DRI-326 for week of 9-1-13: Quantity vs. Quality in Economists

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Quantity vs. Quality in Economists

Students of economics have long complained that economics texts focus too much on quantity and not enough on quality when evaluating goods. The same issue arises when comparing economists themselves. The career of Nobel Laureate Ronald Coase, who died this week at age 102, is a polar case.

Economists advance by publishing articles in prestigious, peer-reviewed journals. The all-time leader in the number of articles published is the late Harry G. Johnson. Despite dying young at age 53, Johnson compiled the staggering total of 526 published articles during his lifetime.

The use of advanced mathematics and abstract modeling techniques has enabled economists to rack up impressive publications scores by introducing slight mathematical refinements that add little to the substantive meaning or practical value of their achievement. When asked to account for the comparative modesty of a list of publications only one-fourth the size of Johnson’s, Nobel Laureate George Stigler countered, “Yeah, but mine are all different.”

Coase stands at the other extreme. His complete list of articles numbers fewer than twenty, but two of those are among the most-frequently consulted by economists, lawyers and other specialists, not to mention by the general public. He published a long-awaited, widely noticed book in 2012 despite having passed his centenary the year before. His life is an advertisement for the value of quality over quantity in an economist.

Another notable aspect of Coase’s work is its accessibility. In an age when few professional contributions can be read and understood by non-specialists, much less by interested non-economists, Coase’s work is readily comprehensible by the educated layperson. Now is the time to rehearse the insights that made Coase’s name a byword within the economics profession. His death makes this review emotionally as well as intellectually fitting.

Why Do Businesses Exist?

At 26 years of age, Ronald Coase was a left-leaning economics student. He pondered the following contradictory set of facts: On the one hand, socialists ever since Saint-Simon had advocated running a nation’s economy “like one big factory.” On the other hand, orthodox economists declared this to be impossible. Yet some highly successful corporations reached enormous size.

Who was right? It seemed to Coase that the answer depended on the answer to a more fundamental question – why do businesses exist? Be it a one-person shop or a huge multinational corporation, a business arises voluntarily. What conditions give birth to a business?

Coase found the answer in the concept of cost. (In his 1937 article, “The Nature of the Firm,” Coase used the term “marketing costs,” but the economics profession refined the term to “transactions costs”.) A business arises whenever it is less costly for people to organize into a hierarchical, centralized structure to produce and distribute output than it is to produce the same output and exchange it individually. And the business itself performs some activities within the firm while outsourcing others outside the firm. Again, cost determines the locus of these activities; any activity more cheaply bought than performed inside the firm is outsourced, while activities more cheaply done inside the firm are kept internal.

Like most brilliant, revolutionary insights, this seems almost childishly simple when explained clearly. But it was the first lucid justification for the existence of business firms that relied on the same economic logic that business firms themselves (and consumers) used in daily life. Previously, economists had been in the ridiculous position of assuming that businesses used economic logic but arose through some non-economic process such as habit or tradition or government direction.

Today, we have a regulatory process that flies in the face of Coase’s model. It implicitly assumes that markets are incapable of correctly organizing, assigning and performing basic business functions, ranging from safety to hiring to providing employee benefits. To make matters worse, the underlying assumption is that government regulatory behavior is either costless or less costly than the correlative function performed by private markets. As Coase taught us over 75 years ago, this flies in the face of the inherent “nature of the firm.”

The “Coase Theorem”

In mid-career, while working amongst a group of free-market economists at the University of Virginia, Ronald Coase made his most famous discovery. It assured him immortality among economists. Just about the best way to make a name for yourself is to give your name to a theory, the way John Maynard Keynes or Karl Marx did. But in Coase’s case, the famous “Coase Theorem” was actually devised by somebody else, using Coase’s logic – and Coase himself repudiated the use to which his work was put!

To appreciate what Coase did – and didn’t do – we must grasp the prior state of economic theory on the subject of “externalities.” Tort case law contained examples of railroad trains whose operation created fires by throwing off sparks into combustible areas like farm land. The law treated these cases by either penalizing the railroad or ignoring the damage. A famous economist named A. C. Pigou declared this to be an example of an “externality” – a cost created by business production that is not borne by the business itself because the business’s owners and/or managers do not perceive the damage created by the sparks to be an actual cost of production.

Rather than simply penalizing the railroad, Pigou observed, the economically appropriate action is to levy a per-unit tax against the railroad equal to the cost incurred by the victims of the sparks. This would cause the railroad to reduce its output by exactly the same amount as if it had perceived its sparks to be a legitimate cost of production in the first place. In effect, the railroad “pays” the costs of its actions in the form of reduced output (and reduced use of the resources necessary to provide railroad transport services), rather than paying them in the form of a fine. Why is the former outcome better than the latter? Because the purpose is not to hurt the railroad as retaliation for its hurting the farmer, the way one child hurts another in revenge for being hurt. A railroad is a business – in effect, it is a piece of paper expressing certain contractual relationships. It cannot feel hurt the way a human being can, so the fine may make the farmer feel better (if he or she received the fine as proceeds of a tort suit) but does not compensate for the waste of resources caused by having the railroad produce too much output. (“Too much” because resources will have to be devoted to repairing the damage caused by the sparks, and consumers value the resources used to do this more than the farmer values the loss.) In contrast, when the costs are factored into the railroad’s production decision, everybody values the resulting output of railroad services and other things as exactly worth their cost.

Of course, the catch is that somebody has to (1) realize the existence of the externality; and (2) calculate exactly how much tax to levy on the railroad to neutralize (or internalize) the externality; and then (3) do it. In the manner of a philosopher king, Pigou declared that this task should be assigned to a government regulatory bureaucracy. And for the next half-century (Pigou was writing in the early 1900s), mainstream economists salivated at the prospect of regulatory agencies passing rules to internalize all the pesky externalities that liberals and bureaucrats could dream up.

In 1960, Ronald Coase came along and gave the world a completely new slant on this age-old problem. Consider the following type of situation: you are flying from New York to Los Angeles on a low-price airline. You have settled somewhat uncomfortably into your seat, survived the takeoff and are just beginning to contemplate the six-hour flight when the passenger in front of you presses a button at his side and reclines his seatback – thereby preempting what little leg room you previously had. Now what?

This is not actually the example Coase used – it was used by contemporary economist Peter Boettke to illustrate Coase’s ideas – but it is especially good for our purposes. Using the same logic Coase applied to his examples, we reason thusly: It would be completely arbitrary to assign either of us a property right to the space preempted by the seatback. Why? Because the problem is not to stop bad people from doing bad things. Instead, we are faced with a situation in which ordinary people want to do good things that are in some sense contradictory or offsetting in their effects. On the airplane, my wish to stretch out is no more or less morally compelling than his to recline. The problem is that  we can’t do both to the desired extent at the same time without getting in each other’s way; e.g., offsetting each other’s efforts.

Indeed, this is true of most so-called externalities, including the railroad/farmer case. Case law usually treated the railroad as a nefarious miscreant imposing its will on the innocent, helpless farmer. But the railroad’s wish to provide transport services is just as reasonable as the farmer’s to grow and harvest crops. It is not unthinkable to enjoin the railroad against creating sparks – but neither should we overlook the possibility of requiring the farmer to protect against sparks or perhaps even not locate a farm within the threatened area. Indeed, what we really want in all cases is to discover the least-cost solution to the externality. That might involve precautions taken by the railroad, or by the farmer, or emigration by the farmer, or payment by the railroad to the farmer as compensation for the spark damage, or payment by the farmer to the railroad as compensation for spark avoidance.

 

In general, it is crazy to expect an uninvolved third party – particularly a government regulator – to divine the least-cost solution and implement it. The logical people to do that are the involved parties themselves, who know the most about their own costs and preferences and are on the scene. These are also the people who have the incentive to find a mutually beneficial solution to the problem. In our airline example, I might offer the man in front of me a small payment for not reclining. Or he might pay me for the privilege of reclining. But either way, we will bargain our way to a solution that leaves us both better off, if there is one. One of us would object to any proposed solution that did not leave him better off.

Of course, it would be useful for bargaining purposes to have an assignment of property rights; that is, a specification that I have the right to my space or that the man in front of me has the right to recline. That way, the direction of compensatory payments would be clear – money would flow to the right-holder from the right-seeker.

What if bargaining does not produce an efficient outcome, one that both parties can agree on? That means that the right-holder values his right at more than the right-seeker is willing to pay. But in that case, no government tax would produce an efficient outcome either.

On the airline, suppose that I value the leg room preempted by the reclining seat at $10. Suppose, further, that airline policy gives him the right to recline. If I offer him $6 not to recline, he will accept my offer if he values reclining at any amount less than $6 – say, $5. Notice that we are now both better off than under the status quo ante bargain. I get leg room I valued at $10 – or course, I had to pay $6 for it, but that is better than not having it at all, just as having the airline’s cocktail is better than being thirsty even though I had to pay $5 for it. He loses his right to recline, but he gets $6 instead – and reclining was only worth $5 to him. He is better off, just as he would be if he accepted an airline’s offer of $500 to surrender his seat and take a later flight, as sometimes happens.

We cannot even begin to estimate how many times people solve everyday problems like this through individual bargains. The world would be vastly better off if we were trained from birth in the virtues of a voluntary society where bargaining is a way to solve everyday disputes and make everybody better off. That training would stress the virtues of money as the lubricant that facilitates this sort of bargain because it is readily exchangeable for other things and because it is the common denominator of value. Instead, most of us are burdened by an instinctive tribal suspicion that money is evil and bargaining is used only to seek personal advantage at the expense of others. Experienced businesspeople know otherwise, but throughout the world the Zeitgeist is working against Coase’s logic. More and more, government and statutory law are held up as the only fair mechanism for resolving disputes.

University of Chicago economist George Stigler used Coase’s logic to devise the so-called Coase theorem, which says that when the transactions costs of bargaining are zero, the ultimate price and output results will be the same regardless of the initial assignment of property rights. This is true because both parties will have the incentive to bargain their way to an efficient improvement, if one exists. The assignment of property rights will affect the wealth of the bargainers, because it will determine the direction of the money flow, but economists are concerned with welfare (determined by prices and quantities), not wealth. No government regulatory body can improve on the free-market solution.

Coase disagreed with the theorem named after him – not because he disputed its logic, but because he foresaw the results. Economists would use it to look for circumstances when transactions costs were low or non-existent. Instead, Coase wanted to investigate real-world institutions such as government to compare its transactions costs to those of the market. He knew that real-world transactions costs were seldom zero but that government solutions almost never worked out as neatly in practice as they did on the blackboard. In fact, he invented the phrase “blackboard economics” to refer to solutions that could never work in practice, only on a theoretical blackboard, because real-world governments never had either the information or the incentive necessary to apply the solution.

Why China Became Capitalist

Ronald Coase devoted his last years to learning how and why China evolved from the world’s last major Communist dictatorship to the world’s emerging economic superpower. In Why China Became Capitalist, he and his research partner Ning Wang delivered an account that contravened the popular explanation for China’s rise. China’s ruling central-government oligarchy has received credit for the country’s emergence as the growth leader among developing nations. Since the Communist Party retained political control throughout the growth spurt, it must have been responsible for it – so the usual explanation runs. Coase and Wang showed that government’s presence as the agency in charge of political life does not automatically entitle it to credit for economic growth.

The death of Mao Zedong in 1976 rescued China from decades of terror, famine and dictatorship. Mao’s designated successor, Hua Guofeng, was an economist who outlined a program of state-run investment in heavy industry called the “Leap Outward.” This resembled the various Five-Year Plans of Soviet ruler Joseph Stalin in general approach and in overall lack of results. Hua’s successors, Deng Xiaoping and Chen Yun, abandoned the Leap Outward in favor of an emphasis on agriculture and light industry. Although Deng was the political figurehead who garnered the lion’s share of the publicity, Chen was the guiding spirit behind this second centralized plan designed to spur Chinese economic growth. It placed less emphasis on production of capital goods and more on consumer goods. Chen allowed state-controlled agricultural prices to rise in an effort to stimulate production on China’s collective farms, which had failed disastrously under Mao, resulting in approximately 40 million deaths from famine. He also allowed state-run enterprises a measure of autonomy and private profit, heretofore unthinkable under Communism.

Although these central-government measures were the ostensible spur to China’s remarkable growth run, Coase and Wang assign actual responsibility to the resurgence of China’s private economy. Private farms had always existed as part of the nation’s 30,000 villages and towns, much as neighboring Russians continued to nurture their tiny private plots of land alongside the Soviet collective farms. And, just as was the case in Russia, the smaller private farms began to outdo the larger collectives in productivity and output. Mao fanatically insisted on agricultural collectivization, but his death freed private farmers to resume their former lives.  By late 1980, the Beijing government was forced to officially acknowledge the private farms. In 1982, China formally abandoned its costly experiment with collective agriculture and de-collectivized its farms. Official grain prices were allowed to rise and grain imports were permitted.

Agriculture wasn’t the only industry that flourished at the local level. Small businesses in rural China labored under official handicaps; their access to raw materials was not protected and they had no officially sanctioned distribution channels for their output. But they bought inputs on the black market at high prices and groomed their own sales representatives to scour the nation drumming up business for their goods. These local Davids outperformed the state-run Goliaths; they were the real vanguard of Chinese economic growth.

