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Principles of Economics Introduction: Organization of Course (Macroeconomics only) The organization of a macroeconomics course requires some explanation. So, we would

like to start by explaining how the macroeconomic portion of this book will be organized.

We’ll begin by packing a tool kit. The first chapter will introduce some definitions of

economics terminology. It will be useful to treat economics like a foreign language.

There will be terms and definitions, which will be listed at the end of each chapter, that

are essential to understanding the course material.

Next we will present the first model in the course, which is called the production

possibility frontier. This model will allow us to reflect on some interesting questions.

For example, it will allow us to consider why countries choose to have the business sector

produce some products, while having government produce other products. Also, it will

allow us to consider whether or not wars are good for an economy. Finally, the

production possibility frontier will help us understand why the vast majority of

economists believe that free trade among nations is good for those countries’ economies.

Hence, this section will discuss foreign trade.

The discussion of foreign trade will be followed by a mini crash course on markets, a

market being any organized situation in which buyers and sellers agree to exchange

something. We will need to understand how markets work for a couple of reasons; the

most important being that the vast majority of output produced in the US economy is

traded in markets. Furthermore, we will develop a model during the course that treats the

whole U.S. economy as if it were one great big market. Hence, we will need to

understand how markets work.

After the crash course in markets, we will continue to pack our tool kit – well actually

more like our medical bag - since our goal in macroeconomics is to become doctors of

the economy. Well, actually, we probably won't become doctors of the economy, so

much as paramedics of economy. The goal of a macroeconomics course is to treat the

whole U.S. economy as if it's one great big living, breathing entity. In fact, it's almost as

if we'll become veterinary paramedics. Our patient – the U.S. economy - cannot talk to

us and tell us when it is ailing. We’re going to have to be able to recognize signs that tell

us if the economy is sick or well. Furthermore, our goal is to be veterinary paramedics

for an enormous behemoth. The U.S. economy produces more than $14 trillion worth of

output each year, by far the largest economy in the world. The California economy alone

is the fifth largest economy in the world. This is one enormous patient we have.

In order to be able to discern the health of the economy, we're going to keep track of

certain economic indicators. The last time you walked into your doctor's office, once you

had the paperwork out of the way and you were actually taken into the examination room

and were told that you would be seeing the doctor soon, there were a few fairly quick,

easy and cheap tests that were done. Someone probably weighed you, took your

temperature and your blood pressure. We want to do something similar with respect to

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the US economy. In place of taking the weight, temperature and blood pressure of a

person, we’re going to measure the unemployment rate, the inflation rate and the balance

of trade of the U.S. economy. These economic indicators will help us determine if the

economy is sick or well. There is a chapter on each one of these indicators.

Following our description of these economic indicators that provide quick and easy ways

to measure the health of the economy, we will learn how the U.S. government measures

the output of the US economy. It is the ups and downs of output that are the primary

measure that economists use to determine whether the economy is doing well or not. If

output is increasing, in general, we will be satisfied that the economy is healthy. If

output is falling, particularly if it falls more than two quarters in a row, we will judge the

economy to be sick, which is to say, experiencing a recession.

It is strongly recommend that you record and graph on time series graphs the

government’s reported numbers for these indicators for a period of several months while

you are learning about the macroeconomy. These concepts are much easier to understand

when you are familiar with what the data actually look like and where they come from.

Plus, if you do track this data, you will find that you will always compare future

unemployment rates against what they were when you were studying macroeconomics.

The data that you record will act as a benchmark for your comparisons of economic

conditions for years to come. Look at the inside cover of your text book or at your DVD

for the websites on which the data is reported and a spreadsheet on which to record the

information. There is an appendix at the end of this introduction which will refresh your

memory about different kinds of graphs, including time series graphs.

The last tool we will need for our paramedic’s bag will be to study money and the

banking sector. We will define money and describe its role in the economy. Then, we

will discuss what banks do, how they affect the amount of money circulating in the

economy and their effect on credit markets, that is, the markets for borrowable funds.

Then, it will be possible to understand the first of several types of policy that may be

prescribed for an ailing economy; namely, monetary policy and what it is intended to do

for the macroeconomy.

Once you have these concepts in place, then we will be ready to seriously look at the U.S.

economy. We’ll do that by chronologically looking at the three major macroeconomic

models that have been used over the years to understand how a macroeconomy works.

The first model to be introduced will be the Classical model, followed by the Keynesian

model, and finally the aggregate demand/aggregate supply model, which is one of the

most widely-used models in recent times that economists use to show how the economy

works.

Having learned to determine whether the economy is healthy or unwell, these models will

help us to diagnose the types of economic problems that the economy may experience.

The last section of this book will be devoted to consideration of economic policy. These

are the prescriptions that policymakers have used to try to help the economy return to

health, if it is experiencing a recession.

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The vast majority of this book will relate to positive economics, which is to say, what

“is” factually descriptive of the economy. At the point that we begin to discuss the

different macroeconomic models that have been used to understand the economy, we will

find that different models suggest different types of economic policies might be

appropriate. To the extent that different economists subscribe to different models, we

will find that economists often differ vigorously on the policies they feel would benefit

the economy. So, we enter the realm of normative economics, or what “ought” to be

done with respect to the economy. Even in the policy realm, it will not be our goal in this

book to offer different normative perspectives concerning what policies the U.S. “ought”

to put in place. Instead, an effort will be made to offer a historical perspective on policies

tried under different circumstances, and a range of views on the policies’ perceived

success.

With that in mind, we will continue our analogy concerning becoming paramedics of the

economy. A long-standing tradition among doctors suggests that they “first do no harm”

to their patients. There is a sizable minority among economists in recent years who have

suggested that economic policymakers should follow the same advice with respect to

policy they prescribe for the economy.

In the late 20th century doctors had a tendency to prescribe antibiotics to patients who

came to see them with colds or the flu. Interestingly enough, antibiotics cannot cure a

cold or the flu. These diseases are viral infections, and antibiotics can only cure bacterial

infections. Doctors seemed to have prescribed antibiotics, because patients expected

their physicians to give them medicine, and because patients sometimes did develop

secondary bacterial infections when they had a cold or flu, in which case the medication

would do some good.

As a result of the frequent prescription of antibiotics to patients with viral infections, the

overuse of antibiotics caused them to lose some of their potency, as bacteria mutated to

resist antibiotics. The net result was fewer drugs that were capable of curing even

bacterial infections, reducing doctors’ arsenal of treatments for diseases ranging from

staph infections to bacterial pneumonia.

In an attempt to reduce the administration of antibiotics to people with colds and the flu,

the Center for Disease Control began recommending to doctors that they not prescribe

antibiotics to patients with colds and the flu, and instead recommend that patients take

over-the-counter cold medications to relieve their symptoms. If you have ever done this,

you may have noticed something. I find that when I take cold medication, I feel quite a

bit better while I am sick, but the cold seems to drag on for weeks. On the other hand, if I

simply go to bed, feel miserable and drink lots of fluids, I seem to recover much more

quickly.

Actually, this makes sense. If one reads the ingredient list for a typical cold “remedy”, it

will often include acetaminophen or ibuprofen. They will make you feel better, because

they relieve body aches and headaches. But, they are also fever reducers. The problem

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with reducing your fever is that a fever is one of your body’s most potent weapons for

killing viral infections - by cooking them to death. By simply going without any type of

medication, one allows one’s body to “cure” the cold, often much more quickly. On top

of this, new reports warn parents to not give cold medication to their children younger

than six, because the benefits are less than the risk to the child of potentially life

threatening overdoses.

Similarly, there are some economists who consider economic policy to be the equivalent

of cold medicine or antibiotics for an economy with a cold or the flu, which is to say,

experiencing a recession. We will want to look at the recovery from an economic

downturn, or recession that the U.S. economy experienced in 1990-91, as lending some

interesting support to the notion that economic policy may make us feel better while the

economy is experiencing a recession, but also creates the preconditions for weaker

growth following the recovery from the recession. Two of the most popular types of

recession-fighting policies, fiscal and monetary policy, are thought by some economists

to put the government too far into debt and/or to cause inflation. Given that some

economists question whether these two types of policies can really help the economy at

all, it is not surprising that these policies are the subject of critical review. We will

consider this theme in the conclusion to the various economic policy approaches

recommended by the majority of economists in the conclusion to this book.

This is the ambitious outline that we will be tackling in macroeconomics. You may want

to refer back to this outline periodically to see where we are in the course.

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Chapter 1: Definitions Section 1.1: The Definition of Economics

Economics is the study of how people allocate scarce resources and products to satisfy

human wants. We will use this particular definition of economics, because it will allow us

to use and define a number of words that have very special meanings in economics.

For example, the word “wants” used in this definition is intended to focus our attention

on the choices we have and make as economic actors. We are all aware that we have a

need for clothing and food and shelter. You are probably aware of Maslow’s hierarchy of

needs from your psychology or sociology courses. Food, clothing and shelter are the most

basic needs that must be satisfied before other needs can be attended to.

However, the truth is, that on the level on which we make most of our day-to-day

economic decisions, we are not making them on a needs basis, but, rather, on a wants

basis. For example, on most days, when I leave the college on my way home, I will stop

at the grocery store. As I am pushing the cart through the grocery store, I am not asking

myself the question, will I eat tonight? Rather, I am asking myself the question, what do

I want to eat for dinner tonight? The truth is, I have three freezers at home. I could

probably live out of those freezers and the food I have in my pantry for a couple of

months. So the decision I am making as I walk through the store is not really a needs-

based question. It is a wants-based question. Likewise, when I woke up this morning,

took my shower and walked into my closet, I wasn't asking myself the question, will I

wear clothing to school today? Rather I was asking myself the question, what do I want

to wear to school today?”

Students tell me all the time that they have to study economics tonight or this weekend. I

suspect they are trying to flatter me. In fact, I have never met a student who would cease

to exist if that student did not study. Hence, the student who tells me that s/he needs to

study, actually means that s/he thinks her/his grade would be better if s/he were to study,

and so the student wants to study. For the purposes of this course and its study of how

people make their economic choices, I’d like to focus on those choices and how we

decide what we want to do.

There are other words in this definition of economics that economists use in special ways.

But before we tackle more definitions, let’s begin by laying out the direction we’re going

to take. Out in the wild, there are resources that we can use to satisfy our human wants.

However, the form in which we find these resources in the wild is not in a form in which

they can satisfy our human wants.

Let's take a very simple case as an example. Let's suppose it's the 1860s, and we're

looking at the “Little House on the Prairie”. The household would like to have a bucket

of water in the house for drinking, for washing dishes and for cooking. The Platte River

is 50 yards outside the house. There's water in the river. However, until someone in the

household picks up a bucket and walks down to the river and dips it into the river and

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then walks it back up to the house, this family will not have water in the house for

cooking, drinking and washing.

What we are assuming here is that there are, what we are going to call, resources that we

will put through a production process in order to produce products. Products are items

that are in a form where they can satisfy our human wants. Another way to say this is

that we need to use inputs in a production process to produce output that can satisfy our

human wants. A third way we can say the same thing, is that we can take factors of

production and put them through a production process to produce final goods and

services that can satisfy our human wants. These are three different ways of saying that

resources, as we find them, are not in a form where they can satisfy our human wants.

But once we manipulate them by putting them through a production process, the results

are able to satisfy our human wants.

In the example I've given, the production process is very simple. Someone picks up a

bucket, dips it in a river and walks it back up to the house. We have the same human

want today - to be able to walk up to a sink, turn on the faucet and have water come out

to drink, or with which to wash or to cook . Consider how much more complex that

production process is today. It involves gathering water. Here in Phoenix, Arizona,

where I live, that process starts by gathering water from the reservoir lakes that our dams

create on rivers throughout the region, and from the Central Arizona Project, a canal that

brings water from the Colorado River to the Phoenix area and beyond. That water must

be collected and brought to a water treatment plant. At the water treatment plant the

water is filtered and is chlorinated to produce drinking water. Then, that water must be

distributed to every home and business in the greater Phoenix area by way of pipes, so

that we can have water when we go to sinks in our homes, schools and businesses.

Clearly, this is a much more involved production process today. However it still involves

pulling together certain resources, putting them through a production process in order to

create a product, tap water, that can satisfy our human wants.

Production

Process

Resources

Inputs

Products

Factors of

Production

Output

Final goods

And Services

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Section 1.2: Factors of Production

Let's list some of the factors of production or resources that were used to produce

drinking, cooking and washing water back in the 1860s, as well as today. One factor of

production used then, and now, was labor. Someone had to walk down to the river

carrying a bucket in order to get the water. Today there are employees of the city who do

the work necessary to produce water. Clearly, labor is still used today to produce potable

water.

Second, there was the bucket. A bucket is an example of what economists call physical

capital. Physical capital is a produced product that will be used repeatedly over a period

of time (a least one year) to produce other products. A bucket is a produced product.

Notice that it will be used perhaps for years by the family to repeatedly bring water to the

house.

Physical capital is generally categorized into three types; machinery, equipment and

buildings. A bucket would probably be considered equipment. Let’s look at these three

types of physical capital more carefully. People tend to think too narrowly about what

constitutes physical capital. You probably have a good idea what machinery is.

However, here are some examples of different types of equipment that you may not have

considered. Today, equipment would include telephones, copy machines and cell

phones. It would also include escalators and elevators. Ships, and trucks, planes and

trains are also examples of transportation equipment. Tractors, cranes and backhoes are

examples of earth moving equipment.

When we think of buildings as examples of physical capital, we think of manufacturing

plants. However, we should also include shopping malls and strip malls, office buildings

and warehouse as well as bus depots, airports, civic centers, sports arenas, hotels and

motels, schools and any type of building in which products are produced. (Like a water

treatment plant). Highways, bridges, tunnels and canals are also physical capital.

Another factor of production used to produce water in the household was the water itself.

