country. Since it is goods and services that provide happiness, not money, we need to be careful and keep our eye on the ball when considering the impact of trade on America's happiness. The second thing to note is that there is no trade deficit in this case: $5,000,000 flows out of the country, and $5,000,000 flows back into the country. The monetary value of the goods we import is exactly equal to the monetary value of the goods we export.

Note that even though the monetary value of imports and exports is the same, Americans are still benefitted from this trade. Because Sears is motivated by profits, we know the reason it was willing to buy the camcorders in the first place was because it figured its customers would pay a higher price to Sears than what Sears paid to the Japanese. As a result, we know that Americans should receive more than $5,000,000 in happiness from these camcorders. Thus, this trade allows American consumers to give up personal computers that would have produced only $5,000,000 of happiness, in order to get camcorders that produce more than $5,000,000 of happiness. Even though there is no deficit or surplus, Americans are clearly made better off by this trade. So far, so good.

Now let's consider the second possibility: JAPAN CAN SPEND ITS MONEY ON GOODS AND SERVICES FROM OTHER COUNTRIES. It just so happens that American greenbacks are widely accepted as payment in international commercial transactions. So if Japan wants to buy, say, oil from Saudi Arabia, it could do that without having to first exchange its dollars for riyals (the currency of Saudi Arabia). Of course, that just pushes back the question of what happens to those $5,000,000. To keep this saga short, let's suppose that after the Saudi's sell their oil to Japan, they take the $5,000,000 they earned from that sale to buy personal computers from America. Now if we follow the flow of goods and services, it will look like this.



You would certainly think that--from the perspective of America's happiness--it shouldn't make a difference whether the Japanese spend their $5,000,000 in the U.S. directly, or buy oil from the Saudi's who in turn spend the money in the U.S. After all, the bottom line is that we are still getting camcorders in return for giving up $5,000,000 of personal computers. But look now at the respective trade balances between America and her two trading partners. Because the U.S. received camcorders from Japan and sent nothing back in exchange, we are recorded as having a $5,000,000 trade deficit with Japan. What significance should we attach to this trade deficit?

Do we even have to say it? This trade deficit with Japan is of absolutely no consequence for the happiness of U.S. consumers. For at the same time that we are running a trade deficitwith Japan, we are running a trade surplus with Saudi Arabia of exactly the same amount. This should make clear that looking at bilateral trade balances can be very misleading. Again, why should we care whether Japan uses its dollars to buy from us or to buy from other countries, who in turn will buy from us? So even though we are now running a trade deficit with Japan, the outcome of this case is precisely the same as in the previous case: the happiness of America's consumers is still increased by the trade.

Let's now look at the third possibility. JAPAN EITHER HOLDS THE MONEY IT EARNS IN TRADE WITH THE U.S. OR BUYS GOODS FROM OTHER COUNTRIES, WHO IN TURN HOLD THE MONEY. This is the last remaining possibility. To see the impact on the happiness of America's consumers, let's keep careful track of the flow of goods and dollars. The diagram represents the case where Japan decides to keep the $5,000,000 it earns from selling camcorders in the U.S.



Just like in the previous case, America is running a trade deficit with Japan. Only this time, the dollars don't come back. There are no trade surpluses from other trade partners to balance this trade deficit. And this fact changes everything from the perspective of (American) society's happiness. Because now in return for getting camcorders, the U.S. gives up....you guessed it--absolutely nothing (or just about absolutely nothing). We have traded $5,000,000 of green pieces of paper in return for 10,000 shiny new camcorders. This is a great trade! As long as we remember that we don't get any happiness from dollars, but from the goods and services that dollars can buy, we see that the U.S. has gotten something of great value (camcorders) by giving up something of very little value (little green pieces of paper). It kind of makes us wonder...has our friend Jim moved to Tokyo?

In summary, when Japan (or any country) sells goods to the U.S., there are three--and only three--things it can do with the dollars it earns. If it comes right back and buys American goods and services, then Americans have to give something up for its imports, but it's still a good trade. If Japan buys goods from other countries, and those countries buy American goods and services, then it's exactly the same as the first case. And if it holds onto the dollars it earns, or buys from other countries and they hold on to the dollars, it's nothing less than a generous gift from one of our trading partners. It's Christmas all over again! Only this time Santa Claus speaks Japanese. That's it. Three possibilities, no more. The first two are good for the happiness of U.S. consumers. The third is even better. So why all this hair-pulling and chest-thumping over the trade deficit?



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Notes

1 The Daily Oklahoman, July 20, 1994.



CHAPTER 36 Trade Wins, and Losses

It seems that most people who are concerned about the trade deficit are bothered by the fact that the U.S. imports more than it exports. But they forget (or perhaps never knew): An increase in imports causes an increase in the happiness of U.S. consumers. In contrast, AN INCREASE IN EXPORTS REPRESENTS A DECREASE IN THE HAPPINESS OF U.S. CONSUMERS BECAUSE IT MEANS THERE ARE LESS GOODS AND SERVICES FOR AMERICANS TO CONSUME. Exports are simply the price we pay to enjoy imports. Once that is understood, a lot of trade policies that pass for wisdom are exposed as plain old foolishness.

For example, why would the U.S. government ever want to put pressure on its trading partners to buy more American goods? It should be doing the opposite. If the elected representatives of the United States really wanted to help ordinary Americans, they should pressure other countries to subsidize their exports to the U.S.

Or how about this one? The U.S. Treasury Department and Federal Reserve often conspire with the central banks of other countries to prop up their currencies against the dollar. For example, the official policy of the U.S. in 1994 was to keep the Mexican peso from declining in value against the dollar. When the Mexican peso is strong, it makes Mexican goods more expensive for Americans to import. Similarly, a strong Mexican peso makes American goods cheaper for Mexicans, and encourages the flight of U.S. goods and services south of the border and out of the hands of American consumers. So why would the U.S. government work hard to make sure its citizens get less foreign goods to consume, but have to give up more of their own goods and services in exchange? Who are these guys working for, anyway?1

So why do so many people get confused on trade issues? That's a hard question to answer. However, it's our experience that most people get confused because they tend to think of a country as a firm. That is, when a firm takes in less money than it spends, it earns losses. So when a country takes in less money than it spends, it seems only natural to think that the country is in trouble. The difference is that a country is not a firm. The goal of a firm is to maximize profits. The goal of a country is to maximize the happiness it gets from consumption.

When more money consistently enters a firm than leaves that firm, its shareholders are enriched. In contrast, when more money consistently enters a country than leaves that country, its citizens are impoverished. Because that means that lots of goods and services are leaving the country, while only a few goods and services are coming back in. As always, the trick is to keep one's eyes on the ball: Happiness doesn't come from little green pieces of paper, it comes from the consumption that those little green pieces of paper will buy. Can it really be this simple you say? The short answer to this question is "yes." But we confess, there is a little more to this story.



The main reason the dollar value of American imports is larger than the dollar value of American exports is not because foreign nations aren't spending their American dollars.2Rather, they're spending their dollars investing in our country, instead of buying our goods and services.3 For example, suppose the Japanese sells us camcorders. But rather than use their dollars to buy American computers, they use their dollars to buy the firms that produce those personal computers. Hah! Now that changes everything! Right? Not exactly.

Let's think of why the Japanese would want to own American firms. Presumably, Japanese investors have the same motivation for owning American firms as American investors do. They want to make money. But what will they do with that extra money? Perhaps they'll buy some more firms. Then they'll be able to make even more money. At some point, however, we have to come to grips with the ultimate reason for why Japanese investors want to make all this money. It's the same reason why American investors want to make more money. The reason they want to make those extra dollars is so they can buy more (American) goods and services.

Yup, we're back where we started from: For the most part, Americans pay for imports by giving up goods and services in return. When a Japanese investor chooses to buy an American firm instead of American goods, he's really saying that--rather than having some American goods right now--he'd rather have even more American goods later. Buying a company, or commercial property, or Treasury Bills, is like buying a stream of future American goods and services. In fact, once this is understood, the overall trade deficit can be understood as a loan by foreigners to Americans. They agree to give Americans goods and services now. In return, Americans agree to send goods and services back to the foreigners, later.

Well, isn't that bad for Americans? There are a lot of ways we can answer this. How about this one: Do YOU have any loans? Do you think that loans have made YOUR life worse off? Suppose we outlawed all loans. Would you be made better or worse off? Most people would agree that the ability to borrow money has improved their quality of life. If someone felt that borrowing money would make them worse off, they could always choose not to borrow. If the ability to borrow money is good for any one individual, how can it be bad when we put a bunch of individuals all in one country and call them Americans?

Does this mean that the standard of living of Americans is going to fall in the future when it comes time to pay off all those loans? That depends. Again, think of yourself. Is your standard of living going to be lower because you borrow money? The answer depends on what you choose to spend the money on.

Suppose you zip out your Visa card and decide to have the vacation of a lifetime. You jet to Acapulco. You spend a glorious month in the sun, drinking Margaritas and writing postcards to all your friends back at home (just to make them jealous). You stay in the Penthouse suite. You order all your meals through room service. The hotel masseuse comes to your room to give you a stress-relieving, mind-numbing, absolutely delicious massage in the comfort of your own room...three times a day. It's quite a vacation all right. Yessiree. You go back



home and everything is just wonderful until one day you get your Visa bill in the mail. And you spend the rest of your life working three jobs to pay it off! In this case, consuming a lot of extra goods now means that you will have to sacrifice future happiness as you pay off those loans in the future.

But not all loans make one poorer in the future. For example, most students borrow money to help pay for their college education. Sure, they'll have to use some of their future income to pay back those loans. But they're banking that the education they receive will make them richer in the future. So much richer, in fact, that even after they subtract their loan payments, their take home pay will be higher as a result of their educational investments.

So what is America doing with all those loans it is receiving from foreigners? Is it enjoying a huge consumption binge? Or is all this borrowing allowing it to invest in its future production capacity? The fact is, nobody knows. And, ultimately, it really doesn't make a difference. Because the most important thing to keep in mind about the trade deficit is...the U.S. is getting a bunch of great stuff.4 Whatever the reason, we're made better off. Maybe it's because foreigners are trading their merchandise for our goods. Maybe it's because foreigners are trading their merchandise for our services. Or maybe it's because foreigners are willing to make loans to us at rates lower than what we're willing to lend to ourselves. This is essentially what happens whenever foreigners pay more for American firms, commercial properties, and government securities than Americans are willing to pay. A full understanding of how this makes Americans better off must wait until we have a chance to talk about financial markets, and interest rates. It just so happens that this is the subject of our very next chapter.



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Notes

1 Interventions in international currency markets such as this are often described as "leaning against the wind." A more apt characterization would be "spitting against the wind." When central banks attempt to resist market forces pushing down the value of a particular currency, they only delay the eventual outcome. Disastrous consequences often follow, as the pent-up forces causing the depreciation eventually prevail, resulting in economic havoc. Such was the case in December 1994 when the Mexican and American authorities stopped trying to artificially prop up the value of the peso. The result



was a tumultuous decline in the value of the peso that shook international financial markets and destabilized the Mexican government. If price controls are a bad idea in domestic markets, why would one think they were a good idea in international markets? Like spitting in the wind, such policies are ultimately helpless in fighting market-driven "headwinds."

2 To be sure, some of the trade deficit, a small portion, is due to this. Because American dollars are useful in international commerce, many nations hold cash balances of dollars to facilitate their trade with other countries. When this happens, it is Christmas, plain and simple: the U.S. gets valuable goods and services in return for little green pieces of paper.

3 It should be noted that, sometimes, what gets reported as the "trade deficit" is actually the "merchandise trade deficit." For example, suppose that instead of buying personal computers with the money they earn for selling camcorders to America, the Japanese purchase other, non-"merchandise" things. Like what? A significant portion of the trade deficit, but not the majority, is accounted for by "services." For example, when Japanese tourists fly American airlines and stay at U.S. hotels, that gets figured into services. Well, you ask, why should it make a difference whether those camcorders get paid for with American personal computers, or romantic nights for Mr. and Mrs. Hayashi at an American Hilton? Exactly.

4 Many economists point out that much of the borrowing represented by the trade deficit during the 1980s was the result of government deficit spending. If the trade deficit is a result of government spending and the government spends the money unwisely, then the trade deficit very well could make us worse off. Of course, the problem here is not the trade deficit, but the government spending which is driving it.



CHAPTER 37 The Information Contained in Interest Rates

So far, most of the resource transfers we have discussed are assumed to take place, if not instantaneously, at least in a very short amount of time. But what about the transferring resources across time? How should society decide whether to consume one ton of coal today, or save that coal for next year? Should we adopt the advice of the Vice President of the United States, who advocates the abolition of the interest rate system for making decisions about resource allocations over time? Even if we took his advice about "quantifying the effects of our decision on the future generations," how would we implement it practically? How should we trade off the well-being of our generation with the well-being of the "seventh generation into the future?" After all, resources saved for future generations represent lost happiness for consumers today. Should the impact of a decision felt 150 years from now be given the same weight as an impact felt 1 year from now? Furthermore, who would be empowered to make these decisions ("Welcome back, Economic Dictator!")? These are tough questions. And yet, they must be addressed. Implicitly or explicitly, a society makes countlessly many decisions every day which profoundly impact both the current and future happiness of its consumers. Before we consider how an economy should allocate resources across generations, let's first examine how individuals allocate resources across time in a free-market economy.

ONE WAY WHICH INDIVIDUALS CAN ALLOCATE CURRENT RESOURCES FOR FUTURE CONSUMPTION IS THROUGH SAVING. Saving represents giving up consumption now in order to gain consumption in the future. When you take home your paycheck and stuff a certain percentage of it in a savings account or a Certificate of Deposit, you are saying--in effect--that you do not want to consume now, but would rather save your consumption for sometime in the future. You are storing happiness. You may be saving for retirement, for a new computer system, or for a child's education. But you are certainly saving for the sake of future consumption. Only a miser stores money for the sake of money. Everyone else saves money so that they can enjoy consumption later on (or so that their loved ones can enjoy consumption later on). So from now on, think of saving as storing happiness.

"We must also change our current use of [interest] rates, the device by which we systematically undervalue the future consequences of our decisions....To accomplish the transition to a new economics of sustainability, we must begin to quantify the effects of our decisions on the future generations who will live with them. In this, we have much to learn from the Iroquois nation, which requires its tribal councils to formally consider the impact of their decisions on the seventh generation into the future, approximately 150 years later."-Al Gore, U.S. Vice President.1



Now that we have an idea of what saving represents, let's turn to its counterpart, borrowing. BORROWING IS A WAY BY WHICH INDIVIDUALS CAN TRANSFER FUTURE CONSUMPTION TO THE PRESENT. Few families can afford to buy a home or a new car and pay for it all at once. Instead, they borrow the money from a lender. However, in order to induce a lender to give up his money, the borrower must promise to pay back an amount whose sum total is greater than the original amount of the loan. Why would borrowers ever agree to pay back more money than they borrowed? The answer lies in human nature.

Most people prefer enjoyment now over enjoyment later. Indeed, it's something for which they're willing to pay a premium. Instead of waiting three more paychecks to buy a big screen television set, a football fan might want it right now, in time for the Super Bowl. If the big screen television costs $1,000 to buy right now, but a total of $1,100 if bought on lay-away, the extra $100 can be thought of as the price the football fan paid for the immediate enjoyment of the television set.

By now, you're probably dying to know if there is some easy way to relate borrowing and saving, present consumption and future consumption. Of course, it's the interest rate. We know we promised to cut through the boring terms like "interest rate," but bear with us a moment, because interest rates may be more interesting than you think. Perhaps the best way to explain how interest rates serve to allocate resources over time is to consider each person's "own" interest rate, something we'll call their "personal interest rate."

To illustrate this, let's consider the situation of one of the authors of this book (let's call him "Max"). Max is a student paying for graduate school with only meager assistance from his parents and the federal guaranteed student loan program. Like most students, Max's life is a constant financial struggle. There never seems to be enough money for even the most basic necessities of life. Max rides a bicycle to school to save transportation costs. He washes his paper dishes to keep his household expenses down. He rarely goes out, even when the most desirable women on campus beg him for a date. ("Sorry, baby, I'd love to, but I'm a little short this month..No, I mean a little short on cash.") And a fancy dinner at home consists of a meal of beaner wieners (RECIPE: one (1) hot dog, carefully sliced, and slowly added to one (1) can of baked beans, gently brought to a boil over an open flame. For a special treat, try pouring the can into a sauce pan.)

As would surprise few, Max has a very high personal interest rate. Max is living off of very little money as it is, and he is already borrowing to help finance his education. Therefore, he values present consumption quite a lot. If pressed, Max would say his "personal interest rate" is currently around 20 percent. This means that Max would be indifferent between having $1200 dollars a year from now, or having a $1000 today. We can think of this in two ways. In order to get Max to save a $1000 today, we would have to guarantee that he receive something more than $1200 a year from now. Alternatively, Max would be willing to borrow $1000 today, as long as he could pay back less than $1200 next year.

Now let's consider the other author of this book ("Bob"). Bob is a family man with a wife, three children, and two dogs to support. As we discussed earlier, Bob is concerned about



having enough money in the future to pay for his children's college educations, future dental bills, and the possibility of having to put in an expensive, French drain system around his house. With all this future consumption in mind, Bob values present consumption relatively little and wants to save his money. If pressed, Bob would admit to having a personal interest rate of around 5 percent. In other words, Bob would be willing to give up $1000 today as long as he received anything more than $1050 a year from now.

Now it seems that Max and Bob have an incentive to trade. Max would be willing to borrow $1000 as long as he could pay back less than $1200 next year. Bob is willing to lend $1000 as long as he can get more than $1050 a year from now. After a (perhaps lengthy) period of bargaining, we would expect that the interest rate established between the two will be somewhere between 5 and 20 percent. (BOB: "Hey, Max, I'm willing to lend you $1000 at 191/2 percent interest." MAX: "191/2 percent! That's outrageous! I thought you said your personal interest rate was only 5 percent?" BOB: "It is." MAX: "Forget it. Some friend you are." BOB: "Have it your way. Hope you enjoy those beaner wieners tonight!" MAX: "Where do I sign?")

Now imagine a million Max's, and a million Bob's (talk about a scary thought!). Each has his own personal interest rate, each wanting to either lend money, borrow money, or consume just equal to their current incomes. After the interaction of all these players, a market interest rate will be determined. What is the information contained in this market rate of interest?