Growth was slower in China’s major cities. Mao had sent some 20 million youths to the countryside to escape unemployment in the cities. After his death, many of these youths returned to the cities – only to find themselves out of work again. They demonstrated and formed opposition political movements, sometimes paralyzing daily life with their protests. This forced Beijing to permit self-employment for the first time – another Communist sacred cow sacrificed to political expediency. This, in turn, created an urban class of Chinese entrepreneurs. This led to yet another government reaction in the form of Special Economic Zones, somewhat reminiscent of the U.S. “enterprise zones” of the 1980s. Economic freedom and lower taxes were allowed to exist in a controlled environment; Chinese officials hoped to encourage controlled doses of capitalist prosperity in order to save socialism.

Gradually, the limited reforms of the Special Economic Zones became more general. Increased freedom of market prices was introduced in 1992, taxes were lowered in 1994 and privatization of failing state-run enterprises began in the mid-1990s. For the first time, China began to replace local and regional markets with a single national market for many goods.

Coase and Wang identify perhaps the most important but least-known capitalist element to arise in China as the improved pursuit of knowledge. They accurately attribute the recognition of knowledge’s role in economics to Nobel Laureate F.A. Hayek and note the increasing popularity of books and articles by Hayek, his mentor Ludwig von Mises and classical forebears such as Adam Smith. The economics profession has pigeonholed the subject of knowledge under the heading of “technical coefficients of production,” but the authors know that this is only the beginning of the knowledge needed to make a free-market economy work. The knowledge of market institutions and the dispersed, specialized “knowledge of particular time and place” that can only be collated and shared by free markets are even more important than technical knowledge about how to produce goods and services.

The upshot of China’s private resurgence has been to make the country a “laboratory for capitalist experimentation,” according to Coase and Wang. That laboratory has brewed a recipe for unparalleled economic growth since the 1990s, leading to China’s admittance into the World Trade Organization in 2001. The final piece of the puzzle, the authors predict, is a true free market for ideas – the one thing that Western economies have that China lacks. When this falls into place, China will become the America of the 21st century.

Thus did Ronald Coase add a landmark study in economic history to his select resume of classic works.

Quality vs. Quantity

Never in the history of economics has one economist achieved so much productivity with so little scholarly output. Ronald Coase economized on the scarce resources of time and human effort (ours) by devoting the longest career of any great economist to specializing in quality, not quantity, of work.

DRI-334 for week of 5-5-13: Economics and Geography: The Case of Africa

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Economics and Geography: The Case of Africa

Economics is the social science dealing with human choice. Geography is the physical science that deals with the above-ground features of the Earth’s surface. The two are seldom mentioned in the same breath. Yet they work hand-in-hand. The subject matter of geography forms the objective physical, structural parameters with which economics must cope. Geography’s brute facts can mold, shape and manhandle economics to a stunning degree. No better example could be cited than the effect of Africa’s geography on its economic history.

The Geographic Dimensions of Sub-Saharan Africa

The continent of Africa encompasses a geographic kaleidoscope. The “Africa” of popular imagination and special economic interest lies to the south of the Sahara – the world’s largest desert whose land area exceeds the size of the continental United States. Sub-Saharan Africa stretches to the tip of the Cape of Good Hope, north of the Antarctic Ocean. It abuts the Indian Ocean to the east and the Atlantic Ocean to the west.

The adjacency of oceans on three sides suggests that African economic history should be a tale of international maritime trade. Just the opposite – although at least three important trade lanes developed between Africa and the rest of the world, international trade was not a tremendous engine of economic development and growth in Africa. The noted economist Thomas Sowell found the source of this apparent paradox in two geographic drawbacks. First, winds and ocean currents near the African coast were (and are) among the world’s trickiest and most variable. Throughout most of world history, the expertise necessary to cope with them was absent.  Second, the African coastline was and is mostly smooth and shallow, thus unsuitable for harbors. Ships had to anchor offshore and transfer cargo by boat – a time-consuming, cumbersome and costly method. This gave rise to one of the great economic-historical ironies, noted by Sowell: As a large fraction of world international trade passed back and forth from Asia around the Cape of Good Hope to the New World, it passed within hailing distance of the African sub-continent – but seldom stopped.

It is hard to overrate the importance of these factors for Africa’s economic development. (And while for most other purposes we would need to analyze African economic development by separating the continent into its constituent nations, this geographic analysis is better conducted by treating the sub-continent as a unitary whole.) These days, many people treat foreigners and foreign trade as unwelcome intruders in economic life, but throughout human history international trade has been the key to a better life for most people and nations. Many of the great nations, from Rome to Greece to Carthage to Phoenicia to Egypt to the modern European nations, were either trading civilizations or encouraged trade beyond national borders. Trade allows nations to consume a broader range and larger volume of goods than they individually produce. It also increases the amount, scope and accuracy of human knowledge. When deliberately imposed from within, trade deprivation is a form of self-starvation.

In Africa’s case, the effects of geography are directly analogous to those of anthropogenic taxes and quotas. Those effects were not limited to the coastlines. They were even more pronounced in the interior. To appreciate their effects, we can compare them with the effects of geography on economic development here in the U.S.

From the arrival of Europeans in North America just prior to and after 1600, rivers were the transportations arteries of choice for north-south (and some east-west) travel. Barge, keelboat and canoe were media of transport. Cities sprung up at the confluence of rivers and at convenient landing points. Today, the history of the nation’s major cities is writ in their rivers. Despite the plethora of new transport media, ranging from planes to trains to automobiles, river transport is still an important secondary source of freight transportation for goods whose ratio of bulk to value is high.

Africa has always has even more and bigger rivers than North America. But they have been a much smaller boon to her economic development, which has been drastically curtailed compared to that of the New World.  The problem has been that African rivers are often unnavigable. Hard-core movie fans are familiar with the 1951 film The African Queen, starring Humphrey Bogart and Katharine Hepburn. The movie follows the adventures of a hard-drinking, World-War I era ship’s captain and a spinster missionary who set out on a long river journey aimed at locating and sinking a German steamer in Central Africa. The two must traverse the length of the unnavigable UlangaRiver (also called the Bora) to reach the Kenyan lake where the steamer resides. The formidable river hazards they surmount form the basis of the movie’s plot. These include rapids, plagues of swarming insects, river animals such as hippos, inclement weather and the river itself – which eventually becomes so choked with reeds and vegetation that they have to climb in the water and pull their weatherbeaten old tub of a tiny craft through the muck. Hollywood films are legendary for mangling the truth, but in this case the screenwriter (and novelist C.S. Forester, on whose book the film was based) hit the nail on the head.

In addition to above-mentioned hazards to navigation, African rivers suffer the drawback that African geologic structure is often mesa-like – plateaus followed by sharp dropoffs that form a falls. (Indeed, sharp changes in altitude hinder mobility on land as well as water over most of the continent.) The result is navigational nightmare; traversing a falls is not merely awkward but downright dangerous. The Zaire River is 2,900 miles long and contains a volume of water second only to that of the legendary Amazon River. But the Zaire’s succession of falls and rapids prevent entering ships from getting very far. This is typical – according to Sowell, “no river in sub-Saharan Africa reaches from the open sea to deep into the interior.” We must travel up the Mediterranean coast to the Nile to find a river that stretches inland. While the 1,500-mile total length of navigable water in the Zaire is impressive, this is not a continuous stretch, but is rather comprised of many discontinuous stretches. For several centuries, a map maker attempting to travel the river’s entire length would have had to make repeated portages across land to bypass the unnavigable parts of the river. This was typical of Africa’s waterways.

When water transport is unavailable or infeasible, animals are the historical second-best means of transporting people or goods. In the U.S., oxen and horses pulled wagons and carried travelers on the westward migrations beyond the original 13 colonies. African settlers made similar attempts to employ draft animals but were thwarted by the tsetse fly, an insect pest that carries disease that is deadly to animals. Animal populations were so ravaged that human beings often stepped in as beasts of burden. The stereotypes of African males as jungle bearers on safari and females carrying loads on their heads were born of this necessity. But the tropical climate was not much friendlier to humans. In the 20th century, some 90% of all deaths from malaria occurred in sub-Saharan Africa.

Bacteria tend to flourish in the tropics because of dampness. Oddly enough, the moisture content is favorable to disease organisms but less so to agriculture. Even though total rainfall seems adequate, the boom-or-bust pattern of rainfall – torrential rains alternating with sizable periods of drought – is hard on soils. Drought bakes and hardens soils, enabling heavy rains to wash them away. This destroys valuable nutrients, damaging agricultural prospects. The use of fertilizers was long hindered by the dearth of animals – yet another point of unfavorable contrast with North America, where animals were a plentiful source of fertilizer.

While it is true that not all regions of sub-Saharan Africa suffered all these deficiencies simultaneously, virtually all areas suffered at least one of them. Normally, when some areas produce some things but sorely lack others, trade can make up for this by allowing each area to specialize in its comparative advantage good and trade a surplus of its good for the other things it lacks. But when transport between areas is absent or highly costly, the value of trade is greatly reduced.

The effect of transport costs is exactly analogous to that of a specific tax. Suppose that it costs $10 to transport a good from point A to point B. This drives a wedge between the price paid by the buyer of the good (located at B) and the price received by the seller (at A). This holds true regardless of who pays the transport costs; in fact, the welfare of buyer and seller are unaffected by the identity of the taxpayer. Suppose, first, that the buyer is responsible for paying the tax and that the final market price is $90. That means that the buyer pays $100 (the $90 market price plus the $10 tax) and the seller receives the market price of $90. Alternatively, suppose that the seller is responsible for paying the tax. We previously established the buyer’s willingness to pay $100 for the same quantity of the good – this time the buyer pays it all to the seller instead of paying $90 to the seller and $10 to the government (collected at the sales counter by the seller). Now the seller receives a larger market price of $100, instead of the $90 market price in the first example. But the seller must subtract the $10 tax paid to the government, so the seller nets only the same $90 as before. In both cases, the buyer pays $100 net and the seller receives $90 net. In public finance, this is called the equivalence theorem. But the same logic applies to transport costs. Both tax and transport costs deter economic activity because they reduce the gain to the seller and increase the sacrifice made by the buyer.

Transport costs are ubiquitous. But they loom especially large in Africa. In African economic history, transport costs have been a figurative cross borne on the shoulders of the African citizen. They have severely limited both international and intranational trade.

African Trade

Northwestern Africa, including what eventually became the countries of Nigeria and Ghana, was least disfavored by nature and accordingly hosted several relatively prosperous civilizations. Because prospects for interior trade with other African nations were so poor, these nations increased their real incomes by regional warfare and international trade. Their higher standard of living allowed them to produce weapons of war with which to subjugate their neighbors and reduce their citizens to slavery. The Niger River provided one of the few navigable water routes leading to the ocean, which facilitated the export of slaves to Europe and the West Indies, whence they were often re-exported to North America.

Slaves were one of the few African export items because a slave was a very valuable capital good, capable of earning a decades-long stream of income for its owner. This future stream of income could be estimated, discounted to a present value using an interest rate and sold for a purchase price that capitalized that future stream of income into a current capital gain for the seller. This made it worthwhile to incur the sizable costs of transporting imprisoned slaves across a vast ocean. Consequently, the Nigerian coast acquired the appellation of the “slave coast.”

Another profitable export of this region was gold, which was mined in Ghana. Gold was (and still is) used for limited industrial and decorative purposes, but its primary value lies in its scarcity and acceptability as a medium of exchange and store of value. Investors bid up its price whenever money loses its value in exchange. Even today, the world’s entire physical stock of gold would fit into a single sanitary landfill. Mined gold resembles dust. This means that gold has an extremely high value relative to its physical bulk – the perfect kind of good to overcome the barrier erected by high transport costs. It is not surprising, then, that the Ghanaian coast acquired the nickname of the “gold coast.”

The third of Africa’s famous “coasts” was its “ivory coast,” located to the west of Ghana in Northwest Africa. The ivory was obtained from the tusks of African elephants, hunted to near extinction because private ownership of elephants was mistakenly forbidden. (In the late 20th century, those African nations that experimented with allowing private ownership of elephants saw dramatic increases in elephant populations and successful control of poaching.) Ivory was greatly prized for a myriad of uses and elephants were extant only in Africa and India. Thus, elephant tusks also attained a high value relative to their substantial bulk.

Overall, this represented an incredibly meager showing for one of the world’s largest continents and populations. At the most, it produced prosperity for small African regions for limited historical periods. The slave trade was outlawed in the 19th century and this edict was policed by the British navy. The ivory trade was a self-limiting business, plagued by its illegal status and the short-sightedness of officialdom. Gold mining is limited by the stinginess of nature and the expense of extracting gold from the ground.

Alternative Explanations for Africa’s Lagging Economic Development

Africa has long been the poster child for the failures of economic development in the Less Developed Countries, or what was formerly called the Third World. Most of the blame for this failure was placed on the fact that, for comparatively short historical time periods, many African nations were colonies of European countries.

On general direction, this seems an odd position to take. The theory of colonial immizeration – if it can be called that – apparently assumes that colonizers gained by withdrawing resources from colonies in some way analogous to that in which, let’s say, an embezzler gains by withdrawing funds from a successful company. But that misconceives not only the basic nature of trade between nations but also the stylized relationship between colonizer and colonized.