Hence another category of factors of production would be natural resources. That would

include; in addition to water, timber, ores like iron ore and gold, as well as petroleum and

other naturally-found substances.

Land could be considered a natural resource, but economists often include it as a separate

category of factors of production. Certainly most production processes require a place

where the production process takes place. Most production processes involve a building

in which the production occurs, which must be placed on a piece of land. Hence, land is

a factor production for almost all products.

While those are the factors of production that are used now and would have been used

back in the 1800s to produce water, today there are some additional factors of production

which would be used. For example, in addition to labor (workers at the water treatment

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plant), physical capital (the water treatment plant and the pipes and canals that deliver

water), land and water; an additional factor of production that would be used today is

called human capital. Human capital is education, training and experience that augment,

or in other words add to, workers’ ability to produce products. We can imagine an

individual working in a manufacturing plant, using a machine, who is taken away for

training, where he/she learns how to clean the machine, calibrate it and tell when it is

producing flawed product. When s/he comes back to the machine, s/he is able to make

more output. The additional input to the production process is the training this individual

has acquired that produces more output.

All of you who are taking a course in economics are probably doing so in order to acquire

additional human capital. You expect that once you have a university degree, an

employer would be willing to pay you more than if you only have a high school diploma.

Clearly, that employer is only willing to pay you more if you can be expected to produce

more output. The additional human capital that study creates will make you able to

produce more. One of the purpose of taking English 101 is to improve your written

communication skills, because that will help you to communicate your ideas better to

other people, which will likely make you able to produce more output.

Technology is another factor production. Technology is improved know-how about how

to produce products. Clearly, there have been numerous improvements in how we

prepare drinking water today as compared to 150 years ago. These new techniques have

drastically reduced the number of water-borne diseases, like typhus, that people are

exposed to, while the addition of fluoride, following the discovery of the importance of

fluoride to dental health, has reduced the number of cavities the typical adult experiences.

Another very important factor of production, one which we will use examples of many

times when we talk about markets, is intermediate goods and services. An intermediate

good or service is a produced product that will be used up in a subsequent production

process. For example, let us suppose a fabric mill produces a bolt of denim. If the bolt of

denim is sold to a jeans manufacturing company, that bolt of denim is an intermediate

good, because it is used up in the process of producing the jeans.

Another example of an intermediate good would be if a flour milling company were to

sell a sack of flour to a cookie making company. In this case, the flour is a factor

production, specifically an intermediate good, because it is used up in the process of

producing cookies. Notice that what identifies a product as an intermediate good or

service is that it is sold to another producer who will use up the intermediate good or

service in the production of another product.

Let's see if we can identify what type of product we are considering in the following

examples. Let's suppose I drive my car into a gas station and fill up the tank. What is

that gasoline? In this case, the gasoline is a final good, because I am going to use it to

drive my personal car. Let's suppose the next car into the gas station is a taxicab. It fills

up its gas tank. What is this gasoline? In this case it is an intermediate good. The

taxicab will use it up to drive people from one place to another.

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Let's suppose instead, we are at a minivan manufacturing plant. A minivan comes off the

assembly line and is sold to a dealership, which then sells it to a family. What is this

minivan? It would be a final good. Let's suppose the next minivan off the assembly line

is sold to the dealership, which sells it to a nursing home, which will use the minivan to

drive its residents to doctor's appointments. What is it? In this case, this minivan is

physical capital. It will be used now and for years to come to drive patients to their

appointments.

This may not be all the possible factors of production that we can imagine. However, this

should be a serviceable set of categories for our use.

Section 1.3: Scarcity

Now what we want to think about is the fact that economists would describe these

resources or factors of production as being scarce. Economists define scarcity to be any

situation in which the quantity of a resource or product that is wanted is greater than the

quantity available, if that resource or product were free. Now when I say free, I mean,

free. Right now, you could walk outside the classroom and pick up a copy of the class

schedule. It is free to you. But I would contend it is not actually free. It costs the college

quite a bit of money to print up the schedules. And so someone, in this case the college,

is paying for it. Well, actually, you are paying for the printing when you pay your

tuition. Hence, it is not free. Someone is paying for the printing of the schedules. When

I describe something as free, I mean, no one is paying for it.

The opposite of a scarce good or service is a free good or service. This is one for which

the quantity wanted is less than the quantity available, if it is free. Let's think about

examples of free goods or services. Some of the classic examples are air, rain and wind.

When you think about it, it is hard to come up with many examples. It's actually quite a

short list. Furthermore, it is not a very interesting list, at least to economists. That's

because everyone can have just as much as they like of free goods or services for free, at

least where they are available. (Occasionally students give examples like garbage and

cockroaches as free goods. I would describe them as economic “bads”, products people

would pay money to get rid of).

The products that are interesting to economists are scarce goods or services. Clearly,

economists’ definition includes a lot of things most people would not think of as scarce.

For example, pencils are scarce by this definition. Everyone cannot have just as many

pencils as they would like for free. However, you would not describe pencils as scarce to

your friends. So, why do economists define scarcity this way? The answer is: anything

that is scarce by this definition must be allocated. The purpose of defining scarcity this

way is to identify those things that must be allocated. To allocate means to divvy up, to

divide or to apportion.

Last summer I took a driving trip through the Pacific Northwest. I drove through Oregon

and Washington states. It's hard to imagine that water is scarce in the Pacific Northwest.

One can't drive more than 30 miles without running into a good-sized river or a lake.

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Nevertheless, water is a scarce resource, even in the Pacific Northwest, at least in the

sense that even there, water must be allocated, divided or apportioned.

There isn't enough water for every producer of products to have as much water as that

producer might like for free. Consider, there are many uses to which water found in the

rivers of the Pacific Northwest could be put. For example, water is necessary for

agriculture in Oregon and Washington states. When we think of the Pacific Northwest,

we often think of the temperate rain forests that are between the Pacific Ocean and the

west side of the Cascade Mountains. However, on the East side of the Cascades, the

climate is rather arid. In order to farm, in the eastern portions of Oregon in particular,

farmers must irrigate. Hence, water is a factor production in agriculture in the Pacific

Northwest.

However, the more water that is used for farming, the less water is available to produce

electricity from the rivers of the Pacific Northwest. These rivers are capable of

producing hydroelectric power. The more water is used for farming, the less water

moves down the rivers to turn the turbines that produce hydroelectric power.

Furthermore, when water is used for producing electricity or for farming, it is that much

more difficult for salmon fishermen to produce their product. The hydroelectric dams

along the rivers of the Pacific Northwest create an impediment to the production of

salmon. You see, wild salmon live the better part of their lives in the ocean, where

fishermen catch them. However, salmon are actually born in the streams that feed into

the rivers of the Pacific Northwest. They grow up to be approximately year-old fish, at

which time they swim down the river of their birth, out to the ocean, where they will

spend the majority of their adult life. Once they are ready to spawn, they must swim

back up the river of their birth to the spot where they were born. The more hydroelectric

dams that span the rivers in which these salmon were born, the more difficult it is for the

salmon to return to breed the next generation of salmon. Clearly, farmers, electricity

producers and salmon fishermen cannot all have just as much water as they would like

for free. Hence, the water of the Pacific Northwest must be allocated. There must be a

means of deciding how much water will be used to produce each of these products.

Any resource you care to choose has multiple uses to which it can be put. Instead of

water, suppose we were to look at the timber of the Pacific Northwest. This region of the

country is heavily forested. However, again, I would argue that these trees, as numerous

as they are, are scarce from an economist’s perspective. There are multiple producers of

products, which is to say, a number of different industries that could use the timber cut in

any one year. For example, timber can be cut down, taken to a sawmill and cut into

lumber, and then used to build the frame of a house. Or timber could be cut down and

cut into veneers and used to produce furniture. And finally timber could be cut and sent

to a pulp and paper mill, where it could be used to produce paper. Clearly, these

industries; the construction industry, the furniture producing industry and the paper

producing industry, cannot have just as much timber as they would like for free. We

must allocate timber. We must have a means to determine how much of the timber we

are willing to cut in any one year will go to each of these industries.

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The same is true of petroleum. Petroleum is used to produce all of our transportation

fuels, from gasoline to jet fuel to diesel fuel. But it's also used to produce home heating

oil. It also the basic feedstock used in the production of plastics. Again, there isn't

enough petroleum for all of these industries to have just as much petroleum as they would

like for free. We must allocate this factor production.

And if factors of production are scarce, then the products they produce must be scarce.

Consequently, we cannot have as much of any product as we might like to have and

consume. And we surely cannot have all the different products we might like to have.

So, products will also have to be allocated or divvied up among those of us who would

like to have them.

It probably makes sense that people have always been faced by scarcity. People have

never had all the food and shelter, healthcare, communication services and clothing that

they might wish to have. As a result, it has always been necessary for people to deal with

scarcity by coming up with social rules about how to allocate resources and products.

This gives us a chance to see economics as a social and behavioral science, studying the

different ways people have dealt with scarcity over the millennia of human existence. It

is fascinating to study the rich array of means by which people have divvied up resources

and products.

Section 1.4: Allocation

Let’s consider a specific example, that of the Native Americans of what are today the

Plains states. You are probably aware that these Amerindians depended heavily on the

use of bison or American buffalo for food, clothing and shelter. Almost no part of a

bison went to waste. The meat was eaten, the hooves were used for rattles, the bones for

digging tools, spears, lances and needles, and the hide for blankets, moccasins and robes.

The intestines were used to store certain sorts of food, while the teeth were used to

decorate clothing and jewelry. With all these uses, it probably makes sense that there

was never enough bison for everyone to have just as much as they would like.

When we imagine the Plains Indians hunting for bison the pictures we tend to have in

mind are the pictures that we've seen of early illustrations of Native Americans hunting

from horseback. However, consider. There were no horses in North America as of the

time that humans began to inhabit this continent. Even after the Spaniards brought horses

to the North American continent in the early 16th century, it took a couple of hundred

years before wild horses found their way North to the region we call the Plains states

today. In fact it is estimated to have been during the late 1700s and early 1800s when

Plains Indians would have begun to hunt on horseback.

So, imagine hunting bison on foot, as it would have been done for the 10 to 12 millennia

before horses were available. Have you ever seen a live bison? These are enormous

animals. Approaching one on foot to kill it with a spear would have been very dangerous

indeed. It would have taken numerous arrows to bring one of these animals down. It

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would have been much more common for a tribe to build a chute to run the animals off a

cliff and to then butcher them at the base of the cliff.

As hard as it was to hunt bison on foot, it makes sense that the early Native Americans

would have been faced by scarcity. There was no way there would have been enough

bison meat and bison hide and bison horn and bison bone for every member of that tribe

to have just as much as s/he would have liked. It would have been necessary to allocate

the limited amount of bison products that were available.

Seemingly, two of the more favorite parts of the bison were the liver and the tongue.

Clearly, there wouldn't have been enough liver and tongue for everyone in the tribe to

have as much as s/he would like. Therefore, the liver and tongue had to be allocated, had

to be divided up. Anthropologists tell us that the way that the liver and tongue were

allocated was that the braves who brought the bison down were the ones who got these

prized parts. The braves could share the liver and tongue with any tribe members they

chose. However, it was the successful braves’ to consume or to share.

Anthropological evidence suggests that there were times when, frankly, there wasn't

enough for everybody to have sufficient quantities of these products to sustain them. As

a result, it would have been necessary to allocate the very limited amounts of bison that

were available even more restrictively. I think in our minds eye we imagine that the rules

that a society would use under such dire circumstances would be to share the deprivation

equally among the members of the tribe. In fact, most societies’ allocative mechanisms,

which is to say sets of rules to determine how people will divvy up, divide or distribute

resources and products, most usually are not equitable.

If a tribe was faced with serious shortages of food, it appears that the allocative rules

usually denied food to the oldest members of the tribe first. The elders would have made

their greatest contributions to the tribe in the past, and were therefore the most

expendable. If the food shortage persisted, even after most of the elders were gone, the

next group to go without would be the children of the tribe. Everything possible would

be done to protect the welfare of the prime aged adults of the tribe. The reason is that

these individuals would be able to provide food, and to begin to rebuild the tribe once

food again became available. Young children could be replaced within a relatively few

number of years. However, prime aged adults take 15 to 20 years to create. Clearly,

allocative mechanisms are not intended to be fair in an abstract egalitarian sense, but

rather pragmatic. If a tribe did cut everyone’s ration equally at the onset of a famine,

there would be a significant risk that no member of the tribe would survive a protracted

period of inadequate food availability.

Today, in the modern US economy we do not use tradition-based allocative mechanisms

that tribes or feudal societies would have used to any significant extent. That not to say

that there are no traditional allocative mechanisms used in our modern society. You, or

someone you know, may tithe, that is to say, donate 10% of your/their income to

your/their church/synagogue/temple. This is a tradition based allocative mechanism. It is

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Biblically based. However, this mechanism accounts for a very small portion of how we

allocate the resources and products of the modern US economy.

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Chapter 2: Allocative Mechanisms

In the modern U.S. economy, we primarily use two allocative mechanisms, or sets of

rules for deciding how to divvy things up. These two allocative mechanisms are the

public allocative mechanism and the private allocative mechanism. First we will describe

each mechanism for deciding what will be produced, how it will be produced and for

whom it has been produced; and then, we will give examples of products produced by

each of these allocative mechanisms.

Section 2.1: The Public Allocative Mechanism

Let’s start with the public allocative mechanism. In the public allocative mechanism,

everyone kicks in dollars together that are used to buy factors of production. Since we

have all kicked in the dollars together, we, collectively, are the owners of these factors of

production. With ownership goes the prerogative of deciding how these resources will be

used. Specifically, we get to decide what will be produced, how will it be produced and

for whom the product has been produced with our factors of productions.