We can think of each individual's personal interest rate just like a personal "willingness to pay" value. For example, a person with a personal interest rate of 10 percent is willing to pay approximately $1100 next year in order to have an extra $1000 right now. Since the market rate of interest is a price like any other price, we can use exactly the same logic that we used in Part I to determine the information contained in this price. In particular, THE MARKET RATE OF INTEREST TELLS US HOW MUCH HAPPINESS SOCIETY WOULD HAVE TO RECEIVE NEXT YEAR--MEASURED IN DOLLARS--TO COMPENSATE IT FOR GIVING UP A DOLLAR'S WORTH OF HAPPINESS TODAY. Alternatively, IT TELLS US HOW MUCH HAPPINESS SOCIETY IS WILLING TO GIVE UP NEXT YEAR--MEASURED IN DOLLARS--IN ORDER TO GAIN AN ADDITIONAL DOLLAR'S WORTH OF HAPPINESS TODAY.

If the market rate of interest is 10 percent, that means that the happiness of society would be increased as long it could get more than $1.10 worth of goods and services next year, in return for giving up $1.00 worth of goods and services today. If giving up $1.00 worth of consumption today results in an increase of less than $1.10 worth of consumption next year, society's happiness is lowered.

Now that we know the information that is contained in interest rates, we can see how free-market economies allocate resources over time. When a firm invests--say by building a new plant, researching a new line of products, or expanding capacity--it takes away resources that could have been used for current consumption, and directs those resources towards



producing greater consumption in the future. THE MARKET RATE OF INTEREST GOVERNS HOW MUCH FIRMS WILL INVEST FOR THE FUTURE, AND HOW MUCH SOCIETY GETS TO CONSUME IN THE PRESENT. When a firm is deciding whether to invest in a project, the owner or manager will compare the projected rate of return from the investment against the cost of borrowing that money. If the firm expects to see a 15 percent return on its investment over the next year, and the market rate of interest is only 10 percent, the profit-seeking firm's choice is clear: it will choose to borrow the needed funds and proceed with its investment plans. However, if the firm decides that it will likely make only a 5 percent return on its investment, the firm will choose to scuttle the proposed project. It cannot make a profit if it borrows the money at a 10 percent interest rate. On the other hand, if the firm already has the money for the project, it could make a greater profit by lending it at the market rate of 10 percent.

The 10 percent market rate of interest is society's way of telling firms, "Hey, guys, listen up! If you want to produce more consumption goods for us next year, that's great. But you better be pretty sure you can produce at least 10 percent more goods with those resources you're taking away from us." If a firm believes it can generate a 15 percent return on its investment, then society's happiness will be increased. Oh sure, the investment will mean taking resources away from the production of current goods and services. But the extra goods and services that consumers will gain next year will more than compensate them for their current losses.

Alternatively, if a firm decides that its investment project will only generate a 5 percent rate of return, then proceeding with the project would serve to decrease society's happiness. In effect, society says to the firm--via the market rate of interest--, "Hey thanks for thinking of us. But we don't want you taking our resources away. We'd rather have the happiness that those resources could produce for us right now, rather than the happiness you'd be able to generate for us next year."

Thus, in a free-market, capitalistic economy, firms allocate resources over time exactly how society wants them to. When interest rates are high, society says it has a strong preference for current consumption as opposed to future consumption. Accordingly, firms invest less. When interest rates are low, society says it wouldn't mind giving up some current consumption right now, as long as there is a modest increase in goods and services next year. Accordingly, firms invest more. Once again, the "invisible hand" guides our firms to allocate resources so as to maximize society's happiness. All of this is great for explaining for resources are allocated within a given generation. But how about across generations?



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Notes

1 Al Gore, Earth in the Balance, Boston: Houghton Mifflin Company, 1992, page 339.



CHAPTER 38 Who Watches Out for Our Children's Children?

The interaction between firms, consumers, and the interest rate goes far in explaining how individuals allocate consumption over their lifetimes. It wouldn't make any sense for individuals to use up all of their resources when they were young and then have nothing left for old age.1 In general, people will save for themselves on their own. They will plan for their futures. But don't the members of society have a built-in incentive to use up all of society's resources during their own lifetimes? After all, what's keeping them from engaging in a happy orgy of consumption now and forgetting the welfare of future generations? An easy answer would be that people often save for their children. But that still leaves the question of future generations unresolved. How can we be sure that we are not consuming too many resources right now, and that not enough will be left for future generations to enjoy?

We will start by assuming that the human race has about the same concern for its future generations as hamsters have for theirs (recall that hamsters are famous for eating their young). That is, let's assume that if people had the chance, they would throw themselves into greed, debauchery, and binge consumption on a scale that would make Nero blush. They would live solely for themselves, with nary a thought for the well-being of future generations.

Let's try to imagine how this hypothetical world--peopled with greedy, thoughtless consumers--would work. Suppose one day, these consumers got together and decided to consume all the natural gas they could. "To heck with the kids," they say, "let's eat, drink, and consume some non-renewable resources, for tomorrow we may die!" (Note how utterly despicable it is for these consumers to deplete non-renewable resources, since these are physically finite and cannot be replenished.) Accordingly, in dead of winter, these consumers leave their doors wide open, take out their energy-conserving windows, remove insulation, and crank up the thermostat to about 105 degrees. They convert their homes into luxury saunas. In short, they commit themselves to using up as much natural gas as possible.

What would happen in a world like this? Would the children of these consumers be left with a planet having little or no natural gas? At first glance, the answer would appear to be yes. After all, if the current generation wants to consume all of the world's natural gas supply, who's going to stop them? Before you conclude that all is hopeless and the fate of the world's grandchildren rests on the dubious goodness of the current generation, think a moment about our old hero--the firm.

Any rapid increase in consumption would certainly cause an increase in the price of natural gas. As prices rose, deposits which previously were too costly to exploit (perhaps too deep in the ground or under arctic ice) would suddenly become profitable. As a result, firms would take resources away from other activities and commit them to natural gas production. The supply of natural gas would increase. And these new reserves would serve to



accommodate the current generation's lust for natural gas, leaving adequate supplies for the future. Thus, we see that profit-maximizing firms will serve as a buffer to protect future consumers from the rapaciousness of current consumers.

"Okay," you say, "but what if there were absolutely no extra deposits of natural gas? What if firms couldn't expand the supply of natural gas?" In that case, the prices of other, substitute energy sources could be expected to rise dramatically. Consequently, the supply of conventional energy sources--like oil, coal, and nuclear energy--would increase. Unconventional energy sources--like wind power, solar power, and geothermal energy--would also become more profitable, and their supply would likewise increase. There would be a great scramble among firms as each struggled to supply alternative energy in order to profit by the depletion of natural gas. As they served their own interests, these energy firms would also be serving future generations of consumers by insuring that energy was as plentiful as possible.

There is yet another reason to be sure that firms will protect the wellbeing of future generations. As the current generation binges on natural gas consumption, driving up its price, firms will have a strong incentive to preserve current supplies of natural gas so that they can sell them at even higher prices in the future. To see why, imagine that you are convinced that--at present rates of consumption--the world will run out of natural gas in ten years. If you really believed this, then you'd want to purchase as much gas as possible now so that you could store it and sell in the future. Imagine what a price natural gas will fetch ten years from now when almost none is left! You could make a fortune!

You don't think firms can figure this out? Rather than passively accommodating consumer's rabid appetites for natural gas, firms would withhold some supplies from today's consumers. They would voluntarily save some of their supplies so that they will have them to sell in the future, when the coming scarcity of natural gas will guarantee a corresponding high price. And so it is. Entrepreneurs and firms will act to counter consumers' rabid consumption of non-renewable resources today, motivated by their desire to make even more money tomorrow.2

Usually, when some shortage causes fears of a resource crisis, policy makers are quick to appeal for conservation on the part of consumers and firms. You will notice that up to this point, we've said relatively little about conservation. Of course, many consumers and firms will voluntarily choose to refrain from consuming a good whose price has risen, and this is certainly desirable.

Nevertheless, it is important to remember (recall our discussion of recycling in Chapter 17) that it takes resources to save resources. Consumers have to buy insulation to save on the consumption of natural gas for home heating. Firms have to employ new machines that can run off of alternative sources of energy. But insulation and machines have alternative uses. These alternative uses may be even more important than preserving natural gas. Without the guidance of prices (including the interest rate) it is impossible to know where these resources have their highest valued use. The beauty of unregulated markets is that firms



have all the right incentives to employ resources to conserve natural gas whenever conservation is the highest valued use of those resources. Nobody has to tell consumers or firms to conserve, or make impassioned appeals to their patriotism. When conservation is the right way to increase society's happiness, consumers and firms will choose this way voluntarily.

In conclusion, we can rest assured that firms will be on the lookout for any future decrease in the supply of a resource. While we sit at home enjoying yet another exciting episode of Baywatch, commodities brokers in Chicago, Tokyo, and London are researching available stocks of energy, predicting future prices and future resource availability. While we snuggle comfortably in our warm beds at night, firms are tirelessly searching for new ways to preserve and expand resources for future generations. The beauty of free-market capitalism is that even in a cold, cruel world, we can sleep soundly. The wellbeing of our children's children is being watched over by those profit-seeking, money-grubbing firms. Our view of the world may sound a bit rosy, and it is. Admittedly, we are incurable optimists. And if history is any guide, we are right.



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Notes

1 Unless they could band together, form a powerful voting block, and then pressure the government to coerce the young to make them transfer payments. NOTE: Any resemblance between this theoretical possibility, Social Security and the American Association of Retired Persons (AARP), is purely unintentional.

2 Perhaps you've heard of commodities and futures markets? In these markets, firms sell contracts in which they promise to make delivery of goods and commodities at specific dates in the future. That is, markets explicitly exist which allow firms to cash in today by agreeing to reserve goods and services for the future. This isn't some nice theoretical possibility, but the real business world as it currently operates!



CHAPTER 39 The Great Timber Famine

We are now ready to play "Guess That Time Period," the exciting game where eager contestants read a series of newspaper excerpts and attempt to guess the year those articles were originally published. The following are excerpts from three newspaper articles. Read them carefully. Try to figure out what year these articles first appeared in the paper. Good luck!

Yes, there once was a time when this nation quaked in fear at the prospect of an imminent timber famine. It was bad. How bad, you ask? Bad enough that pastors asked their congregations to avoid the use of evergreen trees to celebrate the Christmas holidays.1 Yes, it was very bad. Gloom and doom filled the newspapers. America was using up its precious natural resources. The country was running out of trees and "commercial disaster was inevitable." The most reputable experts of the time agreed. The leading political leaders of the time agreed. Something had to be done. And indeed, something was done. Quick now--were you able to figure out what year these articles were published? Here's a hint. It was

"THE END OF THE LUMBER SUPPLY.--There is a growing conviction among the statisticians of the lumber industry that a timber famine is imminent in the near future, and that under the most favorable conditions of systematic forestry it will be impossible to grow wood fast enough to permit the maintenance of the current rate of consumption."

"URGES LAWS TO SAVE TREES. If the present destruction of trees in the United States continues for ten years more there will not be a forest tree left standing in the country, and the commerce, agriculture, and health of the country will be seriously impaired. This was the statement of James S. Whipple, State Forest, Fish and Game Commissioner...he advised a movement to have the Legislature pass stringent laws at once to protect the forests."

"TIMBER FAMINE NEAR SAYS [PRESIDENT]. That this country is in peril of a timber famine...was asserted by President this afternoon in an address before the American Forest Congress. In the course of his remarks the President said: 'If the present rate of forest destruction is allowed the continue, a timber famine is obviously inevitable. Fire, wasteful and destructive forms of lumbering, and legitimate use are together destroying our forest resources far more rapidly than they are being replaced....Unless the forests can be made ready to meet the vast demands which...growth will inevitably bring, commercial disaster is inevitable.'"



because of this great outcry for action that the federal government created the National Forestry Service.

You see, the prevailing wisdom of the time was that lumber firms were good at things like cutting down existing stocks of trees. But they couldn't be counted on for doing things like growing new trees. And that was a problem. Because as the newspaper excerpts make clear, at the rate trees were being cut down, there would soon be few left. And so, with great dispatch, the United States created the National Forestry Service to place vast tracts of land under the control of the federal government. The idea was that under the federal government's careful stewardship, this land could be guarded against wanton lumbering. And in this fashion, the country would be assured that there would be sufficient lumber for their children's children.

Have you figured it out yet? All the excerpts are taken from articles that appeared in the prestigious New York Times.2 The President was Theodore Roosevelt. And the years were 1900 to 1908. "What's that?" you say. You don't remember reading in your history books about any great timber famine in the early twentieth century? Funny thing was, after all the hype and hysteria about a coming timber famine, no great timber famine ever occurred. The story about the great timber famine that never was is a fascinating story of how profit-driven firms responded to rising lumber prices by both increasing the production of lumber and its substitutes, and adopting new technologies to conserve on the amount of lumber.3

This would be just an amusing little footnote in American history except for one fact. Driven by fears of a great timber famine, the federal government began an aggressive program of removing land from the private sector--an effort that continues to the present day. For the idea that the government needs to "protect" resources so they will be available to future generations is an idea that is very much alive and well. As of 1990, local, state, and federal governments owned approximately 40 percent of the American land mass. A little over a third of the entire country is directly owned by the federal government. And while some of this land has been procured for military purposes, the great majority is set aside in order to protect resources of one kind or another from being depleted by the private sector.

Perhaps you still find yourself unconvinced that the private sector can be counted on to serve as stewards of precious natural resources. After all, maybe the reason we have plenty of lumber available today is precisely because the federal government so wisely saved precious timberlands from commercial lumbering many decades ago. This is an interesting hypothesis. And one that is easily tested. What do you think is the correct answer to the following question is:

Ten percent? Twenty-five percent? Fifty percent? (Remember, 40 percent of the entire country is owned by the public sector.) In 1995, the actual figure was approximately 80

QUESTION: What percent of current U.S. lumber needs are provided by trees grown on private forests?



percent.4 Despite the fact that trees must grow ten or more years before they can be harvested for profit--and that the land on which the trees grow can be used for little else--over 80 percent of domestic lumber consumption is satisfied by trees grown on private forests. Companies like Weyerhauser and Georgia-Pacific patiently grow trees for profit on millions of privately-owned acres, providing a powerful refutation to fears that "the investment is too large and the returns too slow to make it attractive as a business proposition."5

In the remainder of this chapter, we want to address two final questions. How does all this tie into our Profit Tables? And what does all this have to say about how societies shouldallocate resources across generations? To answer the first question, let's first consider how a lumber company would approach the decision to grow trees for profit. As has already been pointed out, the problem with growing trees is that the firm incurs costs right now, as it buys land and plants seedlings. However, the benefits from planting trees is received by the firm only after many years later. To see how we can represent this problem in our Profit Table, we have to introduce the notion of PRESENT VALUE.

Suppose the market rate of interest is 10 percent. Then if a firm put $1000 in the bank, it would receive $1100 back ($1000 times 1.10), one year later. Thus, the PRESENT VALUE of $1100 a year from now is $1000. That is, it would take $1000 in the bank today to yield $1100 in principal plus interest next year. Suppose a Georgia pecan farmer determined that he could sell one-year old pecan trees to nurseries for $5 a tree, and that he could grow 220 pecan trees on an acre of land. Suppose further that the costs of renting the land, planting the seedlings, etc., was $800. So an initial outlay of $800 resulted in a return of $1100 (220 times $5) a year from now. In terms of our Profit Table, this transaction would be represented by the following.

Note that we do not enter the $1100 the farmer would earn next year on the Revenues line of the Profit Table. Instead, we enter the corresponding present value amount of $1000. In effect, the pecan farmer says, "Hey, I would have to put $1000 in the bank today to produce $1100 in revenues next year. But I can get the same return next year by putting only $800 into pecan trees. No way am I going to pass up a profitable opportunity like that. What do you think I am...nuts?"

Of course, the farmer would have come to precisely the same conclusion if he had compared the rate of return on his pecan tree investment with the market rate of interest. Earning $1100 next year on an $800 investment today is a 371/2 percent rate of return, which sure

REVENUES:

COSTS:

PROFITS:

$1000

$800

+$200



beats the 10 percent market rate of interest. This demonstrates that our Profit Table is easily generalized to include cases in which the firm's revenues and costs occur over time. Present values are based on interest rates, and interest rates are used to identify where resources will have their highest valued use over time. Since firms employ present value considerations to make decisions, we can be sure that letting profit-maximizing firms allocate resources across time maximizes the happiness of all generations of society, and not just the current generation.

We are now ready to address the questions raised at the beginning of chapter 37, "How should society trade off the well-being of the current generation with the well-being of the 'seventh generation into the future?' Our answer to this question is that WE SHOULD TREAT OTHER GENERATIONS NO BETTER OR WORSE THAN WE TREAT OURSELVES.

If we follow this approach, then the impact of a decision 150 years from now should not be given the same weight as an impact felt 1 year from now. The reason is simple: we ourselves weight the present more than the future when it comes to maximizing our personal welfares. Since society is nothing more than the collection of its individual members, why should "society" have a different rule for allocating resources than the rule its individual members use in their own lives? In other words, this approach says that we should treat the members of the seventh generation just how we would treat ourselves if we were to live that long. No better or no worse. Once this is seen, it follows that our current use of interest rates does not "systematically undervalue the future consequences of our decisions." In contrast, it provides precisely the right value in weighing out the consequences of our actions on future generations.

While we don't claim any higher authority for this social rule of resource allocation, it does come remarkably close to religion's golden rule of "loving your neighbor as yourself"--even when one's neighbor is seven generations removed. And isn't that remarkable? The free-market, capitalistic approach to allocating resources across generations essentially implements the golden rule of moral behavior as advocated by the world's great religions. That's definitely food for thought.



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Notes

1 You think we're making this stuff up as we go along? Read for yourself. The following is also a newspaper excerpt from this same time period: "BANISHES CHRISTMAS TREES.--The Rev. Dr. Robert S. MacArthur of the Calvary Baptist Church advised his Current Events class yesterday morning to...use as few evergreen trees as possible in order that each one might do his share to prevent the deforestation that is believed to threaten the [country]...'How came we to adopt this custom, which is one of the many taken from the heathen? We are deforesting many portions of our State and country. We ought to save the trees to prevent floods and give the proper amount of shade. To do my share in the work I have forbidden the purchase of evergreen trees by this church for the coming holidays."

2 The date of the respective articles are: "THE END OF THE LUMBER SUPPLY"-December 31, 1900; "URGES LAWS TO SAVE TREES"-December 16, 1908; "TIMBER FAMINE NEAR"-January 6, 1905; and "BANISHES CHRISTMAS TREES"-December 7, 1908. This chapter borrows heavily from the chapter "The Timber Crisis," in Charles Maurice and Charles Smithson, The Doomsday Myth, Stanford, CA: Hoover Institution Press, 1984.

