Basic economics / Основи на икономиката: Chapter 4 AN OVERVIEW OF PRICES

Chapter 4

#1

AN OVERVIEW OF PRICES

#2

We need education in the obvious more than investigation of the obscure.

#3

Justice Oliver Wendell Holmes{98}

#4

Many of the basic principles of economics may seem obvious but the implications to be drawn from them are not—and it is the implications that matter. Someone once pointed out that Newton was not the first man who saw an apple fall. His fame was based on his being the first to understand its implications.

#5

Economists have understood for centuries that when prices are higher, people tend to buy less than when prices are lower. But, even today, many people do not yet understand the many implications of that simple fact. For example, one consequence of not thinking through the implications of this simple fact is that government-provided medical care has repeatedly cost far more than initially estimated, in various countries around the world. These estimates have usually been based on current usage of doctors, hospitals, and pharmaceutical drugs. But the introduction of free or subsidized medical care leads to vastly greater usage, simply because its price is lower, and this entails vastly greater costs than initially estimated.

#6

Understanding any subject requires that it first be defined, so that you are clear in your own mind as to what you are talking about—and what you are not talking about. Just as a poetic discussion of the weather is not meteorology, so an issuance of moral pronouncements or political creeds about the economy is not economics. Economics is an analysis of cause-and-effect relationships in an economy. Its purpose is to discern the consequences of various ways of allocating scarce resources which have alternative uses. It has nothing to say about social philosophy or moral values, any more than it has anything to say about humor or anger.

#7

These other things are not necessarily any less important. They are simply not what economics is about. No one expects mathematics to explain love, and no one should expect economics to be something other than what it is or to do something other than what it can. But both mathematics and economics can be very important where they apply. Careful and complex mathematical calculations can be the difference between having an astronaut who is returning to earth from orbit end up crashing in the Himalayas or landing safely in Florida. We have also seen similar social disasters from misunderstanding the basic principles of economics.

#8

CAUSE AND EFFECT

#9

Analyzing economic actions in cause-and-effect terms means examining the logic of the incentives being created, rather than simply thinking about the desirability of the goals being sought. It also means examining the empirical evidence of what actually happens under such incentives.

#10

The kind of causation at work in an economy is often systemic interactions, rather than the kind of simple one-way causation involved when one billiard ball hits another billiard ball and knocks it into a pocket. Systemic causation involves more complex reciprocal interactions, such as adding lye to hydrochloric acid and ending up with salty water,{viii} because both chemicals are transformed by their effects on one another, going from being two deadly substances to becoming one harmless one.

#11

In an economy as well, the plans of buyers and sellers are transformed as they discover each other’s reactions to supply and demand conditions, and the resulting price changes that force them to reassess their plans. Just as those who start out planning to buy a villa at the beach may end up settling for a bungalow farther inland, after they discover the high prices of villas at the beach, suppliers likewise sometimes end up selling their goods for less than they paid to buy them or produce them, when the demand is inadequate to get any higher price from the consuming public, and the alternative is to get nothing at all for an item that is unsalable at the price originally planned.

#12

Systemic Causation

#13

Because systemic causation involves reciprocal interactions, rather than one-way causation, that reduces the role of individual intentions. As Friedrich Engels put it, “what each individual wills is obstructed by everyone else, and what emerges is something that no one willed.”{99} Economics is concerned with what emerges, not what anyone intended. If the stock market closes at 14,367 on a given day, that is the end result of a process of complex interactions among innumerable buyers and sellers of stocks, none of whom may have intended for the market to close at 14,367, even though it was their own actions in pursuit of other intentions which caused it to do so.

#14

While causation can sometimes be explained by intentional actions and sometimes by systemic interactions, too often the results of systemic interactions are falsely explained by individual intentions. Just as primitive peoples tended to attribute such things as the swaying of trees in the wind to some intentional action by an invisible spirit, rather than to such systemic causes as variations in atmospheric pressure, so there is a tendency toward intentional explanations of systemic events in the economy, when people are unaware of basic economic principles. For example, while rising prices are likely to reflect changes in supply and demand, people ignorant of economics may attribute price rises to “greed.”

#15

People shocked by the high prices charged in stores in low-income neighborhoods have often been quick to blame greed or exploitation on the part of the people who run such businesses. Similar conclusions about intentions have often been reached when people noticed the much higher interest rates charged by pawnbrokers and small finance companies that operate in low-income neighborhoods, as compared to the interest rates charged by banks in middle-class communities. Companies that charge for cashing checks also usually operate in low-income neighborhoods, while people in middle-class neighborhoods usually get their checks cashed free of charge at their local banks. Yet profit rates are generally no higher in inner city businesses than elsewhere, and the fact that many businesses are leaving such neighborhoods—and others, such as supermarket chains, are staying away—reinforces that conclusion.