Can you recognize this allocative mechanism? The dollars we all kick in together are

taxes. We are allowed to have some input into the decision about what resources will be

purchased and how those resources will be used. But, since each of us pays in only a

very small percentage of the taxes paid to government, each of us has only a very small

say in how those resources will be used. We get to express our ownership prerogative by

voting for government officials, who will determine what resources will be purchased

with our taxes, what they will be used to produce and who receives the products that have

been made.

There are four primary levels of government in the United States. We’ll take a look at

each level of government, and identify what taxes are paid to that level of government,

what products are produced by that level of government, and what group of government

officials makes those decisions. To answer the last question first, it is the legislative

branch of every level of government that determines, at least generally, what products

that level of government will produce.

Let's start with the federal or national level of government. The taxes we pay to this level

of government are primarily federal income taxes and Social Security taxes. Now Social

Security is an example of a transfer payment program. Transfer payments are not tax

dollars that go to produce products. Rather transfer payments fund programs where the

government takes tax dollars from some individuals or parties and turns around and pays

those dollars out to other parties, not in return for a good or service. Social Security is

the transfer payment program that is paid for by tax dollars identified on your pay stub by

the letters OASDI, which stand for the program’s official name; Old Age, Survivors, &

Disability Insurance. These taxes are not used to buy factors of production. Rather, they

are paid out to individuals who are currently eligible to receive Social Security benefits.

We will discuss transfer payment programs at a later point this course. For the moment

we will set all transfer payments aside, and instead describe the actual products that the

government produces.

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The decisions about what the federal government will produce are usually most directly

made by the legislative branch, which is to say, by Congress. Indirectly, we make the

decisions when we vote for our Congresspersons. Each citizen age 18 or older who

registers to vote and then actually does vote has some input. However, ours is a

representative form of government, which means we elect individuals, who then make the

actual decisions.

We tend to think that, at the federal level, it is the President who decides these things.

The President is required to present Congress with a budget proposal which lays out what

the President thinks the federal government should produce. However, the Congress is in

no way obligated to take the President’s recommendations and very often does not.

Congress not only determines what the federal government will produce, it decides how it

will produce it and for whom. Let's take an example of a couple of products the federal

government produces, and see if we can see how Congress is answering the questions,

what will be produced, how will it be produced and for whom. About a fifth of the

federal government's budget, or more than $500 billion, is currently spent on national

defense. Another $50 billion is spent on construction and maintenance of the interstate

highway system and other ground transportation projects. It probably makes sense that

when Congress produces a budget and determines how much will be spent on national

defense and how much will be spent on construction and maintenance of interstate

highways, Congress is deciding what the federal government will produce.

Furthermore, as Congress sets out how many dollars will be spent on different types of

factors of production that will be used to produce a product like national defense, it is

also deciding how that product will be produced. We can give examples of each of the

different categories of factors of production that we listed in Chapter 1 that the federal

government purchases and uses in order to produce national defense. The federal

government uses land to produce national defense. That land is military bases. The

federal government uses labor to produce national defense. The personnel in the armed

services and civilian Defense Department employees are the labor that produces national

defense. The federal government uses physical capital to produce national defense. So,

for example, the military purchases ships and aircraft and has buildings built so that it can

produce national defense.

There is a very important point that needs to be made here. The federal government does

not produce ships. It buys them from companies that produce ships. The federal

government does not produce weapons. It buys weapons from companies that produce

them. It does not produce aircraft. The federal government buys aircraft from companies

that produce aircraft. I think sometimes students think that the government, in fact,

builds naval ships and fighter aircraft. The government, in fact, buys these factors of

production.

The federal government also uses intermediate goods and services also to produce

national defense. For example, the government uses shoes and clothing, specifically

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boots and uniforms. It uses food and gasoline to produce national defense. Again, the

government buys theses factor of production from companies that produce these

products. An example of an intermediate service would be internet services for the

troops in the armed services.

The federal government also uses human capital to produce national defense. This is a

factor of production that the government does not entirely buy from other producers, but

some of which it actually produces itself. The majority of training of national defense

personnel is done by the armed services. However, the Defense Department encourages

armed forces personnel to take college courses. These courses are mostly produced by

independent colleges and universities. I regularly have armed forces personnel from a

nearby Air Force base take my classes. That makes the creation of the human capital a

student of mine acquires a product of Glendale Community College.

Technology is also used to produce national defense, as is found in advanced weapons

systems and satellite surveillance systems. These products are often purchased from

private-sector businesses. Hence, all six categories of resources we listed in Chapter 1

are purchased or produced by the federal government to produce national defense.

Furthermore, when Congress sets out a budget, it determines what combination of factors

of production will be used to produce a product like national defense. In recent years,

Congress has been closing military bases. Hence, the answer to the question, how will

national defense be produced involves less land. At the same time, Congress has been

funding development of a missile defense system. Hence another part of the answer to

the question, how will national defense be produced can be answered, with more

technology and more physical capital.

There are numerous products that the federal government produces. The way you can

sort them out is to remind yourself that there is a legislative, administrative and judicial

branch of the federal government. Each branch produces products. Legislative services

are produced by Congress. If we tried to measure the amount of output produced by

Congress, it might be possible to add up how many bills passed through Congress. Our

best measure would more likely be to sum what is paid for the factors of production used

to produce legislative services. What this means is that if we added up how much the

members of Congress are paid and the cost of upkeep on congressional office buildings

and the Capitol building and add that to what is paid in salaries to congressional aides and

staff persons and what is spent maintaining photocopiers and providing paper and

stationery and all the other things necessary for Congresspersons to produce laws, we

would have a measure of the output of Congress.

The administrative branch of the federal government produces many products. For

example, it produces air traffic control at the major airports in this country. The federal

government produces buildings, like federal courthouses and penitentiaries and constructs

and maintains interstate highways. The federal government also monitors air quality and

water quality. It incarcerates prisoners at federal penitentiaries. It maintains and staffs

our national parks. It carries out our space program through NASA. The federal

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government has numerous police agencies. These include the CIA, the FBI, the NSA, the

ATF, ICE and the border patrol. We have a federal justice system in which the Justice

Department prosecutes cases on behalf of the people of the United States.

We also have a judiciary branch that provides adjudication of federal cases at the circuit

court, District Court and Supreme Court levels. You may see more examples of the

products of the federal government in Table 2.1

Congress also decides who will receive the products that this level of government

produces. About fifteen years ago Congress decided to complete a section of Interstate

10 that connected the West and Central sections of Phoenix. It seems quite clear that this

highway extension benefits the residents of Phoenix a whole lot more than the citizens of

Portsmouth, Maine. Can you see how Congress answered the question for whom has this

product been produced in this case?

Table 2.1: Government-Produced Products

Level of Govt. Types of Taxes Legislative Body Examples of Products

Federal Income tax

Social Security tax

Congress National defense

Adjudication of Justice

Air Traffic Control

Testing of prescription drugs

Federal policing

National parks

Represents U.S. abroad

State Income taxes

Property taxes

Sales taxes

(not all states have

each type)

State Legislature

(name varies by

state)

Education

Adjudication of Justice

State highways and roads

State parks

County, Twp.

and Municipal

(called local

governments)

Property taxes

Sales taxes

(rarely, income

taxes)

City Council

(name varies

by jurisdiction)

Street paving & sewers

Tap water

Garbage removal

Street lighting

Traffic signals

Police

Parks and libraries

Let’s next consider the state level of government. First it's important to know what taxes

we pay at the state level. This varies from state to state. In the state in which I live,

Arizona, the citizens and businesses of the state pay a state income tax as well as a state

sales tax. Businesses pay a state property tax, though individuals do not.

Again, it is the legislative branch of government that determines what the state level of

government produces. In the state of Arizona, the legislative branch of government is

called the State Legislature. In most states, education is among the most important

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products produced by the state level of government. Here in Arizona, over 50% of state

spending is on education. Other products produced by the state government are

construction and maintenance of state highways, maintenance and staffing of state parks,

regulation and testing of air and water quality, and a state policing provided by, in this

state, the Arizona Department of Public Safety.

As at the federal level, the State Legislature provides legislative services similar to those

produced by Congress. There is also a state judiciary that tries cases, on behalf of the

people of the state of Arizona, and adjudicates cases in our state court system, that

involve violations of state law.

A third level of government in this country is the municipal level of government. The

taxes paid to a city or municipality vary by region. To use Phoenix as an example, the

City Council is the legislative branch of the municipal government, which decides what

the city produces.

Arizonans pay a city sales tax and a city property tax. These taxes are used to buy factors

of production that allow the city to produce a wide range of, predominantly, services.

Some examples of these services include city street lighting, traffic signals, street

cleaning, street paving and maintenance, construction and maintenance of the city sewer

system, garbage removal for private homes, public transportation, city parks and libraries.

The city also produces tap water that comes out of our faucets in our homes, businesses

and schools.

The fourth level of government varies in importance. It is the county level of

government. In some states, the township level of government is more important. In

Arizona counties are an important level of government. The taxes paid to the county

level of government are sales tax and property taxes.

The legislative branch of an Arizona county is called the County Board of Supervisors.

This legislative branch of the county level of government decides what the county

produces. Phoenix, Arizona is the county seat for Maricopa County. Maricopa County is

an unusually large county, being about the size of the state of New Hampshire. There are

areas of Maricopa County that are outside of any city’s borders. These are referred to as

unincorporated areas. The county level of government provides many of the same

service to these unincorporated areas that the municipal level of government provides to

residents of a city. The Maricopa County government does street paving, provides police

services and county parks to residents of the county who live outside of the cities and

towns of Maricopa County. It is also at the county-level that cooperative efforts among

cities provide for products like the mass transit system for Phoenix and its surrounding

suburbs.

City water and public transportation provide an important opportunity to point out an

interesting feature of the products governments produce. Usually, the products of

government are not paid for in the way we pay for products produced by what I'm going

to describe as private sector businesses. We can usually tell when we’re buying the

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products produced by a the private sector, because we will either go into a store and pay

for the product in order to leave with it, or we will receive a bill in the mail, which we

pay for a service, such as cable television service or our electricity. As a general rule, we

can identify those products produced in the public sector by government, because we

don't pay for them that way. We don't receive a national defense bill in the mail. We

don't receive a meat inspection bill in the mail.

There are, however, some rare cases where we pay for publicly produced products in a

manner that makes it appear that they are produced in the private sector. For example,

when we step onto a city bus, we pay a fare. It looks very similar to how we pay when

we get into a taxicab. The bus ride, however, is produced in the public sector by the

municipal government, while the cab ride is produced by a private sector business, a taxi

cab company. Likewise, households receive bills in the mail to pay for their tap water,

which makes this product appear to be produced in the private sector, when, in fact, it is

produced in the public sector. Finally, when we want to mail a first-class letter, we buy

stamps that we put on the letter. This appears very similar to our purchase of other

private sector produced products. However, first-class mail delivery is provided by the

federal level of government, albeit by a semi public entity, the U.S. Postal Service.

With rare exception the products of the federal, state and local governments are paid for

by way of taxes. As a consequence, we tend to be unaware some times of the multiplicity

of products produced by the government. The fact is, the governments of the United

States produce, on average, about 15% of the total output of the United States.

Section 2.1.b: Government Finance

We have discussed the fact that the governments of this country collect taxes that are

used to buy the factors of production used to produce the products of the public sector,

which is to say of the government sector of the economy. Let’s consider what happens

when a government decides to spend more money than it collects in a year. In fact,

households sometimes spend more than their income in a particular year. On those

occasions when a household buys, perhaps, a house or a car, it must either draw down on

previous savings or borrow the money that will be used to make purchases above and

beyond the household’s present income. A business may also spend more in one year

than the business’s revenue for that year, especially when buying physical capital. When

a business does so, it must either draw on previous years’ profits (draw on savings) or it

must borrow.

Likewise, if a government spends more than the taxes and fees it receives in a year, it is

said to have a deficit and must draw on previous years’ surpluses (years when the

government’s revenue was greater than its spending) or it must borrow its shortfall.

Currently, the federal deficit, the extent to which the federal government’s spending is

expected to exceed its revenue, is approximately $200 billion.

As you can imagine, the federal government cannot stroll on in to the First National Bank

of Washington, DC, and fill out some loan papers to borrow money the way you would.

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The federal government would need to borrow too much money for any one bank, or

even group of banks to lend to a single borrower. So, the federal government must

borrow in a different manner than we do. In order to borrow money the federal

government sells bonds, or more precisely, sells treasury securities (often called just

Treasurys). A bond is a promise, in this case, a promise to pay back money borrowed.

The government, as the bond seller, is the borrower. The bond buyer is the lender.

Some of you may have been given a savings bond when you were growing up. Some

adult, perhaps a relative, bought the bond for you. When that adult bought the bond, he

or she lent the federal government the purchase price of the bond. By giving you the

savings bond, that adult was giving you the right to request that the federal government

repay you the borrowed money (the purchase price) with interest at your choice of point

of time in the future.

Treasury securities work similarly. The U.S. Treasury Department decides the total

amount of money that the federal government must borrow (though Congress does limit

the total amount the federal government can borrow at any point in time. It’s like the

federal government’s credit limit). It then borrows the money in small amounts by

selling treasury securities of $1000 to $10,000 denominations. An individual could lend

the government $30,000 if s/he chose, by buying, for example, three $10,000 treasury

securities.

There are three types of treasury securities; treasury bills, treasury notes and treasury

bonds, called t-bills, t-notes and t-bonds. What distinguishes these three types of

securities from one another is the length of the maturity of the security, which is to say,

how long the government will borrow the money. Treasury bills have maturities ranging

from a few days to a year. Treasury notes have maturities from two years to 10 years.

Treasury bonds have maturities greater than 10 years. Typically, the U.S. federal

government has sold 30 year treasury bonds.