3 An excellent account of these events can be found in Sherry Olson, The Depletion Myth, Cambridge, MA: Harvard University Press, 1971.

4 This number was reported to one of the authors in a telephone conversation with a spokesman from the U.S. Forestry Service, Department of Agriculture. It is consistent with the statement "that private forestlands have accounted for about 85 percent of the total tree planting and seeding in the United States" (Ronald Bailey, The True State of the Planet, New York: The Free Press, 1995, page 203).

5 This statement was made by the chief geographer of the U.S. Geological Survey, in the article "THE END OF THE LUMBER SUPPLY," cited above.



CHAPTER 40 A Little Bit of Heaven on Earth

While we believe that economics is good at explaining an awful lot of things, even we have to admit that there are some topics outside its purview. For example, we don't intend to address the issue of issue of whether "Christ preached socialist values." That's best left to theologians (and former heads of state). Instead, in this and the next chapter, we want to ask the following question: Which system do you think would do a better job of promoting peace and goodwill on earth among men? Socialism or capitalism?

In discussing socialism, we agree with former Soviet President Gorbachev that it is best to focus on "true socialism." "True" socialism is to be distinguished from "observed" socialism, which is the only form of socialism that has actually been implemented in human experience. "Observed" socialism is the form of economic organization that has been practiced in the former Soviet Union, China, the former East Germany, Cambodia, Uganda, Cuba, Iraq, and many other countries with equally distinguished economic records.

Observed socialism is usually associated with tyrannical dictatorship centered around one absolute ruler. Observed socialism is now widely recognized for being primarily responsible for the economic impoverishment of much of the world's population. And under observed socialism, literally hundreds of millions of people have been killed in the twentieth century by their own governments in places like the former Soviet Union under Stalin, China under Mao Tse Tung, Cambodia under Pol Pot, etc. Indeed, as proponents of socialism are quick to point out, true socialism should never be confused with observed socialism. So what would "true socialism" be like?

Since it's never been tried in real life, this is a difficult question to answer. But let's suppose we attempted to organize a society around the idea "from each according to his ability, to each according to his need." To begin with, let's suppose that our society is composed entirely of saints. Big-hearted people. People who are motivated solely by the desire to help others. In other words, let's suppose we have an entire society composed of Mother Theresa's and her ilk.

In this kind of world, how would the well-intentioned Mother Theresa's know what to do? How would they know whether their fellow citizens needed more carrots, or more green beans? Whether they wanted bigger homes located outside the cities, or smaller apartments

"GORBACHEV CLAIMS CHRIST PREACHED SOCIALIST VALUES. Milan, Italy (AP)--Former Soviet President Mikhail Gorbachev says true socialism promotes the values preached by Christ. In a newspaper interview published here he said true socialism works for social justice, freedom, equality and human values. 'In short,' he added, 'we promote the cause of Christ.'"1



located within the cities? How would they know whether they should produce more cars, or more roads; or maybe both, but fewer schools? In other words, how would the do-gooders know what good to do?

Consider the following problem. Suppose two Mother Theresa's went to Proletariat-Mart, the state-owned version of Wal-Mart. They both had poor neighbors who needed extra blankets to keep them warm at night. But there wasn't enough blankets at the store for both neighbors. What should Mother Theresa Number One do? Which is the nicer thing to do? Let Mother Theresa Number Two have the blankets for her neighbor, or try to get them for her own neighbor? You see, even in a world where people are very nice and are trying to help their fellow man, the problem of allocating goods to their highest valued use doesn't go away.

Even in an imaginary world populated by tender-hearted do-gooders, it's not at all clear that a socialistic society would be a place you'd want to live. Oh the people would be very nice. But it would be a very confusing and chaotic world. In fact, we imagine that a socialistic society full of Mother Theresa-like beings would be a little bit like two very nice people trying to enter a building.

FIRST PERSON: "Please, you go first."

SECOND PERSON: "Thank you, that's very nice of you, but, please, you go first."

FIRST PERSON: "No, I insist, you go first."

SECOND PERSON: "No, I just couldn't, you go first."

FIRST PERSON: "No, no, no, your time is much more valuable than mine. Please, you go ahead."

SECOND PERSON: "No, really, I wasn't in any hurry at all. I just couldn't bear the thought of cutting in front of you."

POLICE OFFICER: "If you ladies don't get moving, I'm afraid I'll have to arrest the two of you for loitering."

BOTH PERSONS: "Oh please officer, it wasn't her fault, arrest me."

Now consider the following scene in a free-market/capitalistic economy: A man walks into a department store. He examines the winter coats on the rack. He decides not to purchase one. He walks out. To the untrained eye, this might seem like a fairly unremarkable event. Not the kind of thing which would cause one to call the city newspaper and tell them to stop the presses. But consider what has just happened. A consumer went into a store interested in buying a winter coat for himself. After examining a particular coat, he decided that the price was too high. While he wanted a new winter coat, it wasn't worth it to him to pay that much money. In other words, he decided to leave the coat for somebody else who wanted the coat



more than he did.

It is exactly the same as if the man had said to himself: "You know, I like this coat. I would get some pleasure from having this coat. But there is a brother of mine--somewhere out there in the economy--who wants this coat more than I do. I don't know who he is or where he lives. I don't know if his old coat is wearing thin, or if he's shivering in the cold even now. But I do know this. If I take this coat, it won't be available for him. So I choose to leave this coat so that it will be here for him when he comes into this store. I hope it brings him much happiness." And as he leaves the store without the coat, he quietly sings, "He Ain't Heavy, He's My Brother."

Of course the reality is that this consumer probably didn't spend a moment thinking about the other consumers in the economy. And that's too bad. Indeed, the world would be a nicer place if people spent more time thinking of others. We heartily agree that a first-best world would be a place where people really cared about other people.

But free-market economies do an amazing thing. They take people, imperfect as they are, and get them to behave AS IF they really cared about other people. This is a truly amazing achievement. For surely the next best thing to having a world full of caring people is having a world full of people behaving as if they cared. FREE-MARKET ECONOMIES TAKE GREEDY, SELFISH, SELF-INTERESTED PEOPLE AND GET THEM TO BEHAVE AS IF THEY WERE RAVING ALTRUISTS.



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1 The Daily Oklahoman, September 12, 1992.



CHAPTER 41 All for One and One for All?

"Rallies, concerts, vigils, and news conferences." "Tens of thousands of people." Oh my goodness! And why? Because of competing demands for scarce resources. On the one hand, there are the environmentalists who want to preserve the old-growth forest home of the northern spotted owl. On the other hand, there are the men and families who earn their livelihoods from cutting the timber and operating the mills that feed America's lumber industry. And in the middle is the federal government, owning the land in behalf of "all of us"...and stymied in trying to find a palatable solution for the parties.

For you see, when we say that the government owns society's resources, what we really mean is that nobody owns the resources. But each person thinks he does. And so the system of allocation becomes an intensely political one. Each side musters its supporters. Each side flexes its political muscles. They converge in rallies and demonstrations. They hold news conferences. Since the decision will partly be decided in the court of public opinion, each side attacks the motives of the others. Timber firms are called "greedy corporations wantonly exploiting the environment." Environmentalists are called "tree huggers who would rather save an owl than feed a family." And as the government attempts to make political compromises, each side feels angry and ripped off.

It is often said that there are no laboratories in economics. And yet, every day across the country, we get a nation-wide experiment in what an economy would look like in which private property doesn't exist, and everything belongs to everybody. These experiments are held Monday through Friday, every week of the year right in your home town. You can find them taking place at your local day care center.

At the local day care center, there is no private property and none of the children are allowed to rent toys for their private use. Put a bunch of three-year olds in a room full of toys and what happens? Anybody who has kids knows only too well. SALLY: "Give me that." MARY: "I was playing with it first." SALLY: "You got to play with it yesterday." MARY: "No I didn't!" SALLY: "If you don't give it to me, I'm going to tell the teacher." MARY: "If you tell the teacher, I'm going to bite you." SALLY (grabbing toy): "Lemme have it!" MARY (holding on to toy): "No, it's mine!" (Both kids yank and jerk on toy. Toy breaks.)

"PRESIDENT URGES TRUCE FOR TIMBER. Portland, Ore. (Reuter) President Clinton called Friday for a truce between environmentalists and loggers to find a solution to the bitter battle over saving timber jobs and protecting a threatened owl and its ancient forest home....Tens of thousands of people descended on Portland to press their case. On the fringes of the conference, in a convention center, there were rallies, concerts, vigils, and news conferences."



SALLY and MARY (together): "Waaaaah!"

Of course, as consumers get older, they learn to behave in somewhat more sophisticated ways. Rather than kicking and screaming and biting each other, the consumers hold rallies, concerts, vigils, and news conferences. They generally act in a more restrained manner. Yet the dynamics are the same. Each side believes that the resources belong to them. Each side believes that the other side is illegitimately taking their resources away. And the government has to play the role of day care provider in deciding who gets what.

Contrast this system of resource allocation with how things work in the private sector. Every day, millions of resources are allocated with hardly a notice. When the steel companies decide for whom to produce their steel, there aren't demonstrations and news conferences. The Teamsters don't send bus loads of workers to Bethlehem, Pennsylvania to argue that the steel needs to be used for Mack Trucks so that there will be jobs for their members. Consumer rights advocates don't hold news conferences to alert the public that if the trucking industry gets the steel, there will be fewer automobiles available for working class families. Doctors don't demonstrate outside the steel plants on behalf of their patients who need the steel so that there will be more iron lung machines.

Why not? Because the system of private property rights that underlies free-market/capitalistic economies says that resources go to those who pay for them. Nobody has to give something up unless the person who wants to take it from them makes sufficient compensation. In the process, both buyer and seller are pleased by the working of the market. Each side feels as if they are made better off by the trade. And in the end, society is a more decent, civilized place.

It is our impression that most people seem to think that free-market economies--since they are allegedly based on greed--are morally inferior to socialistic economies. While they admit that free-market economies make their societies wealthier, they also consider the wealth that is produced to be a "dirty" kind of wealth. Socialism is thought to represent the higher road. We beg to differ.

It is very important in this respect to see the distinction between the nature of consumers--be they greedy, tender-hearted or whatever--and the nature of the economic system they are placed in. The free-market doesn't require individuals to be greedy. Even in a world full of Mother Theresa's, we would need to have prices to direct the Mothers so that they would know where resources have their highest valued use. On the other hand, the free-market also doesn't require individuals to be saints. It takes people as they are. Saints or sinners, the beauty of the free-market system is that it provides the information they need to make the right choices.

However, free-market capitalism also has two incredibly beneficial attributes that are often overlooked. First, the free-market is able to get people to act AS IF they cared about others even when they don't. And second, it minimizes the social conflicts that invariably arise when scarce resources need to be allocated among competing wants. In a twentieth-century



world that has seen great turmoil and strife, the social benefits of free-market economies represent remarkable achievements indeed.



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CHAPTER 42 What's the Catch?

This chapter closes our discussion of the simple framework and how prices direct resources to their highest valued use. No doubt at some point, probably at many points, you've asked, "Can it really be this simple?" After all, if it really were like we said it was, why do economists disagree on so many issues? Surely, there must be a catch somewhere. And there is. But before we get to it, let's review the assumptions we've made so far in our analysis.

First, we've assumed that there are a large number of consumers in the market for any particular good. And second, we've assumed that the prices that buyers and sellers transact at are "market prices." By this we mean that sellers are free to increase or decrease their prices in accordance with supply and demand; and that there are plenty of goods and services available to buyers at the prices sellers set. We haven't required that consumers have perfect information. We haven't required that there be an infinite number of sellers in the market. We haven't required that all firms sell identical (homogeneous) products. In short, we haven't required a lot of things that economics textbooks associate with "perfect competition," that ethereal world that exists in the minds of economists but nowhere else. As generations of economics students have no doubt wondered, if the advantages of a free-market/capitalistic economy require the conditions of perfect competition, and if perfect competition doesn't exist, then what's so great about free-market/capitalism?

Now comes the catch. The last assumption we need for our conclusions to hold is that there are no "market imperfections" (usually called "market failures"). What's a "market imperfection?" The cute answer is that it is anything that invalidates our previous analysis. Economists usually attempt to define market imperfections by example. In particular, there are three types of market imperfections which have dominated the debate about the proper role of government. These three are (i) monopoly, (ii) externalities, and (iii) public goods.

When one finds two economists who disagree about a particular public policy, the great majority of the time their disagreement can be traced to how significant each one thinks these market imperfections are. If one believes that neither monopoly, externalities, or public goods are significantly present in a particular instance, then one is led to the conclusions of our previous analysis. Namely, government interventions will distort the allocation of resources and lower society's happiness. On the other hand, if one believes that one or more of these imperfections exists in a significant way, and if one believes that government intervention is likely to successfully address the market imperfection, then government intervention can serve to increase society's happiness.

As we discussed above, most government interventions can be grouped into one of five categories: (i) price controls, (ii) subsidies, (iii) taxes, (iv) quotas, and (v) mandates. The art of government intervention consists of applying the right "dose" of the right intervention. Just because government intervention can improve society's happiness, doesn't mean that it will. Indeed, as we shall show, public sector allocation decisions are also plagued by "imperfections." So there is no guarantee that a particular intervention will ever improve the



imperfect allocation of resources made by the private sector. Government intervention always carries with it the risk of making things worse. Once we leave the world of no market imperfections, we return to the world of the economic planner--a world of darkness and uncertainty--where we are never quite sure of what we can do to improve society's happiness. These are the issues of our next, and final, section.

OPTIONAL SECTION FOR ECONOMISTS: What we call "market imperfections" is synonymous with the term "market failures" that is commonly used in economics tex tb ooks. We eschew the term "market failure" b ecause we b eliev e it conv eys a mislead ing impression ab out priv ate sector allocations. When economists say that the market "fails, " what they are saying is that the market has not achiev ed the perfect allocation of resources. T hat strikes us as b eing a little harsh. When a stud ent scores less than a perfect g rad e on an ex am, nob od y claims that the stud ent "failed . " L ikewise, when economists say that the market "fails, " they d o not mean to imply that the market has performed d ismally b ad . R ather, they are saying that the market has not achiev ed an A + performance. P erhaps the market d eserv es an A - g rad e, or a B + , or a C -. T hat is, perhaps the market is d oing a g ood , b ut not perfect, j ob in allocating resources to their hig hest v alued use. L ikewise, we shall see that the pub lic sector also suffers from prob lems that cause it to miss the perfect allocation of resources. A t the risk of confusing read ers with an unfamiliar v ocab ulary, we prefer the use of "imperfections" ov er "failures" so that we can emphasiz e that the choice facing citiz ens is one of two, imperfect--thoug h potentially b eneficial--allocation systems, as opposed to two "failed " systems.



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CHAPTER 43 Market Imperfections I: Monopolies

The most complicated--and misunderstood--of market imperfections is monopoly. For our purposes, we will state that a "monopoly problem" exists whenever a firm can significantly increase the price it can charge by restricting the quantity of goods it sells. Economists call this ability MARKET POWER. To illustrate the monopoly problem, we are going to analyze one of the most egregious and ubiquitous examples of monopoly to be found anywhere in the economy: the neighborhood lemonade stand.

In particular, we will consider the case of one John D. Rockefeller, Jr., "J.D." as he is known to his friends. From 7:30 a.m. to 3:00 p.m. on Mondays through Fridays, J.D. lives a life similar to most 10 year-olds. He goes to school, does his classwork, looks forward to recess, and is in most respects a strikingly unremarkable kid. However, every day after the school bus lets J.D. off at the stop near his home, he does something unusual. He races home in front of his two school chums, Sammy and Susie, and opens up his lemonade stand. For you see, J.D. is the neighborhood entrepreneur. He earns his lunch money by selling lemonade to his two friends as they walk home from school. Oh yeah. There's one more thing you should know about J.D.: his is the only lemonade stand in this section of town. J.D. is a monopolist.

Because J.D. sells the same lemonade to the same two kids everyday, he has learned a lot about the preferences of his two school chums. Sammy derives intense pleasure from lemonade and is willing to pay 80¢ for a first glass of lemonade, though he never has any interest in purchasing a second glass. Susie likes lemonade too, but not as much as Sammy. She is willing to pay 50¢ for a glass of lemonade; and, like Sammy, never wants more than one. We summarize the willingness to pay of J.D.'s two customers in the table below.

Willingness to Pay Values for J.D.'s Customers

Given the preferences of his customers, we see that the quantity J.D. sells affects the price he can charge. If J.D. wants to sell 2 cups of lemonade, the highest price he can charge is 50¢ a cup. Any amount above this price and Susie will refuse to buy any.1 However, if he limits his "production" to only 1 cup of lemonade, he can raise his price to 80¢ a cup. In other words, J.D. can significantly increase the price he charges by restricting the quantity of lemonade he sells. He has "market power."

Based upon his experience as CEO, Chairman of the Board, and majority stockholder of Rockefeller's Lemonade Stand, J.D. has calculated the following revenue table with respect to his lemonade sales. Pay particular attention to the change in Total Revenue as Quantity

Sammy Susie

80¢ 50¢



increases from 1 to 2.

Like all great entrepreneurs, J.D. is a profit maximizer. He has calculated that it costs about 25¢ to "produce" a cup of lemonade (this includes the cost of the lemonade mix, plus the value of the paper cup, etc.). So what quantity of lemonade will maximize J.D.'s profits? To answer that question, J.D. has expanded the table above to identify the profit he makes for differing levels of lemonade "production."

Column (5) reports the Total Profit that J.D. earns for each level of output. As the table clearly shows, J.D. maximizes Total Profit when he produces and sells 1 cup of lemonade. By restricting output to 1 cup, he can charge a price of 80¢ a cup. This yields him a Total Revenue of $0.80, versus a Total Cost of production of only $0.25. The bottom line is a Total Profit of $0.55, which is higher than at any other level of sales.

Now things start to get interesting. We are about to see what monopolies do wrong. What Quantity of lemonade production maximizes society's happiness? From the information we have concerning Sammy's and Susie's preferences, we know that when only 1 cup of lemonade gets produced, it goes to Sammy, who receives 80¢ of happiness. In contrast, society loses 25¢ in happiness from withdrawing resources from other activities in order to produce that cup. Thus, the Total Net Happiness received by society from the first cup of lemonade is 80¢ - 25¢ = 55¢.

When J.D. produces 2 cups of lemonade, the second cup goes to Susie. She receives 50¢ of happiness from her cup. However, society loses another 25¢ of happiness in producing this cup. Thus, the increase in Total Net Happiness from the second cup is 50¢ - 25¢ = 25¢. If we add this to the happiness from the first cup, we see that the production of 2 cups of lemonade results in 55¢ + 25¢ = 80¢ of Total Net Happiness. Column (6) reports Total Net Happiness for each level of output. Clearly, society's happiness is maximized when J.D.