There is a theory that colonizers gained by imposing unfavorable terms of trade on their colonies and by substituting less efficient trade relationships for those that colonies would otherwise have developed with the rest of the world. But even if we subscribe to this, it does not imply that colonizers wanted to prevent or retard economic development in their colonies. Presumably, just the opposite was true, since development would enable the colonies to produce more and better goods for the colonizer to acquire via biased trade. And in fact, colonizers expended vast sums of time and money on attempts to promote development in the African colonies. If they failed, their failures seem small in comparison to the spectacular failures achieved by Western economists and development agencies like the World Bank and the International Monetary Fund after World War II.

Another oft-cited villain in African non-development is authoritarian political institutions. Doubtless, the fact that Africans exchanged colonial masters for home-grown despots in case after case is not only ironic but tragic, in view of the appalling human toll taken by famine, executions and all-around misery. But the question here is: Is despotism per se responsible for the lack of economic development in Africa? There is a very well-established relationship between political freedom and economic freedom, but the causality seems to run mostly in one direction – from economics to politics, not vice-versa. It seems reasonable to think that more democratic institutions would lead to fewer executions and political imprisonments and less repression in Africa. But Western nations have proven that democracy is fully compatible with economic serfdom and penury.

One of the most objectionable theories of African economic development is racial. It ascribes Africa’s development failures to the genetic inferiority of a predominantly black population. Since this theory offends current sensibilities, it seldom receives serious discussion. A dispassionate examination would cite, among other objections, the economic and intellectual success that the same genetic strains have achieved elsewhere in the world. Indeed, one of the most compelling counterarguments was played out in southern Africa itself, where the successful competition of poor black workers forced dominant white minorities to impose apartheid in order to protect white incomes. The same scenario was played out in the American South under the Jim Crow laws. If blacks are inferior in some economically meaningful sense, why do whites so often need the law to enforce economic protection against black competition?

That last example should click on the light of realization in our minds. Africa seems to be an object lesson in how badly a free market is needed. The African continent is home to less than 10% of the world’s population but over one-third of its languages. This cultural indicator reeks of economic and cultural isolation. In an America blessed with plentiful natural resources, navigable rivers, hospitable climate and a century’s worth of relatively benign colonial stewardship, some sort of economic development was virtually inevitable. Our experience with free markets was a huge bonus that made us the world’s leading economic power. Scandinavia, with its added advantages including complete cultural homogeneity, needed free markets even less. But nothing less than free markets would have sufficed to bring economic development to the Dark Continent.

Free markets do not work miracles; they merely permit the best to be made from available opportunities at any particular point in time. They also provide the widest scope for innovation and technological advancement over time. When nature has dealt you an inferior hand of cards, you can only make the optimal draw, then play those cards for all they are worth. Freedom and free markets are that optimal strategy for economic development.

Today, there are stirrings of economic development in Africa, as there are in longtime development laggards like China and India. The Economist has reported on the ability of individual African fishermen to use cellphones to check the market prices of their daily catch. At long last, technology is beginning to improve the bad hand that Africans have been dealt. Technology has been working its wonders for a couple centuries in the West. Now free markets are bringing them to the poorest of the poor in the heart of Africa.

DRI-233 for week of 12-9-12: Subsidy Nation

An Access Advertising EconBrief:

Subsidy Nation

Recently, several think tanks such as American Enterprise Institute have quantified the degree of Americans’ dependence on government. Federal-government transfer payments have increased from less than $100 billion dollars in 1960 to well over $2 trillion dollars today. Even in real terms, adjust for inflation, transfer payments per capita have increased sevenfold. In 1983, around 30% of U.S. households contained at least one member receiving a subsidy check from the federal government. Today, the number is close to 50%. The fraction of individuals between ages 18 and 64 who were receiving Social Security disability payments in 1960 was about 0.04%. By 2010, the percentage on disability had risen to about 4.6%. (This coincides with the time period in which government agencies charged with policing workplace safety were created.)

A book by AEI’s Nicholas Eberstadt summarizing our dependence on government summarizing our dependence on government is entitled A Nation of Takers. That conjures up the picture of a government-run gravy train on which an army of citizens queues up to hitch a ride, like hobos gathering just outside town at dusk. Transform that picture into a painting and its title would be: Subsidy Nation.

The Roots of Subsidy Nation

The roots of subsidy nation were planted in the 19th century with Henry Clay’s American System. Clay built a political coalition that offered American businesses protection from foreign competition in the form of tariffs – taxes levied on imported foreign goods. The owners and employees of import-competing domestic businesses gained from these tariffs. Everybody else lost, even allowing for the fact that the taxes were the primary basis for federal-government revenue prior to 1913. The American System died with Clay but the tariffs remain. Their height waxed with the Fordney-McCumber and Smoot-Hawley bills of 1922 and 1930, respectively, and waned with subsequent multilateral bureaucratic efforts to free up international trade through the General Agreement on Trade and Tariffs (GATT). But when the chips were down – e.g., when re-election was at stake – politicians could be relied upon to sacrifice the general interest of consumers and import-dependent producers to the special interests of import-competing producers.

American businessmen learned a valuable lesson from U.S. commercial policy. An ounce of protection purchased from government is worth a pound of competitive zeal. Subsidy Nation was born.

Over the course of American history, its farmers have made us the world’s breadbasket. Along the way, they have had to overcome the twin handicaps of price-inelastic and income-inelastic demand for most of their products. That is, when the prices of food and fiber decline and real incomes rise, people do not increase their purchases proportionally. After all, you can only eat so much or wear so many clothes. And falling prices were the norm throughout the 19th and 20th centuries, thanks to continuous improvements in technology and productivity and the resulting increases in agricultural supply.

But American farmers are tough. They know that when the going gets tough, the tough get going – to the government for handouts. Activist farmers carefully picked out a year when agricultural prices were high, then enshrined that year’s prices as their desideratum. They demanded “parity” – farm prices commensurate with those in the good old days. Eventually, after a few decades of hectoring by populist legislators, the New Deal acquiesced with agricultural subsidies.

Federal-government farm-subsidy programs have used techniques like price supports, which prop up prices artificially high using government purchases, creating huge surpluses and wasteful storage costs – not to mention the waste of resources in producing more agricultural goods that are desired in the first place. Target-price programs at least got rid of the surpluses by allowing market prices to fall until the surpluses were disposed of, while paying farmers a direct subsidy to make up the difference. But farmers were embarrassed at getting welfare checks instead of price-support checks, so taxpayers got stuck with the storage costs after all when target prices got shot down. Acreage allotments paid farmers not to farm part of their land. This produced a crop of undesirable consequences, ranging from overfarming and overfertilization of the smaller allotments to monopoly rents accruing to owners of the subsidized acreage.

The joke turned out to be on farmers in the end. Technology gradually turned agriculture into big business by requiring sizable capital investment for machinery and expertise (both scientific and financial). Large corporations are designed for the express purpose of raising large amounts of capital. Not surprising, agribusiness took over most of agriculture. Subsidy programs rewarded farmers according to output; therefore, most of the farm subsidies went to owners of the large corporations. The political left wing, who had called the loudest for government involvement to protect the small “family farmer,” now screamed bloody murder when the beneficiaries turned out to be Archer Daniels Midland instead of Okies from the Dust Bowl.

Subsidy Nation was up and running.

Social Insecurity

The concept of “social insurance” dates back at least to the 18th century, but it found concrete expression in late 19th century Germany. Chancellor Otto von Bismarck had his hands full coping with the socialist movement that had swept over Europe beginning in 1848. To consolidate his power by appeasing the opposition to his left, he agreed to a system of old-age, sickness and accident benefits, funded and administered by the state. By the 1930s, proponents of Social Security had convenient forgotten its origins and remembered only its intentions; namely, to end poverty and neglect suffered by the elderly.

The Roosevelt Administration sold its proposal to the American public by trading heavily on the word “insurance.” Social Security would take in “contributions” from citizens and “invest” them in “special trust funds” where they would be “pooled” for future need. In other words, it would operate much like private insurance, except it would have no need to earn profits and would consequently behave in a reasonable, compassionate manner toward its “beneficiaries.”

This always was, and remains, pure malarkey. Like all so-called “social insurance” systems of its day and until the last two decades, the U.S. Social Security system began and remains a “pay as you go” system in which current benefits are paid from taxes levied on contemporaneous workers and employers. (In the true economic sense, the full incidence of the tax falls on the worker even though half the tax is nominally paid by the employer; the worker pays the other half in lower wages.) The tax is a regressive tax levied on earnings up to a maximum. Thus, it transfers income not merely from young to old but from poor to rich(er). Total benefits have virtually no connection with amounts paid in. The first Social Security recipient began paying in 1937, receiving in 1939, lived to age 100 in 1974, paid in $24.75 and received $22,888.92. Today, most new recipients will not receive even what they pay in, let alone a reasonable rate of return on their “investment.”

For years, Social Security was pointed out as the crown jewel of the welfare state. The baby boom created huge numbers of payees relative to recipients, masking the inherent unsoundness of the system. Today, the reverse is true. Recent falling birth rates throughout the Western world have combined with increasing life expectancies at age 65 to produce an actuarial nightmare – the unfunded liabilities of social insurance systems are off the charts, dwarfing even those of sovereign debt. Politically powerful senior citizens’ groups like AARP agitate against reforms to the system and demand the return of “their” money, oblivious to the facts that it is long gone and that the trust funds are mere accounting fiction.

When private citizens save for their own retirement, their savings are invested in productive assets. Of course, not every investment is successful, but on net balance, American business is productive. After all, the increase in productivity from year to year is what enables more goods and services to be produced and consumed; that is what has constituted America’s rising standard of living. When government takes our Social Security contributions in lieu of allowing us to save, that money is spent to pay current benefit recipients and the productive investment that would otherwise occur is never made.

With the passage of Social Security, America had crossed an invisible divide. Subsidy Nation had hit the big time.

Welfare – But Whose?

In the mid-1940s, the federal government began subsidizing the lunches of public schoolchildren. The program was originally designed to do two things: help get rid of surplus foodstuffs piled up by federal farm subsidies and improve the nutrition of poor schoolchildren. Over the years, the program grew in size and scope. It expanded to include breakfasts as well as lunches – of course, this required children to arrive at school earlier. Recently, dinners have showed up on the menu. And what started out as a school-lunch program for the poor has now become an all-purpose program of nourishment for public schoolchildren.

As a means of improving welfare, it suffers all the defects of government programs. The program has expanded pari passu with an increase in childhood obesity and incipient diabetes. We now know that government-imposed dietary standards are responsible for some large measure of this; today’s new nutritional learning has stood yesterday’s virtually on its head. The subsidized prices students pay (or not) distort the choices made; encouraging food consumption via artificially low prices is not the way to deal with obesity. The distortion affects the supply side of the market, too, by reducing the incentive to craft desirable menus; yesterday’s wasted rotting food surpluses are today’s uneaten food shoveled down the drain or into trash bins.

Emboldened by its rip-roaring success with school children, the federal government broadened its food-subsidy programs to include poor people generally in the early 1960s. It began issuing stamps for use as vouchers in purchasing food, with each stamp good for a value of food purchases. Again, the program began with limited purposes – to insure a minimum amount of nutrition for citizens with incomes below the poverty line. Again, the program grew like Topsy. Today, some 47.7 million people – nearly 1 out of every 7 Americans – receive food stamps.

Was this stupendous growth owing to the brilliant success of the program? Hardly. The food-stamp program is such a notorious example of government subsidy gone wrong that it is featured in economics textbooks as a case study in what not to do when trying to help people. Over the years, food stamps have usually traded at a discount for cash in the black market – sometimes at rates of 50 cents per dollar of nominal value. The words “waste, fraud and abuse” should appear in dictionaries alongside the entry for “food stamps.”

Both school lunch and food-stamp programs run afoul of the general economic principle that subsidies in cash are generally preferred to subsidies in kind. People can use the cash in any way they prefer but are limited to particular uses for school lunch or food-stamp subsidies. This raises the highly pertinent question: Whose welfare are welfare programs supposed to increase – that of recipients or taxpayers? Given the tremendous waste inherent in both programs, that may seem a dumb question. Yet taxpayers display stubborn resistance to reform of these programs, typically based on the presumption that cash subsidies would be wrongly used by the poor and needy – who, unlike taxpayers, are presumably too stupid to be able to judge their own best interests.

At a moment in history when Western governments are staggering under the burden of overwhelming debt, it seems germane to point out that cash subsidies sufficient to life every man, woman and child in the U.S. above the poverty line would amount to much less money than is currently spent on “welfare” programs of all types. How much less? Over the decades, back-of-the-envelope estimates have ranged anywhere from two to ten times less.

In other words, these subsidies are staggeringly inefficient.

Medicare and Medicaid

In the 1960s, President Lyndon Johnson’s Great Society observed that there was evidently political capital in creating benefits for the elderly. Even more importantly, the fact that these benefits were financed by taxes and cost more than the value they created did not seem to be generally recognized. Nor did it affect their political popularity. Johnson’s advisors rubbed their hands and set to work creating a system of government medical care for the elderly and the indigent.