In case you are wondering who lends the government money by purchasing treasury

securities, the answer is any saver may choose to hold savings in the form of owning a

treasury security. Savers desire a reward for choosing not to spend their entire incomes

and instead, putting some part of them aside and holding them as savings to spend at

some future point in time. In order for people to be willing to put aside money and not

spend it when it's earned, they desire some reward for that behavior. So savers may

decide to put their money in a savings account in the bank, where it will earn interest.

The interest is their reward for deferring spending the money. Alternatively, savers may

use their savings to buy a piece of property, where the rental income on the property is

the return for holding savings in the form of owning that piece of property. Another way

that savers might choose to hold their savings is in the form of owning treasury securities.

In this case, the interest on the treasury security is that saver’s reward for saving the

funds held in the form of that treasury security.

Suppose a saver decided to hold some of his or her savings in the form of buying a 30

year treasury bond. Furthermore, suppose that individual subsequently decided that he or

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she would like to use those savings to buy a car 10 years after purchasing the treasury

security. Fortunately, that individual can access those savings, even though the

government will not be paying back the money borrowed for another 20 years. The

individual can access his or her savings by selling the treasury security in the New York

bond market. The New York bond market is what is called a secondary market. It is a

market in which individuals with existing treasury securities can sell those treasury

securities to other individuals or organizations.

In order to sell an existing bond, an individual would need to contact his or her stock

brokerage company, which has brokers who can trade treasury securities on the New

York bond market. Only individuals or businesses that own a “seat” on the New York

Stock Exchange can trade treasury securities in the New York bond market. The

individual seller would tell his or her broker the price he or she would like to receive for

the bond. That price will be in the vicinity of the price paid for the “treasury”, since the

government pays the full amount borrowed back to the bond owner in one lump sum

payment on the maturity date of the bond. If a buyer can be found at that price, the

buyer, represented by his or her broker, will complete the transaction. As a student of

macroeconomics, you will find that the New York bond market will figure importantly in

our study of how economic policy is carried out in the U.S.

There is one more important point to understand concerning the federal government’s

finances. While the federal government has occasionally run budget surpluses, in most

years since World War II, the federal government has run deficits. If we sum all the

deficits and surpluses the federal government has ever run, we will have measured the

national debt. Depending on how one measures it, the national debt of the United States

is in excess of $5 trillion. It is the total amount the government owes at any specific

point in time.

When confronted with this sizeable debt, there are often questions in people's minds

about how the federal government can borrow so much, and whether it ought to borrow

so much. Clearly, this is a normative question. Reasonable people could differ on the

probity of such a debt.

While we will usually leave normative arguments alone, there is one argument made

which suggests that the federal government’s deficits and debt are too large that deserves

our attention, mainly because we can address it in the positive, rather than normative,

manner. People often suggest that state and local governments balance their budgets

(have revenue at least equal to spending), while the federal government routinely does

not; and on that basis alone, decide that the federal government borrows too much.

People question whether the federal government should run deficits, while the other

levels of government typically do not.

When governments, as well as households and businesses, “invest”, which is to say, buy

physical capital, specifically, machinery equipment and buildings, we all tend to borrow

at such times. So, when households buy houses or cars and when businesses buy

machinery equipment or buildings, they often borrow for such purposes. Likewise,

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when governments want to invest, which is to say, buy machinery, equipment or

buildings, they also tend to borrow.

For example, a few years ago the community college district at which I teach decided it

was time to buy land for new campuses and to build new buildings on its existing

campuses. In order to undertake these investment projects, the district wanted to borrow

money in order to begin construction. In order to borrow, the district first had to place a

referendum on the ballot of an up-coming election to ask the tax payers of the county

whether they were willing to pay additional taxes that would be necessary to pay the

loans back. The community college district was required to explain quite specifically

how much it intended to borrow and what the borrowed money would be used for. The

citizens of the county did approve the bond referendum.

The citizens of Maricopa County have begun to pay the new taxes for the land and

buildings approved by the voters. However, the district will not have to wait until it has

collected enough taxes to begin its projects. Rather, the community college district has

sold bonds in order, as allowed by the ballot initiative, to borrow the money to begin

construction already. Over the next 20 years, the community college District will collect

taxes that will be used to pay back the bonds with interest.

State and local governments also sell bonds in order to build city halls and court

buildings, highways and streets, water treatment plants and libraries and police stations

and prisons. However, there is a difference between how state and local governments

(like the community college district) and the federal government present their spending

on physical capital (machinery equipment and buildings).

State and local governments have separate capital budgets that show how much they have

borrowed to buy physical capital. These are separate from their current budgets which

show how much they have paid in wages and salaries and other expenses for items that

will not last a long time the way physical capital does. State and local governments’

current budgets show their expenditures for on-going spending on wages and salaries,

electricity and paper and all other types of operating expenses necessary to keep the

government going. The governments’ current tax revenue is expected to cover their on-

going expenditures in much the same way that households’ income would be expected to

cover food, electricity and other on-going expenses. A household is in trouble if it needs

to borrow for these items. Likewise, governments are expected to be able to cover their

“current” expenditures with current tax revenue, or in other words, to balance their

current budget.

The federal government, in contrast, has what is called a consolidated budget. The U.S.

Constitution has no requirement that the federal government distinguish its current from

its [physical] capital budget. Consequently, it traditionally has not made the distinction.

(Only in recent years has it begun to publish data that makes a distinction between its

capital and current spending). Since the federal government does borrow to buy physical

capital, and importantly, in times of war, the federal government typically runs deficits on

its consolidated budget.

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Most state and local governments are required by their state constitutions to balance their

current budgets. However, any time they have bonds outstanding (yet to be paid off),

they have run a deficit on their capital budgets, which they may do as long as either their

state legislatures or their voters have approved the capital projects for which they are

borrowing.

Many critics of the federal government’s budgets will point out that the federal

government routinely runs deficits, while state and local governments balance their

budgets. Hopefully it is clear by now that this compares apples and oranges. If state and

local governments had consolidated budgets, they would have deficits, too, due to their

borrowing on their capital accounts. Thus, while it is a perfectly legitimate normative

argument to suggest that the federal government’s deficits are too large, it cannot be

fairly argued that even very small federal deficits are too large by arguing that the state

and local governments have no deficits at all. They do on their capital budgets.

Section 2.2: The Private Allocative Mechanism

Having described the public allocative mechanism, it is time to describe the private

allocative mechanism. In the private allocative mechanism or the private sector of the

economy, small groups of individuals, or perhaps single individuals, kick in the dollars

together that are used to buy factors of production. With ownership of these factors of

production goes the prerogative of deciding how those resources will be used.

In the private sector resources are organized into businesses or firms or companies.

These words can be used interchangeably. Private sector businesses can be owned by

single individuals, in which case we call them sole proprietorships, or by very small

groups of individuals, in which case they may be organized as partnerships or limited

liability companies. Finally, businesses may also be organized as corporations.

In all these forms of business organization the owners decide what the firm will produce

and how it will be produced. Unlike the public allocative mechanism, however, the

owners of the business do not decide who will receive the products that have been

produced, at least not all by themselves. That will be determined in markets. A market is

any circumstance in which buyers and sellers agree to exchange something. We will

reserve a thorough description of markets until a later chapter.

Sole proprietors, partners and the owners of limited liability companies have a very direct

decision-making role in their firms, because they do literally own the resources their

firms use to produce their products. Specifically, business owners take their own

personal savings or personally borrow money in order to buy the factors of production

that will be used by their firm. Let’s look at a specific example.

I have a friend who owns her own business. It’s a kitchenware shop. She sells all sorts

of kitchen gadgets and equipment in her shop. When she started her business, she took

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her own personal savings and used it to lease shop space in a strip mall and to buy

equipment like shelving, her cash register, telephones and decorations.

As she built her business, my friend discovered a very interesting market “niche” for her

business. She pays well-known chefs from popular restaurants throughout the city to do

cooking classes in her kitchen shop. In order to do the cooking classes, it was necessary

for her to install equipment for a typical kitchen, like stoves, ovens, microwaves and

refrigerators. All this equipment, she bought with her own savings.

In addition, my friend went to the bank and borrowed money to buy the kitchen utensils

and equipment that she sells in her store. Then, as she sells her kitchenware, this

provides her with the funds to pay her loan back. However, she simply takes out a new

loan the next time she is ready to restock the inventory on her shelves. She has what is

called a line of credit at the bank that lends to her. The stock of inventory she puts on her

shelves is investment. (Remember, in economics investment measures purchases of

physical capital, but investment also includes changes in business inventory). Hence, my

friend has used her own personal savings along with borrowed funds in order to acquire

the physical capital for her store. Most firms use both the personal savings of the owner

as well as borrowed funds in order to operate their businesses.

This description begs the question of why my friend would be willing to take her own

savings, and in addition, to borrow funds in order to operate a business. The answer is

that this is another way of holding savings that offers the saver a chance of receiving a

return or reward for saving. We have already talked about the variety of ways an

individual or household can hold savings in order to receive some sort of return. An

option besides putting savings in a bank account, or owning a piece of property to rent

would be to use the savings to buy machinery, equipment and buildings in order to

operate a business from which the owner hopes to receive a return in the form of the

profits of the business. Profits are the return to the owners of the physical capital and

inventory of private sector businesses.

Let's define profits. When a business sells its product, it receives revenue. A firm's

revenue is equal to the price the firm charges for its product times the number of units of

the product the firm sells. Hence, if my friend charges $20 for a cooking class and sells

20 tickets to the class, her revenue is equal to $400 for that particular class. To determine

the profit from that class, she would have to subtract from that $400 all the costs that she

incurs in order to hold the class, which is to say everything she pays for factors of

production in order to hold the class. So, her costs would include what she pays the chef

to teach the class, what she pays for the food that will be prepared during the class, the

heating or cooling of the shop during the class and any other expenses for factors of

production for which she must pay in order to hold the class.

If her revenue from the class exceeds her costs for the class, she will have experienced a

profit from offering the class. That profit is her return for the time and effort she put into

organizing the class, as well as the return on the factors of production that she owns, and

that were used in order to produce the class. The profit or earnings of her business are

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her compensation. As a sole proprietor she cannot pay herself a salary. Her profit is her

income, which she must report on the front of her 1040 federal income tax form, the same

way you would list your wages or salary on the front of your 1040 tax form. There are

risks to operating a business. It is always possible that the firm’s revenue will not exceed

its costs, in which case the firm experiences a loss, and there is no return to the time and

efforts of the business owner. In that case the owner has lost some of the savings s/he put

into the business.

It is probably evident that there are limits to how big my friend’s business could become.

It is limited by the amount of savings she had available to used to buy factors of

production and limited by her ability to borrow funds. When she went to the bank, to

borrow for her new business, the bank was interested in knowing what collateral she had

for the loan, in other words, what she owned that the bank could repossess in case she

defaulted on her loan (stopped making payments before the loan was paid off).

Fortunately, she owned her house free and clear, in the sense of having paid in full for her

house. Therefore she could use her home as collateral for her business loan. Many

individuals do not own their homes outright, and therefore would be more limited in how

much money they could borrow. Furthermore, if her business had failed, she would have

lost both her business and her house, since the bank would have repossessed her house to

sell to recover the funds to repay her business loan. Fortunately, her business has been a

wonderful success.

There is a fourth form of business organization, called a corporation that is intended to

address some of the limitations of the other forms of business organization. In the case of

a corporation, again, the owners of the business provide their savings to be used to buy

the physical capital of the firm, which is to say, the machinery, equipment and buildings.

However, the process for accessing the savings of the owners is different than in the case

of a sole proprietorship, partnership or limited liability company. A corporation taps into

the savings of its owners by means of an initial public offering (IPO) of shares of stock.

When a corporation sells shares of stock for the first time, it is selling part ownership of

the physical capital and inventory of the corporation. The individuals that buy the shares

of stock are using their savings to buy a small part of the corporation’s resources, and are

therefore entitled to a share of any profits the firm may earn. That is the shareholders’

reward for holding their savings in the form of owning a portion of the corporation’s

physical capital.

There are a few distinct advantages to the corporate form of business organization. For

example, my friend had to use almost all her personal savings to start up her business.

One may choose to place only a small portion of one's savings in ownership of shares of

stock in any particular corporation. If you were to decide that you no longer wanted to

own a part of that corporation, you would simply sell your shares of stock in that

corporation. You wouldn't have to sell the entire business, as my friend would have to if

she chose to no longer own and operate her kitchenware shop.

Second, corporations are able to raise much larger amounts of financial capital, which is

to say money, for the purposes of buying physical capital, by means of an IPO sale of

26

shares of stock in the corporation. As a result, most major manufacturing companies or

firms that require large quantities of physical capital tend to be organized as corporations,

simply in order to be able to acquire sufficient amounts of machinery, equipment and

buildings.

One downside to the corporate form of business organization, is that decision-making is

not as direct. In my friend’s sole proprietorship, she makes all the decisions about how

her product will be produced or what individuals she will hire or fire. In corporations,

because most have rather large numbers of owners, decision-making is indirect. The firm

must hire a management team to make the day-to-day decisions of the firm.

Let me give you an example. I own shares of stock in a corporation called Archer Daniel

Midlands (ADM). It is a grain processing company. By law, I must receive an annual

report each year in which the corporation provides information about what the firm is

currently producing, its revenues, it costs and its profits or earnings. Does it make sense

that I am very interested in the profits of the corporation, because those profits belong to

me and the other shareholders of ADM. In fact, the firm pays a portion of its profits or

earnings out to shareholders each year in the form of dividends. That's my return for

being willing to hold a portion of my savings in the form of owning some of the physical

capital of Archer Daniel Midlands.