Price Quantity Total Revenue

80¢/cup

50¢/cup

1

2

$0.80

$1.00

Price Quantity

(1)

Quantity Quantity

(2)

Total Revenue

(3)

Total Cost (4)

Total Profit

(5)

Total Net Happiness

fr(6)

80¢

50¢

1

2

$0.80

$1.00

$0.25

$0.50

$0.55

$0.50

$0.55

$0.80



produces 2 cups of lemonade.

Anybody remember how many cups of lemonade maximize J.D.'s profits? As demonstrated above, the profit-maximizing level of lemonade production is 1 cup. Did you catch that? One cup! The happiness-maximizing quantity is 2, while the profit-maximizing quantity is 1! Herein lies the great sin of monopolies. Left to their own devices, MONOPOLIES PRODUCE TOO LITTLE OUTPUT. In the case of John D. Rockefeller, Jr., society would like him to produce and sell 2 cups of lemonade. Instead, young Mr. Rockefeller chooses to sell only 1 cup of lemonade, since that is what maximizes his profits.

Why does J.D. produce too little? As a result of the market power that J.D. possesses, a decrease in lemonade production increases the price he can charge. For example, if J.D. were to produce 2 cups of lemonade, he could only charge 50¢ a cup. By decreasing production from 2 cups to 1, J.D. is able to raise the price he can charge to 80¢ a cup. As a result, when J.D. sells one less cup of lemonade, he doesn't lose 50¢ in Revenue. The decrease in sales only costs him 20¢ in Revenue (check out Column (3) in the table above).2

However, producing one less cup of lemonade saves J.D. 25¢ in Cost. As a result, decreasing production from 2 cups to 1 cup increases his Total Profit by 5¢, even though it lowers society's happiness (check out Columns (5) and (6)).3

All of this can be illustrated in the context of our familiar Profit Table. The Profit Table below represents J.D.'s decision to produce a second cup of lemonade. As discussed above, the extra Revenue associated with increasing production to 2 cups is 20¢. However, the Cost of producing a second cup of lemonade is 25¢. Increasing production from 1 cup to 2 would thus lower J.D.'s Profit by 5¢.

Now this is a fine pickle indeed! Here we have a resource transfer that would make society better off by approximately 25¢. Unfortunately, J.D. loses 5¢ in profit if he makes this resource transfer. This keeps him from producing any more than 1 cup of lemonade. And that is a shame. Because society is a little less happy than it could be if only J.D. would think of the happiness of others, as opposed to selfishly maximizing his own profits.

What makes J.D.'s situation unique? J.D.'s firm is different from the firms we previously analyzed because we assumed that J.D. has market power, while the other firms did not.

PRICE: 50¢

REVENUE:

COST:

PROFIT

20¢

25¢

- 5¢

Change in society's happiness is 50¢ - 25¢ = + 25¢



When a firm doesn't have market power, an increase in production will have little effect on the Price the firm can charge. If the Price is 50¢, and the firm sells another unit, then the extra Revenue it receives will also equal 50¢. And we get a Profit Table just like the ones earlier in the book. However, when a firm has market power, selling more output means the firm has to charge a lower price. In this case, if the Price is 50¢ and the firm sells another unit, then the extra Revenue it receives will be significantly less than 50¢.

In conclusion, it's important to remember that even when a firm is a monopoly, prices still send the right information. The price still approximates the additional happiness that society would receive from consuming one more unit of the output good. The problem isn't with the prices. The problem lies with the Revenue incentives facing the firm. Even so, it should never be forgotten that monopolies are good. They transfer resources from lower-valued to higher-valued activities. They increase society's happiness. They just don't increase society's happiness as much as we would like them to.

OPTIONAL SECTION FOR ECONOMISTS: T h e m o n o p o l y p r o b l e m a r i s e s w h e n e v e r t h e d e m a n d c u r v e i s d o w n w a r d s l o p i n g . W h e n t h i s h a p p e n s , M a r g i n a l R e v e n u e i s l e s s t h a n P r i c e . I n t h e f i g u r e b e l o w , Q * i d e n t i f i e s t h e q u a n t i t y t h a t m a x i m i z e s s o c i a l w e l f a r e . N o t e t h a t s o c i a l w e l f a r e i s m a x i m i z e d a t t h e q u a n t i t y w h e r e P r i c e = M a r g i n a l C o s t . I n c o n t r a s t , Q M i d e n t i f i e s t h e p r o f i t -m a x i m i z i n g l e v e l o f o u t p u t f o r t h e m o n o p o l i s t . I t i s t h e q u a n t i t y a t w h i c h M a r g i n a l R e v e n u e = M a r g i n a l C o s t . T h e s h a d e d a r e a r e p r e s e n t s t h e w e l f a r e l o s s t h a t r e s u l t s b e c a u s e t h e m o n o p o l i s t p r o d u c e s l e s s t h a n t h e s o c i a l l y o p t i m a l q u a n t i t y , Q * .





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Notes

1 We assume that J.D. is forced to charge both Sammy and Susie the same price. While this may be a bad assumption in this particular case, it is generally valid when considering most monopolies. One reason is most customers would be unwilling to pay a high price when others were able to buy the good at a lower price. The other reason is the monopolist usually doesn't know which customers would be willing to pay a higher price. As a result, the monopolist charges all customers the same price.

2 Economists use the term "Marginal Revenue" to denote the change in Total Revenue caused by an increase in output of one unit. The "monopoly problem" arises whenever Marginal Revenue is substantially less than Price at the firm's profit-maximizing level of output.

3 In the case of a competitive market, or a market in which firms have little or no market power, restricting production would result in lower revenues. For example, when Ura Hogg takes her watermelons to a watermelon broker, she has to "take" the market price. The broker won't give her more per watermelon if she offers fewer watermelons to him (e.g. she may sell him 1000 watermelons at $5 apiece for total revenues of $5,000. If she sells him 500 she will have to take the same price, and her revenues will be halved ($5x500=$2,500)).



CHAPTER 44 A Government Price Fix

And now for the moment you've been waiting for. Are you ready? Having determined that unregulated, private markets will not maximize society's happiness when a monopoly problem exists, we now ask the question: Is there anything the government can do to make things better? Any way that it could intervene in this market to make society better off? Finally, a mere 44 chapters into our book, we are able to say...YES!

The last chapter demonstrated that the problem with monopolies is that they produce too little. Therefore, if the government wants to make society better off, it has to get the monopolist to produce more output. One obvious possibility is to subsidize the monopolist, so that it will find it profitable to expand production. However, taxpayer-funded subsidies to monopolists tend not to be very popular with voters. A more politically sensitive solution, and the one that is by far more commonly employed, is to impose a ceiling on the price that the monopolist is allowed to charge its customers.

In our example, we could imagine that lawyers from the Antitrust Division of the Justice Department (perhaps in conjunction with agents from the Federal Trade Commission and the U.S. Department of Agriculture) might arrange to meet young Mr. Rockefeller one day after school. After patiently appealing to his youthful idealism and patriotic fervor--and after explaining how they would confiscate his lemonade stand and throw him in jail if he chose to disobey them, these government agents would help our fledgling entrepreneur to see the error of his ways. To correct the monopoly problem, the monopoly regulators impose a price ceiling of 50¢ a cup. As we shall see, this price ceiling changes J.D.'s profit-maximizing strategy. The table below represents the relevant price, cost, and profit information for Rockefeller's Lemonade Stand after the government imposes a price ceiling on lemonade of 50¢ a cup.

Column (1) shows the immediate effect of the price ceiling. Before the price ceiling, J.D. could charge 80¢ for lemonade if he restricted output to 1 cup. After the price ceiling, J.D. can't charge any more than 50¢ per cup. This produces a number of other changes in the table. In fact, inspection of Column (5) shows that the new profit-maximizing level of output for J.D. is now two cups of lemonade, in contrast to the one cup which maximized profits before the price ceiling.

Price Quantity

(1)

Quantity Quantity

(2)

Total Revenue

(3)

Total Cost (4)

Total Profit

(5)

Total Net Happiness

fr(6)

50¢

50¢

1

2

$0.50

$1.00

$0.25

$0.50

$0.25

$0.50

$0.55

$0.80



Let's get this straight. Are we saying that A PRICE CEILING CAN CAUSE A MONOPOLIST TO PRODUCE MORE OUTPUT? Yes, we are. Does this strike you as a strange result? It should. Price controls almost always result in less, not more, output being produced. The exception to this rule occurs with monopoly.

How can a price control get a monopolist to produce more output? Look at the effect of the price ceiling on the firm's Revenues in the table below. A comparison of Columns (3) and (6) shows that--before the price control--an increase in Quantity from 1 to 2 cups caused Total Revenue to increase by only 20¢. In contrast, after the price ceiling, the increase in Total Revenue associated with the second cup of lemonade was 50¢! Thus, the price ceiling has the effect of increasing the additional Revenue associated with producing more output. This provides an incentive for the firm to expand production.

This greater incentive to produce is illustrated in the Profit Table below. As before, we represent the relevant Revenue and Cost information for J.D. as he decides whether to produce a second cup of lemonade. Before the price ceiling, J.D. found that increasing production from 1 to 2 cups of lemonade resulted in a 5¢ loss in Profit. After the price ceiling, the same increase in production produced a 25¢ gain in Profit. All because the price ceiling increased the Revenue associated with the second cup from 20¢ to 50¢.1

BEFORE PRICE CEILING AFTER PRICE CEILING

Price Quantity

(1)

Quantity Quantity

(2)

Total Revenue

(3)

Price Quantity

(1)

Quantity Quantity

(2)

Total Revenue

(3)

80¢

50¢

1

2

$0.80

$1.00

50¢

50¢

1

2

$0.50

$1.00

Before Price Ceiling After Price Ceiling

PRICE: 50¢ 50¢

REVENUE:

COST:

PROFIT:

20¢

25¢

- 5¢

50¢

25¢

+ 25¢

Change in society's happiness is 50¢ - 25¢ = + 25¢



In conclusion, when a monopoly problem exists--that is, when a firm has a significant degree of market power--government intervention can increase society's happiness. Under the right circumstances, a price ceiling will cause a monopolist to produce more output. Since the problem with monopoly is that the firm produces too little output, this improves the allocation of society's resources. However, this raises a question. Can we be assured that the government intervention will increase society's happiness? Is it possible that government intervention could make us worse off than if we just left the monopoly problem alone? We explore this subject in the next chapter.

OPTIONAL SECTION FOR ECONOMISTS: T h e f i g u r e be l o w s h o w s h o w a p r i c e c e i l i n g c an c au s e a m o n o p o l i s t t o p r o d u c e m o r e o u t p u t . T h e i m p o s i t i o n o f t h e p r i c e c e i l i n g , P C , c h an g e s t h e f i r m ' s M ar g i n al R e v e n u e c u r v e t o P C-a-b-c . T h i s n e w M ar g i n al R e v e n u e c u r v e i n t e r s e c t s t h e m o n o p o l i s t ' s M ar g i n al C o s t c u r v e at q u an t i t y QC . N o t e t h at t h i s i s l ar g e r t h an t h e l e v e l o f o u t p u t t h at t h e m o n o p o l i s t w o u l d h av e c h o s e n i n t h e abs e n c e o f t h e p r i c e c e i l i n g ( QM ) .





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Notes

1 Don't be confused into thinking that the price control has made J.D.'s lemonade business more profitable. Before the price control, J.D. produced and sold 1 cup of lemonade and made a profit of $0.55. After the price control, J.D. produced and sold 2 cups of lemonade and made a profit of only $0.50. Thus, the overall effect of the price ceiling is to decrease the profitability of J.D.'s business.



CHAPTER 45 Regulating a Monopolist

Let's assume that cable TV is a local monopoly (there is only one supplier in a given town). If you asked most people what's wrong with cable TV being a monopoly, they would probably respond that monopolies charge "too much money." It is true, by selling less output than society wants them to, a monopolist is able to obtain a higher price for its goods. But it would be a mistake to focus on this part of the problem.2 The real problem with cable TV being a monopoly is that it results in too few cable TV services being supplied to consumers.

In evaluating the effect of cable TV regulation on the happiness of society, the trick is to keep one's eye on the ball. Once again, that means concentrating on how the rate regulation is likely to affect the allocation of resources in the economy. Can this government intervention increase society's happiness? Following the arguments of the last chapter, we know the answer is yes. But to be effective, the intervention must cause the cable TV company to provide more cable services.

For example, suppose--prior to government intervention--a cable TV company had thought about attracting new subscribers by lowering the cost of its basic package from $25 to $20 a month. Providing cable TV to additional subscribers would require the firm to transfer resources away from consumers elsewhere in the economy. What kind of resources? Office personnel would be needed to keep track of subscribers' accounts. Service representatives would have to be available to handle customers' problems. These represent withdrawals of labor from other activities. If adding extra customers resulted in an increase in labor costs of approximately $15 per customer, then that means that the extra labor required to service an additional subscriber would produce approximately $15 of happiness at some other activity.

Weighed against this cost is the extra revenue the firm would receive. Suppose the firm calculated that the extra revenue from selling more cable subscriptions would not compensate it for the cost of servicing those subscriptions. While the new subscribers would be paying $20 for their cable service, the cable TV company, in order to attract these new subscribers, would have to lower prices for everybody. Thus, the extra revenues that the firm would gain by reaching out to these new customers would be less than $20 per customer. How much less? Let's say that the extra revenues from an additional customer worked out to

"CABLE INDUSTRY EXPECTS PROBLEMS. Less than two years after Congress passed the Cable Act of 1992 in an effort to regulate rates, cable companies are again under fire. The Cable Commission met Tuesday in Washington and voted to cut cable prices across the board by seven percent....Decker Anstrom, president of the National Cable Television Association, said the rate decrease won't help the cable industry...'This will seriously disable cable companies' ability to invest money in future technology,' he said."1



about $5 per new subscriber. Clearly, given these numbers, the cable TV company would not have a financial incentive to make this resource transfer. This is illustrated for a representative customer on the Before side in the Profit Table below. The revenue, cost, and profit lines do not represent totals, but rather the revenue, cost, and profit that occurs from the production of the extra cable only.

Everything is different when the government intervenes in the market. Suppose the Cable Commission imposes a price ceiling on the company, forcing it to lower its rates from $25 to $20. As discussed in the last chapter, the effect of this policy is to increase the firm's profits if it increases production, from -$10 to $5. Now the cable company finds that it is better off dropping its rates and providing more cable services. And that's great. Because the reality is, as this representative account shows, servicing another customer takes resources worth $15 elsewhere in the economy and directs them to a cable TV customer who gets $20 of happiness. And while the company's customers rejoice and its shareholders weep, the bottom line is that society is a little bit happier because of the market intervention of the good folks at the Cable Commission.

The previous discussion has demonstrated that ordering cable companies to cut their prices can make society better off. But will it? Now that's an entirely different question. For example, the government must be careful that it's intervention doesn't decrease the amount of output the monopolist produces. How can that be, you ask? If the cable TV company is forced to charge a lower price, and that lower price induces more consumers to subscribe to cable TV service, won't that necessarily cause the quantity of cable TV services to increase? Consider the statement by Decker Anstrom, "This will seriously disable cable companies' ability to invest money in future technology."

Suppose you were the owner of a cable TV company. What would be your incentive for adopting new technology (e.g., better transmission equipment) or making improvements in your service (e.g., more attractive bundling of channels)? Higher profits. But suppose you also knew that the Cable Commission was always looking over your accountant's shoulder, making sure that you didn't make "too much" profit. How would that affect your incentive to make investments in future technology and improvements?

Before Price Ceiling After Price Ceiling

PRICE: $20 $20

REVENUE:

COST:

PROFIT:

$5

$15

- $10

$20

$15

+ $5

Change in society's happiness is $20 - $15 = + $5



It's a "heads you lose, tails you draw" proposition. If the new technology is a bust, or the improvements aren't a big hit with customers, you've entailed extra expenses with no rewards. You lose. But suppose your consumers love the new changes and cable demand increases dramatically. Do you get to reap the rewards? Not necessarily. The Cable Commission stands poised on the industry sidelines, ready to jump onto the playing field and take away your profits. If they appropriate your profits, you're back where you started from. You draw. Who could blame you for asking, why risk it? Why not stay with the safe, old technology and get your normal, Cable Commission-approved profits? No sweat, no pain.

When this happens, rate regulation can have the effect of lowering society's happiness by causing the monopolist to produce less output in the future. Sure, the cable TV company may have more customers paying lower rates. But the quality of that service will be adversely impacted by the negative incentives to invest which are a byproduct of rate regulation. Measured in quality-adjusted units, output may actually fall. Too few resources will end up being transferred to the cable TV industry. Government intervention will have served to exacerbate the monopoly problem.

And this is only one possibility. The same lack of incentives that apply to investing in new technology also apply to lowering costs. Why should the cable company reduce its costs when regulators will take away any increase in profits by forcing the firm to lower rates still further? If rate regulation causes the company not to work so hard in reducing costs, that also decreases society's happiness. Resources aren't being released as they would be in the absence of regulation. That means lower happiness for consumers elsewhere in the economy.

Being a regulator is a bit like walking a tightrope...blindfolded. The regulator knows his job is to get the monopolist to produce more output. But how much more? Here's the rub...HE HAS NO IDEA. In real life, there are no tables like J.D.'s hypothetical revenue table from the previous chapter. So the regulator takes a stab in the dark. He sets a new, lower price. More output gets produced (at least in the short run). But the second he intervenes, everything changes. The incentives of the monopolist to introduce new technology, improve service, and reduce costs all change dramatically. Now the regulator can't look at the firm's actual revenues and costs. He has to imagine what they would be in the absence of his intervention. He has to imagine a world without regulation, and calculate the happiness-maximizing level of output in THAT world. And then he has to figure out a way to manipulate the firm so it produces that level of output in this, the regulated world.

To know whether he has done his job successfully, the regulator has to see how the world would have existed in the absence of his intervention. Since that world is forever unseen--leaving the regulator blindfolded, if you will--he can only inch along on the tightrope, hoping he is increasing--and not decreasing--society's happiness.

Actually, we exaggerate when we say that the unregulated world is forever unseen. Every now and then, a window into that world opens up. It happens whenever the government



decides to deregulate a previously regulated industry. For example, in the 1980's the airline, trucking, and telephone (long-distance) industries were all deregulated. The original argument for regulating these industries was that each of these represented a monopoly. Hence government intervention was called upon to increase society's happiness. If government regulation of these industries had been successful, then that regulation should have persuaded these industries to produce more. Thus, deregulation should have resulted in these industries producing less output than when they were regulated. What was the actual result? In each case, industry output increased dramatically under deregulation. Our evaluation of regulation in these cases can be clear and unequivocal: government intervention exacerbated the monopoly problem and made things worse, lowering society's happiness.