#16

The painful fact that poor people end up paying more than affluent people for many goods and services has a very plain—and systemic—explanation: It often costs more to deliver goods and services in low-income neighborhoods. Higher insurance costs and higher costs for various security precautions, due to higher rates of crime and vandalism, are just some of the systemic reasons that get ignored by those seeking an explanation in terms of personal intentions. In addition, the cost of doing business tends to be higher per dollar of business in low-income neighborhoods. Lending $100 each to fifty low-income borrowers at pawn shops or local finance companies takes more time and costs more money to process the transactions than lending $5,000 at a bank to one middle-class customer, even though the same total sum of money is involved in both cases.{ix}

#17

About 10 percent of American families do not have a checking account,{100} and undoubtedly this percentage is higher among low-income families, so that many of them resort to local check-cashing agencies to cash their paychecks, Social Security checks or other checks. An armored car delivering money in small denominations to a neighborhood finance company or a small check-cashing agency in a ghetto costs just as much as an armored car delivering a hundred times as much value of money, in larger denominations of bills, to a bank in a suburban shopping mall. With the cost of doing business being higher per dollar of business in the low-income community, it is hardly surprising that these higher costs get passed on in higher prices and higher interest rates.

#18

Higher prices for people who can least afford them are a tragic end-result, but the causes are systemic. This is not merely a philosophic or semantic distinction. There are major practical consequences to the way causation is understood. Treating the causes of higher prices and higher interest rates in low-income neighborhoods as being personal greed or exploitation, and trying to remedy it by imposing price controls and interest rate ceilings only ensures that even less will be supplied to people living in low-income neighborhoods thereafter. Just as rent control reduces the supply of housing, so price controls and interest rate controls can reduce the number of stores, pawn shops, local finance companies, and check-cashing agencies willing to operate in neighborhoods with higher costs, when those costs cannot be recovered by legally permissible prices and interest rates.

#19

The alternative, for many residents of low-income neighborhoods, may be to go outside the legal money-lending organizations and borrow from loan sharks, who charge even higher rates of interest and have their own methods of collecting, such as physical violence.

#20

When stores and financial institutions close down in low-income neighborhoods, more people in such neighborhoods are then forced to travel to other neighborhoods to shop for groceries or other goods, paying money for bus fare or taxi fare, in addition to the costs of their purchases. Such business closings have already occurred for a variety of reasons, including riots and higher rates of shoplifting and vandalism, with the net result that many people in low-income neighborhoods already have to go elsewhere for shopping or banking.

#21

“First, do no harm” is a principle that has endured for centuries. Understanding the distinction between systemic causation and intentional causation is one way to do less harm with economic policies. It is especially important to do no harm to people who are already in painful economic circumstances. It is also worth noting that most people are not criminals, even in high-crime neighborhoods. The fraction of dishonest people in such neighborhoods are the real source of many of the higher costs behind the higher prices charged by businesses operating in those neighborhoods. But it is both intellectually and emotionally easier to blame high prices on those who collect them, rather than on those who cause them. It is also more politically popular to blame outsiders, especially if those outsiders are of a different ethnic background.

#22

Systemic causes, such as those often found in economics, provide no such emotional release for the public, or moral melodrama for the media and politicians, as such intentional causes as “greed,” “exploitation,” “gouging,” “discrimination,” and the like. Intentional explanations of cause and effect may also be more natural, in the sense that less sophisticated individuals and less sophisticated societies tend to turn first to such explanations. In some cases, it has taken centuries for intentional explanations embodied in superstitions about nature to give way to systemic explanations based on science. It is not yet clear whether it will take that long for the basic principles of economics to replace many people’s natural tendency to try to explain systemic results by intentional causes.

#23

Complexity and Causation

#24

Although the basic principles of economics are not really complicated, the very ease with which they can be learned also makes them easy to dismiss as “simplistic” by those who do not want to accept analyses which contradict some of their cherished beliefs. Evasions of the obvious are often far more complicated than the plain facts. Nor is it automatically true that complex effects must have complex causes. The ramifications of something very simple can become enormously complex. For example, the simple fact that the earth is tilted on its axis causes innumerable very complex reactions in plants, animals, and people, as well as in such non-living things as ocean currents, weather changes and changes in the length of night and day.