According to the annual report, there were approximately 25,000 shareholders of Archer

Daniel Midlands last year. That represents a rather large number of people chipping in

some of their savings in order to own the physical capital of ADM. (I would still refer to

this as a relatively small number of people in a country with a population of 300+ million

people). Since I own only a hundred shares of stock in ADM, I have no interest in trying

to help the firm made the day to day decisions about how the firm should operate that my

friend must make in operating her kitchenware shop. However, I do have a great interest

in how the firm operates, since my return for owning a portion of the physical capital of

this firm depends on its profit. So once again I get to vote, in this case for the individuals

on the board of directors, who will make the decisions about what the corporation will

produce and how it will produce those products at the Board’s monthly meetings.

Can you see why an individual or family who owns, let’s say, 15% of the shares of stock

in a firm might want to vote him/herself onto the board? Such an individual would have

a lot at stake when that board of directors makes decisions about what the firm should

produce and how. There is a family, the Andreas family, that owns 8% of the shares

outstanding (that currently exist) of ADM. There is always a member of the Andreas

family on the ADM board of directors, and sometimes among the senior executives, too.

I, on the other hand, own only 100 shares of the several hundred million shares of ADM

in existence. If I do not approve of actions the firm takes, I cannot elect a new board of

directors or vote myself onto the board. But, I do have the option of “voting with my

feet”, which is to say, I can sell my shares of ADM in the secondary market for existing

shares. Archer Daniels Midland lists its stock on the New York Stock Exchange

(NYSE). That doesn’t mean that I can fly to New York and go down to Wall Street to

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sell my shares. Rather, I call my stock brokerage company, which owns trading

privileges on the NYSE, and ask them to sell the shares of stock on my behalf. I tell the

broker what price I will accept, and the brokerage company traders on the floor of the

exchange try to find a broker representing a client that would like to buy shares of ADM

and who is willing to pay the price I am asking. If so, the shares of stock trade hands.

Notice that when shares of stock are traded on one of the stock exchanges of this country,

that the money from the transaction does not go to the corporation whose shares are being

traded. Instead, the shares go from the seller to the buyer, and the money goes from the

buyer to the seller. The corporation only receives the payment for the purchase of shares

of stock in the IPO, or the first time the shares are sold to the first owner. All subsequent

trades of those shares take place in the secondary market of the stock exchange, and

rarely involve the corporation itself. (There are occasions when corporations do buy back

existing shares of their own stock.)

Perhaps you can see the sense in which the initial sale of stock taps into the savings of the

shareholders and represents the ownership of factors of production in the same way that a

sole proprietor uses his/her savings to buy factors of production. Likewise, corporations

can also borrow some of the money they use to buy factors of production. The process is

often the same as for sole proprietors, or households for that matter, in that they go to a

bank for a loan. However, large corporations sometimes want to borrow an amount of

money that no single bank, or even group of banks, can lend responsibly to a single party.

In that case, the corporation borrows in the same manner as the government. It sells

bonds; in this case, corporate bonds. The process is quite different than when the

government sells bonds, however it is similar in the sense that the bond seller is the

borrower and the bond buyer is the lender. Again, the bond buyer is going to hold

savings in the form of a loan to a corporation with the intent of receiving interest on the

bond.

Remembering that the way it is determined who will get the products produced in the

private sector is determined in markets, do you recognize some of the products produced

in the private sector? Anything you buy in a store is probably produced in the private

sector. Services for which you are billed are also likely produced in the private sector.

Hence, most food, including restaurant meals, clothing, and housing are produced

privately, along with cars, appliances and furniture. In fact, somewhere between 75%

and 85% of the products we consume are privately produced by businesses or firms.

All of which begs an interesting question. Why use two allocative mechanisms? Why

not use all public or all private allocation? Now that’s an interesting question; one that

will take the better part of Chapter 3 to answer.

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Chapter 3: The Production-Possibility Frontier

The simple answer to the question why we use two allocative mechanisms is that some

products are better produced in the public sector and other products are better produced in

the private sector. It turns out that there are even a few products that don't seem to care

one way or the other, whether they're produced in the public or the private sector.

However, as long as there are some products that are better produced in the public sector,

then it's appropriate to have government produce those products. If there are other

products that are better produced in the private sector, then businesses should produce

those products.

Section 3.1: Products Best Produced in the Public Sector

I'd like to give a few examples of each of these types of products. I'm going to start with

the more difficult case, and that is to convince you that there are some products that are

better produced, in the sense of actually being more efficiently produced using fewer

resources, in the public sector.

My first example of a product better produced in the public sector is national defense. If

you remember, we described it as being produced by the federal government, hence in the

public sector. The best way to understand what I mean by better produced is to imagine

what it would look like if we tried to produce national defense in the private sector,

instead.

First of all, businesses produce the products in the private sector. So, to produce national

defense in the private sector, we'd have to have firms that would offer this product for

sale. We couldn't call it national defense, in this case, since people would only consume

defense services if they were willing to buy and pay for these services from a firm, and

there is no reason to think all households would want to buy this product.

Imagine what it would look like if the government produced no national defense and

households only had defense if they were willing to buy it from a company. Can you

imagine representatives from a firm coming to your home to give you a presentation

explaining why you should consider buying defense services from that particular firm?

Can you see in your mind’s eye the glossy brochure that the firm would give you,

picturing groups of large burly people in uniforms - company uniforms? Each would

probably have a M4 or AK47 fully automatic weapon. The firm might even have a few

Black Hawk helicopters or tanks or missile launchers.

Let's think about the nature of the defense such firms would be able to provide to their

clients. In the absence of U.S. national defense, produced by the federal government,

perhaps those feisty Canadians would come streaming across our Northern border.

Consider what we would be asking these defense firms to do. As the Canadians would

approach the firms’ clients’ homes, the “defense” firms would have to mobilize their

personnel to surround the clients’ homes and defend them.

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Does it make sense that a firm would need to protect the entire immediate neighborhood,

in order to successfully produce its product? There is the potential for the clients’

neighbors to be free riders, in this sense that they would enjoy the defense services of

their neighbor without paying for them. This possibility creates a strong disincentive for

individuals to buy defense services, since they might just as well rely on one of their

neighbors to protect their homes.

There are currently free riders on the US defense system, even though the federal

government produces the product. For example, the Canadians free ride on the current

U.S. national defense system. It is not possible to defend the entire United States without

also defending the majority of Canadians, 90% of whom live within 100 miles of the U.S.

border. Obviously, Canadians do not pay taxes to the U.S. government, and therefore do

not have to pay for this part of their nation’s defense. Perhaps you can think of other free

riders on the current U.S. defense system.

There are other reasons private sector defense would be poor quality. For example, firms

producing defense would not be likely to have a navy. Any one firm would not be likely

to have enough clients on or near the coast to justify the expense of ships. Even a naval

destroyer runs about $1 billion. A firm can build a full line steel plant for that much

money. A ship would represent a large amount of physical capital to defend a rather

small number of clients.

One of the ways our current government-produced defense system defends us is by

means of aircraft carriers. A single aircraft carrier costs about $4.5 billion. An aircraft

carrier is good at projecting power, but is vulnerable to attack. Hence, an aircraft carrier

is only sent out as part of an aircraft carrier group, consisting of the aircraft carrier, a few

destroyers, fueling and supply ships, and one or two submarines. Since each of the

smaller craft cost approximately $1 billion each, an aircraft carrier group is a $20 billion

investment in floating physical capital. Most firms would be unable to borrow enough or

tap into enough savings of shareholders to buy such vast quantities of physical capital.

The United States currently has 11 aircraft carrier groups.

Clearly, producing defense in the private sector would mean that substantial numbers of

Americans would choose to go without defense services. There would be free riders on

those Americans who would choose to buy the services. Furthermore, the services would

tend to be distinctly inferior in quality and quantity to those being produced today by the

federal government, because they would use substantially smaller quantities of physical

capital. Furthermore, the various companies producing defense services would not be

coordinating their activities, as the various branches of our armed services are today.

Finally, if you think about how much you would have to pay for defense services from a

private sector business, it would be likely to be quite expensive. People with home

security systems pay up to $100 or $150 a month for home security. And that service

simply alerts homeowners and the police when their houses have been broken into.

Given that a defense firm would have to send out armed personnel to protect clients’

homes from invasion, the price of such a product would be many times higher than the

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price of a home security system. In fact, businesses that do hire security guards, dogs and

other protective services pay many times more than the price of a home security system.

By producing national defense in the public sector, and by having all citizens kick in tax

dollars to produce national defense, our national defense is much cheaper to produce per

person protected. The U.S. defense budget is currently running about $500 billion a year.

For a country of 300 million people (and given that a billion is a thousand million), that

means that we pay approximately $1667 per person per year for national defense.

Calculated on a monthly basis, as we pay for most services, that would come out to

approximately $140 a month per person. When one considers that the U.S. government

provides the best quality national defense in the world for the low, low price of $140 per

month, that is actually a very good deal for such a high quality product. Hence, I would

argue that our current national defense system produces a better quality product more

efficiently in the public sector than could be produced by the private sector.

A second product that is arguably produced better by government than the private sector

is street paving. Again, it is easier to understand this if we imagine a household hiring a

firm and paying for its own paving. Can you imagine what our roads and streets would

look like if each individual household were responsible for paving and maintaining the

street in front of its house?

If you have ever known someone who had to do some paving on their own, you probably

know that it is expensive. I paved a 12 foot section of my driveway a few years ago. The

company I hired to do this paving had to bring in all the same types of trucks and

equipment that would have been necessary if I had been paving an extended swath of

street. In total, it took a half a day for the firm to accomplish this 12 foot stretch of

paving. The cost per foot to do this paving was quite high.

When the city government does street paving, the process is much more efficient in the

sense of requiring less time and expense per foot paved. My entire subdivision was

repaved a year and a half ago. The city brought out all the same type of trucks and

equipment that my paving firm had used. But the city only had to set up once, and then

could pave long stretches of the street. The entire subdivision was done in a day. Surely

this is a much more efficient approach to paving.

If you look around the world, you will find that virtually all countries produce national

defense and street paving in the public sector, where government produces the product.

This is so because 1) these products are more efficiently produced in the public sector, 2)

it is possible to avoid the free rider problem, since all citizens pay the taxes that pay for

the product, and 3) because these products are thought of as pure public goods. Pure

public goods or services tend to be non-excludable and non-rivalry products.

A non-rivalry product is one which, as one person consumes more of the product, it does

not reduce the amount available for others to consume. National defense is a non-rivalry

product. Canadians can enjoy U.S.-produced national defense without reducing the

defense residents of this country enjoy. Streets, however, are a rivalry product. The

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more cars that pour onto a street, the more the resulting congestion impedes drivers’

ability to access the services of the street as a public conveyance.

A non-excludable product is one for which it is difficult, if not impossible, to exclude

someone from consuming the product. National defense is non-excludable. It would be

impossible to exclude Canadians who live near the U.S. border from receiving defense

services without excluding Americans living very near our Northern border.

City streets are also generally non-excludable, because the city cannot keep a particular

person from traveling on a city street. On the other hand, residents of gated communities

must pay for the paving of their community’s streets without taxpayer help. But, having

paid for those streets, the owners have the prerogative of deciding who may travel on

their streets. By means of the gate or guard at the entrance, the residents of the

community may exclude people from traveling on their streets, hence the streets of a

gated community are an excludable product.

It is easy to see why all countries put national defense in the public sector, except for

countries in such political disarray that citizens are reduced to acquiring personal

weapons, bodyguards or militias. Since no resident of the U.S. can be excluded from

consuming national defense, which is to say it is a non-excludable product, and since

consumption of defense by one person does not reduce the defense available to other

residents, making it a non-rivalry product, it makes sense that all citizens have to help

pay for this product. This is best accomplished by payment of taxes for this pure public

service. That way every adult contributes to our common defense. See Table 3.1 for

other examples of pure public and pure private goods.

Excludable Non-excludable

Rival Milk

Cars Pure Private

Houses

Fish in the open ocean

City streets

Legal defense

Non-rival Cable TV

Radio broadcasts

National defense

Constitutional rights

Pure Public

Section 3.2: Products Better Produced in the Private Sector

There are some products that are better produced in the private sector, which is to say,

produced by firms or businesses. The example of a pure private product that I’d like to

discuss at length is from the agricultural sector of the economy, specifically grain

production. If you look around the world, you will find that farming is almost universally

a private sector industry. In other words, farms are businesses. Many farmers are sole

proprietors. They own their own land, though they may have a mortgage on it, which is

to say, they owe a bank the money that they borrowed to buy the farm. As the owners of

their property, the farmers decide what crops will be grown, what factors of production

will be used to grow those crops, when they will be harvested and where they will be

32

offered for sale. Since the answer to the question, “for whom has this product been

produced” will be determined in the grain market, the farmers offer the crop for sale, but

do not unilaterally determine who receives the resulting output.

In Section 3.1 we had to imagine what it would look like for national defense to be

produced in the private sector. We won't have to use our imaginations in order to try to

imagine what grain farming would look like in the public sector. During the 20th century

there were a number of countries which tried to produce all products in their economies

in the public sector. These were the communist countries. It will be well worth our

while to look at the experience of countries that tried placing all factors of production in

the public sector of their economies.

The first country to attempt the communist experiment was the country that early in the

20th century was called Russia, as it is again called today. But, during its communist

phase, this country was called the Soviet Union. It's important to look back at the

historical origins of this grand communist economic, social and political experiment, to

understand why it was ever attempted in the first place. It can be argued that the origins

go back to the 19th century history of Russia.

You are aware that slavery existed early in this country’s history, and that it only ended

as a result of the Civil War (1861-1865) and the addition of the 13th

Amendment to our

Constitution. Most Americans may not be aware that Russia had a very strict version of

serfdom which was very similar to slavery that existed until Czar Alexander II

emancipated the serfs in 1861.