We don't give these examples to say that regulation of monopolies will always produce lower social happiness. Nor to say that regulators are bungling bureaucrats who should know better. We give these examples to point out the daunting task facing a regulator. Just because a monopoly problem exists does not mean that government intervention will make things better. It could make things worse.

So what should society do? The best economics can do is to point out the right questions to ask. First, just HOW SERIOUS IS THIS MONOPOLY PROBLEM? Is the monopolist producing a lot less than the amount of output that would maximize society's happiness? A monopolist will only produce a lot less than the social ideal if it can substantially jack up its price by restricting the amount it sells (recall J.D. Rockefeller's revenue table from the previous chapter). While it might be true that the local cable company is the only cable game in town, even the cable TV company has competitors. There's ABC, NBC, CBS, and Fox, all of which do not require cable. There's Blockbuster Video and the local video rental stores in town. Heck, even grocery stores rent videos nowadays. ("Yes, Ma'am. We do have the new release of Die Hard VII. You'll find it right next to the frozen artichokes in the Produce section.") In addition, there are all sorts of satellite dish and on-line computer technologies that stand ready to steal consumers away from cable TV companies should those companies raise their prices too high. The ability of a monopolist to charge higher prices is restricted by the willingness of consumers to pay those higher prices. To the extent reasonably close alternatives exist, the monopolist will not be able to substantially increase its price, and there will not be a serious monopoly problem.

The second question which needs to be asked is, CAN THE GOVERNMENT REGULATOR BE REASONABLY CONFIDENT THAT HE CAN INDUCE THE MONOPOLIST TO PRODUCE MORE OUTPUT? AND CAN HE DO SO WITHOUT SUBSTANTIALLY REDUCING THE INCENTIVES OF THE MONOPOLIST TO REDUCE COSTS? A necessary condition for regulation to increase society's happiness is that one be able to answer these questions affirmatively.

To be sure, these are incredibly difficult questions to answer. Reasonable people will disagree. One never knows--indeed, cannot know--whether their own answers to these questions are correct. That doesn't mean that society should never regulate. It simply means



that society should be mindful that the presence of a market imperfection does not guarantee that government intervention will make things better. Once we leave the unregulated world of market prices and profit-maximizing firms, we enter a world of darkness--with no guarantee that the steps we take will move us closer to maximizing society's happiness.



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Notes

1 The Oklahoma Daily, February 23, 1994.

2 Lowering prices makes cable consumers better off and cable TV shareholders worse off. Note that not all cable consumers are poor, nor are all cable shareholders wealthy. For example, many stocks are owned by mutual funds. Mutual funds obtain much of their financial capital from employee pension funds. As a result, a line worker in an automobile factory may be a shareholder of a cable TV company if his pension contributions are being invested in mutual funds. Thus, lowering cable TV prices inevitably makes some relatively wealthy people better off, and some relatively poor people worse off. This is a very crude way to transfer wealth. If the motivation of the government really is to help poor people, it shouldn't lower cable TV rates. It should just give poor people money and let them spend it on what they want.



CHAPTER 46 Market Imperfection II: Externalities

Smokestacks belching soot; overfishing causing depletion of fish stocks in the oceans; species made extinct by the encroachment of man; and to top it all off, a possible warming of the globe that threatens to disrupt everyone's way of life. All of these are examples of externalities. AN EXTERNALITY IS A COST OR BENEFIT EXPERIENCED BY A THIRD PARTY TO A RESOURCE TRANSFER.

For example, Harry the Hog Farmer owns a piece of land out in the country where he raises hogs for a living. As Harry is quick to confess, he's not in the hog business because it's a great way to meet interesting people. Harry's in it for the money. And, in general, hogs have been good to Harry. He's managed to make a decent living for himself and his family.

It just so happens, that Harry lives right next door to the Golden Years' Retirement Home. Each day the residents of the Golden Years' Retirement Home are subjected to the disturbing--and downright unappetizing--sound of a herd of pigs all squealing over whose turn it is to sit in the mud pit. On top of that, Harry is constantly running around the farm yelling "Soooiee" like there's no tomorrow. Some lucky residents can just turn off their hearing aids and enjoy the show. But the rest of Golden Years' inhabitants are forced to put up with this porcine noise pollution. How bad is it? If the truth were known, these residents would be willing to collectively pay $10,000 a year to silence Harry and his hogs.

Suppose Harry can earn revenues of $40,000 from raising hogs, with costs of $36,000. From Harry's perspective, this is great. The hog business is profitable. And so he keeps on raising those porkers. However, from society's perspective, all is not well. When one adds in the $10,000 of "damages" from the noise pollution suffered by the residents of the Golden Years' Retirement Home, it is seen that this resource transfer lowers society's happiness. In fact, the real (gross) Benefit to society from producing the hogs isn't $40,000, it's only $30,000. That is, the $40,000 in benefits received by the pork consumers must be diminished by the $10,000 loss of happiness resulting from the noise pollution. Once this externality of the noise pollution is counted, we see that the Cost is greater than the Benefits. Rather than increasing society's happiness by $4,000 as Harry's profits seem to indicate, this resource transfer actually lowers society's happiness by $6,000.

BENEFITS: $40,000 - $10,000 = $30,000

REVENUE:

COST:

PROFIT:

$40,000

$36,000

+ $4,000



What happened? Society wants to say, "Let those resources go! Those hogs aren't valuable enough to justify taking those resources away from other consumers." But Harry's not getting the message. WHEN EXTERNALITIES ARE PRESENT, PROFITS FAIL TO ACCURATELY REPORT THE GAINS AND LOSSES TO SOCIETY FROM A RESOURCE TRANSFER. At its root, the externality problem is a problem of INCOMPLETE INFORMATION.

The reality is that Harry is making a resource transfer which impacts three distinct groups of consumers: (i) the consumers of pork products; (ii) other consumers who lose happiness because resources (land, Harry's time, etc.) are taken away from alternative activities; and (iii) the residents of the Golden Years' Retirement Home. The price system has done a good job of reporting the respective happinesses of Groups (i) and (ii). However, the senior citizens of Group (iii) are ignored in this resource transfer. They are a "third party" that is suffering a cost from this resource transfer. Because Harry the Hog Farmer never has to "feel the pain" of the senior citizens, he makes a socially incorrect choice. His positive profits encourage him to make a resource transfer which will lower society's happiness. And that's a shame.

Can the government intervene to make society better off? Yes it can. In fact, there are a number of avenues open to the government. Ideally, the government would like to get Harry the Hog Farmer to feel the pain he imposes on his neighbors. As things currently stand, nobody owns the "airspace." As a result, Harry can "pollute" it with impunity. In contrast, if the government conferred ownership (or "property") rights of the airspace around the Golden Years' Retirement Home to its residents, Harry would have to compensate them for filling it with unpleasant noise pollution. He could purchase the right to pollute that airspace. Does that strike you as being too weird?

If so, consider this. Suppose Harry wanted to use some of the retirement home's land to dump corn husks left by his hogs after their feedings? The price Harry would have to pay for that land would force him to think long and hard whether that property was more valuable to him or the residents. If it was really important for Harry to "pollute" that land with his refuse corn husks, he would have an incentive to buy it (and the residents an incentive to sell it). As a result, that resource would go to its highest valued use. The fact that somebody owns the land keeps Harry from doing to the land what he is doing to the air.

THUS ONE WAY GOVERNMENT CAN INTERVENE WHEN THERE ARE EXTERNALITIES IS TO ESTABLISH AND ENFORCE PROPERTY RIGHTS. This is generally the most preferred course of action when addressing an externality problem (though sometimes it is not enough to solve the externality problem). Establishing property rights to "airspace" would force Harry to internalize the costs he imposes on his neighbors. It fixes the "hole" in the price system that allows the interests of third parties to go unrepresented. We also admit that--in this case at least--establishing property rights to

Change in society's happiness is $30,000 - $36,000 = - $6,000



airspace is not very practical. But it is useful to think about; it reminds us why prices are failing to report the correct information about the gains and losses from this resource transfer. And in many cases, it is a practical solution to addressing externality problems.1

If the government can't establish property rights, then what? A COMMON GOVERNMENT INTERVENTION FOR ADDRESSING EXTERNALITIES IS TO IMPOSE FINANCIAL PENALTIES AND REWARDS. We must remember that the problem with externalities is that they cause a misallocation of society's resources. In the case of Harry the Hog Farmer, too many hogs are being raised. Thus the government could improve the allocation of resources by discouraging farmers from raising hogs. Suppose hog farms were well recognized for being a public nuisance. Then the government could require hog farmers to buy a permit to operate a hog farm. Let the price of the permit be $7,000. Look at how this government intervention changes the Profit Table associated with this resource transfer.

The tax associated with operating the hog farm is causes Harry the Hog Farmer to feel some of the pain he is imposing on the residents of the Golden Years' Retirement Home. In this case, it is enough to drive Harry out of business. And that's good. Because society does not want this resource transfer to take place. From the perspective of society's happiness, there are only two numbers in the table that matter: $30,000 and $36,000. Harry the Hog Farmer has taken resources worth $36,000 elsewhere in the economy and directed them to an activity that produces only $30,000 of net happiness. Society's happiness is lowered. By discouraging this resource transfer, the government has made society $6,000 better off.

This example of Harry the Hog farmer illustrates the problem of NEGATIVE EXTERNALITIES. Negative externalities occur whenever third parties to a resource transfer suffer costs from that resource transfer. When negative externalities are present, too many resources are directed to an industry. Government intervention can increase society's happiness by discouraging that industry from withdrawing resources from other activities.

Less common is the problem of POSITIVE EXTERNALITIES. Positive externalities occur whenever third parties to a resource transfer experience benefits from that resource transfer. When positive externalities are present, too few resources are directed to an industry--that is,

Before Permit After Permit

BENEFITS: $40,000 - $10,000 = $30,000 $40,000 - $10,000 = $30,000

REVENUE:

COST:

PROFIT:

$40,000

$36,000

+ $4,000

$40,000 - $7,000 = $33,000

$36,000

- $3,000

Change in society's happiness is $30,000 - $36,000 = - $6,000



the industry does not produce enough of the good. Suppose that instead of being a public nuisance, Harry and his hogs sang four-part harmonies. Then the residents of the Golden Years' Retirement Home would be blessed by the heavenly melodies emanating from Harry's farm. In order to make sure that Harry produced the right number of hogs, we would want him to internalize the pleasure that the residents received from his hogs. Government could intervene to increase society's happiness by helping Harry to "feel their joy." Subsidies and mandates are two ways that government can accomplish this.

Before proceeding to a real life application of the externality problem, it's worthwhile to consider some of the problems that we mentioned in the beginning of this chapter. When overfishing causes depletion of fish stocks in the oceans and species are made extinct by the encroachment of man, there is an externality problem. In this case, the source of the problem is the lack of property rights. Because nobody owns the fish in the oceans, there is no incentive to save fish so that consumers can enjoy them next year. Fishermen don't "feel the pain" they impose on consumers by depriving them of fish next year. Likewise, since most animal species are not owned by humans, there is no incentive to preserve them. Again, the firms that destroy the natural habitats of these animals aren't being forced to "feel the pain" that future generations may have to experience because valuable animal species will not be around to provide happiness for them. In many cases, modern technology can provide innovative ways to establish property rights.2 In other cases, such as ocean mineral rights, the problem isn't lack of technology, but lack of law. In both sets of cases, governments can make dramatic improvements in the allocation of resources by assigning and enforcing property rights.

Sometimes, as in the example of the noise pollution from Harry and his hogs, establishing property rights is not a practical solution. When smokestacks send forth plumes of soot into the atmosphere, costs are imposed on third party consumers who suffer from having to breathe polluted air. Even if households owned the "air-rights" to the air they breathed, it would be impractical to identify and prosecute those parties responsible for polluting their air. In such cases, financial penalties like punitive taxes can help firms to feel the pain they impose on others. However, how large should the government make these penalties? How can the government know the amount of third party costs being suffered by consumers? These are difficult questions which are highlighted in our next chapter on environmental mandates.

OPTIONAL SECTION FOR ECONOMISTS: T h e f i g u r e b e l o w i l l u s t r a t e s t h e c a s e o f a n e g a t i v e e x t e r n a l i t y . I n t h e a b s e n c e o f g o v e r n m e n t i n t e r v e n t i o n , f i r m s i n t h e i n d u s t r y w i l l p r o d u c e a q u a n t i t y Q * . I g n o r i n g t h e i m p a c t o f t h e n e g a t i v e e x t e r n a l i t y o n t h i r d -p a r t y c o n s u m e r s c a u s e s t h e m a r k e t t o o v e r v a l u e t h e b e n e f i t o f t h e g o o d . I f t h e m a r k e t c o u l d i n t e r n a l i z e t h e s e e f f e c t s , i t w o u l d p r o d u c e Q * * ( t h e s o c i a l o p t i m u m ) . T h e s h a d e d a r e a i d e n t i f i e s t h e w e l f a r e l o s s a s s o c i a t e d w i t h n e g a t i v e e x t e r n a l i t y .



T h e c a s e o f a p o s i t i v e e x t e r n a l i t y i s h a n d l e d a n a l o g o u s l y ( s e e f i g u r e b e l o w ) . W i t h a p o s i t i v e e x t e r n a l i t y , t h e m a r k e t u n d e r v a l u e s t h e b e n e f i t o f t h e g o o d . I n t h e a b s e n c e o f g o v e r n m e n t i n t e r v e n t i o n , Q * g e t s p r o d u c e d . H o w e v e r , Q * * i s t h e s o c i a l o p t i m u m . T h e s h a d e d a r e a r e p r e s e n t s t h e c o r r e s p o n d i n g w e l f a r e l o s s .





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Notes

1 The insight that the establishment of property rights provides a solution to the externality problem is attributable to Ronald Coase, 1991 recipient of the Nobel Prize in Economic Science. It is widely known in the economics literature as the "Coase Theorem." Coase first explained his ideas in a very readable, nontechnical--and now famous--article entitled "The Problem of Social Cost," Journal of Law and Economics 3 (October 1960): 1-44.

2 Terry Anderson and Donald Leal discuss a number of innovative attempts to use new technologies to establish and enforce property rights, such as the following: "Some environmental groups have proposed that wolves by re-introduced into Yellowstone National Park, but ranchers oppose the plan because they fear that the wolves will leave the park and prey on livestock. Could the wolves be fenced? Technology is currently available for "fencing" dogs by burying a cable that emits a radio signal on the perimeter of a piece of land; the signal, received in the dog's collar, shocks the animal, which then retreats from the perimeter. Could the same technology be applied to wolves? When red wolves were reintroduced into South Carolina wildlands, they were equipped with radio collars that allow the animals to be tracked. If a wolf wanders too far afield, a radio-activated collar injects the animal with a tranquilizing drug so that it can be returned to its designated habitat. Whales can also be "branded" by genetic prints and tracked by satellites, providing another way to define property rights [Anderson and Leal, Free Market Environmentalism, San Francisco: Westview Press, 1991, page 34]."



CHAPTER 47 Environmental Regulation

In the case cited by the newspaper excerpt above, the EPA was requiring the city of Weatherford, Oklahoma to install liners in their existing landfills. In other words, the EPA was mandating that Weatherford make a specific resource transfer. Why couldn't the residents of Weatherford be trusted to make the right decision about this resource transfer? Installing liners in their municipal-owned landfills would make the citizens of Weatherford better off. There would be a decreased probability that landfills would ooze harmful substances into the local community. This would mean greater health, and happiness, for the residents of Weatherford.

Against this benefit is the cost of installing the liners. As we know, these costs represent the lost happiness that consumers elsewhere in the economy would experience if resources--such as the labor and materials employed in installing the liners--were withdrawn from other activities. If the residents of Weatherford decided that the increased happiness they would receive from having a safer environment was greater than the costs of installing the liners, one would expect that their political leaders--like Mayor Gary Rader--wouldn't need federal mandates to make them do the right thing.

The problem here is that there is a third group of consumers whose interests are not being considered. If harmful substances leach into Weatherford's soil and groundwater, that doesn't just hurt the citizens of Weatherford. Not too far away are the cities of Clinton, Thomas, and Hydro. Their citizens could also be harmed by Weatherford's leaky landfills. When Weatherford considers the costs and benefits of installing liners in their municipal landfills, it doesn't consider how the citizens of neighboring towns feel about this. That's natural, since the city of Weatherford has no way of collecting revenues from the citizens of other cities. But it is unfortunate. Because it means that Weatherford will not "feel the joy" that other citizens will receive from new landfill liners. This POSITIVE EXTERNALITY

"EPA OFFICIAL DEFENDS STRICT MANDATES. While some city officials in Oklahoma feel federal mandates handed down by the Environmental Protection Agency are too stringent, the EPA says the benefits of keeping the earth clean far outweigh the costs. Roger Meacham, a spokesman with the agency's regional office in Dallas, responded to claims that expensive environmental standards are placing a heavy burden on municipal taxpayers,...'While there may be some expense involved initially...the benefits outweigh the costs.'...Weatherford Mayor Gary Rader said he feels a federal mandate requiring significant upgrades for solid waste disposal is unreasonable....The mayor estimates the cost of bringing his city into compliance with this order at $9 million. The city of Weatherford's total annual budget is just over $3 million."1



could cause Weatherford to make a socially incorrect resource decision.

Suppose the costs of the new liners is $9 million, and that the citizens of Weatherford would be willing to pay about $5 million to have these new liners put in. Further, suppose the residents of the neighboring towns of Clinton, Thomas, and Hydro would be made $7 million happier if Weatherford installed the new liners. We can use our Profit Table to show how the City of Weatherford's budget office might approach this problem (see "Before EPA Mandate").

It's pretty clear that without any mandates from the federal government, Weatherford has no incentive to install new liners in the city's landfills. The residents of the city receive too little benefit ($5 million) to warrant the expense they would have to bear ($9 million). Any local elected official who tried to implement this resource transfer would certainly incur the voters' ire. And that's a shame. The reality of the situation is that this resource transfer would make society better off.

From the perspective of society's happiness, there are only two numbers in the table that matter: $9 million and $12 million. Installing landfill liners is a resource transfer that takes away $9 million of happiness from consumers who are denied the goods and services that these resources could have produced doing something else. But in exchange, the citizens of Weatherford, Clinton, Thomas, and Hydro collectively receive $12 million in happiness. Therefore, the net gain to society's happiness of installing the landfill liner is $3 million.