On the surface, Medicare may seem different than government-owned and operated systems like Great Britain’s National Health Service. The difference derives almost completely from the fact that Medicare is administered by large private contractees, such as Blue Cross and Blue Shield and hospitals. That does make at least one important difference on the supply side of the market – the presence of profit throughout the system means that there is an incentive to make and maintain capital investments in medical technology and pharmaceutical products. In Great Britain, by contrast, the lack of state-of-the-art equipment is a scandal.

But as the consumer experiences them, there is little to choose between the U.S. system and government systems. The overriding similarity is the rule of the third-party payment, in which the consumer chooses treatments but the government/insurance company pays the bills. Thus, the consumer has almost no incentive to economize or choose wisely and resources are wasted hand over fist. Walk into a U.S. emergency room – the context in which high prices would and should place the highest premium on careful choices by consumers – and chances are that hospital staff will refuse to quote a price for any particular service, at most providing a flat rate for provision of service. The consent to treatment form that the patient is obligated to sign is either a blank check written on the insurance company or (for the uninsured) a farewell note to his or her net worth.

Even worse is the effect on the demand for medical care. When somebody else is paying the bill, consumers react as if the price of medical services were zero. Demand zooms into the stratosphere. Proponents of government-run health care pretend that medical care is an absolute necessity, but only a tiny fraction of it pertains to immediate threats to life. The need for a working price system in health care is urgent.

All this is bad enough, but Medicare and Medicaid compound their basic felonies with Byzantine regulations that add complication in the name of saving money without reducing true economic costs. Economic cost is the value of alternatives in production and consumption, as reflected in market prices. Since Medicare and Medicaid suppress market prices, their supposed “cost savings” are bogus. Both bureaucrats and government contractees lack the information necessary to centrally plan the medical care of millions of individuals. Arbitrarily reducing the fees of doctors is not cost savings; it merely reduces the level of care and substitutes poor service for higher prices.

Subsidy Nation had achieved another milestone: entrapping the elderly in an inferior system of subsidized medical care with no escape route.

Environmentalism, Alternative Energy and Streetcars

The publication of Rachel Carson’s Silent Spring in 1962 marked the watershed when the movement for conservation of natural resources – a goal with some basis in logic – changed course into a secular religion called environmentalism. The latter term has no logical underpinnings since it offers no grounds for favoring one aspect of “the environment” over another. Clean air is a good thing, right enough – but how clean does it need to be? And whose idea of “clean” gets imposed on everybody else? Ditto for water, land and the rest of “the environment.” The very essence of free markets is to provide an efficient answer to questions like that, while in Subsidy Nation those questions not only go unanswered, but even unasked.

Insofar as environmentalism has anything one could call “principles,” it believes that there is some sort of absolute standard for damage to the holistic, personified entity called Mother Nature, and that the resources of nature cannot be exploited without violating that standard. This provides the implicit justification for subsidizing technologies like solar and wind and fuels like ethanol. Without subsidies, these would vanish from sight due to their unproductiveness. Indeed, the subsidies must be given on both sides of the market – business-firm subsidies to stimulate production and consumer subsidies to stimulate consumption. This is the sine qua non of Subsidy Nation: government at every level has to play Dr. Frankenstein by artificially animating the entire market.

Environmental hysteria reaches its apogee with the recent fad for streetcars. In an age when science has given us the power to ride in computer-guided, driverless cars, trucks and planes – thus vastly enhancing safety, increasing speed and boosting human productivity – we are going to ride around in streetcars? Voluntarily? These are so monumentally inefficient and ineffectual that they require massive subsidies funded by taxes enacted by stealth. This is Subsidy Nation run amok.

Uneconomic Development

Over the last quarter century, casual observers of state and local business blinked in amazement at the rise to prominence of “economic development.” Every state in the nation established a department, bureau or corporation of economic development. “Economic development incentives” became the order of the day. After a couple centuries of folding, spindling and mutilating economic principles and logic, at last local politicos were finally getting the message. Surely prosperity would follow closely in the wake of this phenomenon.

Not.

Seasoned observers knew better. They knew that the discipline of economics contained a field of specialization called “economic development,” pioneered by one of the most famous economists of all time, Joseph Schumpeter. They had remarked the curiosity that – like the dog that didn’t bark in the nighttime – state departments of economic development seldom employed actual economists and almost never spoke a word of genuine economic development theory.

The reality of economic development after World War II in the undeveloped Third World – Africa, most of Latin America and much of Asia – foundered on the lack of effective markets. A major roadblock was the stifling effect of crony capitalism – the preemption of investment by friends, relatives and associates of those in power. This is the kind of “economic development” being preached and practiced at the state and local level today. It may have been best described by the wags in Arkansas who remarked drily that, while Governor, Bill Clinton was bent on achieving economic development one business at a time – starting with his friends.

EDIs take various forms, but they all involve artificial encouragement of business and particularly of investment. The operative meaning of “artificial” is defined in two ways: by selectivity and by distortion. Selectivity implies the granting of favors and making of distinctions for one or a few, but not for any or all. The process known at “tax increment finance” is a classic example. It allows recipient businesses to get favored tax treatment on their business investment and it is awarded by a commission, not available to all on equal terms. Naturally, the commission is set up precisely to award TIF status to those who enjoy the favor of and/or play ball with the local political establishment. Also naturally, the pretense is made that TIF follows sound, established economic principles. Accordingly, awards and publicity are well larded with jargon terms and blue sky prospectuses. Distortion involves the waiving or modifying of normal outcomes and procedures, such as market prices, taxes and government rules and processes.

It takes a professional to see all the way through the economic development charade. For example, many well-meaning amateurs comment approvingly about the “competition between state and local governments for business” that gives rise to EDIs, and compare it with states that lower corporate and individual income tax rates to attract business and residential inhabitants. In the first place, tax reductions for everybody do not distort the relative merits of individual investments the way that EDIs do. Secondly, taxes discourage economic activity by distorting prospective returns and incentives – hence reducing taxes is eliminating a distortion when the reductions apply across the board. EDIs create distortions; by making one investment appear misleadingly attractive, they are making another one misleadingly less attractive.

But the professionals aren’t fooled. Organizations as diverse as the Minneapolis Federal Reserve and the United Nations have commented unfavorably upon EDIs. Economists across the political spectrum have condemned them. The problem here is that the only time public attention can be distracted by economists is when the debate focuses on unemployment, inflation, “creating jobs” or predicting interest rates. Since these are things economists don’t do well, the well is poisoned for discussion of genuine economics.

Going Down for the Third Time

Today, the U.S. is drowning in a sea of subsidies. Most Americans have grown up being subsidized by the federal government. They have watched their friends, neighbors and enemies being subsidized with their tax dollars. They have come to view the political process exclusively as a zero-sum game, a fight in which the majority gets to use its absolute power to take the minority’s money for its own use. “Rights” simply define the ways and means of effecting the seizure. Economic growth, if it is pondered at all, is viewed not in the aggregate but rather as their own, personal, cost-of-living increase, decreed from above by somebody in authority. Apparently, the source of all that bounty that comprises the American way of life is a mystery to them.

The truth is grim. Throughout the 20th century, real income rose in the U.S. But this aggregate outcome concealed an underlying struggle between two forces pulling real income in opposite directions. Technology was advancing, increasing productivity and driving real income up. Meanwhile, each new round of subsidies was reducing economic efficiency, driving real income down. The net result, fairly steady increases in real income, reflected the fact that science, technology and a brain-inflow from the rest of the world was enough to pay the subsidy bills with a little left over to grow on. But that long holiday is now over. The end of the baby boom and the death knell of Reaganomics sent economic growth on a downhill slide.

And we aren’t alone. A good part of the world preceded us, even outdid us, in the transition to Subsidy Nation. Their downfall is the preview of our coming detractions. They are already underwater. We are going down for the third time. Like them, we are going not with a bang, but with a whimper. Crying for political compromise. Moaning for our entitlements. Whining for our subsidies.

DRI-221 for week of 11-25-12: Free-Market Environmentalism


An Access Advertising EconBrief:

Free-Market Environmentalism

Stop a random passerby on the street and ask: “What are the three most important functions of government?” One of the answers would surely be: “To protect the environment.” Ask a sample of academicians “Why can’t we simply step back and allow markets to work freely and without interference by government?” and the leading answer would probably be: “Because the adverse effects on the environment would be too numerous and large.” Ask anybody what the biggest threat to the environment is and the answer will probably be something on the order of: “Greedy corporations and businessmen.”

The linkage between free markets and the physical environment may be the most misunderstood relationship in all of economics. It is often overlooked even by professional economists. To the general public, it is a complete mystery.

The Roster of Environmental Disaster

If government action is required – or thought to be required – to protect the environment against disaster, what kind of disaster is in prospect? A backward glance at history supplies various cases and kinds of environmental disaster. Industrial society has inflicted atmospheric pollutants on the air, producing high levels of smog, ozone and particulates in major cities like Los Angeles, Chicago, London, Tokyo, Bombay, Shanghai and St. Petersburg. Cities and towns have polluted water sources by allowing raw sewage to drain directly into them. Dumps and landfills have accumulated unsafe levels of toxins through careless disposal of waste products.

Pollution is not the only type of environmental damage. Land has been abused in myriad ways – through over-cultivation, over-grazing and over-fertilization. Aside from pollution, water has been overused and misused. It has also suffered damage at its sources. Although the process of evolution features extinction as an integral element, living species have been driven to or near extinction by human beings acting outside the boundaries of nature.

Americans have been schooled in the lore of these disasters. The extinction of the North American passenger pigeon in the 19th century, the near-extermination of the bison and the virtual disappearance of the wolf and the bald eagle are the staples of schoolbooks. Likewise the fate of the Dust Bowl in the 1930s and the problems of Southern farming prior to the development of crop rotation methods. Less well-known but no less telling are contemporary abuses resulting from Western cattle ranges and federal farm subsidies.

Virtually all of these examples are given a stylized narrative in which greed and capitalism are faulted. Heedless, bloated industrialists created pollution in order to fatten their profits while blackening the lungs of little children. Eastern meat-packers killed off the passenger pigeon. Rapacious buffalo hunters and their railroad bosses nearly did in the buffalo, ruining the civilization of the American Indian as a consequence. Farmers were too greedy; they should have settled for lower profits and planted fewer crops so as not to overwork the land.

The problem with these explanations is that they are morality tales rather than logical sequences. They provide no clue as to how disaster might have been avoided other than “make bad men with bad motives do good things instead.” The real story of past environmental disaster and prospective environmental policy incorporates the role played by markets and two key free-market institutions – property rights and prices. Disaster ensues when both of these are missing.

The Tragedy of the Commons

Ecologist Garrett Hardin is credited with enunciating the principle of the tragedy of the commons. Passenger pigeons and bison were not privately owned resources; they were a common resource, available to all at no nominal charge. Private owners would have realized that the cost of allowing animal numbers to dwindle below the reproduction point was prohibitive, but in a commons nobody takes that cost into account.

It is important to realize that the “tragedy” had nothing to do with morality per se and everything to do with the institutional framework in which consumption occurs. Pious, religious people; socialists; conservatives; libertarians – everybody behaves pretty much the same when faced with a commons. And they behave similarly in a free-market environment as well.

Property Rights and the Environment

A right to property is embedded in free-market economics and political philosophy. It dates to John Locke and Adam Smith and the founding fathers of the United States. In order to be effective, property rights must include not only ownership, but also the right to control the use and disposal of property. These guarantee that the rights holder has an incentive to protect and conserve the value of the property, which is a (potentially) valuable asset.

Americans have consumed vast annual quantities of beef for well over a century. Why did the comparatively modest demand for passenger pigeons suffice to eradicate them while cattle thrive despite the enormous demand for beef? Cattle are owned; their owners insure that breeding stock survive to reproduce the breeds and maintain the tremendous investment of the owners. Passenger pigeons had no owners; hunters had no practical option but to maximize their kill to get the most out of the limited supply while it lasted. Nobody derived specific benefit from preserving the species, so it vanished.

The bison were well on the way to a similar fate until the conservation movement – the precursor of environmentalism – stepped in, led by Teddy Roosevelt. The public sector barely managed to preserve a precarious survival for the bison until the private sector began commercially harvesting the animal, thus guaranteeing the survival of the species. The bald eagle and wolf were once threatened by hunters, not for their meat but to protect them from taking privately owned animals as prey. Their existence continues to be precarious despite their so-called “protected status” as “endangered species.” Why? Because they have no owners; nobody has a vested economic interest in their survival, only in their extermination. True, they have defenders who are emotionally committed to their well-being, but history and logic tell us that emotion is no substitute for economics.

The clinching argument for property rights as the key to environmental protection was made in Africa, not America. In 1990, economist Tyler Cowen noted that Africa had long struggled with the problem of elephant poaching by hunters. Because the African elephant was rapidly nearly extinction, hunting was banned on the continent. But ivory from elephant tusks was prized throughout Asia for various uses ranging from piano keys to billiard balls to aphrodisiacs. Poachers were willing to flout the law to get ivory for the lucrative black market, and African governments were reluctant to devote the substantial resources necessary to police vast land areas merely in order to save a small population of elephants whose value was merely symbolic and emotional.