Under strict serfdom the life of a Russian serf was remarkably similar to that of an

American slave. The difference was that while slaves belonged to a person, and therefore

moved with the owner, serfs belonged to a piece of property and did not move when the

property to which they belonged changed hands. A serf didn't choose the work that he or

she did, could not move from the property to which he or she belonged, could not marry

whom he or she chose, particularly if the intended spouse lived on another property, bore

children that were also serfs and owned no property of his or her own.

The emancipation of the serfs created a very large population of landless peasants in

Russia, representing a much larger proportion of the population than freed slaves

represented in the U.S. This resulted in a badly skewed income and wealth distribution in

post-emancipation Russia. What this meant was that the income and wealth of Russians

were very unbalanced; income being what an individual or household earns in a year and

wealth being the accumulated savings of a person or family. There were a very small

number of very wealthy Russians, mostly the nobility, and very large numbers of

peasants with no savings or property, and therefore, no wealth at all.

During the last few decades of the 19th century, the industrial revolution finally began in

Russia. Economic development brought substantial improvements in standards of living,

including broader land ownership by peasants. As peasant households’ standard of living

rose, many accumulated enough savings to buy small plots of land.

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These general economic improvements continued until 1914 and the onset of World War

I. The war went badly for the Russians, and economic hardship set in. As the war went

from bad to worse and starvation set in, a revolution in February 1917 forced the Czar to

abdicate the throne. A provisional government was established to organize elections,

which were intended to move the country toward democracy. In October of 1917 a coup

d'état toppled the provisional government, and established the Bolsheviks in St.

Petersburg, and subsequently in Moscow. Their leadership was not initially accepted

throughout the country, resulting in a civil war that lasted to the end of 1920.

The Communists intended a grand social and economic experiment that would place all

factors of production in the public sector. The purpose was to correct the badly skewed

income and wealth distribution in Russia, which was presumed to have created the

discontent that resulted in the revolution. The intent of the communist project was to

have the government own all factors of production, so that no small group of wealthy

families would receive and own the majority of the income and wealth of the nation.

Rather, the government would own all resources on behalf of the people of the Soviet

Union, and the government would allocate resources and products guided by the motto

“from each according to their abilities, to each according to their needs”. This

experiment in Marxism was expected to leave the citizens of the new Soviet Union

happier in their new economy of essentially equal incomes for all citizens.

Beginning in 1924, the communist government began to expropriate the property of

private businesses, thereby moving factors of production from the private sector to the

public sector. The first industries expropriated, or collectivized, were in the financial

sector of the economy, for example, banks. Next the communist government

expropriated the physical capital of industrial companies, along with small shops, like

groceries, barber shops and restaurants. The last sector to face government expropriation

was the agricultural sector.

Since significant numbers of Russian peasants had only become landowners in their own

lifetimes, these peasants were very reluctant to give up their newly acquired land to the

government. In the late 1920s, the Soviet government attempted to induce farmers to

voluntarily turn over in their land to the state. However, it quickly became clear that only

coercion would get them to give up their land. Peasants in large numbers resisted the

expropriation of their land, even killing their livestock, rather than turn their animals over

to the government.

In the early 1930s, at the end of the crop year, the Soviet government sent in the military

to take the harvest from the countryside, leaving virtually no food behind for the peasant

farmers. Gleaning fallen grain left behind was punishable by death. Conservative

estimates suggest that 12 million Russian and Ukrainian peasants died, mostly from

starvation, in the collectivization of agriculture in the Soviet Union. This had now

become a very expensive social experiment in terms of the loss of human life it caused.

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Now that agricultural factors of production were in the hands of the government,

agricultural land was organized into large state farms. Tractors and trucks were sent to

the state farms to help farm workers produce more. Those former peasants still on the

land were now government employees who drew government salaries just like every

other Soviet worker. A Soviet planning bureaucracy was created, which made the

allocative decisions about what each farm would produce, what seed and fertilizer and

tractors would be sent to the farm to produce its product, and where the resulting crop

would go. The large scale of the farms, the increased use of mechanized equipment, and

the professional bureaucracy making the allocative decisions led many to expect large

increases in Soviet agricultural output.

It took some years to see the results of this grand experiment. In the late 1930s and early

1940s the Soviet Union was again caught up in world war. Not until the 1950s was it

possible to gauge Soviet agricultural productivity. Initial results looked promising.

However, by the late 1960s and early 1970s, the Soviet Union began to import greater

and greater quantities of grain. This was totally unexpected since, as a result of the peace

treaty following WWI, the Soviet Union included the country that today is the

independent nation called the Ukraine. The Ukraine in the first two decades of the 20th

Century was referred to as the Breadbasket of Europe. In other words, the Ukraine

produced so much grain, that it not only managed to feed itself, but exported large

quantities of grain to Western Europe.

The fact that the Soviet Union could not produce enough grain by the 1970s to feed itself,

despite controlling the resources of the former Breadbasket of Europe, suggested that the

large state farms were not very productive. Government bureaucrats did not seem to be

up to the challenge of distributing factors of production among farms. State farms

routinely were unable to acquire replacement parts to keep farm machinery working.

With harvesting equipment broken down, military troops sometimes had to be sent to the

countryside to help bring in crops. Soviet dependence of foreign sources of food became

so great, that in 1979 when the Soviet Union invaded Afghanistan, then-President Carter

chose to punish the Soviets by not allowing any more U.S. grain sales to the Soviets.

The Soviet experience was subsequently repeated in every communist country. After

China became communist in 1949, it also collectivized agriculture, creating giant peasant

communes, its version of large state farms. By the 1970s, China also could not feed

itself. After the fall of South Vietnam to communist North Vietnam in 1975, the

Vietnamese also collectivized agriculture. By the early 1980s Vietnam could not feed

itself. There is some speculation that Vietnam’s invasion of Cambodia in the early 1980s

was in small part to access additional food.

All communist regimes have found themselves unable to feed their citizens under

collectivized agriculture. In the fall of 1990 reports out of Moscow suggested that the

stores had run out of bread, and according to a New York Times article from September

of 1990, the citizens of Moscow viewed this as simply another indication of “the

continuing breakdown of the state run economy”.

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North Korea remains the only communist country today with only collectivized

agriculture and no private sector-type incentives to individual workers to produce. Since

the late 1990s, each year has brought new reports of starvation in North Korea, with the

toll of those dying of hunger and malnutrition ranging as high as 800,000 people in 1997.

(Los Angeles Times: 8/20/98). The crisis continues amid recent reports of “millions of

city dwellers being forced to work as farmhands in the countryside on weekends.” (Wall

Street Journal: 6/2/05). Hence, no matter how productive a country’s agricultural sector

was before communism, after collectivization of agriculture, the country could not

produce enough food to feed itself.

There is other evidence that grain is not efficiently produced in the public sector. That is

provided by the experiment that China undertook beginning in 1979. The communist

leadership, under Deng Xiaoping began to “decollectivize” agriculture, by breaking up

the peasant communes. The government offered the Chinese peasantry, the following

deal: individual households would be allowed to lease small plots of land. (They could

not own the land, since China is still a communist country. However, they were allowed

a long term lease of the land). The peasant family would be allowed to decide what

would be produced on the small plot, how it would be grown, when it would be

harvested, and where it would be sold. However, there was a kicker. Peasant families

that took the government up on this offer would have to live off the proceeds of their

crop. They would no longer receive a government salary.

The Chinese peasantry overwhelmingly took the government up on its offer, and the

output of the agricultural sector in China surged. To show the effects of this second

experiment that returned agricultural resources to individual farmers to allocate, the

following is a quote of a few paragraphs from a book titled The New Russians. This

book was written by an American by the name of Hedrick Smith, who is now an editor

with the New York Times, but at the time this book was written in the early 1990s, Mr.

Smith was the recently-returned Moscow correspondent for the New York Times. While

The New Russians describes Russia immediately after the collapse of communism, these

paragraphs describe the Chinese experiment in agriculture, which amounted to the

reintroduction of private sector- type decision-making in China’s farming sector.

Hedrick Smith writes:

“For five years [after 1978], Deng had been decollectivizing agriculture-

dismantling China’s infamous peasant communes and turning over land to individual

peasant households to farm on their own. After delivering a set quota to local

governments, peasants were allowed to sell the rest of their crops for personal profit. To

heighten incentive, Deng had raised the prices for farm produce.

“A sudden, stunning explosion had taken place in the Chinese countryside. Most

of China’s roughly three hundred million peasants had seized the opportunity, and

generated a great leap ahead in production and living standards. Since 1978, grain

output had shot up 33% …Overall, the farm sector was rolling along a 7% growth a

year- certainly enviable in Moscow, and unheard of not only in other Communist

countries, but almost anywhere in the world. New cottage industries had sprung up all

36

over the countryside-small service shops, little textile mills, and the like- creating an

economic boom in rural China: 52.9% growth in 1984 alone. Close to seventy million

people were now at work in that sector, and the Chinese press carried stories of new

millionaire-entrepreneurs in the hinterlands.

“Marxism seemed turned on its ideological head”.

You can probably see why Marxism was “turned on its ideological head”. The whole

communist experiment was intended to make sure that income and wealth never became

so skewed that there would be “millionaires in the hinterlands”, or anywhere else, for that

matter. While inconsistent with the goals of Marxism, the more important outcome was

that people now found food “fresher, varied and plentiful”, and general standards of

living improved.

Vietnam ran a similar experiment to that of the Chinese after withdrawing from

Cambodia in the late 1980s. The following is a quote from an article in The Economist

magazine from June 19, 1993. This article describes the results of the experiment in

Vietnam that broke up peasant communes and allowed individual families to farm small

plots of land.

The Economist writes:

“In the past four years, Vietnam has risen from nowhere to become the world’s

third largest exporter of rice, after Thailand and the United States. Co-operatives have

been largely replaced by the family farm… Production has soared. Rice, which used to

be grown largely in the Mekong delta, is now grown throughout the country. In 1992

Vietnam exported more than 2 million tonnes of rice and earned around $400 million,

making rice its second biggest earner after oil.”

In summation, there is ample evidence that Communist countries that tried producing

grain in the public sector of the economy by means of collectivized agriculture in every

case experienced massive declines in output, resulting in hunger and malnutrition, if not

outright starvation. Countries which then tried experiments in which collectivized farms

and peasant communes were broken up into individual plots to be farmed by individual

peasant households found production soared, and ample stocks of food, if not exportable

surpluses, resulted. Clearly, private sector allocation is the far more efficient way to

produce agricultural products.

(Please see the box below for some recent research on what causes societal unhappiness).

Remarkably, the resulting disparities in income and wealth in China and Vietnam have

not caused any evident unhappiness. No riots have broken out as a result of these

wealthy new “entrepreneurs in the hinterlands”. In fact, the Chinese and Vietnamese

societies in which these experiments have taken place have shown few indications of

social friction arising from the resulting widened income and wealth gap. Most

indications are that people were poorer, hungrier and unhappier under Communism.

37

They, additionally, lacked any incentive or ability to improve their lots, which appeared

to have been socially and politically, as well as, economically enervating.

The issue of what makes people so unhappy that they can be spurred to political violence

became a research emphasis for American political scientists in the 1960s, after the

assassinations of President John Kennedy, his brother and presidential aspirant Robert

Kennedy, and civil rights leader Martin Luther King. Congress enlisted the help of a

broad range of researchers to address the question of what was causing the political

upheaval of the 1960s. The result of the Congressionally-appointed committee which

looked into this problem was an anthology of research edited by Ted Gurr, a political

scientist at UCLA at the time, titled The History of Violence in America: Historical and

Comparative Perspectives. This compendium of research suggests that there were other,

perhaps more important, sources of human unhappiness besides disparities in income and

wealth; e.g., see James Davies’ article in Gurr’s Violence in America, “The J-Curve of

Rising and Declining Satisfactions as a Cause of Some Great Revolutions and a

Contained Rebellion”.

Europeans have been asking the same questions about the causes of violence since riots

among ghetto youth in the suburbs of France in November of 2005 and riots and

assassinations in response to films (the assassination of film director Theo Van Gogh)

and political cartoons. New research was presented in Rome, Italy, at an April 2-3, 2007,

Organization of Economic Development and Cooperation (OECD) conference titled: “Is

Happiness Measurable and What Do Those Measures Mean for Policy?” Research

presented by Claudia Biancotti and Giovanni D’Alessio of the Bank of Italy at that

conference suggested that whatever effects inequality has on happiness, the effects are

“conflicting and often appear to be domain-specific (country, class, etc.)” Furthermore,

they conclude that “…those who are more moderate in opinion and more supportive of

social inclusion than their fellow citizens tend to dislike inequality”. That particular

conclusion doesn’t explain why inequality would spur political violence, since inclusive

moderates constitute a segment of the population particularly unlikely to resort to

violence.

Other presentations at the same conference cited unemployment and lack of opportunity

as more meaningfully related to unhappiness. Marcel Canoy of the European

Commission, Bureau of European Policy Advisers, suggested that increasing opportunity

may be a particularly fruitful policy approach to making citizens happier. Interestingly,

this is similar to James Davies’ conclusions for the U.S. thirty years earlier. Certainly,

American political violence diminished significantly after equal opportunity legislation

passed in the 1960s began to take hold. A number of commentators on the European

scene have observed that greater employment opportunity in Europe is likely to lessen

restiveness among Muslim youth, who have experienced very high unemployment rates

and have questioned their ability to access educational and employment opportunities.

What is important about this research is that it suggests that the assumed importance of

disparities in income and wealth distribution to peoples’ happiness may have been vastly

overestimated by Communists and democratic socialists. It would be sad indeed if the

38

entire Communist experiment, and the loss of tens of millions of lives associated with it,

was predicated on an incorrect assumption about the importance of evenly distributed

income and wealth to human happiness. *See also the work of Syracuse University

Professor Arthur C. Brooks.____________________________________________

If you think about the products that the former Soviet Union produced well, they include

national defense (it was the other super power), education (many well-trained Soviet

citizens have successfully migrated to Western scientific communities since the fall of

communism) and its space program. But these are all products that, in the West, are

produced in the public sector, too. Those products that the Soviet Union produced poorly

or in insufficient quantities, like food, housing, cars and gasoline, are produced in the

private sector in most Western countries. Clearly, the resources used to produce these

latter products were being misallocated, which is to say, incorrectly allocated by being

placed in the public sector under communism.