Now the EPA steps in. They tell Weatherford that they better fix their landfill problem--or else. Or else what? Or else the EPA will hit the city of Weatherford with a very substantial penalty, a $7 million fine. This changes everything. Now the mayor and the city manager huddle over the city's budget and come to an entirely different conclusion. By installing the new liners, the city can make its citizens $5 million better off, and avoid having to pay the $7 million fine. Once this PENALTY AVOIDANCE BENEFIT is factored in, the citizens of Weatherford, and their elected officials, decide it is in their best interests to do what the EPA says. In effect, this penalty avoidance benefit helps the citizens of Weatherford to "feel the joy" that their neighbors receive from having Weatherford's landfills lined.

Before EPA Mandate After EPA Mandate

BENEFITS: $5M + $7M = $12M $5M + $7M = $12M

REVENUE:

COST:

PROFIT:

$5M

$9M

- $4M

$5M + $7M = $12M

$9M

+ $3M

Change in society's happiness is $12M - $9M = + $3M



In this fashion, the federal government encourages a resource transfer that increases society's happiness by $3 million.2 This is a clear demonstration that an environmental mandate in the presence of externalities can make society better off. But will it? Once again, that is an entirely different question.

To show how government intervention could make things worse, let's suppose that everything about the problem is exactly the same--with one exception: This time, we assume that the citizens of the neighboring towns get only $1 million of pleasure from Weatherford putting liners in their landfills. The only effect this has on the numbers in the Profit Table is that now the gross Benefit from installing the liners is only $6 million, instead of the $12 million in the previous example. Importantly, this change in the valuation of the benefit by residents of Clinton, Thomas, and Hydro alters nothing from the perspective of Weatherford's city budget.

It's still the case that before the intervention by the federal government, Weatherford had no incentive to install the new liners. And it's still the case that after the intervention, it is in Weatherford's best interests to do what the EPA says. But now the only two numbers in the table that matter from the perspective of society's happiness are $9 million and $6 million. The EPA's environmental mandate has forced through a resource transfer that is going to deprive consumers of $9 million of happiness while producing a gross Benefit of only $6 million. Rather than increasing society's happiness, this same environmental mandate has now caused society's happiness to decrease of $3 million.

Why the different result? Why did government intervention increase society's happiness in the first example, but decrease it in the second? It has to do with the size of the penalty compared to the size of the externality. In the second example, the penalty was too large relative to the external benefit received by the residents of Weatherford's neighboring towns ($7 million versus $1 million). You see, the purpose of the penalty is to help Weatherford "feel some of the joy" that citizens in other towns will get from the resource transfer. In other words, the penalty is supposed to mimic the information that the price system should be reporting, but isn't.

Before EPA Mandate After EPA Mandate

BENEFITS: $5M + $1M = $6M $5M + $1M = $6M

REVENUE:

COST:

PROFIT:

$5M

$9M

- $4M

$5M + $7M = $12M

$9M

+ $3M

Change in society's happiness is $6M - $9M = - $3M



By threatening Weatherford with a hefty fine, the EPA manufactured an extra $7 million incentive for Weatherford to install the landfill liners. Unfortunately, this extra incentive sent the wrong information to Weatherford. It overstated the benefit that the landfill liners would produce for the other towns. It caused Weatherford to "feel too much joy" from this resource transfer. As a result of this bad information, the EPA induced Weatherford to misallocate society's resources. If only the EPA had set the penalty at $1 million instead of $7 million, Weatherford would not have made this mistake.

This illustrates an important lesson for government intervention: IN ORDER FOR GOVERNMENT INTERVENTION TO IMPROVE RESOURCE ALLOCATIONS IN MARKETS WITH EXTERNALITIES, GOVERNMENT MUST SET THE PENALTIES/REWARDS EQUAL TO THE VALUE OF THE EXTERNAL BENEFITS/COSTS RECEIVED BY THIRD PARTIES. If the penalties/rewards are too large, government intervention can make society worse off.

But how can government know the size of the externalities? It can't. Once again, the problem here is lack of information. When there is a market imperfection due to externality, firms will misallocate resources because prices contain incomplete information. The interests of the third party are not being reported by the price system. But they're also not being reported by anybody else. Who can look into the hearts and souls of the citizens of Clinton, Thomas, and Hydro to know how much happiness they would get from having liners put into Weatherford's landfills?

The whole wonder of the price system is that it is able to produce information that is virtually unknown and unknowable by any other means. When the price system fails, we are back to the world of the central planner trying to figure out who wants what. We are forced to depend on panels of "experts"--like the EPA--as they make their best subjective guess about the unseen sizes of the externalities.

Does this imply that government should never intervene when there are externalities present in a given market? Of course not. If a city's landfill is leaking toxic chemicals and people are falling over dead all around town, then reasonable people will agree that spending $9 million to line that landfill is a justifiable expense. It gets a lot trickier, however, when the externalities are smaller and not so visible. How large a number should one assign to externalities in cases like Weatherford's, where people are not falling over dead all around town? Reasonable people can--and will--disagree. But it doesn't help when EPA administrators like Roger Meacham unequivocally state, "the benefits outweigh the costs." The regulators entrusted with making these resource decisions ought to realize that the benefits of their actions cannot be known for certain--and that they have the power to do harm, as well as good.





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Notes

1 The Oklahoma Daily, September 16, 1992.

2 Perhaps this strikes you as unfair. Why should the citizens of Weatherford be asked to subsidize Clinton-ites, Thomas-ites, and Hydro-ites? Why should people in Weatherford have to pony up money to pay for something they don't value very much? Note that the EPA could have mandated that the citizens of these neighboring towns be required to contribute some of the expenses for the new liners. The fact that they didn't means that there is an implicit wealth transfer from the citizens of Weatherford to the citizens of these neighboring towns. As always, wealth transfers don't figure into our evaluation of society's happiness. Weatherford's loss is Clinton's, Thomas', and Hydro's gain. What matters from the perspective of society's happiness is merely that resources have been transferred from lower-valued uses to higher-valued uses. Society's total happiness has increased.



CHAPTER 48 Market Imperfection III: Public Goods

The last market imperfection that we will look at is "public goods." The name is misleading. When economists speak of public goods, they are not talking about goods that are produced by the public sector (though oftentimes these goods are). Rather, the adjective "public" is used to distinguish those goods that are not "private" goods. A private good is a good like a hamburger. When you take a bite out of a hamburger, that's one less bite that is available for somebody else to consume. Contrast this with a football game. When you watch a football game on TV, there's just as much of that football game available for somebody else to watch (consume).

In fact, from the perspective of maximizing society's happiness, WE CAN THINK OF PUBLIC GOODS AS GOODS THAT ARE CHARACTERIZED BY POSITIVE EXTERNALITIES. Suppose you are both an avid football fan, and a very wealthy individual. You love football so much that you arrange with the owners of the Dallas Cowboys and the San Francisco 49ers for their two football teams to come to your home and play a scrimmage in your backyard. Chances are, once your neighbors hear about it, they also will want to watch the game. In other words, though you arrange to watch the game in your backyard for your private benefit; your neighbors expect to receive an external (third-party) benefit. And that's okay with you. After all, if they want to come and watch, it will not diminish your pleasure. As long as the amount you are willing to pay is greater than the cost of putting on the game, society's happiness is increased. Your neighbors' happiness is just icing on the cake.

But suppose your willingness to pay isn't large enough to pay the costs of putting on the game. As a result, no game is held in your backyard. What happens to society's happiness then? This case is almost identical to the example of the landfill liners of the previous chapter. If the external benefits received by your neighbors--like Mr. and Mrs. Clinton, Mr. and Mrs. Thomas, and Mr. and Mrs. Hydro--are sufficiently large, then society's happiness would be increased if you arrange the game. The problem here is that you don't "feel their joy" in deciding to schedule the game. In doing what is in your interest, and by not considering the spillover benefits to your neighbors, your action no longer maximizes happiness.

THE PROBLEM WITH PUBLIC GOODS, LIKE THE PROBLEM WITH POSITIVE EXTERNALITIES, IS THAT THE PRIVATE SECTOR WILL PRODUCE TOO LITTLEOF THE GOOD. Too few resources will be withdrawn from other activities and directed to the production of this good. And that's a shame. Society will miss out on an opportunity to increase its happiness.

It's important to note that private markets are not completely helpless in dealing with goods that have positive spillover benefits. Profit-seeking entrepreneurs will try to figure out some way of "capturing" the externalities from public goods. For example, one thing you could do to capture the spillover benefits received by your neighbors from the Cowboys-49ers



scrimmage is build a high wall around your property and then charge admission for those who wanted to see the game. Then you could begin to "feel their joy." The revenues you collect would provide information about the amount of pleasure your neighbors received. If the sum of these revenues and your own willingness to pay was larger than the costs of putting on the game, you would find it in your interest to arrange the football match. You would have a private incentive to act in the public interest. In essence, building a wall and charging admission has turned the third party--your neighbors--into direct participants in the economic transaction. It has allowed you to internalize the external benefits associated with hosting the game. The "public" good has been "privatized."

Many times, however, private markets aren't able to capture the external benefits from public goods. For example, take jokes ("Take my wife...please"). A paying consumer (let's call her Mary) goes to a comedy club and pays admission to hear a professional comedian tell jokes. Mary's willingness to pay is a measure of the happiness that she expects to receive from the show. But consider what happens after she returns home from the club.

The jokes Mary heard are still able to be enjoyed by others even after she has "consumed" them. Suppose she tells her friends--Laurie Clinton, Lisa Thomas, and Jennifer Hydro--some of the funny stories she heard. And they get a big guffaw from hearing the comedian's jokes. While Mary may consider these people her friends, from an economist's perspective, they're just third parties to a resource transfer. They are getting a benefit from the comedian's jokes without having to pay for it. As a result, the revenue the comedian receives from producing jokes does not reflect the pleasure Mary's friends receive. Like all goods with positive externalities, this is likely to result in too little of the good being produced. Society is a little less happier--and a little less funnier--because the price system has failed to report the full pleasure that consumers receive from this comedian.

Note how difficult it would be for the comedian to internalize these external benefits. He would have to assign a private detective to each paying consumer to follow them around after the show. Every time Mary told one of the comedian's jokes to a friend, the detective would have to collect money from the person who heard the joke.

DETECTIVE: "Excuse me, ma'am, I'm from the Comedy Club and that joke's going to cost you five dollars."

MARY'S FRIEND: "Five dollars, you've got to be joking."

DETECTIVE: "No, ma'am, that's not my job. My job is to collect money for the people who are joking."

Clearly, it is not practical for the comedian to do this. At least by performing in a club and charging admission at the door, the comedian is able to capture some of the benefits from producing this good.

For other types of public goods, even this isn't practical. Consider a road in a downtown area



of a major city. After one consumer uses the road, there is still plenty of road available for another consumer to use. A private entrepreneur might try to charge each of the users of the road a fee, but imagine what a mess that would be. Every time one turned the corner from one street to another, there would be a tollbooth to collect money from drivers. Just think of the traffic jams this would cause during rush hour as cars queued up to pay tolls at every corner!

In summary, because public goods produce positive spillover benefits, there arises a problem in how to get people to pay for the benefits they enjoy. An alternative to the methods discussed above is voluntary contributions. However, this raises the famous "FREE RIDER PROBLEM" which is the topic of the next chapter.



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CHAPTER 49 Public Goods and Free Riders

Suppose you own a store in a major shopping district. After two break-ins, you meet with the owners of several other nearby businesses who have had similar problems. You propose that you all band together to hire a watchman to patrol the neighborhood after dark. For the five businesses attending, including yourself, the table below reports how much each is "willing to pay" for this police protection:

It turns out that a watchman can be hired for $15,000. If the costs are equally divided across the five businesses, each would pay $3,000 apiece. Since everyone's "willingness to pay" is more than this amount, hiring a night watchman would make each person better off. That is, this resource transfer would increase society's happiness.

But would you expect each businessperson to agree to this plan? The problem is twofold. First, each person only knows his or her own willingness to pay. Despite the fact that we have reported the other businesses' willingness to pay values in the table above, in reality, this information is hidden--unseen and unknowable. Second, each business knows that they will enjoy an external benefit if the other businesses hire the night watchman. This external benefit arises because once burglars know that the neighborhood is being patrolled at night, they will divert their attention to other parts of town. A business that didn't pay for the night watchman could still derive benefits from the other stores' having hired a night watchman.

As a result, the owner of Business B might say to his colleagues, "Hey, I really haven't had any problems. If you guys want to go ahead and get a night watchman, that's fine. Just don't expect me to pay." The truth is that the owner of Business B values a night watchman's services at $6,000. But by lying to his friends, he can wind up paying nothing and still get the benefit of a having a night watchman in his neighborhood. The owner of Business B is what economists call a "FREE RIDER." You may call him a leech.

The problem with free riding is that if the other businesses follow the same strategy, the watchman will not be hired. And that is a shame. It is in the interests of society's happiness to hire a watchman.

Everyone has had experience with free riders. If you have ever worked on a team project in school, you've probably seen the problem up front and dirty. Suppose a team consists of one conscientious student and three slackers. These three may be slackers, but they are certainly no dummies. They know that the conscientious student will work hard no matter what. As a

YOU BUSINESS A

BUSINESS B BUSINESS C BUSINESS D

$7000 $5000 $6000 $4000 $8000



result, the slackers can sit back and goof off, and still receive an acceptable grade for the project. They experience a positive externality from the work of the conscientious student. As a result, they don't work as hard as they would if they were being graded on their own efforts, and the project suffers.

Another example of free riding occurs every Sunday morning in houses of worship all across America. People sit in the pews at church, listen to the sermon, enjoy the fellowship of the congregation, and take advantage of the many services the church has to offer. Yet when the collection plate gets passed around, does everybody pitch in a contribution to help pay the costs of the services? Those who don't are free riding on the contributions of the others.

From these examples, one can see how difficult it is to get the private sector to produce the quantity of a public good which maximizes society's happiness. Whether because of the impracticality of collecting revenues or the free rider problem, for-profit enterprises will find it difficult to collect revenues commensurate with the happiness society receives from public goods. As a result, the private sector will tend to produce too little of the public good. When this happens, there is a role for the public sector.

To be sure, most of us would feel uncomfortable about having the government take over the production of church services. On the other hand, most would agree that government should play a role in the provision of public goods like city streets, the criminal justice system, and national defense. But how does the public sector decide how much of these goods to produce? And will the public sector allocation necessarily be better than the private sector allocation? To answer these questions, we will need to examine just how the public sector makes allocation decisions. That is the topic of the final chapters of this book.



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CHAPTER 50 Voting on Public Goods: All in Favor, Say "Aye"

One way the public sector can allocate resources in the presence of market imperfections is by a dictator. However, famous resource allocators like Joseph Stalin, Adolph Hitler, Pol Pot, and Idi Amin have generally given this alternative a bad name. As a result, most people seem to prefer the alternative of MAJORITY VOTING. In the next few chapters, we want to investigate whether majority voting is likely to improve upon the resource allocations produced by the private sector in the presence of market imperfections. To do that, we first need to understand how majority voting works.

City streets are widely acknowledged as being public goods.1 Let's consider an example from the make-believe city of Dinky, North Dakota. The little township of Dinky consists of five homes at the end of a cul-de-sac. The cul-de-sac is not paved. In fact, in its current form it's a miserable excuse for a road, consisting solely of dirt and gravel. Every time the snow melts or there is a significant rain, the area turns into a sea of mud and pot holes. As a result, each of the five households has given a lot of thought to the possibility of hiring a contractor to pave the cul-de-sac. After checking around, they locate a contractor who is willing to pave their cul-de-sac for $25,000.

The table below represents how much happiness each of these families would receive if the cul-de-sac was paved.

As the table shows, each household has a different "willingness to pay" value. This is because some of the families live at the end of the cul-de-sac and have to drive over more potholes than others. In addition, some of the households own cheap compact cars which have a tough time making it through the mud and the sludge; while others own Range Rovers and Jeeps that can go through almost anything.

And now for the really important question: Should Dinky get paved? From the perspective of maximizing society's happiness, the answer is a resounding yes. The total dollar value of happiness from paving the cul-de-sac is $10,000+$8,000+$6,000+$3,000+$3,000 = $30,000. In contrast, since the cost of paving the road is $25,000, we can infer that society will lose $25,000 of happiness from having the resources used to pave the road--the laborers of the road crew, the tar and asphalt, etc.--withdrawn from other activities. The net effect will be an increase in society's happiness of $5,000.

But will the households of Dinky work together to arrange this resource transfer? Let's first consider how resources would be allocated under a PRIVATE SECTOR arrangement. This

Andersons Bakers Custers Demeters Ewings

$10,000 $8,000 $6,000 $3,000 $3,000



would be problematic, to say the least. While we know the willingness to pay values of the five households, this is private information. Each household only knows how much happiness it would receive. Because of this, and because the residents of Dinky are no stranger to the phenomenon of FREE RIDING, there is no telling what is going to happen. Maybe all five will agree to contribute enough money so that they road is paved. That would be great.

On the other hand, maybe some of the families will try to free ride. That is, some of the families might not really be willing to pay their "willingness to pay" values. For example, suppose the Ewings decide to free ride off of the other families. They tell their neighbors that, personally, they enjoy the mud and the potholes. On top of that, it keeps those pesky door-to-door salesmen away. They lie about the fact that they really want a paved road. And it just might work. After all, the Andersons, Bakers, Custers, and Demeters together sufficiently value paving the road. These four families might voluntarily contribute enough money to pull it off. Then again, they might not. Another family might also try to free ride. If that happened, then the whole project would fall apart, and the road would not be paved. No one household gets sufficient happiness out of the paved road to pay for it themselves. It requires coordination with other households. This points out the problem with private sector allocations of public goods. If people free ride, or if it's too costly to collect revenues from those who benefit, there will be a tendency to devote too few resources to the production of the public good. In this case, the road might not be built or a lesser road, such as a gravel road, will be chosen over the optimal solution of a paved road.

Now consider what happens when the resources are allocated under a majority voting arrangement. Suppose the town of Dinky puts a proposition to pave the road on the ballot in the next general election. In the table below, we reproduce the "willingness to pay" values from above on the "Benefits" row, but now we include two additional rows. Since the township of Dinky will arrange with a contractor to have the road paved, it will need to raise tax revenues. Let's assume that Dinky raises $5,000 in taxes from each family if the proposition to pave the cul-de-sac passes. We represent this personal tax cost to each family on the "Costs" row. The "Vote" row reports how each family will vote. If the household's personal "Benefits" are greater than their "Costs," they vote YES on the proposition. Otherwise they vote NO. Here are the results. (Note: we let each household have one vote.)