In 1979, some African countries began allowing private ownership and commercial harvesting of elephants. Sure enough, elephant populations in countries allowing private property rights in elephants – Zimbabwe, Malawi, Namibia and Botswana – grew to robust levels. Owners had the motivation necessary to protect and breed their elephants. They also had the advantage of having to police only their own delimited property lines. Meanwhile, neighboring countries that did not allow private property rights – Kenya, Tanzania and Uganda, among others – saw continual declines. Kenya’s elephant population fell from 140,000 at the start of its hunting ban to 16,000 as of 1990. From 1970 to 1990, Tanzania’s population fell from 250,000 to 61,000; Uganda’s fell from 20,000 to 1,600.

Today, the principle is well-recognized in its application to ocean fisheries, which are threatened by depletion because they are mostly a public commons rather than protected by private ownership. Large areas of Africa feature barren terrain interspersed with healthy grasslands. The grasslands are privately owned; the barren spots are public lands that have been reduced to desert by over-grazing of nomadic herds. Public roads are the most familiar negative case of the commons and property rights at work, although they are seldom recognized as such. Because roads are publicly owned, nobody owns them. Everybody has an incentive to use them at will and without taking costs imposed on others into account. The inevitable result is rush-hour congestion and gridlock. An owner, though, would not allow that state of affairs to persist. That brings us to the other vital element of free-market environmentalism: prices.

A Price is Right

People react badly to the idea of private ownership because they believe that a private owner will somehow hoard or guard a resource “for themselves.” But it will very seldom be in the owner’s interest to prevent exploitation of a resource, simply because public demand will make it worthwhile to make it available. Because the resource has long-term value, the owner will want to use it only to the extent, and in such a way that, the long-term value is preserved. This notion is strikingly congruent with the idea of “conservation” that formed the original basis of the environmental movement.

Limitation of usage implies limitation of demand. The classic means to this end is charging a price for usage, which rewards the owner while signaling to the user that the resource is limited in quantity. Higher prices limit demand more effectively than lower prices; whether they are more rewarding to the owner technically depends on the price-elasticity of demand, or the responsiveness of buyer demand to changes in price when the other determinants of demand (income, tastes, prices of substitute and complementary goods) are unchanged.

Once again, people instinctively react against paying a price for goods and services. “Free” sound intuitively preferable. But free is only better in the very rare cases when the goods really were provided at no cost. Sunshine is truly a free good. Tangible goods and most services merit a price because this allows the buyer to compare the expected value received from consumption with the cost of production embodied in the price. (That cost of production will reflect the value of alternative output foregone in the production of the good under consideration.) Politicians who promise us free stuff are doing us no favor, since this merely wastes resources and ultimately gives us less stuff to enjoy.

Because resources in a commons are not owned, they typically do not command a price. Sometimes governments will try to remedy this deficiency by assigning a price of sorts to publicly owned goods, but this price does not reflect the true cost of production and the value of foregone alternative output because the government price is not the outcome of a competitive market. This kind of price – not prices charged by private owners – is the one of which the public should beware.

The failure to charge a (proper) price is the second major source of environmental disaster. For well over a century, municipalities have charged a flat fee for water usage. In effect, this levies an effective price of zero, since the flat fee does not change no matter how many times the consumer turns on the tap. (A true price is marginal, applying to each successive unit purchased.) Consequently, this encourages consumers to use water not only for drinking and bathing, but for washing dishes, cars and dozens of successively lower-valued uses. Meanwhile, the actual production of water requires resources for distribution and purification. Those resources have alternative uses that merit the application of a price tag on each successive unit of water consumed.

Various parts of the western United States, such as the Central Valley in California, would be unsuitable for agriculture without irrigation. The federal government has built dams, diverted streams and distributed water far below cost to farmers. This has enabled the production of crops that would otherwise not be produced. The future survival of the Colorado River, perhaps the key waterway in the southwestern U.S., is imperiled due to repeated impoundment of its waters for use by farmers and ranchers. Because the river is not owned, the farmers and ranchers do not pay a proper price for its use – and the river is on the road to extinction. Not only that, the land is being used in ways for which it is inherently unsuited. This is a classic tragedy of the commons and failure of pricing.

Good Guys and Bad Guys

The simplistic environmentalist tale reduces life to a cinematic conflict between good buys and bad guys, in which the outcome depends on the strength and purity of the participants. Today, American colonists and founders are cast as bad guys who despoiled the purity of the North American wilderness. American Indians are cast as the good guys, the “indigenous peoples” who lived in harmony with nature a la Rousseau. And American frontiersmen did indeed kill game and clear land without concern for the consequences of their actions on the supply.

But so did the Indians. The Plains Indians, for example, routinely migrated throughout a region, killing off buffalo and other game and freely polluting and despoiling land in their immediate vicinity. After all, they had no need to conserve natural resources when their numbers were so tiny in a vast natural preserve the size of North America. When local resources became scarce, they simply moved on. Then as now, economics was the prime mover, not philosophy or morality.

Air Pollution – the Special Case

The reader will have observed the absence of air pollution in the property rights and pricing examples discussed thus far. The logic previously developed explains that. Unlike animals, land and water, air is much less amenable to private ownership. (Nation states assert ownership to “air space,” so clearly the concept of owning air is not infeasible. The trick is to bring it within the private domain.)

Once more, it is tempting to treat the issue of air pollution as a morality tale. And once more, this temptation should be resisted. The world’s worst cases of air pollution are located within the borders of socialist or communist states, ostensibly dedicated to principles of social justice, public ownership and fair shares for all. Air is a classic commons, and the basic principles of property and pricing apply just as strongly to good guys as to bad guys. Indeed, in this context it would seem that the only good guys are those who strive to bring property rights and pricing to the public.

While the general public associates capitalism with pollution, the truth is just the opposite. The most capitalistic countries should be the least-polluting ones in theory and tend to be least-polluting in practice. This agrees with common sense (a quality in short supply among the general public). Capitalism operates under private property. Private owners don’t want to run down the value of their property or allow others to do so; thus, they are averse to pollution. Socialism implies public (i.e., government) ownership, which means the absence of incentive to protect property value and impede polluters. Passing laws to make government responsible does not actually make government responsible – as the old saying goes, who watches the watchers? Consequently, it is not surprising that Soviet Russia and Communist China were the champion polluters of the 20th century. In the U.S., the famous case of Love Canal was originated not by Hooker Chemical Co. but by the government to whom they sold their property, which actually polluted the canal.

The modern-day environmental movement is sometimes dated from the publication of Rachel Carson’s book Silent Spring in 1962. This is the point when the movement changed from emphasizing conservation to promoting a vague, indefinable concept of “the” environment as a holistic entity rather than a collection of heterogeneous elements. Prior to this, the strongest opponents of pollution were libertarian political philosophers like Murray Rothbard – the same people who were also the strongest defenders of free markets and capitalism. These libertarians took a per se approach to air pollution, forbidding it in principle as a violation of property rights.

More recent free-market environmentalist approaches take a different tack, noting that the economic approach is to compare the costs and benefits of any activity. If the benefits of steel production outweigh its costs – even when pollution costs are taken into account – then forbidding steel production in order to cut pollution to zero is too harsh. The idea should not be to ban pollution altogether – it should be to encourage efficient production in which the benefits of the produced output outweigh the costs of production including pollution. When regulating pollution, the emphasis should be on cost-effective pollution abatement. That is, we want to urge producers to find the best, least-costly ways to limit pollution.

In the past, governments have regulated industrial pollution by hiring experts to dictate the “right” ways to produce things, then requiring businesses to follow those rules. But the problem is that this “one-size fits all” approach is very inefficient. As F.A. Hayek noted, free markets are superior because they generate information about “the economics of particular time and place.” Each business should have the freedom to decide the best way to cut pollution based on its own particular circumstances and sources of expertise. Instead of telling businesses how to produce, government should simply tell businesses what outcome to achieve in terms of pollution reduction, and then leave the means of achieving that outcome to them.

Large Numbers and Small

For many years, economists believed that government regulation was the only way to handle all issues involving the environment. Because the existence of a commons entailed costs that a user would never take into account, so the argument went, the action of government was required to bring these costs into play. The cost was called an “externality” because it was external to the calculations of those participating in the non-governmental production and consumption of the good. Government would enter the picture by levying a tax on the good equal to the amount of the externality, thus “internalizing” it and forcing the user to take that cost into account in his or her consumption decisions.

In 1960, law-and-economics specialist Ronald Coase stunned the economics profession by pointing out that, in general, this approach was wrong. The problem was not an externality; the problem was the absence of property rights caused by the commons. The minute property rights are assigned, the rights holder has an incentive to internalize the externality without any interference by government. In fact, this solution is greatly preferred to government action since the property owner will probably know the costs involved while the odds are greatly against government knowing the correct size of the tax necessary or having an incentive to levy it even if it did know. This Coase Theorem eventually (and belatedly) earned Coase the Nobel Prize in economics.

Because the Coase solution will necessitate negotiation between property rights holder and counterparty (property owner and consumer, say), this still leaves air pollution as the hard case. The usual circumstances of industrial pollution involve very large numbers of third parties affected by the pollution. The business owner(s) will find it prohibitively costly to negotiate with each victim individually and the victims will find it too costly to organize in order to negotiate with the business owner. Thus, this “large numbers” case still leaves a role for government as regulator of air pollution.

Not Market Failure – Education Failure

The logic of free-market environmentalism is compelling – so much so that it extends beyond the environmental domain. Specialists in monetary and financial economics have pointed out that the federal government turned banking into a commons through federal insurance programs. The FSLIC and FDIC were ostensibly intended to reduce worry of S&L and bank failures by insuring deposits up to stated values. Unfortunately, this allowed owners of financial institutions to take investment risks beyond the norm because neither they nor the depositors were worried about the consequences – the taxpayers were the ones ultimately on the hook if the S&L or bank went bust due to bad investments. Thus, both the S&L crisis of the early 1980s and the financial crisis of the late 2000s were tragedies of the commons, analogous to the environmental disasters reviewed above.

In view of all this, why isn’t the logic of free-market environmentalism widely known and practiced? The only answer must be that the economics profession, whose members are disproportionately members of and supported by government, has done a deplorable job in educating the public about economics. If economists refuse to teach economics, who can we look to?

DRI-311 for week of 11-04-12: Natural and Unnatural Disasters

An Access Advertising EconBrief:

Natural and Unnatural Disasters

A natural disaster can wreak havoc on the economy of a city or a region. But it remains to be seen whether this is worse than the unnatural disaster created by politicians grimly determined to cope with the resulting crisis.

Hurricane Sandy stuck the U.S. East Coast last weekend. Although only a Category 1 storm – hardly of vast magnitude by historic standards – Sandy nevertheless inflicted considerable death and destruction. Among her sundry devastations were the trashing of New York City harbor and the interruption of electric power for millions of local residents.

By interdicting shipments of gasoline into the port, Sandy left inhabitants of metropolitan New York City and New Jersey temporarily out of gas. By shutting off power, the storm left many gas stations unable to open for business even if they had gas to sell. On Friday, some two-thirds of New York City gas stations were closed. On Saturday, the proportion of closures still numbered one-third.

A triumvirate of elected officials – Gov. Andrew Cuomo of New York, Gov. Chris Christie of New Jersey and Mayor Michael Bloomberg of New York City – reacted in the inimitable way of politicians everywhere when faced with a career-defining, character-revealing problem.

They ran amok.

The Political Devastation: Gasoline Rationing

Gov. Chris Christie of New Jersey is a Republican. He is highly regarded in certain right-wing circles. Once that would have testified to his economic bona fides. His reaction to Sandy and the sudden spike in scarcity of gasoline, though, was more reminiscent of the Neanderthal left.

Gov. Christie imposed gasoline rationing. This is a time-honored reaction to a decrease in supply or increase in price of something popular or important. Honored by time, that is, but not by logic. Rationing is a political means of deciding which buyer’s desires get satisfied when there’s not enough of the good to satisfy everybody. And the reason why there’s not enough is that the good’s price is not allowed to rise high enough to call forth a sufficient quantity supplied.

After all, the Law of Supply is one-half of the Laws of Supply and Demand. It says that producers will wish to produce more of any good for sale at higher prices of that good than at lower prices – all other things equal. Superimpose this Law over the Law of Demand – which says that buyers will wish to buy more of any good at lower prices of that good than at relatively higher prices, all other things equal – and you have the makings of a market. Together, the two Laws combine to generate an equilibrium price – the price at which the quantity buyers wish to purchase equals the quantity producers wish to produce for sale. This is the price towards which a competitive market will tend to gravitate and the only price that could (in principle) persist indefinitely.

Competitive markets tend to equalize the amount people want to purchase and the amount producers want to produce and sell. They do this through fluctuations in price. If a drastic decline in supply occurs – perhaps through the intervention of a disaster like Hurricane Sandy – the immediate effect of this will be a shortage of the good at the previously prevailing equilibrium price. Suddenly buyers are no longer able to get the amount of the good they previously purchased at the former price. Their dissatisfaction will goad sellers to increase production and shipments to the market in order to enjoy a higher price and increase their profits.

Gradually, as price rises ever higher, two things happen. Producers supply more and more because they are making more and more profit. Buyers wish to buy less and less as price continues to rise. Consequently, the shortage gets smaller and smaller. Ultimately – bam! – the point is reached where the amount producers ship and sell equals what buyers wish to purchase. At that point, nobody has an incentive to change their behavior further. The fewer the political and logistical constraints exist, the shorter this adjustment process will be.