Furthermore, food, housing, clothing and the like are pure private products, which is to

say, both exclusive and rivalry products. If I buy and drink a pint of milk, no one else

can consume that milk, hence it is a rivalry product. Besides, I can easily keep others

from consuming that milk by storing it in my refrigerator until I drink it, making it an

exclusive product. Pure private products tend to be produced by most countries in the

private sector, because their exclusivity and rival natures make them hard to share, and

therefore to consume collectively.

Section 3.3: The Production-Possibility Frontier

It is actually possible to see what it has taken me several pages to describe by using a

model called a production-possibility frontier. A production-possibility frontier is a line

whose points represent every possible combination of two types of products that is the

maximum an economy can produce with the resources that it has available. We are going

to graph the U.S. production-possibility frontier (P-PF). Obviously, we produce millions

of products in this country. But we want to graph in just two dimensions, so we will use

two categories of products. Some textbooks have used goods and services on the two

axes. Others have used consumption products (products that households and businesses

buy for immediate use) on one axis and investment products (physical capital) on the

other axis. I’m going to put public sector output (products produced by government) on

the vertical axis, and private sector output (output of companies or businesses) on the

horizontal axis.

What we are going to graph is every combination of public and private output the U.S.

economy can produce with its current resources. Those resources would include the

current land mass of the U.S.; the human effort to produce products of the 150+ million

individuals in the labor force; supplemented by their accumulated human capital or

knowledge, skills and experience; the approximately $25 trillion worth of production

physical capital in place in the U.S.; aided by the technology and natural resources that

are currently available. This is an impressive array of factors of production that currently

produces about $14 trillion of publicly and privately produced output in this country.

39

If we were to graph every possible combination of public and private output we could

possibly produce, can you see why the resulting P-PF would have to have a negative

slope? With only our current resources, if we were to produce more public output, we

could only do so by producing less private output, since it would be necessary to shift

some resources from production of private sector output to public sector production.

Likewise, to produce more private sector output, it would be necessary to shift resources

from the public sector to the private sector. Hence, there is a trade-off between the two

types of output we are measuring on the two axes.

Figure 3.1

Public Output

Private Output

Let’s take our PPF one step further. This is where our discussion about the fact that there

are some products that are produced more efficiently in the public sector and others more

efficiently produced in the private sector comes in. This fact of the real world means that

the PPF is not a straight line, but rather is concave with respect to the origin, as shown in

Figure 3.2.

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Figure 3.2 A More Realistic Production- Possibility Frontier

Public Output

Private Output

Suppose the U.S. currently produces half of its output in the public sector and half in the

private. That would place us at the midpoint of our PPF curve. Well, we do not actually

sit on the PPF, but rather somewhere within it. That’s because the points on the curve

itself represent our production- possibility frontier; that is the maximum output

combinations the U.S. can produce with the resources we currently have. The truth is we

never use all the factors of production available in the economy. There are always some

resources that are unutilized. We always have a measurable unemployment rate in this

country, which means some individuals who would like to have jobs, cannot find work.

Hence, they are not currently producing output. One can always find office space

available to rent or lease. Hence, there is physical capital that is not in use. As a result,

we always function somewhere inside the production possibility frontier.

Starting from just within the midpoint of the production possibility frontier, suppose we

decided to take a number of steps towards producing more public output. That would

move us vertically and, necessarily to the left, along the production possibility frontier. If

the production possibility frontier were a straight line, then each equal-size increase in

public output would cause us to give up the same amount of private output.

But, that is not what would happen in real life. That was not the experience of the

communist countries. Instead, what they found was that with each industry they

41

expropriated and collectivized, they gave up greater and greater amounts of private

output. With each industry that they collectivized, they put even more resources that

were less and less well suited to the public sector into the government's hands. So, with

each increase in public output, a larger and larger decrease in private output occurred. By

the time, the Soviet planners put all factors of production in the public sector, and

reached the vertical axis of their production-possibility frontier, total output would have

been significantly below the level of output that the straight line production possibility

frontier would suggest.

The same would have been true of an economy that took repeated steps towards

producing more and more private sector output. Again starting in the middle of the P-PF,

with each step to the right, a greater and greater amount of public output would be given

up for the same size increase in private output. By the time, a country would be

approaching the horizontal axis and producing all private output, total output of goods

and services would be well below what a straight line production- possibility frontier

would suggest. That is because, as a country would approach the horizontal axis, or in

other words, approach producing all private output, more and more factors of production

would be shifted to the private sector that are more and more poorly suited to be

organized by businesses. Probably the last product a country would force into the private

sector would be national defense, because, as we saw in our earlier example, defense

produced by firms rather than the national government is of profoundly lower quality and

considerably more expensive.

This suggests that the reason the production possibility frontier is concave with respect to

the origin is that as a country moves to either end of its production possibility frontier, by

placing larger and larger proportions of its resources into only one allocative mechanism

or the other, it is pushing some resources into an allocative mechanism for which they are

poorly suited. Hence, the production possibility frontier bends in and away from a

straight line production possibility frontier at each end.

So, when the Chinese undertook their late 1970s experiment of decollectivizing

agriculture, they were starting at their vertical axis, and taking steps towards producing

more private sector output. To accomplish that, it would have been necessary to produce

less public output. After all, peasant communes had to be broken up into the small plots

individual farm families were going to till. Hence, public output would have declined.

But remember how Hedrick Smith described the resulting increase in private sector farm

output in his book The New Russians, “A sudden, stunning explosion had taken place in

the Chinese countryside.” Clearly, the increase in private-type output was much greater

than the decrease in public output from the old state farms. The problem with the two

ends of the production-possibility frontier is that the tradeoffs are very unbalanced. No

democracy would choose to shift all its resources into either the public or the private

sectors exclusively. The output given up to do so is simply too great.

A further indication of this point is to see where democracies place themselves on their

respective production possibility frontiers. Let us suppose that rather than drawing the

U.S. production possibility frontier, we have drawn a generic one on which we could

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measure any country’s combination of public and private output. In table 3.1 are data

from the Organization for Economic Cooperation and Development (OECD) that

measure for 2004 the “general government final consumption expenditure as a percent of

GDP”, which is governments’ purchases of factors of production relative to the total

output of the economy. This should give us a good estimate of each countries’

government output share of the total goods and services produced in that country.

Table 3.1: Government’s Share of Output*, an International Comparison

Country Govt. final consumption as a % of GDP for 2004 (latest year available)

Canada 19.7%

France 23.9

Germany 18.4

Italy 19.2

Japan 17.7

Sweden 27.7

United Kingdom 21.2

United States 15.6

*These numbers underestimate slightly, the governments’ share of total output, since it

likely lacks government investment in physical capital.

Figure 3.3 Democracies’ Production-Possibility Frontiers

Public Output

Private Output

Sweden

France

U.K.

Germany

U.S.

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Citizens of democracies choose the combination of public and private output that their

countries produce. It is true that no nation’s citizens walk into a polling booth and

choose whether they will produce 15% public and 85% private output, or 25% public and

75% private output. However, through constitutionally designated electoral processes

citizens choose the men and women in the legislative and executive branches of their

country’s government. Since these elected officials will collectively determine what the

government produces, how it produces those products, and for whom those products have

been produced, democratically accountable leaders effectively choose the combination of

public and private output produced by choosing the public output of that country.

As you can see from Figure 3.2, most democracies choose combinations within a fairly

narrow range. There is no country producing two-thirds public output and one-third

private. Even Sweden, a country with a relatively strong preference for public output,

produces a little more than a quarter of its output in the public sector. Does it make sense

that these combinations must be where the production-possibility frontiers of these

countries must have slopes very close to equal to negative one. At slopes of one the

trade-off is equal. The amount of public output given up must be essentially equal to the

private output gained, and vice versa.

There are a couple of clear conclusions. First, production of a rather large majority of

products is more efficient in the private sector. Second, the governments of economically

developed democracies produce between a seventh and a quarter of their countries’ total

output. Third, those rare products which can be relatively efficiently produced in either

sector probably account for about 10% of most countries’ output; the difference in

Sweden’s and the U.S.’s shares of public output. Hence, the majority of the difference in

where democracies place themselves on their P-PF’s has to do with where they place

industries that do relatively well in either the public or the private sector; most notably,

their health care sectors.

In the U.S. the majority of health care is provided by the private sector, while in Europe

the majority is in the public sector. This reflects an historical emphasis on efficiency and

choice in the U.S. and equity and accessibility in Europe. Interestingly enough, these two

different approaches are slowly evolving to meet in the middle.

Let’s look at a specific example. In the U.S. when you go to see a doctor, s/he has her/his

own office or, perhaps, shares an office with other doctors. The doctor or doctors operate

the business as a partnership, limited liability company or corporation. The doctors lease

or own their office space, the equipment in the offices and hire and fire the staff that

works in the office. Alternatively, you may go to an HMO, or Health Maintenance

Organization to see a doctor. These HMO’s have names like CIGNA or United Health.

These are corporations and, therefore, private sector businesses. Most doctors work in

the private sector in the U.S.

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Most American hospitals are also in the private sector. Here in Arizona, there are a few

public hospitals. There is a Veterans Administration hospital that cares for veterans of

the armed services. There is also one State mental health hospital. Maricopa County

operates one general hospital, as do several of the dozen or so counties in the state. All

the other hospitals in the state are private.

In stark contrast Canada has an almost entirely public health care industry. The vast

majority of doctors work in government clinics or hospitals. They receive a government

established salary. The buildings and equipment with which these doctors work are

government owned.

In both countries citizens receive very good quality health care by international standards.

However, while U.S. health care is innovative and technologically advanced, there have

long been concerns about the number of Americans without health insurance. Starting in

the 1960s, Congress created the Medicare system, which provides health care for those

people age 65 or older. Subsequently, the Medicaid program was created to provide

health care services for the poor. Medicare and Medicaid, along with Veterans

Administration health care now account for 40% of total health care provided in the U.S.

These are publicly provided health care services. Despite the fact that seniors go to the

same doctors as other Americans and the same hospitals as their fellow citizens, these are

publicly provided services, because it is Congress that decides what services are covered,

how they are covered and which specific individuals will be provided the services.

Furthermore, it is tax dollars that pay for the services.

In the US., we are currently engaged in one of our periodic debates concerning whether

we should have public healthcare for all citizens. This certainly appears to be an issue

that will be debated in the upcoming general elections, as candidates present their

proposals for health care reforms.

Likewise, the Canadian system is not entirely public. Canadians, who would like

corrective eye surgery, cosmetic surgery, or specialized dental services have to acquire

those services from private sector doctors. In OECD countries, generally, 73% of health

care services are publicly provided.

In Canada, however, change also appears imminent. The Canadian health care sector has

long been plagued with long waits by patients for appointments to see specialists or for

technologically advanced diagnostics and treatment. In 2005 a Canadian Supreme Court

decision stated that a place on a waiting list to receive medical services did not constitute

equal access to health care. It appears that some type of private healthcare or insurance

will become available in new Canadian healthcare markets soon.

In conclusion, it seems likely that both the American and Canadian healthcare systems

will blend more equal amounts of public and private health care services in the future. In

an attempt to have the benefits of both high quality care and broad access to health care

services, both countries are blending public and private provision of healthcare services.

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Section 3.4 Economic Growth

To this point, our goal has been to use the production possibility frontier to illuminate

why countries use two allocative mechanisms simultaneously. We have seen what

combinations of public and private output a number of democracies choose to product.

There are a few other insights, we can garner from the production-possibility frontier.

For example, we can use this model to see how economies grow. Since economic growth

is important to improvements in peoples’ standards of living, we need to know what

causes economies to grow.

Since the production-possibility frontier measures all combinations of two types of

products that a country can produce with the resources it has, we can see that to push any

country’s production possibility frontier out and to the right, so that the country can

produce larger combinations of both types of output, the economy must add factors of

production. So, if an economy is to grow, it must acquire additional resources.

One source of resource growth was population growth, which caused the number of

available workers to grow. Consequently, economic output grew. While labor force

growth does not guarantee per capita growth, or output per person growth, the historical

experience of the U.S. economy has been on average strong growth in the production of

final goods and services.

The Industrial Revolution of the second half of the 19th

century and the first couple of

decades of the 20th

century saw rapid accumulation of machinery and equipment that

caused substantial economic growth in the industrialized countries of the world. The

computerization of the last thirty years has caused another burst of growth in

industrialized economies.

Because physical capital can be shipped and installed almost anywhere, a gratifying

number of countries, that had struggled to grow, are now investing in machinery,

equipment and buildings that are expanding their ability to produce. Countries like

China, India and even Zambia (Wall Street Journal: 7/17/07) have growing middle

classes of citizens who can afford modest, though much improved standards of living,

thanks to expanded investment in physical capital and the consequent increases in output

per citizen. In all three countries, this economic growth is the result of expanded private

sector investment opportunities after years of government economic regulation and/or

lack of available credit. In India, Zambia Afghanistan, Nicaragua, the Congo and other

lesser developed countries the recent availability of very small loans, often less than

$100, called micro-loans, has expanded the opportunity for even very poor people to start

new businesses. The success of these micro-loans in expanding business opportunities,

and consequently raising standards of living, has garnered their originator, Muhammad

Yunus and his Grameen Bank, the Nobel Peace Prize for 2006.