The people have spoken! The proposition to pave the cul-de-sac is passed by a 3 to 2 vote. The road shall be paved, and society's happiness shall be increased. It may seem a little


BENEFITS:

COSTS:

VOTE:

$10,000

$5,000

YES

$8,000

$5,000

YES

$6,000

$5,000

YES

$3,000

$5,000

NO

$3,000

$5,000

NO



unfair that the Demeters and the Ewings had to pay $5,000 in taxes when they only valued the road at $3,000. But once again, we are not concerned with fairness. We are concerned with maximizing society's happiness. In the private sector, the road might not have been paved because the community had no way of forcing everybody who received a benefit from the road to pay for it. When the government intervenes--precisely because it's the government--it can force people to pay taxes so that enough money will be collected to pay for the road paving. It is the ability of the government to coerce individuals to pay for things that they otherwise wouldn't pay for that enables the government to increase society's happiness in this case.

Will majority voting always result in public goods being provided if they increase society's happiness? The answer is no. This is easily seen by manipulating a few numbers to obtain the table below. If it happened that the Bakers valued the road paving at $10,000 (instead of $8,000) and the Custers valued it at $4,000 (instead of $6,000) we would obtain the opposite vote outcome.

In this case, the vote on the road paving proposition would be 3 to 2, against. The road would not be paved under majority voting. And that's a shame. After all, paving the cul-de-sac still would generate a net increase in society's happiness of $5,000. The residents of Dinky would still receive $30,000 of happiness ($10,000+$10,000+$4,000+$3,000+$3,000) from paving the road; while withdrawing resources which would have produced $25,000 of happiness elsewhere in the economy.

THEREFORE, MAJORITY VOTING DOESN'T GUARANTEE THAT PUBLIC GOODS WILL BE PROVIDED EVEN IF THEY INCREASE SOCIETY'S HAPPINESS. How about the other way? Can majority voting approve resource transfers that lower society's happiness? What do you think?



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BENEFITS:

COSTS:

VOTE:

$10,000

$5,000

YES

$10,000

$5,000

YES

$4,000

$5,000

NO

$3,000

$5,000

NO

$3,000

$5,000

NO



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Notes

1 While the following discussion is targeted towards the provision of public goods, the same general analysis is applicable to instances of market imperfections relating to monopoly and externalities.



CHAPTER 51 Free Riders Versus Forced Riders

In this chapter, we want to continue with the same Dinky example we used last chapter. Five families. All living at the end of an unpaved cul-de-sac. It still costs $25,000 to hire a contractor to pave the road. Only this time, we want to use some different "happiness values" for the five families. After all, nobody ever sees other people's valuations of public goods. So the following happiness values are in principle just as reasonable as any other.

Given these values, do we want the cul-de-sac paved? In this example, the residents of Dinky get only $20,000 of happiness ( = $7,000+$6,000+$5,500+$1,000+$500) from having the road to their homes paved. Since paving this road would remove resources worth $25,000 elsewhere in the economy, we don't want Dinky paved.

Here's the good news: Under a PRIVATE SECTOR arrangement, this road would never be paved. Figure it out. Even if every one of the residents paid the entire dollar value of the happiness that the paved road would provide for them, they still wouldn't have enough money to pay the contractor. To get enough money to pay the contractor, these families would have to contribute more money than the project was worth to them. Since this would never happen under a voluntary contribution system, the road would not be paved. This illustrates a general principle about the private sector provision of public goods (and goods characterized by positive externalities): UNDER PRIVATE SECTOR ALLOCATIONS, INDIVIDUALS WILL NEVER ARRANGE TO HAVE PUBLIC GOODS PRODUCED WHICH LOWER SOCIETY'S HAPPINESS.

But now consider what happens under MAJORITY VOTING. Once again, we reproduce the individual households' willingness to pay values in the "Benefits" row. The "Costs" row represents each household's tax burden. The "Vote" row shows how each household would vote if the road-paving proposition appeared on the Dinky general election ballot.


$7,000 $6,000 $5,500 $1,000 $500


BENEFITS:

COSTS:

VOTE:

$7,000

$5,000

YES

$6,000

$5,000

YES

$5,500

$5,000

YES

$1,000

$5,000

NO

$500

$5,000

NO



In this case the proposition passes by a vote of 3 to 2. The road is paved. And that is a shame. In approving this proposition, the majority of voters have initiated a resource transfer that will take resources that would have produced $25,000 of happiness elsewhere in the economy, and directed them to an activity that generates only $20,000 of happiness. MAJORITY VOTING HAS JUST LOWERED SOCIETY'S HAPPINESS BY $5,000. How could this happen? How could the majority do this to society? What went wrong?

The solution to this puzzle has to do with NEGATIVE EXTERNALITIES. Only this time, it's not a private sector externality, but a public sector "externality." Recall what a negative externality is. It is a cost experienced by a third party to a resource transfer. When a factory belches black clouds of breath-stifling smoke into the atmosphere, it imposes costs on consumers who live near the factory. But consider this: When a voter votes for a proposition that makes other citizens worse off, he also imposes costs on those citizens. Economically speaking, this voter has just done to other citizens what the factory has done to its neighbors.

We can see this more clearly in the table below. The third row in the table reports the gains or losses ("Profits") that each voter experiences if the road-paving proposition passes. Note that the three voters who vote in favor of the proposition receive relatively small gains as a result of the resource transfer ($2,000+$1,000+$500 = $3,500). In contrast, the two voters who vote against the proposition sustain relatively large losses ($4,000+$4,500 = $8,500). Thus, majority voting has allowed the first three households to vote $3,500 of positive "profits" for themselves at the expense of $8,500 in negative "profits" for the other households, generating a net decrease in society's happiness of $5,000. Because the Andersons, Bakers, and Custers do not internalize the costs they impose on the Demeters and Ewings, they make a socially incorrect resource transfer.

Perhaps we're being a little too harsh on our voters. Maybe voters are more broadminded than we give them credit for. Here's a way to check close this story comes to reality. Think back to the last Presidential election. Did you vote for the Republican or the Democratic candidate for President? When you voted, did you stop and consider how your friends and loved ones felt about your choice? How your co-workers and neighbors felt about it? Probably you knew somebody whose political views were exactly the opposite of yours. Did that make a difference in your presidential vote? And that's just the feelings of people you


BENEFITS:

COSTS:

PROFITS:

VOTE:

$7,000

$5,000

+ $2,000

YES

$6,000

$5,000

+ $1,000

YES

$5,500

$5,000

+ $500

YES

$1,000

$5,000

- $4,000

NO

$500

$5,000

- $4,500

NO



know. How about the feelings of people you don't know? Did you stop and think of what you were doing to them? Every four years millions of Americans are made miserable for at least "four more years." Yet most Americans will not let that affect their decision. They will simply vote for the candidate that they want. In so doing, they are the political equivalent of belching smokestacks.

In fact, there is an interesting parallel between the imperfections of private sector and public sector provision of public goods. Private sector provision of public goods is imperfect because there are external benefits which are difficult for profit-seeking individuals to capture. Public sector provision of public goods is imperfect because there are external costs which are difficult for profit-seeking individuals to avoid. Both kinds of imperfections can lead to resource allocations which do not maximize society's happiness.

Think of public goods provision as a bus ride. When the private sector operates the bus, an entrepreneur is in control of the steering wheel. He decides where to take the bus. Of course, the passengers don't have to go along for the ride. They are free to get on or off. The problem for the private sector lies in the collection of the fares. The nature of public goods is such that some--perhaps many--passengers can ride the bus without having to pay the fare. This results in "free riders." If there are too many free riders, the entrepreneur may not collect enough money to compensate him for operating the bus. So the bus line may go out of business--even though it's increasing society's happiness.

In contrast, when the public sector operates the bus, the majority is in charge. They control the steering wheel and take the bus wherever they want it to go. The problem for the public sector lies in the passengers who have to ride the bus. They are not free to get on or off. Once a majority decides on a destination, everybody is forced to ride the bus and pay the fare. The nature of government is such that some--perhaps many--passengers will be forced to pay for the ride even if they don't want to go where the bus is going. This results in "forced riders." If the forced riders are made sufficiently worse off by where the majority want to go, society's happiness will be decreased. But because government makes everyone pay, the bus line stays in business. It keeps on going even though it lowers the happiness of its passengers.

Of course, this does not imply that public provision of public goods will lower society's happiness. Indeed, the previous chapter provided an illustration of how government intervention in the public goods market could increase society's happiness. It's just that--as in the case of externalities and public sector regulation of monopoly--there is no guarantee that government intervention will improve on the private sector allocation of resources. It could make things worse.

In summary, there is nothing magical about democratic majorities. When it comes to resource transfers, the problem is always one of information. Majority voting does not produce the detailed information that is missing in private markets. It tells us how manypeople gain or lose from a particular resource transfer. It doesn't tell us how much people gain or lose from resource transfers. It is the latter information that we need to know in order



to make resource transfers which maximize society's happiness. And because this information is lacking in political markets, resources can easily be misallocated in the public sector--just as they are misallocated in the private sector--when market imperfections are present.



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CHAPTER 52 Exploiting Fellow Citizens for Fun and Profit

Why would Congress spend $100 million a year to store helium gas in underground caverns in the Texas panhandle? What's that? You haven't heard about that program?

Or how about $35 million for a monorail in Altoona, Pennsylvania.

Or how about $25 billion dollars in subsidy payments given to American farmers through programs like the following:

"Washington so loves helium that it has a billion dollars worth of gas stored underground in the Texas panhandle for fear it will run out of the inert gas. While the gas sits, the Bureau of Mines of the Department of Interior suffers a loss of $100 million a year....It all started with blimps in World War I. Military strategists decided that airships were the weapon of the future, and in 1929, Congress appropriated money to put the government into the helium producing business in case we had to fight that war all over again. Plants were built and for 30 years, the U.S. government was the major (almost exclusive) producer of helium in the United States. Washington provided all the helium needed by agencies like NASA--who used it to purge fuel tanks in the missile program...'How much helium do we have underground?' I asked a director of the program in Washington. At least he was frank. 'We have a whole lot--in fact, 35 billion cubic feet.' 'How long will that last at our present rate of use?' I asked innocently. He didn't hesitate. 'Well over a hundred years.'"1

"The three-mile-long Suspended Light Rail System Technology Pilot Project is not only a classic government title, it's a $35 million monorail that is being built by the federal government as part of the $153 billion Intermodal Surface Transportation Efficiency Act of 1991...The monorail had been projected for a small town in Pennsylvania--specifically, Altoona--population 57,000. The chairman of the Subcommittee on Surface Transportation is Congressman Bud Schuster of Pennsylvania. His district? Where else but Altoona....This was only one of 460 "demonstration projects" attached to the mammoth bill. Congressman Schuster managed to put in 13 projects worth $287 million for his own district."2



Millions of dollars for the underground storage of helium gas (to prepare our forces for the imminent Russian blimp invasion?); a monorail for Altoona, Pennsylvania (to alleviate the traffic congestion around this metropolis?); and cash subsidies for farmers not to grow crops (no comment). And this is only the tip of the iceberg. The list goes on and on. How is it that elected officials--popularly chosen by democratic majorities--can engage in such massive squandering of taxpayers' money? Why can't they just say no to wasteful spending? In this section, we want to show the inescapable logic that underlies these wasteful uses of public funds.

Let's consider a particular resource transfer, say the storage of helium gas in underground caverns in the Texas panhandle. Let's assume there are a hundred voters in the economy and that it costs a $100 to purchase and store the helium gas--$50 to buy the helium and $50 to rent the land under which the helium is stored. Thus, each voter would have to pay $1 in taxes to fund the program.

To keep it simple, we assume that everyone in the economy agrees that there are absolutely no social benefits to storing helium gas. However, some voters do receive a financial benefit from this government program. These are the landowners--we'll assume there are five of them--from whom the government will rent the land to store the helium. If the government didn't rent this land, these five landowners could each receive $6 by putting their land to some other purpose (say drilling oil). But if the government goes ahead with the helium gas storage program, it will pay these five landowners $10 each to use their land. Accordingly, each of these five landowners would receive a $4 financial gain from the program. Now suppose we held an election to determine whether we wanted the government to store helium gas. The table below reports how this election would go.

"One of the most abrasive programs in the farm-welfare armamentium is the "0-92" scheme, a true farmer dole. It is a bizarre federal idea that allows a farmer not to work, not to plant at all, and live as well as he ever did...The Congressional Budget Office explains...'Current law allows participants in U.S. Department of Agriculture price- and income-support programs to receive 92 percent of their deficiency [subsidy] payments even though...they do not plant any of the program crop (the 0-92 program available for wheat and feed grain producers).'...What's behind all this? The federal official involved in auditing the farm program...adds...'The politicians in the farm areas are desperately trying to keep their constituents in business and agriculture happy, and they seem to be successful at it.'"3

Landowners (5)

Other Voters (95)



The electorate--in its infinite wisdom--chooses not to support the helium gas storage program. The vote is 5 in favor and 95 against. And that's great. Because the helium gas storage program would decrease society's happiness by $80. Why $80? First there is the withdrawal of helium gas which costs $50. The price of the helium gas tells us that this gas would produce $50 of happiness elsewhere in the economy if it wasn't stored under the Texas panhandle. On top of that, the helium gas storage program would have withdrawn $6 of land from each landowner. Therefore, we know that this land could have produced a total of $30 of happiness ($6 times 5 landowners) if it were used for something else--like cattle production. Thus, the $100 cost of the program consists of an $80 decrease in society's happiness plus a $20 wealth transfer ($4 times 5 landowners).

But, unfortunately, we have left out an important part of the story. Suppose that voting took some effort. That is, a person had to leave work and drive to the polling booth or find a babysitter to watch the kids while she went off to vote. Let's suppose that this effort made each voter worse off by $2. Now let's reconsider our election results. First the "Landowners": If this bill gets passed, each landowner will be made better off by $3 (see the "Profits" row). Even with a $2 cost to voting, it still pays for the landowners to go to the polls and vote in favor of the storage program.

But now consider the "Other Voters": if the bill passes, each of these voters is made worse off by a $1. This dollar loss is small compared to the $2 cost of voting. As a result, these voters stay home, or at work, and don't turn out to vote. That is, the loss that they suffer from this program is too small to justify protesting against it. The final election result? 5 in favor and 0 against. The helium gas storage program passes in a landslide! Welcome to the LAW OF CONCENTRATED BENEFITS AND DISPERSED COSTS.

That's crazy, you say. It doesn't work like that. It doesn't? Okay, here's a little test for you. Now that you know that the government is stockpiling a hundred year's worth of helium gas under the Texas panhandle--and assuming that you don't live in the Texas area--what are you going to do about it? Are you going to contact your congressman (what's his name?) and demand that he put an end to this program?

Part of the problem is that the funding for this program is buried somewhere deep in the federal budget (and since the federal budget contains over 200,000 line item accounts and is well over a thousand pages long, it could be very deep). This means that there is no House or Senate legislation entitled "The Precious Gasses Conservation and Storage Act" which

BENEFITS:

COSTS:

PROFITS:

VOTE:

$4

$1

+ $3

YES

$0

$1

- $1

NO



your congressman could argue and vote against. Rather, he'd have to lobby his colleagues on the respective budget appropriations committees to have this item removed from the federal budget. But why should he?

Your congressman has only so much time in the day. If he spends his time lobbying against funding for this program, that's less time he has to work on other issues. And relative to most of the issues your congressman faces, this program is hardly worth noticing. Because the reality is, as federal programs go, $100 million is only a drip in the public bucket. It amounts to less than 1/15,000th of the total federal budget! It's so small that it might not even appear as a separate item in the federal budget. So even if your congressman wanted to do something about wasteful federal spending, it wouldn't make any sense for him to focus his efforts on this measly, little $100 million federal program.

But why would your congressman want to work hard to eliminate specific programs that waste taxpayers' money? Are you going to vote against him if he doesn't? Let's try and figure this out. As a rough approximation, let's say there are about a 100 million, taxpaying households in America. Assuming you are an average American household, how much is this program costing you? About a dollar a year. One dollar. A hundred pennies. That's it. We repeat the question: Now that you know that the government is stockpiling a hundred year's worth of helium gas under the Texas panhandle--and assuming that you don't live in the Texas area--are you going to badger your congressman to do something about this? And if you're not, who will? We should hardly expect congressmen to wage battle against wasteful government programs if the elimination of these programs is of such small concern to ordinary voters.

In contrast, there is a group of voters for whom these programs are very important. Now suppose you are a resident in this Texas panhandle district and a recipient of government funds from the helium program. You hear that Congress is thinking about axing this program. What are you going to do? Maybe you're making $100,000 a year from this program. Do you have an incentive to protest this cut? Yes indeed. At the very least, you'll phone your congressman's office and tell him you want him to fight this budget cut. Since losing this program means you're out a $100,000, you'll probably do a lot more. You might threaten your congressman that unless he stops this budget cut, you'll stop donating the thousands of dollars you contribute each year to his campaign. Maybe you'll hire a lobbyist--if you haven't already--to plead your case before the relevant congressional subcommittees. Your congressman gets the message: this program means a lot to his constituents. And now he'll fight like a dog to make sure this program is preserved.

How will this congressman mobilize support for this program? He won't do it by telling his colleagues on the budget committee that they should preserve this program because it's a huge boondoggle for you and your friends. No way. He'll give a rousing speech on the floor of the House that will sound something like this:

Mr. Speaker, my colleagues in this distinguished institution, my fellow



Haven't you heard this--or something like this--before? And when the committee that's in charge of considering the budget cuts sits down to deliberate--after they've heard speeches like the one above--they'll likely hear some more speeches. But this time not from politicians. Farmers, housewives and their children, small businessmen, all will be flown into Washington to testify before the committee about the great good this program has done for them. And there will be tearful pleas to the congressmen to preserve this program.

Americans. I am here today to talk to you about a vital, vital program. The helium gas storage program has been in existence for over half a century. During this time, this program has served important American interests. As most of you know, these gasses played a fundamental role in our space program that helped put the first man on the moon, and kept the missiles in place that have protected this country so ably over the past decades against foreign aggressors.

And now there's talk about cutting this program. This program costs Americans virtually nothing. In fact, it costs the average American family less than A PENNY A DAY. And what does America get in return for this minuscule investment? I'll tell you what America gets. It gets a guaranteed supply of precious gasses that can never be disrupted by the vagaries of the market. Gasses that are vital to the functioning of this economy.