If the supply disruption caused by a natural disaster were sufficiently protracted in time – something like, say, the dislocations caused by the earthquake and follow-up tsunami in Japan in 2010 – the continuing availability of supranormal profits would attract entry by new firms into the industry. The increase in supply caused by this new entry would eventually lower price until all firms were earning merely a competitive rate of return.

But Hurricane Sandy is a short-run phenomenon whose supply disruptions will be handled entirely by existing firms. Recent declines in crude oil prices have reflected a brewing worldwide recession. These declines have translated into lower gasoline prices. Refineries have accordingly cut back on production in response to this cyclical decline in demand. The trick is to get them to increase production and stand the cost of shipping product to the East Coast to meet this sizable temporary need. That is the function of the price system – one is ideally equipped to handle.

There is no rationale for intercession by government into the process, either in the short run or the long run. The stated justification for government rationing is always the same. It is to prevent the price from rising “too high,” to prevent the good from becoming “unaffordable,” to preserve “equity” and “fairness,” to prevent sellers from “exploiting an emergency” to earn “windfall profits” or “obscene profits” or “profiteering” or “putting profits above people” or “earning profits off the backs of the disadvantaged victims.” None of the quoted phrases have any objective meaning or definition. All of them are emotive terms designed to evoke terror or pity or outrage in an observer without having to meet any analytical standard of proof. In short, they are the rhetorical currency of the politician.

In this case, Gov. Christie announced a formula for gasoline rationing. He announced it with the utmost gravity despite the fact that it was entirely whimsical. It was the “odd-even” formula. New Jersey motorists whose license plates ended in an odd number could legally acquire gasoline only on odd-numbered days of the week. Owners of plates ending in even numbers bought on even-numbered days.

Competitive markets allow price to move to the level necessary to equate the quantity supplied and the quantity demanded of the good in question. Rationing has the specific intent of preventing price from increasing to the level it would otherwise reach. Rationing deliberately strives to preserve the condition of shortage. Of course, it does so in the name of “fairness.” But then, what political atrocity isn’t committed under some noble-sounding pretext or another?

More Political Devastation: “Free” Gasoline

Not to be outdone by a neighboring politician, Gov. Andrew Cuomo of New York state elbowed his way into the act with an executive announcement of his own. No less august an agency than the Department of Defense – presumably taking a break from its successful prosecution of various wars or “wars” – was riding to the rescue. It would establish mobile fueling stations in New York City and Long Island, with gas supplied by the federal government.

“And the good news is,” the governor concluded triumphantly, “it’s going to be free.” What a triumph for the NannyState! State disaster relief provided free by the federal government herself! (Of course, there would be a 10-gallon limit on purchases – the Governor was countering Christie’s proposal with his own differentiated rationing product.)

Unfortunately, the best-laid economic plans of bureaucrats gang aft agley. In fact, they gang invariably agley. It apparently never occurred to these master planners to worry about what people would do at the prospect of “free” gasoline.

What they did at the Freeport Armory in Long Island was to line up, some 1,000 strong, waiting for the station to open. But when it did, they learned that it would be eight hours until the gasoline itself arrived. At another mobile station in Queens, would-be buyers formed a line that stretched for 20 blocks.

Needless to say, the public was not happy when it felt the strings on that “free gas” offer. One caption on a picture of the resulting turmoil read: “Tempers flared after people camped out all night, waiting for their turn at the pump…” Teacher and gasoline consumer Lauren Popkoff commented, “There’s just so many people getting very frustrated. People don’t know what to do.”

At length, the State Division of Military Affairs intervened with a plea that the public eschew the mobile stations until additional gasoline supplies arrive. Now the government had to order the public to avoid the special gas stations it had set up especially to relieve their “gasoline poverty.” It finally fell to the State Division of Military Affairs (!) to administer this fiasco, which lent just the right comic-opera touch to the proceedings.

There’s No Such Thing As A Free Lunch – Or Free Gasoline

Students often react reflexively to tales like this with responses such as, “Well, at least the people got their gas free.” Of course, this is arrant nonsense. We are so habituated to smoothly functioning markets that we see ourselves driving up to a pump, getting out, pumping gas and leaving – all within a short span of time. This is the implicit context within which we define our notion of “free gasoline.”

Significant time spent queuing – let alone marathon waits of eight hours or more – changes this picture completely. Now we must face the fact that the true economic price of gas also includes the opportunity cost of the time spent acquiring it. That is represented by the value of our time – either our labor time or our leisure time.

What is an hour of your time worth? Back east, eight dollars an hour is a low wage. Yet that means that the 10 gallons of “free gas” cost customers at the Freeport Armory in Long Island a minimum of $6.40 per gallon – and that’s just the price for a minimum-wage customer who was first in line. Customers who were last in line might easily have “paid” double that much. If they were people with decent jobs, paying $20-50 per hour – they might have paid six or seven times that much. It is odd that the egalitarian left wing, obsessed with the concept of discrimination, has never worried about the differential pricing effects of rationing. Perhaps the right wing should coin a slogan for these cases – something like “people, not politics” or “reason, not rationing.”

Go back to September 11, 2001. On that day, “runs” on gasoline stations were not uncommon. Quite a few motorists anticipated widespread dislocations and disruptions resulting from terrorism – at this point, the scale, scope and source of the attacks were unknown. Long lines formed at the pumps, which game a few enterprising station owners the brainstorm of charging ultra-high prices of $5 per gallon for “no-waiting” gasoline. Predictably, this gave rise to cries of discrimination and price-gouging. But these entrepreneurs were solving the problem and making us better off. They simply allowed the public to sort itself into those people with low-valued time – who waiting in line at Quik-Trip or at oil-company stations – and those with high-valued time – who paid $5 per gallon to avoid paying much more in lost time at work or lost leisure.

The contrast between these two types of response is instructive. Government takes arbitrary actions that are mandatory and coercive and take no account whatsoever of individual differences and preferences. They are designed purely to serve the interests of politicians and bureaucrats. The private market takes actions tailored to the interests of the different customer groups they serve. Those actions allow customers to maximize their own welfare by meeting their own needs and tailoring their actions to the differing prices and values they confront at each point in time. Entrepreneurs act this way not necessarily because they are noble and altruistic – they may or may not be – but because they have to serve their customers well in order to survive commercially and prosper.

Anti-Price Gouging Laws Gouge Consumers

It is easy to laugh at the comical antics of chief executives – mayors, governors and presidents. They are chosen more for their personalities and political instincts than for their analytical skills. But attorneys general and legislators are mostly lawyers who are supposedly trained analysts. They craft, pass and enforce complex legislation. These are people whose mental faculties are finely honed. Yet when they open their mouths on economics, they become blithering idiots.

Beginning immediately after 9/11, state legislatures began to pass anti-price-gouging bills, ostensibly designed to protect consumers against high prices in emergencies. In New Jersey, businesses were forbidden from raising prices more than 10% within 30 days of a declared emergency. In New YorkState, merchants could not charge “unconscionably excessive price[s]” for “vital and necessary” goods. As to what constitutes “unconscionably excessive,” the law remained mute.

And sure enough, no sooner has Sandy made landfall than the respective AGs went into their act. New Jersey Attorney General Jeffrey Chiesa: “Anyone violating the law will find the penalties they face far outweigh the profits of taking unfair advantage of their fellow New Jerseyans during a time of great need.” Just to make sure that people knew the government meant business, it had previously hit a gas station with a $50,000 fine for raising its price by 16% during Hurricane Irene.

This reminded economist Benjamin Powell of the famous directive of Roman emperor Diocletian in 301 A. D. The emperor instituted a maximum price for bread and threatened violators with death. Powell noted that the chief result of this was an absence of bread. And “much as the Roman threat of death couldn’t force producers to bring products to the market, neither can New Jersey’s excessive fines.”

The one thing Northeasterners want most is gasoline. Prosecuting producers who supply it will not encourage them in this pursuit. And a theoretical right to obtain unlimited free quantities of a good of which there is no supply is not worth a tinker’s dam to consumers.

And Then There Was Bloomberg

Hovering over the crisis like a Big Brother was Mayor Michael Bloomberg of New York City. It isn’t often that Mayor Bloomberg is upstaged in a public controversy, but in this case he was technically outranked by Gov. Cuomo. Still, he managed to get his rhetorical licks in. On Saturday, he announced that the gas shortages should be over “in a couple more days,” when the Port of New York City was reopened. But as recently as Wednesday, November 6, Huffington Post still carried accounts of the shortage. Offers to trade sex for gas were popping up on Craig’s List.

A reliable byproduct of any durable program of rationing is the appearance of black (illicit) markets. Technically, the motivation for black markets arises due to the condition of shortage. When price is not allowed to rise and eliminate the shortage, this creates a permanent condition in which the maximum price buyers are willing to pay exceeds the legal price suppliers currently receive at the shortage-constrained price. Buyers have an incentive to offer a higher-than-legal price to get more of the good; producers have an incentive to violate the law by supplying more to the market at prices above the legal level. Thus, the dance floor is prepared for the black-market tango.

Sex-for-gas is somewhat irregular, but by no means outré. After all, a cash transaction would be traceable, at least theoretically, but sexual barter is much more difficult to trace and prove.

Rationing By Price vs. Non-Price Rationing

Supply disruptions create a situation in which a limited quantity must be allocated among many buyers. Economics suggests that there is a good and a bad way to do that. The good way is to ration the demand of many buyers using price. The bad way is to ration demand by queue, by coupon or by some other non-price method.

Rationing by price has certain key advantages. Among these are: 1. the ability of price to rise is an inherent advantage to the supply of the commodity, since it gives producers an incentive to supply the good. And in cases like Sandy’s, that is exactly what exasperated consumers want most – they want the good in question. 2. A higher price gives buyers the incentive to conserve and allows each buyer to take his or her own particular circumstances into account. A poor consumer, for example, may nonetheless need to purchase a large amount of the good and may want to pay a high price to do it. 3. In order to maximize utility or satisfaction in an ordinary marketplace setting, a consumer equalizes his personal rate of tradeoff for the good to that offered by the market. That is to say, he buys the amount of any good that equates its marginal value or benefit to its marginal cost or price. All consumers face the same price for a good; all consumers equalize their personal rates of tradeoff to that offered by the market. Since two (or more) things that are equal to the same third thing are equal to each other, that means that marketplace exchange guided by money prices achieves the same ideal outcome that would otherwise require an impossible amount of time and effort to reach using barter exchange without money. In contrast, rationing frustrates this outcome by driving a wedge between consumers’ personal rates of tradeoff. This encourages black markets and criminality.

This analysis is a staple of microeconomics textbooks, the kind used to teach undergraduates in hundreds of U.S. colleges and universities. Economists testify to its validity as expert witnesses in court cases of various kinds – regulatory, antitrust, civil and criminal.

Venality or Stupidity?

There is a venerable maxim governing motivation and behavior: “Never ascribe to venality that which can be explained by mere stupidity.” In a world of imperfectly distributed information and intractable subjective perception, this is a sound rule of thumb.

Yet the continual refusal of politicians, regulators and lawmakers to take seriously the best-established principles of economic theory and logic – while embracing only the quack remedies of macroeconomics – cannot any longer be put off to mere stupidity. People who are smart enough to gerrymander legislative districts to cement their incumbency and bury their mistakes in legislation numbering thousands of pages cannot be written off as simply too stupid to master basic economics.

This means that they must have ulterior motives for acting as they do. Since their actions harm the constituents they are sworn to help, those motives are clearly anything but benign.

The logical motivation would be to deliberately thwart suppliers in order to leave constituents at the mercy of government. By making the public dependent on government, the minions of government protect the permanence of their own positions by enhancing their budgets and the scope of their power.

Natural vs. Unnatural Disaster

Natural disasters are bad enough. When the free market is given free play to cope with them, their effects can be mitigated. But when politicians, lawmakers and bureaucrats are allowed to use them as vehicles to serve their own interests at the public’s expense, the long-run harm of the resulting unnatural disaster rivals that of its natural counterpart.

DRI-358 for week of 10-7-12: More Expensive Free Lunches

An Access Advertising EconBrief:

 

More Expensive Free Lunches

 

Last week’s EconBrief developed the economic concept of the free lunch. “There’s no such thing as a free lunch” may be the most famous of all economic aphorisms. Often credited to Milton Friedman, it owes much to that late Nobel laureate’s astonishing talent for exposition. Friedman pointed out that the notion of a free lunch violated the principle of opportunity cost, which undergirds the very subject of economics. Since resources have alternative uses, anything produced using scarce resources must be costly. The highest-valued alternative output foregone constitutes the opportunity cost of production.

Neglect of opportunity cost is the hallmark of the free lunch. Another distinctive feature is the underpricing of a scarce good or resource on the pretext of improving welfare. The pretext obscures the true purpose of the free lunch, which is to grow government. Expansion of government regulation, agencies, bureaus and programs is another characteristic of the free lunch. Finally, the presence of unintended collateral damage – often the result of overindulgence in the underpriced “free” good – is an unmistakable sign of a free lunch.