#25

If the earth stood straight up on its axis,{x} night and day would be the same length all year round and in all parts of the world. Climate would still differ between the equator and the poles but, at any given place, the climate would be the same in winter as in summer. The fact that the earth is tilted on its axis means that sunlight is striking the same country at different angles at different points during the planet’s annual orbit around the sun, leading to changing warmth and changing lengths of night and day.

#26

In turn, such changes trigger complex biological reactions in plant growth, animal hibernations and migrations, as well as psychological changes in human beings and many seasonal changes in their economies. Changing weather patterns affect ocean currents and the frequency of hurricanes, among many other natural phenomena. Yet all of these complications are due to the one simple fact that the earth is tilted on its axis, instead of being straight up.

#27

In short, complex effects may be a result of either simple causes or complex causes. The specific facts can tell us which. A priori pronouncements about what is “simplistic” cannot. An explanation is too simple if its conclusions fail to match the facts or its reasoning violates logic. But calling an explanation “simplistic” is too often a substitute for examining either its evidence or its logic.

#28

Few things are more simple than the fact that people tend to buy more at lower prices and buy less at higher prices. But, when putting that together with the fact that producers tend to supply more at higher prices and less at lower prices, that is enough to predict many sorts of complex reactions to price controls, whether in the housing market or in the market for food, electricity, or medical care. Moreover, these reactions have been found on all inhabited continents and over thousands of years of recorded history. Simple causes and complex effects have been common among wide varieties of peoples and cultures.

#29

Individual Rationality versus Systemic Rationality

#30

The tendency to personalize causation leads not only to charges that “greed” causes high prices in market economies, but also to charges that “stupidity” among bureaucrats is responsible for many things that go wrong in government economic activities. In reality, many of the things that go wrong in these activities are due to perfectly rational actions, given the incentives faced by government officials who run such activities, and given the inherent constraints on the amount of knowledge available to any given decision-maker or set of decision-makers.

#31

Where a policy or institution has been established by top political leaders, officials subject to their authority may well hesitate to contradict their beliefs, much less point out the counterproductive consequences that later follow from these policies and institutions. Messengers carrying bad news could be risking their careers or—under Stalin or Mao—their lives.

#32

Officials carrying out particular policies may be quite rational, however negative the impact of these policies may prove to be for society at large. During the Stalin era in the Soviet Union, for example, there was at one time a severe shortage of mining equipment, but the manager of a factory producing such machines kept them in storage after they were built, rather than sending them out to the mines, where they were sorely needed. The reason was that the official orders called for these machines to be painted with red, oil-resistant paint and the manufacturer had on hand only green, oil-resistant paint and red varnish that was not oil-resistant. Nor could he readily get the prescribed paint, since there was no free market.

#33

Disobeying official orders in any respect was a serious offense under Stalin and “I don’t want to get eight years,” the manager said.

#34

When he explained the situation to a higher official and asked for permission to use the green, oil-resistant paint, the official’s response was: “Well, I don’t want to get eight years either.” However, the higher official cabled to his ministry for their permission to give his permission. After a long delay, the ministry eventually granted his request and the mining machinery was finally shipped to the mines.{101} None of these people was behaving stupidly. They were responding quite rationally to the incentives and constraints of the system in which they worked. Under any economic or political system, people can make their choices only among the alternatives actually available—and different economic systems present different alternatives.

#35

Even in a democratic government, where the personal dangers would be far less, a highly intelligent person with a record of outstanding success in the private sector is often unable to repeat that success when appointed to a high position in government. Again, the point is that the incentives and constraints are different in different institutions. As Nobel Prizewinning economist George J. Stigler put it:

#36

A large number of successful businessmen have gone on to high administrative posts in the national government, and many—I think most—have been less than distinguished successes in that new environment. They are surrounded and overpowered by informed and entrenched subordinates, they must deal with legislators who can be relentless in their demands, and almost everything in their agency that should be changed is untouchable.{102}

#37

INCENTIVES VERSUS GOALS

#38

Incentives matter because most people will usually do more for their own benefit than for the benefit of others. Incentives link the two concerns together. A waitress brings food to your table, not because of your hunger, but because her salary and tips depend on it. In the absence of such incentives, service in restaurants in the Soviet Union was notoriously bad. Unsold goods piling up in warehouses were not the only consequences of a lack of the incentives that come with a free market price system. Prices not only help determine which particular things are produced, they are also one of the ways of rationing the inherent scarcity of all goods and services, as well as rationing the scarce resources that go into producing those goods and services. However, prices do not create that scarcity, which will require some form of rationing under any other economic system.