While the addition of factors of production expands the production-possibility frontier

and the output capacity of an economy, it stands to reason that anything the decreases the

quantity of resources in an economy will decrease its P-PF. Hurricanes Katrina and Rita

in 2005 damaged and forced the closure of a fifth of U.S. gasoline refining capacity.

46

Clearly, this shrunk, at least temporarily, the U.S. P-PF. Likewise, the 9/11 attack in

2001 destroyed the twin World Trade Center towers and a couple of other buildings in

their immediate vicinity, along with four jetliners, a wing of the Pentagon and

approximately 3000 lives. Insurance claims for the physical capital destroyed in New

York City placed its value at close to $100 billion. Given the small percentage that

represents of the more than $20 trillion of physical capital in the U.S., it is not surprising

that it is not possible to see any effect on U.S. output from the attack, but there was

unquestionably some small reduction in what we produced, as compared to output

without the attack.

Some of you may have been told that wars are good for economies. A few moments

thought about the effect of the 9/11 attack should make it clear that wars cannot be good

for economies. Sometimes people draw the wrong conclusions from our experience

during the first and second world wars.

The United States did not enter the first and second world wars until years after the wars

began. The U.S. was in the fortunate position of supplying goods to participants in the

war for some time before actually entering the wars. This created new markets for our

products that would not have existed without the wars. This expanded output, putting

many unemployed Americans back to work, particularly during the late stages of the

1930s Great Depression, when the unemployment rate hovered around 15% and the U.S.

economy was producing well within our P-PF. (Today the unemployment rate is less

than 5%). Supplying our future allies under programs like Lend/Lease, in which the U.S.

government bought armaments and then “lent” them or “leased” them to the Soviets and

the British so they could continue their war efforts, probably moved actual American

output closer to our production-possibility frontier, rather than moving the whole P-PF

out by adding to our factors of production.

But the war only helped out the economy, because we were not at war ourselves. Once,

however, we entered the conflicts, the wars were not good for the economy. It is clear

that wars kill and destroy factors of production. Hence, wars cause production possibility

frontiers to shift inward and to the left, suggesting that the country is no longer capable of

producing as much output as previously.

We have plumbed our production-possibility frontier for a lot of information about how

people allocate their resources. Most economies of the world produce output in both the

public and private sectors, each sector producing those products at which it is more

efficient. The combinations of public and private output are quite similar in most

democracies, with government producing about one fifth and businesses producing about

four fifths of output. The capacity of economies to produce goods and services depends

on the quantity of resources they have accumulated. The quantity of physical capital

(machinery, equipment and buildings) per worker is pivotal in determining the standard

of living the citizens of a country enjoy. By diminishing the quantity of resources a

country has, participation in wars is not good for economies.

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In the next chapter we will put our production-possibility frontier model to work one

more time. We will use it to explain the economic arguments in favor of international

trade.

Chapter 4: International Trade

You have probably watched a movie at some time that told the story of a wagon train

taking settlers to new lands. In the movies there would come a point when a family

would break away from the wagon train to carve out a new farm on the prairies. If the

story followed the settlers, you would see them establish a new home. In no time at all,

the family would be living in a nice snug wood home, with a windmill-powered pump in

the yard and a stand of fine crops.

The reality was quite different. It usually took years for a family to carve a farm out of

the prairies. In its first year on the land, the family would set up a small lean-to to live in,

and begin with a small garden. They would probably settle near a river or stream to be

near water. It would have been some family member’s job to haul water each day.

As time passed, the family might build a sod house out of sun-baked blocks of earth,

wood being largely unavailable out on the prairies. The family would be lucky to plow

one or two new acres of land each year. Plowing the tangled mass of shoulder high

grasses for the first time was called “sod busting”, and took a team of horses and a good

plow. Since most farmers had one horse, possibly two, sod-busting was a service the

farmer hired out to professionals.

Let's take a moment to think about the standard of living a family out on its own on the

prairies would have lived. Almost every product a family consumed would have been

produced by a family member. It probably makes sense that the quality of the products

the family consumed was only as good as some member of the family could make.

Suppose your family ate only the bread a member of your family could knead and bake,

wore only clothes someone in your family had sown, ate meat only if someone in your

family had trapped or shot and cleaned it, and had light of an evening that was as good as

the candles dipped by some family member could produce. How good would the

standard of living in your household be?

Most homesteaders placed their houses on their property as close to neighbors as

possible. That way, neighbors could help one another, thereby improving the quality of

products consumed in that small community of friends. If a town was established nearby,

specialization would soon develop. The individual who was best at making horse shoes

would make enough horse shoes for himself and extras to shoe other townfolks’ horses,

creating blacksmithing services to trade for, perhaps, bread made by one of the best

bakers in town, or a shirt made by one of the best seamstresses in town. Before long, the

standard of living in town would be significantly better than out on the farms, because the

products town folks consumed were the quality that could be produced by the most able

producer in town. The bread consumed in town would be made by the best baker in

town. The shirts worn in town would be those produced by the best seamstress in town.

48

This is the underlying argument in favor of trade. The higher quality of life in town is

higher because each adult resident in town would specialize in making that which s/he

produced relatively well, would then produce a surplus, and exchange that surplus for the

products that other individuals produced particularly well. The net result was that town

folks lived a better standard of living than those out on isolated farms.

The same continues to be true today. Each of us tries to find that activity, or vocation, we

do particularly well. We specialize in it, producing more than we need for our own

purposes. Then we trade that surplus with others for the things that others produce

particularly well. Dr. Lamkin and I have each specialized in understanding how the

economy and markets work. We know far more about the economy than we need to get

through life comfortably. However, we sell our surplus knowledge of the economy to

others. That’s what Dr. Lamkin and I do in our classrooms. For that, we receive any

income. We can then take that income to the store to buy other products that we may not

produce so very well.

Likewise, the various states of this country have products that each produces particularly

well. Each state produces a surplus that it can then trade with other states. Here in

Arizona, we produce the five “C’s”: citrus, copper, cattle and cotton, and “climate”,

which is to say tourism. We produce more oranges, grapefruit and lemons than we need

for our own purposes, so we trade our surplus to the residents of other states for products

like cars, gasoline and paper.

Every country has products that it produces well relative to the other products it could use

its resources to produce, at least as compared to other countries. Said another way, every

country has areas of comparative advantage. A country has comparative advantage in

producing a product if it produces the product at lower opportunity cost than most other

countries. In order to understand what that means, we need to define opportunity cost.

Opportunity cost is the value of the next best alternative. Anyone sitting is an economics

class had other things s/he could be doing instead of sitting in these lectures. I’m

assuming you are studying economics because you have decided this is the best use of

your time. Whatever is your next best use of this time is your opportunity cost. Your

opportunity cost is likely to be different than that of all the people studying this subject.

Let’s use this idea of opportunity cost and comparative advantage to explain why trade

should benefit all participants.

Let's use a very simple example of comparative advantage. Let's suppose we have two

countries, country A and country B. Let's suppose the citizens of each country produce

only two products, food and clothing. I guess they live in the trees. We can draw a two

dimensional production possibility frontier for each country, measuring the amount of

food being produced on the vertical axis, and the amount of clothing being produced on

the horizontal axis. These will be production possibility frontiers that show all

combinations of food and clothing that can be produced in country A and country B in a

single day. We'll assume that country A has 15 citizens and country B as 50 citizens.

49

Let's suppose the citizens of country A go out and produce only food, no clothing all day,

and on average each citizen manages to produce six units of food. The resulting vertical

intercept of our graph will be 90 units of food. If instead all 15 citizens of country A

produce clothing instead, they can produce on average two units of clothing. Hence, the

horizontal intercept will be 30 units of clothing. The resulting concave production

possibility frontier that results runs from 90 units of food to 30 units of clothing, and is

shown in Figure 4.1(a) below. The citizens of country A can choose any combination on

their P-PF of clothing and food to actually produce and consume, presumably somewhere

in the middle region of the production possibility frontier. They will want some food and

some clothing, though the specific combination will reflect country A’s citizens’ national

tastes and preferences. They may be gourmands, who like to skip and go naked which

would place them near the top of their production possibility frontier, or they may be

ascetic clothes horses, which will place them near the bottom of their P-PF.

Figure 4.1(a) Figure 4.1(b)

Country A Country B

In country B, on the other hand, if the citizens go out and work all day producing

food, they each will produce one unit of food on average. If instead they all go out to

produce clothing, they will also produce one unit each on average. Since there are 50

citizens, this means their P-PF will extend from 50 units on the vertical axis to 50 units

on the horizontal axis, as shown in Figure 4.1(b).

Can you see why, if country A is producing for its citizens only, it would be

necessary to pay 3 units of food for one unit of clothing. After all, they each represent a

half day’s work. In country B one would expect that food and clothing would trade one

for one.

Let’s initiate trade between countries A and B. First it will be necessary to

identify each countries’ area of comparative advantage. Remember that would be the

product which each country produces at lower opportunity cost. This is the product a

country produces relatively well compared to other things it could be producing, at least

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compared to the other country. It probably makes sense that country A seems to be very

good at producing food. Let’s see if that’s their area of comparative advantage. If a

citizen of country A produces a unit of food, s/he give up the opportunity to produce 1/3

of a unit of clothing. If a citizen of country B produces a unit of food, s/he gives up the

opportunity to produce 1 unit of clothing. Yes, country A’s citizen produces food at

lower opportunity cost (1/3 unit) than a citizen of country B (1 unit). Food is country A’s

area of comparative advantage.

This is not very surprising so far. It was very clear that country A is very good at

producing food. But, what about country B? I’ve made country B’s situation particularly

difficult, because I have presented a scenario in which country A is at an absolute

advantage over country B. Said another way, country A’s citizens are more efficient at

producing both food and clothing than citizens of country B. However, that doesn’t

matter. The fact is, the citizens of country B have a comparative advantage in the

production of clothing. Let’s see why. If a citizen of country A produces a unit of

clothing, can you see that s/he gives up the opportunity to produce three units of food.

However, if a citizen of country B produces a unit of clothing, s/he gives up the

opportunity to produce one unit of food. Citizens of country B produce clothing at lower

opportunity cost (1 unit) than citizens of country A (3 units). The issue is not which

country’s citizens are more efficient in the use of resources, but rather which product

does the citizens of a country produce relatively well compared to other products that

could be produced.

So, country A should specialize in its area of comparative advantage, food,

producing only food, part of which would be consumed by the citizens of Country A and

the rest traded to country B in return for clothing. Country B’s would specialize in its

area of comparative, producing only clothing, part of which it would consume

domestically, and the rest trade with country A for food. As a result, both countries

would be better off. Before we can see how much each country will benefit, we have to

establish what price these countries will pay for one another’s productions once trade

begins. It is most common for the prices of internationally traded products to move to a

price somewhere in between the prices which existed in each of the two countries before

trade. Since the price of clothing was three units of food in country A and one unit of

food in country B, let’s make the terms of trade, as the trade price is called, exactly in the

middle, or two units of food for one unit of clothing.

To see what combination of food and clothing each country’s citizens would

consume, we need to ask ourselves the ridiculous. Starting with country A, suppose the

citizens of country A produced only food and traded it all to county B, how much could

they buy. They won’t really do that, but we are trying to find country A’s new horizontal

intercept. If country A took all 90 units of food and traded it to county B for clothing at

two units of food per unit of clothing, they could buy 45 units of clothing. Hence, county

A’s new horizontal intercept would be at 45 units. Now let’s ask an even sillier question

about country B. Suppose the citizens of country B took all 50 units of clothing they

could produce and traded it to country A for two units of food for each unit of clothing.

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In theory at least, they could buy 100 units of food. Country A can’t produce that much,

but we’re just trying to find country B’s new vertical intercept.

You can see in Figure 4.2 (a) & (b) each country’s new production-possibility

frontier once they establish trade. Notice that the citizens of both countries will be able

to consume larger combinations of both food and clothing.

Figure 4.1(a) Figure 4.1(b)

Country A Country B

An effective argument could be made that the U.S. produces all products that both

the U.S. and Mexico can produce with their respective resources more efficiently.

Hence, the U.S., it could be argued, has an absolute advantage over Mexico. However,

that does not mean that the U.S. and Mexico cannot trade profitably for both countries.

Each country has products that it makes relatively well, compared to other products it

could produce, at least as compared to the other country. For example, the U.S. makes

aircraft, computers, movies, insurance and grains particularly well. Mexico, on the other

hand, makes tiles, glassware, silver jewelry, tourism, fruits and vegetables, and petroleum

particularly well. That’s not to say the U.S. doesn’t produce those same items very

efficiently. It is only to say that we would be wasting the very high quality of the

resources we would use to make, for example, glassware, when we could be using the

same factors of production to make fiber optic cable and screens for laptop computers.

(American firm Corning Glass used to make glassware, but now makes laptop screens).

If the benefits of trading are so obvious, why don’t all countries trade freely with

one another? That important question has a number of answers. First, the argument that

all participants of free trade can benefit was first put forward to a limited extent by Adam

Smith in his famous Wealth of Nations published in 1776. But the argument was more

completely made and described as comparative advantage by David Ricardo in his

Principles of Political Economy in 1819. At that time it was peoples’ belief that

mercantilism was the correct way to understand foreign trade. Under mercantilism, it

was believed that a country should export as much as possible and import as little as

possible, and that was the way to enrich a nation. That difference between exports and

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imports would make gold or silver payment flow into the country exporting more. While

that plan did tend to enrich the crown, that is the king, it also tending to shrink trade. If

every country is trying to export as much as possible and import as little as possible, most

countries imported little. Hence, trade was very low.

Furthermore, if we look back at Figure 4.1 (a) & (b), suppose country B offended

country A. Do you see a problem? Country A might embargo (refuse to sell food to)

country B, whose citizens would starve. It is frankly unlikely that countries will be

willing to open their borders to imports of products they consider essential, but are not in

their areas of comparative advantage.