 

Water Subsidies in the West

The lure of the free lunch acts as a sort of political Venus Fly Trap, tempting unwary citizens within range so as to swallow them up. Once gobbled up by the system, nobody emerges whole.

Farmers in the western United States were sucked in during the late 1800s and early 1900s. In this case, the lure was not a free lunch but a free drink – of water. The federal government built huge reservoirs and accompanying dams that it used to provide electric power. It made the water available to farmers in California’s Central Valley for purposes of irrigation.

As with free lunches to schoolchildren, the accompanying rhetoric was redolent with poetry and sentiment. The irrigation would “make the desert bloom.” And so it did. Eventually, farmers were able to grow crops on land that previously had little agricultural use. The federal government paid the farmers not to grow crops on the land, causing the farmers to set aside acreage and farm remaining land much more intensively, using larger amounts of water, fertilizer and pesticides. Then the federal government bought the crop surpluses produced by the farmers to artificially support crop prices, using taxpayer funds to pay for storage.

The tilled land was burned out by over-cultivation. Insects became resistant to the pesticides. Water shortages plagued the West. This was particularly irksome to farmers on better land located closer to the dams and reservoirs, who nevertheless needed some water for irrigation. Waterfowl and other wildlife species died by the tens of thousands as wetlands habitat dried up.

Acrimonious political divisions developed between Central Valley farmers and outsiders. Needless to say, farmers defended their subsidies, which had become a lucrative source of income.

Economists saw the problem as another free lunch gone wrong. The government undercharged Central Valley farmers for the water provided to them. Indeed, most communities through the U.S. and the world do not charge a true economic price for water. That is, a government-owned and operated water monopoly charges a flat rate for water usage instead of charging a price per unit of water consumed. This flat rate is economically equivalent to a price of zero.

Why? Because it is unchanged whenever the consumer increases or decreases water consumption. Thus, the marginal sacrifice (in terms of consumption foregone) for additional water consumed is zero. Under these circumstances, people are moved to treat water as a free good, to consume the maximum amount of it. Water is not a free good; additional quantities of it must be discovered, pumped, purified sufficiently for human consumption and made available to the consumer. Thus, by lying to the public, government encourages people to consume water well past the point where the personal value people place on additional water consumption is equal to the cost of producing and supplying that additional water. Because the cost exceeds the value, we are made poorer by the government policy.

Once more, practically everybody loses from the government “free lunch” policy on Western water. The possible exceptions are Central Valley farmers and government employees in the Department of Interior. Members of the Bureau of Reclamation and the Department of the Interior have made careers out of serving their constituents in the Central Valley. And, of course, proponents of big government can point to the irrigation projects and blooming desert and harvested crops. What can opponents point to? About all they can do is point to the environmental blight, the dead and dying wildlife. But farmers can deny that this has anything to do with them – they are just hardworking farmers, tillers of the soil – hardworking, God-fearing families who developed the desert in good faith.

Once again, the pattern is clear. A form of subsidy that benefits a few at the expense of the rest becomes entrenched and cannot be eradicated. No wonder, then, that economists wince when these programs start up. No wonder they take such an irritating, unyielding, hidebound stance against them. Once the programs are in place, dynamite cannot dislodge them.

Road Use

Americans are accustomed to climbing in their automobiles and taking off across the open road without let or hindrance. Public ownership of most roads has contributed to the fiction that road use is free, a fiction assiduously promoted by government policy. Sometimes a toll is charged for the use of a particular road, but traditionally the toll merely amortizes the debt incurred in construction. Expenses of road maintenance and repair are covered by revenues raised from the tax on gasoline purchases.

In fact, road use is not a free lunch. Roads are a capital good that must be built, maintained and replaced. The resources required for this are scarce and have alternative uses. Not only that, my use of the road at any point in time precludes use by somebody else, which violates the economic definition of a free good.

Opportunity costs of road use arise in both production and consumption. The resources necessary to build, maintain, repair and replace roads have alternative uses. This argues in favor of a price to place a value on use of the road. Consumers could then compare their personal valuation to the value of the alternative output foregone by making the road available for individual use. Driving would occur as long as the personal value exceeded the value of the output foregone in producing a usable road. But what usually happens is that the “free-lunch good” is underpriced, causing overuse. That is particularly true of road use at certain places, times and locations.

The overuse causes congestion. This congestion causes all sorts of collateral damage, including time wasted sitting in traffic queues, delays, road damage, accidents, gasoline wastage and air pollution. The cumulative effect is hardly trivial, since the time lost to traffic delays is estimated to have quintupled in the last 30 years.

As always, the free lunch has served the ends of big government. The Department of Transportation owes its existence to it, as doe various sub-departments and bureaus like the Federal Highway Transportation Safety Administration. State highway departments dole out money for care, maintenance and policing of state highways.

The seminal problem with this free lunch is ownership. Public ownership of the roads implies that nobody has an incentive to earn profits from them, maintain them to conserve their profit-earning capability or price their services to serve the needs of consumers. The conventional thinking (as opposed to “wisdom”) has always been that profits are bad – and prices are bad because they lead to profits. Experience has taught us the folly of this line of thinking. Profits point to goods and services that consumers want more of. Prices allow consumers to compare their valuation of each additional unit to the value of the resources used to produce it (e.g., the value of output foregone due to production). Prices and profits are the rational tools markets use to govern economic life.

The best way to reform the public road system is to privatize it. The second-best way is to use free-market techniques within a government context. Lease public roads to private firms for conversion to toll roads. Institute time-of-day pricing, or congestion pricing, to charge higher prices for road use during rush hours. This will divert some traffic away from rush hours to off-peak hours, which is a cheaper and more efficient solution than building more roads with peak usage points that last only 2-4 hours per day.

These approaches are now being followed, albeit on a small scale. Various states have leased highways to private firms as toll roads. In the Manhattan borough of New York City, all fixed tolls have been converted to congestion tolls in an effort to divert some of the city’s fearsome rush-hour traffic to off-peak points.

Military Conscription – A Ghost of Free Lunches Past

The opportunity to discuss a failed government policy in the past tense is so rare that it should not be bypassed. Military conscription in the U.S. began with the Civil War and continued through two World Wars and various lesser conflicts. The practice became hotly controversial during the Vietnam War, when many young men of draft age left the country to avoid involuntary induction into the military. The unpopularity of the draft undoubtedly led to its discontinuance in 1973.

Today the all-volunteer military operates smoothly and accepts both men and women. Occasional calls for a return to conscription echo the arguments made for the practice during its heyday. Foremost among these is that conscription saves money by allowing government to force inductees to work for lower wages than they would accept voluntarily.

It is indubitably correct that conscription forces many recruits to work for less pay than they would otherwise demand in a voluntary setting. Whether this amounts to “saving money” is a semantic question. What it certainly does not do, though, is to reduce the economic cost of providing national defense. When it comes to acquiring enlisted personnel for the military, the cost of service is not simply the monetary payment received by those soldiers. It is the value of the output they could have produced in their highest-valued alternative occupation, or the value of their marginal product. In a competitive market, their wage will be bid up until it reaches this level.

If a conscript is forced to accept a draftee wage of (say) $20,000 per year instead of the $30,000 per year he could have earned in civilian life, this is not really a fiscal victory for the draft. The government has merely levied an implicit tax on his labor, with the incidence of the tax falling on the conscript and the rest of us. The conscript earns $10,000 less than he would have otherwise; we receive military services that are less valuable than the civilian goods or services he could have produced instead.

Conscription has traditionally been portrayed in purely emotional terms. Proponents cite submission to compulsory military service as a patriotic duty. Those unwilling to defend their country are unworthy to enjoy the rights and privileges of citizenship. Opponents perceive state compulsion of its citizens as immoral; why should people be forced to fight and die for a cause they reject?

Economists cut this philosophical Gordian knot. Patriots want to win wars. The best way to do that is to put the best and most willing fighters on the front line, the best strategists in the war room and the best suppliers in the factories. Conscription completely louses up efficient resource allocation by forcing the unwilling and training the less able to fight; by making sergeants out of factory superintendents and officers out of the politically connected. More technically, conscription makes unskilled labor artificially cheap, encouraging the military to use too much of it and not enough capital goods (skilled labor and sophisticated weaponry). Indeed, this argument applies just as forcefully in peacetime.

The problem with the arguments of moralists is that they are neither necessary nor sufficient to deal with the problems posed by war and the necessity of raising and keeping a military force. In this pinched worldview, there is no stopping point between conscription on the one hand and unilateral disarmament and full-blown pacifism on the other hand. But voluntarism respects the arguments of the moralists while still allowing for optimal prosecution of war and national defense.

That conclusion is not merely theoretical. The record of the U.S. military in armed combat worldwide since the changeover to a voluntary force has been nonpareil. Recruits are now better educated – almost all are high-school graduates – and grade higher on aptitude tests at enlistment than under conscription. The military exhibits better morale, discipline and experience as a voluntary force. The logic developed above has been borne out in practice. If we were to revert to conscription, as is occasionally proposed, the resulting lower quality of recruits would raise the pecuniary costs of training to offset any monetary benefits accruing from lower wages.

In its heyday, conscription fit the free-lunch pattern like a glove. The opportunity cost of the conscript’s labor time – his or her civilian output – was ignored. The conscript’s work was underpriced, thereby distorting his or her use by government. Conscription contributed to the growth of big government in the form of the Veteran’s Administration, a massive bureaucracy devoted to processing, caring for and subsidizing citizen-soldiers rather than an army of professionals. And the collateral damage of the draft included not only the inefficiency of the armed services, but the contempt that it brought upon them and the lives it blighted.

Government Money Creation

Long before there were public schools to provide free lunches to, the foundations of the free-lunch concept were poured by the oligarchs of antiquity. They clipped coins, adulterated the metallic content of the money stock and generally debased the exchange value of the monetary media.

With the advent of paper money in the age of the printing press, monetary manipulation came into its own. Governments could pretend to create wealth by creating money – working the printing presses overtime creating currency for the public to spend. Prosperity is no farther away than the printer’s office. Happy days are here at last.

Unfortunately, money is not wealth. It merely allows the holder to acquire title to goods and services. Rapid money creation by government merely causes a mad scramble by holders of money to exchange it for the things they really want. Since the short interval between distribution of printed money and purchase does not allow for wholesale expansion of output, the result is more and more money holders waving currency and chasing a fixed supply of goods and services. The effect is to bid up prices.

The term “inflation” has come to be associated with the effect of money creation on prices when it might better be applied to the cause of the process; namely, the inflating of the money supply. The distinction is crucial, but we are only belatedly realizing that. It is sometimes true that the inflating of the money supply causes only some prices to rise. Even when all prices rise, they virtually never rise in perfect synchrony. And the world is now experiencing the most unusual case of all – a vast increase in government money creation with comparatively little effect on prices of goods and services (as of yet) but considerable effect on interest rates and the pattern of investment.

Governments today perceive virtually no monetary cost in money creation, since it is now effected by computer keystrokes to bank reserve accounts. The opportunity cost is that money that would otherwise be efficiently used in exchange and investment is now used inefficiently. Not only is its general purchasing power diluted – an effect that holds for all or most good, services and assets – but the distortion of relative values distorts specific markets such as housing, real estate, agriculture and many more. Once again, we see overuse of the free good whose value has been artificially cheapened by the free-lunch policy. As the supply of money rises, the urgency heightens to spend it before its value declines further.

And once again, we see the growth of government as beneficiary of the free lunch. The U.S. Federal Reserve was created in order to afford government control over the supply of money and credit. The Fed’s tentacles have spread until it now controls the banking and investment sectors, usurping not only private functions but even some functions of other government agencies.

Trying to sort out the direct from the collateral damage is somewhat arbitrary. For example, the entire financial crisis and ensuing Great Recession can be viewed as the collateral damage of the Fed’s money creation earlier in the decade, since the crisis would have been unthinkable in the absence of the monetary excess. But no matter how you allocate it, the overall damage has been enormous.

How Many Free Lunches Can We Afford?

As we have seen, the worst thing about economic free lunches is that they cost so much. That is the paradox of the free lunch – that it inherently promises what it logically cannot deliver. If this were all, perhaps we could write off the free lunch as a noble experiment. But the attempt to get something for nothing carries with it a big price tag. First there is inefficiency – neglect of opportunity cost means that resources are wasted and we become poorer. Then there is collateral damage – water shortages, water and air pollution, slaughter of wildlife, land devastation, road damage, highway gridlock, rush-hour tie-ups, inflation, malinvestment, unemployment add up to a gruesome butcher’s bill for just the four cases we discussed.

The Western world is currently undergoing a protracted financial crisis traceable to government overspending and debt. The crisis has its origins in the expensive free lunch.

DRI-398 for week of 8-5-12: ‘Buying Local’: Reinventing the Wheel – Square

‘Buying Local’: Reinventing the Wheel – Square

According to popular folklore, the 1950s were temperamentally straitlaced and artistically straitened, a time of airless conformity and retrograde sentiment. By contrast, the present day is technologically advanced, artistically avant garde and politically progressive.