#39

Simple as all this may seem, it goes counter to many policies and programs designed to make various goods and services “affordable” or to keep them from becoming “prohibitively expensive.” But being prohibitive is precisely how prices limit how much each person uses. If everything were made affordable by government decree, there would still not be any more to go around than when things were prohibitively expensive. There would simply have to be some alternative method of rationing the inherent scarcity. Whether that method was through the government’s issuing ration coupons, the emergence of black markets, or just fighting over things when they go on sale, the rationing would still have to be done, since artificially making things affordable does not create any more total output. On the contrary, price “ceilings” tend to cause less output to be produced.

#40

Many apparently humanitarian policies have backfired throughout history because of a failure to understand the role of prices. Attempts to keep food prices down by imposing price controls have led to hunger and even starvation, whether in seventeenth-century Italy, eighteenth-century India, France after the French Revolution, Russia after the Bolshevik revolution, or in a number of African countries after they obtained independence during the 1960s. Some of these African countries, like some of the countries in Eastern Europe, once had such an abundance of food that they were food exporters before the era of price control and government planning turned them into countries unable to feed themselves.{103}

#41

Failure to supply goods, as a result of government restrictions, must be sharply distinguished from an inability to produce them. Food can be in short supply in a country with extraordinarily fertile soil, as in post-Communist Russia that had not yet achieved a free-market economy:

#42

Undulating gently through pastoral hills 150 miles south of Moscow, the Plava River Valley is a farmer’s dream come true. This is the gateway to what Russians call “Chernozym”—“Black Earth country”—which boasts some of the most fertile soil in Europe, within three hours’ drive of a giant, hungry metropolis. . . Black Earth country has the natural wealth to feed an entire nation. But it can barely feed itself.{104}

#43

It is hard even to imagine, in a free market economy, a hungry city, dependent on imports of foreign food, when there is extraordinarily fertile farmland not far away. Yet the people on that very fertile farmland were as poor as the city dwellers were hungry. The workers harvesting that land earned the equivalent of about $10 a week, with even this small amount being paid in kind—sacks of potatoes or cucumbers—because of a lack of money. As the mayor of a town in this region said:

#44

We ought to be rich. We have wonderful soil. We have the scientific know-how. We have qualified people. But what does it add up to?{105}

#45

If nothing else, it adds up to a reason for understanding economics as a means of achieving an efficient allocation of scarce resources which have alternative uses. All that was lacking in Russia was a market to connect the hungry city with the products of the fertile land and a government that would allow such a market to function freely. But, in some places, local Russian officials forbad the movement of food across local boundary lines, in order to assure low food prices within their own jurisdictions, and therefore local political support for themselves.{106} Again, it is necessary to emphasize that this was not a stupid policy, from the standpoint of officials trying to gain local popularity with consumers by maintaining low food prices. This protected their political careers, however disastrous such policies were for the country as a whole.

#46

While systemic causation in a free market is in one sense impersonal, in the sense that its outcomes are not specifically predetermined by any given person, “the market” is ultimately a way by which many people’s individual personal desires are reconciled with those of other people. Too often a false contrast is made between the impersonal marketplace and the supposedly compassionate policies of various government programs. But both systems face the same scarcity of resources and both systems make choices within the constraints of that scarcity. The difference is that one system involves each individual making choices for himself or herself, while the other system involves a small number of people making choices for millions of others.

#47

The mechanisms of the market are impersonal but the choices made by individuals are as personal as choices made anywhere else. It may be fashionable for journalists to refer to “the whim of the marketplace,” as if that were something different from the desires of people, just as it was once fashionable to advocate “production for use, rather than profit”—as if profits could be made by producing things that people cannot use or do not want to use. The real contrast is between choices made by individuals for themselves and choices made for them by others who presume to define what these individuals “really” need.

#48

SCARCITY AND COMPETITION

#49

Scarcity means that everyone’s desires cannot be satisfied completely, regardless of which particular economic system or government policy we choose—and regardless of whether an individual or a society is poor or prosperous, wise or foolish, noble or ignoble. Competition among people for scarce resources is inherent. It is not a question whether we like or dislike competition. Scarcity means that we do not have the option to choose whether or not to have an economy in which people compete. That is the only kind of economy that is possible—and our only choice is among the particular methods that can be used for that competition.

#50