But it gets more--a lot more. It provides support to honest, hardworking Americans who have dedicated their lives to helping this country stay strong. They were there for the working people of this country back when many Americans really wondered whether we could put a man on the moon--or whether we could defend ourselves against the communist threat. If we cut this program now, we will throw these hardworking, god-fearing American families out in the cold. Thousands of jobs will be lost. Communities will be devastated. Families will be broken apart. These very same families who have sacrificed so much--so that we could have the peace and prosperity that we know today.

I was not elected to this great institution to sit idly by while misinformed and mean-spirited budget-cutters throw decent folks out in the street. This isn't a vote about saving a few million dollars. It's a vote about what we stand for in this great country. It's a vote about whether we care more about people--or about dollars. I trust that you--my distinguished colleagues--will also not sit idly be and allow this great injustice to be done. And so I appeal to you, don't cut this vital program. Think of the families. Think of the children. And may God bless America.



Who will be there to speak against this program? Where will the advocates come from to argue in behalf of the millions of Americans who have to pay for this? The fact is, there won't be many. It just isn't an important enough issue for any one voter or household to try to fight. It's not worth the effort. Just like it wasn't worth the effort for our "Other Voters" to show up and vote against this program in our hypothetical example above. When the members of this committee get together to decide the fate of this program after a hard day of hearing testimony, what do you think the vote will be? How about 5 in favor and 0 against?

Does all of this still sound too-farfetched? Consider the following. The political scientist James Payne, author of the book The Culture of Spending, spent several years in Washington, D.C. in the late 1980's. During that time he attended a large number of House and Senate appropriation committee meetings. He kept a running count of the number of supporters of federal spending programs; and compared this to the number of opponents of federal spending programs. What do you think the ratio of supporters to opponents was? Five to one? Ten to one? A hundred to one? Try 145 to 1! Of 1,060 witnesses who appeared before appropriation committees during this time period, 1,014 were supporters of or program or spending; 39 were neutral or mixed; and only 7 were opponents of programs or spending.4 How can we explain this? CONCENTRATED BENEFITS AND DISPERSED COSTS.

When the benefits of a federal spending program are concentrated on a relatively small percentage of the population, there is a great incentive to mobilize support for that program. When the costs are spread across the entire taxpaying population--as they are when programs are funded out of general tax revenues--there is little or no incentive to mobilize opposition against that program. In effect, the beneficiaries all vote in favor of the program while the taxpayers stay home and don't fight it. The result? A virtual landslide of electoral support in favor of individual spending programs! So everybody complains about high taxes and wasteful federal spending, but when it comes time to vote for their congressman, they reelect the ones who bring home the pork.

This very simple truth goes far to explain why we see Congress approving billions of dollars to special interest groups. When the congressional delegation from Texas fights hard for the preservation of the helium gas program, the congressmen from Pennsylvania and the Midwest farm states are easily won over. They agree to vote for the helium gas program. In exchange, the congressmen from Texas agree to vote for a monorail for Altoona, Pennsylvania; and agricultural subsidies for wheat farmers. These programs produce concentrated benefits for their respective constituents. And these constituents will reward their congressmen for preserving these programs by reelecting them to office. In return, since the costs of these programs are so spread out, no congressman from Texas is going to lose an election because he didn't fight a monorail project for Altoona, or an agricultural subsidy for wheat farmers.

It's a crazy system, but it all makes perfect sense. For the most part, it has nothing to do with corrupt politicians. It is not the character of the people who are sent to Congress. Rather, it is the incentive structure that exists when they get there. An incentive system imposed on



politicians by their own voters. And if Congressman Smith tries to fight the system singlehandedly by voting against special interest legislation, what will happen to him? Chances are his colleagues in Congress won't be very willing to approve programs that provide special benefits for Mr. Smith's constituents. Perhaps after a few years, the voters in Mr. Smith's district will get disgusted with him for not bringing enough federal money back to their district. Perhaps they'll throw him out of office and replace him with somebody else who can do a better job.

If all this were a simple tale of wealth transfers between groups, it might strike one as unfair, but it wouldn't be a source of alarm. However, when wealth transfers to special interest groups result in resource misallocations, society as a whole becomes poorer. Think back to our example of voting for the helium gas storage program. A relatively small group of landowners was able to generate a resource transfer that made them $20 better off ($4 times 5 landowners), but lowered society's overall happiness by $80. Now multiply this example by thousands--tens of thousands--of special interest groups, each interested in increasing their share of the economic pie, but not concerned with the costs they impose on others, and one sees just how alarming this problem can be. BECAUSE OF THE LAW OF CONCENTRATED BENEFITS AND DISPERSED COSTS, DEMOCRATIC MAJORITIES HAVE AN INHERENT TENDENCY TO MISALLOCATE RESOURCES AND LOWER SOCIETY'S HAPPINESS.

As long as individual self-restraint, or constitutional restrictions, is able to discourage widespread feeding at the public trough, public sector interventions powered by democratic majorities are not likely to cause significant damages to society's happiness. However, once these constraints are relaxed, societies face the prospect of voting themselves poorer. A sobering insight. But not a new one. Not at all. The eighteenth-century Scottish historian Alexander Tytler wrote:

Think about it.



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"A democracy cannot exist as a permanent form of government. It can only exist until a majority of voters discover that they can vote themselves largess out of the public treasury."



Notes

1 Martin L. Gross, The Government Racket: Washington Waster from A to Z, New York: Bantam Books, 1992, pages 98f.



4 James Payne, The Culture of Spending, San Francisco, California: ICS Press, 1991, page 13.



CHAPTER 53 Why Economists Disagree

Just as we promised, once one leaves the world of many buyers, market-clearing prices, and no imperfections, things become awfully complicated. Furthermore, it must be conceded that one can always find a market imperfection if one looks hard enough. Take MONOPOLY for example. Virtually every business has some degree of market power. That is, almost every business could charge higher prices if it was willing to settle for fewer sales. The gas station on the corner. The neighborhood hair salon. The movie theater at the mall. Does this mean that the government should take over every business in the economy and regulate its price and output? If you answered yes to this question, then there's no point in reading further. Rather, may we recommend a fine, three volume work on economics called Das Kapital by Karl Marx. We think you'll like it.

Since the problem with monopoly is that the monopolist doesn't produce enough, a necessary condition for government intervention to improve society's happiness is that it force the monopolist to produce more. Most people don't believe that government regulation of prices would result in more output from gas stations, hair salons, and movie theaters. (Just imagine if the local beauty parlor were run like the Post Office.) On top of that, a vast amount of resources would have to be spent setting and controlling prices for so many companies. These are resources that could produce happiness doing something else. In other words, massive price regulation would be a prescription for pain with little gain. Accordingly, most people would agree that it probably is best not to price-regulate these firms.

So let's move on to a case where reasonable people can disagree. Let's consider the case of a privately owned subway (as in underground transportation) company in a large city. Here is a textbook example of a monopolist--a single seller. It seems reasonable to assume that a subway company--like J. D. Rockefeller's lemonade stand in Chapter 43--would have a significant degree of market power in setting its price. It could charge a very low price and get many riders. Or it could charge a much higher price and get fewer riders. As a result, it is likely that the fare that would maximize the subway company's profits would result in "too few" passengers. What should society do?

Regulation is certainly an option. A Subway Commission could be elected, or appointed by other elected officials, to regulate the subway's fares. Would lower rates result in more passengers? It's not so clear, is it? On the one hand, lower fares would mean that more consumers will want to ride the subway. On the other hand, the subway company would make less money. One way it could try to get its profits back up is to decrease the quality of its service. It could do this by spending less money on keeping its cars clean and attractive. Or it could spend less money on keeping its cars in good repair, increasing the risk of passengers being subject to inconvenient disruptions in service. Furthermore, the subway company might decide that the lower fares were not sufficient to maintain the frequency of its trips during off-peak hours. So it might cut back service during these times. Another possibility is that the company might decide that certain routes were unprofitable at the



lower fares and cancel service to these areas.

On top of this, since the Subway Commission is politically appointed, it would be subject to the forces of CONCENTRATED BENEFITS AND DISPERSED COSTS discussed in the last chapter. That is, special interests might attempt to capture benefits for themselves at the expense of other citizens. How might this happen? For one thing, downtown merchants might find that frequent service to their store locations increased their profits. So they would lobby the Subway Commission to make sure that the subway made frequent stops in their part of town. Or residents from a particular section of the city would fight to make sure that service to their neighborhood was continued, even though the subway company wanted to cancel that service because it was unprofitable. What are we left with in the end? Do we think that the allocation of resources under public sector regulation will result in greater happiness than what would have resulted if the subway company had remained unregulated? Tough question.

An economist sympathetic to the working of unregulated private markets and distrustful of public sector intervention might reasonably come to the opinion that it was best to leave the subway company unregulated. While he would acknowledge the potential gains to society's happiness from lowering fares and encouraging greater ridership, he would also place great faith in the ability of the subway company's managers to find ways to subvert the lower fares by reducing service. On the positive side, he would have faith that the bus, above-ground train, and cab companies would all opportunistically attempt to steal away the subway's customers if it tried to raise fares too much. This economist would also be fearful that the influence of special interests on the Subway Commission would result in the subway company making resource transfers which actually lowered society's happiness, such as continuing service on routes that were unprofitable--something the subway company would never do in the absence of regulation.

How about an economist who was sympathetic to the benefits of government intervention? This economist would see the same things the first economist did. But he would likely believe that the gains in happiness from lower fares and increased ridership far outweighed any negative effects from service cutbacks and resource misallocations. Who's right? Let's just be honest here. Nobody can know for sure. Despite the fancy analyses that economists get paid to do in order to answer questions like this (and the more the money, the fancier the analysis), the fact is the ultimate answer depends on things that nobody can know. How many extra riders would ride the subway if the company charged lower fares? (How could we know until we actually lowered fares?) How will the company respond to the lower, regulated fares? (How could we know until we actually tried to lower the company's fares?) What will be the influence of special interests on the Subway Commission? (How could we know until a Subway Commission was actually established?)

Let's shift gears now and consider the case of a negative externality. Suppose a developer wanted to build a shopping mall close to a residential section of town. With the shopping mall would come increased traffic in the residential neighborhood. Residents in that neighborhood would be adversely impacted by the increased traffic. As a result, the



shopping mall would impose a NEGATIVE EXTERNALITY. What should society do?

Once again, regulation is an option. In an ideal world, public sector regulators would determine the dollar value of the negative externality. They would then tax the mall an amount equal to the cost it imposed on residents. The developer would then consider this along with his other costs to determine whether it was profitable to build the mall. In contrast, what usually happens in the real world is that a Zoning Board, composed of or appointed by elected officials, approves or denies permission for the developer to build the mall. That is, the Zoning Board attempts to weigh out the (unseen) costs caused by the increased traffic against the gains society would receive from the mall.

An economist sympathetic to the working of unregulated private markets and distrustful of public sector intervention might reasonably come to the opinion that it was best to let the developer proceed unhampered in his pursuit of increased profits. This economist would recognize that the developer--by not internalizing the costs he was imposing on nearby residents--might make the wrong resource allocation decision. That is, the developer might go ahead and build the mall even though the net effect was to lower society's happiness. On the other hand, this economist would recognize that the Zoning Board might also make a wrong resource allocation decision. The Board might overestimate the costs of the (unseen) externalities and subsequently deny permission to the developer. On top of that, this economist would be fearful that special interests might influence the Zoning Board's decision. For example, residents in the neighborhood might have a great incentive to lobby the Board members to keep the mall from being built. Local merchants might band together to influence the Board so that this unwanted competition was prevented from "invading their territory."

And how about an economist sympathetic to government intervention? He would see all these things too. However, in contrast to the free market economist, he would be inclined to emphasize the benefits of controlling unwanted external costs from development. He would have greater faith in the Zoning Board's ability to accurately guess the relevant costs and benefits and to remain unswayed by the lobbying efforts from special interests. Who would be right? Again, an honest answer is that we just don't know. It's a judgement call.

There you have it. Now you know a major reason why "if you laid all of the economists from end to end they would never reach a conclusion." It's not that economists have different frameworks. Indeed, the main theme of this book is that there are not multiple frameworks for understanding economics. There is only one. The difference isn't in the framework. Its lies primarily in two subjective evaluations. So let's lay out these evaluations clearly.

FIRST, ECONOMISTS DISAGREE BECAUSE THEY DIFFER IN THEIR OPINION OF THE SEVERITY OF THE MARKET IMPERFECTION. How much below the socially optimal level is the monopolist producing? How much beyond the socially optimal level is the firm with the negative externality producing? Is the private sector producing too little of the public good? Because these questions cannot be answered objectively, reasonable people can--and will--arrive at different answers to these questions. If one believes that the market



imperfections are not very severe, then one is led to a laissez faire position of leave well enough alone. On the other hand, if one believes that the private market is off by a lot, then one will want to seriously consider whether government intervention could make things better.

SECOND, ECONOMISTS DISAGREE BECAUSE THEY DIFFER IN THEIR OPINION OF GOVERNMENT'S ABILITY TO MAKE THINGS BETTER. Will price regulation of the monopolist backfire so that the end result is less output than what the unregulated monopolist would have produced? Will governmental restrictions on firms producing negative externalities be so burdensome that consumers receive too few goods and services? Will public sector provision of public goods result in so many "forced riders" that the public sector allocation is worse than the private sector allocation? Finally, will special interests use their political influence to exploit government oversight of the private sector for their own gain at the expense of society's overall happiness?

The great value of the economic way of thinking is that it leads one to ask the right questions. The answers to these questions, however, are open to debate. They oftentimes depend on factors that are unknown and unknowable. In the final analysis, each individual must come to their determination of the proper role of government.



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CHAPTER 54 Closing Thoughts

It is the argument of this book that there is a simple framework by which one can evaluate public policy. Every policy involves transferring resources from one activity and to another. As a consequence, every policy has winners and losers. The framework presented here provides a means by which one can organize and--under the right circumstances--measure, the resulting gains and losses. Good policy, as we define it, is policy for which the gains of the winners are larger than the losses of the losers.

A major insight gained from our analysis is that when there are no significant market imperfections, profit-seeking firms will tend to direct resources towards their highest valued use. In this case, government interventions (price controls, subsidies, taxes, quotas, and mandates) can only decrease society's happiness. In contrast, when market imperfections are present, government interventions can--but may not--increase society's happiness. Thus, A MAJOR IMPLICATION OF OUR FRAMEWORK IS THAT CITIZENS--and that includes you, dear reader--SHOULD EXPECT PROPONENTS OF GOVERNMENT ACTIVISM TO IDENTIFY A SIGNIFICANT MARKET IMPERFECTION BEFORE INTERVENING IN MARKETS. For example, in the public debate over health care policy, or education, or regulation of industry, the first step should consist of identifying the market imperfection which causes private markets to misallocate society's resources.

Unfortunately, even when a market imperfection is identified, there will be many instances where our simple framework will be unable to determine the desirability of a given public policy. As we have seen, this determination will oftentimes depend on factors that are unknown and unknowable (e.g., the size of the negative externality associated with pollution, the effect of special interests on regulatory boards, the willingness to pay of consumers for a public good, etc.). Thus two individuals, both using the same framework for analyzing public policy, might justifiably come to opposite conclusions. But if that is the case, how useful can our framework be?

Remarkably, just THE MERE RECOGNITION THAT RESOURCES HAVE ALTERNATIVE USES WOULD REPRESENT SIGNIFICANT PROGRESS IN MANY PUBLIC DEBATES OVER POLICY. City, state, and federal governments commonly pass legislation that guarantees basic rights or services to selected groups without debating, or even acknowledging, that these laws have the potential of lowering society's happiness. Indeed, resistance to the idea that public policies should consider costs as well as benefits runs deep.

When environmental advocates argue that we should preserve an endangered species "no matter what;" when health advocates argue that everyone is entitled to the "best medical care available;" when legal aid champions argue that every citizen--no matter what their race, sex, age, religion, sexual orientation, etc.--is entitled to "fair treatment" on the job; it should always be remembered that these policies withdraw resources from other activities. These may be good policies. These may be desirable policies. But they are certainly costly policies.



Wishing they weren't costly doesn't make it so. Indeed, one of the great services of prices in a market economy is that they force us to confront the fact that resources have alternative uses, even when we prefer to close our eyes to this fact.

But what are we to do when, having acknowledged the costs of policies, our framework still leaves us unsure about the desirability of government intervention? Is there any guide, any rule of thumb, that can guide us as we confront difficult policy issues? We wish to close this book by suggesting that the twentieth century contains a vitally important lesson in this regard.

In the 1940s and 1950s an intense debate raged among economists about the merits of socialism. Previously, most economists had focused on the incentives of economic agents to produce under socialism. That is, if firms weren't allowed to keep their profits, and individuals weren't allowed to keep their earnings, then how could society motivate its members to make their resources available for the public good? In the midst of this debate came a number of free-market economists who said that this controversy was centered around the wrong question. The most important question with respect to maximizing society's happiness is not, how can we get people to use their resources for the public good? Rather, the most important question with respect to maximizing society's happiness is, how can we know what the public good is?

This debate came to be known as the Socialist Calculation Debate. It proved to be the intellectual deathknell for socialism. It was eventually recognized that socialism could provide no alternative to the informational role of prices in a free-market/capitalistic system of resource allocation. In the end, socialism had no intellectually credible answer for how the state could identify the public good. The fundamental problem of economics--lack of information--had to be acknowledged.

Half a century later, the superiority of a market-based system of resource allocation over socialism is no longer confined to mere intellectual argument. It has been demonstrated in the great laboratory of the world's economies. Indeed, nowadays it is commonly asserted that socialism is dead. THE GREAT ECONOMIC LESSON OF THE TWENTIETH CENTURY IS THAT PUBLIC SECTOR CONTROL OF THE ECONOMY--PRECISELY BECAUSE IT HAS NO WAY OF DETERMINING THE HIGHEST VALUED USE OF RESOURCES--IMPOVERISHES ITS PEOPLE.

What should citizens do when our framework leaves the desirability of government intervention uncertain? While each individual must decide for himself, we recommend a presumption in favor of unregulated private markets, and against government intervention in the economy. The theory of how private markets tend to increase society's happiness provides an explanation for the great success of the wealthiest economies in the world. It teaches us that it is no accident that the most prosperous economies in the world are those economies that have generally favored private over public control of the allocation of resources.



At the very least, citizens who favor greater reliance on public sector direction of the economy should be keenly aware of what they leave behind. The system of prices directing resources in unregulated private markets yields a number of invaluable benefits for society. It is a system that generates information vital for knowing how best to employ society's resources. It is a system that channels the self-interest of man and directs it in favor of the public good. It is a system that minimizes social conflict over the use of resources. And it is a system that has produced the wealthiest societies in the history of mankind. These are extraordinary accomplishments. The great economic lesson of the twentieth century should teach us not to dismiss them lightly.


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