Neither stereotype stands up to scrutiny. The 50s produced critically acclaimed cinematic masterpieces like Vertigo, The Searchers, Singin’ In the Rain, Touch of Evil and The Night of the Hunter. They spawned the Civil Rights movement, Jack Kerouac, the Beats and the birth of National Review magazine. The current cinema is top-heavy with inferior remakes of previous classics, knockoffs of television series and comic-books. Our politics is poisoned by the zero-sum implications of the bi-partisan devotion to big government. We stand on the verge of repudiating the commitment to freedom and individualism made by the Founding Fathers over two centuries ago.

Historians will one day cite the doctrine known as “political correctness” as one of the most toxic pollutants of the political climate. One ingredient in the politically correct brew is the behavioral posture known as “buying local.”

The Principle of Buying Local

The guiding principle behind “buying local” (hereinafter, “BL” for purposes of brevity) calls for consumers to confine their purchases, as much as possible, to production originating in the local community. This program is deceptively simple. Close examination, however, reveals that it is adherents who are deceived.

The simplicity of the plan dissolves as soon as one tries to put it into practice. In order to limit purchases to goods produced in the local community, one must distinguish local from non-local. For exemplary purposes, consider the metropolitan area of Kansas City, MO/KS. This is an area of over 2 million people, overlapping the border between two states, consisting of over 30 separate, contiguous municipalities.

Does each one of those municipalities constitute a “local community?” Do the residents of Fairway, KS (population 3,952) pointedly refrain from shopping in neighboring Westwood, KS (population 1,533)? Should they both religiously shun neighboring Kansas City, MO (population 440,885), immediately across the state line to the west and MIssouri’s largest city? In practice, it is safe to assert, virtually nobody does. After all, Kansas City is where the lion’s share of gastronomic, artistic, athletic and cultural amenities are located – not to mention more mundane but even more practical venues like Wal Mart, Target, Costco and the Country Club Plaza (the world’s first outdoor shopping center) are located.

Very well. We will assume that advocates of BL will stipulate that the entire Kansas City metro area qualified as a “local community.” Once that’s settled, we confront questionable cases like Olathe, Leavenworth and Lawrence, KS and Peculiar, Harrisonville and Belton, MO – all small towns lying within a 40-mile radius of Kansas City. And the argument is reversible, since residents of Kansas City will want to travel to and import goods and services from these outlying communities.

Suddenly, it dawns that there is no objective, universal meaning to the term “local community.” This effectively torpedoes the concept. But that does not destroy its usefulness, which is utterly independent of economic logic and practical value.

Emotion and Politics

BL is a useful concept because pretending to use it allows people to regard themselves favorably. Because they associate the term with pleasant feelings, they do not react badly when they see the concept used to practice economic protectionism;that is, totake money away from efficient producers and give it to inefficient producers. Thus, buying local is useful to those who advocate and promote protectionism. Mostly, these are left-wing sympathizers like union members, environmentalists and central planners.

Ever since the dawn of the Industrial Revolution and the advent of mass production, small-scale production has been gradually but continually displaced by large-scale, mass production. The assembly line allowed larger quantities of output to be produced at lower unit cost than older production systems such as handicraft and piecework. All other things equal, the law of demand states that consumers will wish to buy more of any good at lower prices of that good. A corollary implication is that consumers will prefer to buy a lower-priced good to a higher-priced one – provided they view the two goods as otherwise homogeneous.

Mass production allowed firms to serve national markets. Larger firms tended to displace small, local firms. This trend began in the 18th century and continues today. Decades ago, Wal Mart established itself by entering small-town markets and displacing the monopolies enjoyed by local merchants through Wal Mart’s low prices and tremendous variety of goods. Now it faces competition from discount retailers like Target and Costco.

The economic logic underlying this historical evolution is unassailable. Countries, states, regions, cities and municipalities specialize in producing goods that highlight their “comparative advantage,” which means goods whose production they can accomplish with the smallest sacrifice of alternative output. After production, the goods then travel throughout the world via trade – international, intranational, inter-state and inter-local. Money tends to obscure the underlying barter nature of this trade by interposing itself as a medium of exchange.

Although efficient trade tends to optimally enhance the real income of just about everybody, less efficient producers often object to the outcomes realized under competition. That is where BL comes in. Promoters use it as a pretext for preventing consumers from buying lower-priced outside alternatives to local goods, or trying to, or scolding consumers who succeed. The local producers and their employees gain from this interference. The promoters of BL gain power and influence as brokers of the benefits enjoyed by local producers. And these gains come at the expense of everybody else.

The Tribal Roots of BL

The pleasant feelings associated with BL are stimulated by human instincts traceable to the evolution of our species. When male/female pairs began to aggregate into groups, the human race spent thousands of years developing habits conducive to the survival and growth of the local tribe. Production was organized to benefit the group; dependence on outsiders was dangerous. Although trade dates back as far as recorded history, the full realization of its advantages developed slowly.

Over time, more sophisticated institutions took the place of the tribe. Religion provided a form of group identification, as did geographic origin and residence. With the nation state came confederations bringing together towns, states and regions under one banner. The common denominator of appearance made ethic membership another popular source of group differentiation.

The ambiguity of the word “local” makes the concept of buying local to stretch far enough to cover all of these bases. Jews can feel good about keeping kosher. Residents of Tightwad, MO can feel virtuous about keeping their deposits at Tightwad Bank instead of Bank of America. Without quite realizing why, we can all bask in the inner glow of belonging to the tribe.

What’s the Harm?

Casual boosters of BL may object to the objections raised by economists. What’s the harm in a little local color, a little local favoritism? After all, we’re going to buy our vegetables somewhere, aren’t we? Surely economists aren’t suggesting that we shouldn’t root for local sports teams and nourish local traditions, are they?

An example may clarify the relevant distinction. Professional sports leagues were organized by creating teams linked to geographic localities (typically cities). Observation indicates that most people root for and identify with teams based on “tribal” factors like geography. On the other hand, some people derive pleasure from sports based purely on the athletic excellence displayed, regardless of geographic loyalty. If tribal loyalty is itself an originary source of happiness or utility, economists have no basis for decrying it. But the suggestion that tribal loyalty should be artificially elevated above otherwise higher-ranking considerations of economic efficiency is wrong.

There is nothing wrong with being a fan of the New York Yankees. There is nothing wrong with living in New York and being a fan of the New York Yankees. But saying that New York residents must (or should) be Yankees fans is wrong. And the inherent meaning of buying local is that natural market outcomes cannot be trusted and must be overridden in favor of local loyalty. Otherwise, why would we need the slogan?

Most people are quite willing to subordinate the appreciation of athletic excellence to tribal loyalty because it costs them little or nothing to do so. But in cases where it does cost- perhaps quite heavily – to elevate the tribe above all else, it is idiotic to do so.

Price and Perishability

This is the moment to point out that local production has its own set of countervailing advantages and efficiencies, sometimes offsetting those of mass production and national markets. The beauty of free markets is that these are already reflected in the data generated by market competition – we do not need the artificial intervention of BL to make us aware of them.

One of the most frequently cited products by BL advocates is local produce. This is hardly surprising. Consumers across America have come to know and love the products purchased in New York’s Fulton Fish Market, San Francisco’s Fisherman’s Wharf and the Farmer’s Market in Los Angeles’ Westwood Village. There are sound economic reasons why these markets arose and endured throughout the era of corporate farming and aquaculture.

After goods are produced, they must find their way into the hands of consumers. Since the locus of production is chosen to minimize production costs, it will be close to some consumers but distant from others. The price of any good must reflect not only the costs of production but also the costs of transportation from production site to the consumer. In this respect, local production has a built-in advantage – by definition, transport costs are lower for local production than for non-local. But this advantage is automatically conveyed to consumers via the price system, in the form of a lower price – or rather, a lower transport-cost component of the price. This invisibly nudges consumers towards local production. There is no need to interpose BL in the decisionmaking process. Of course, the influence of lower transport costs may not be decisive, since other factors may more-than-counterbalance it.

Although economics textbooks sometimes downplay the fact, quality is a choice variable no less important than price. One drawback of produce is its perishability. Local production enjoys another automatic advantage over non-local here and in the closely-related characteristic of freshness. And once again, markets transmit the qualitative superiority of local produce to consumers without the quasi-coercive force of BL being applied. The continuing survival of city produce markets and roadside vegetable stands is tacit evidence of this.

BL in Action

In its most innocuous form, BL is found in casual references on a variety of media. Hosts and callers to sports-talk shows will urge fans to support the home team by implying or stating outright that “loyalty” demands it. While analytically indefensible, this is comparatively harmless. The relevant comparison is to demands that taxpayers be made to support sports teams with subsidies ranging from operating subsidies to sweetheart stadium leases to bond issues supporting stadium construction. Although the rationale for sports-team subsidies often invokes secondary, multiplier benefits and job creation – none of which has the slightest logical or empirical validity – the tacit premise lurking underneath the pseudo-economic jargon is that tribal loyalty, usually disguised as civic pride, should rule.

In hiring, there may be something to be said for resolving toss-ups or obscure choices in favor of local candidates. For one thing, familiarity with local conditions may carry some advantages in buying, negotiating or adhering to protocol. But BL is a time-honored means of delivering graft by requiring city contracts to give preference to local contractors, vendors or labor.

An all-star example of the BL fallacy is the insistence that BL will “keep your money in the local economy” – as if that were a desideratum devoutly to be wished. The best way to apprehend the money-leakage fallacy is to compare a local community to a country in international trade. When U.S. citizens buy foreign goods, they send dollars outside the country – or, more precisely, to the foreign-exchange market, where the dollars exchange for foreign currencies. But this dollar exodus is not permanent. Foreigners do not consume dollars directly by eating them or using them to mop their brows. As a first approximation, they will buy them from foreign-exchange dealers to use in buying U.S. goods. Now the dollars return home. (Observe that the fundamental nature of exchange is barter, the trade of goods for goods, even though money greatly facilitates this exchange process.) This logic applies to purchases of financial assets as well; the only effect of BL will be to prevent local residents from enjoying a higher rate of return on their money.

Movements in exchange rates and trade in financial assets will tend to equalize the value of a nation’s imports and exports over time. This even holds true when exchange rates are fixed and invariant, although the outcome is accomplished not through movements in exchange rates but through money flows and changes in real income and employment. The same thing applies to local communities – trade inside the U.S., for example, is conducted in a common currency, so imports and exports between the community and the rest of the country tend to equalize. It is true that occasionally a “dying” community will suffer when business leaves and money flows in only one direction. BL will not rescue this situation, though – it will merely lower the standard of living of remaining inhabitants. Lack of tribal loyalty did not cause the civic mortality and BL cannot cure it.

The international realm is the venue for perhaps the most popular display of BL. It is also the only one to attract much serious support from economists. This is the demand for preference towards “indigenous production” in developing countries. In practice, it is usually invoked in support of local agriculture. Expressed concisely, it invokes a scenario in which the real income effects of price changes overshadow the substitution effects. Farmers are so numerous that they cannot benefit from purchases of imported agricultural products, even when those products are lower-priced. The resulting loss of demand for their output causes farmers to lose more as producers than they gain as consumers. Farming is so dominant that the gains in non-agricultural sectors cannot compensate for the net losses suffered by farmers.

The remedy prescribed by the left-wing is BL on a national scale – the restriction or outright prohibition of agricultural imports from developed nations. The problem with this cure is that its success keeps the patient on permanent life support. The only hope for economic growth is to diversify the economic base sufficiently to achieve some measure of balanced development. Protecting domestic agriculture has the opposite effect; it keeps resources employed in agriculture instead of diverting them into alternative sectors.

BL, Raw Materials and Economic Development

The case of (potential) immizerizing trade is by far the exception in international economics. The typical case is that of a developing country producing raw materials, particularly extractive substances such as tin, oil, or rare minerals, or raw agricultural commodities such as cocoa or coffee beans. It would be absurd to limit consumption of these substances to their production locus; in fact, they are transported throughout the world and used as production inputs in thousands of goods and services. Less developed countries are heavily dependent on income from their export. Yet the BL doctrine, taken literally, would dictate their exclusion.

Really, the current flap over BL is simply the same as the “buy American” imbroglio that periodically emerges to bedevil U.S. consumers and economics instructors. Scratch almost any product and you discover that there is no such thing as a purely American good, because the complexity and efficiency of modern markets enables least-cost production to combine inputs from around the globe. Toyota is a “foreign” car because of its nameplate, but it is assembled in the U.S. and its so-called “American content” exceeds that of many domestic models. Meanwhile, goods with impeccable American pedigrees nonetheless employ inputs and labor from abroad.

A list of thousands of key imported inputs used in everyday U.S. production is sufficient to scotch any realistic notion of BL as an actual program. Some of these inputs are imported because they do not exist within our national borders. Others could be produced here, but only as astronomical cost. Still others were domestically produced or still are, but cannot be produced in sufficient quantities to meet domestic demand.

BL and Environmentalism

BL is so economically unsound that only political coercion could even begin to put it into widespread practice. Thus, it has much in common with environmentalist doctrine, which is likewise based on emotive, tribal considerations that dissolve into contradiction when subjected to scrutiny.

The modern reaction against “globalism” is clearly related to BL; indeed, “localism” may be viewed as the opposing metaphor to “globalism.” Environmentalists have hopped onto the anti-globalist bandwagon and made common cause with such fellow left-wingers as labor unions and socialists. Labor unions oppose international trade because trade seeks out least-cost production, and this enables producers to circumvent the local labor monopolies created by unions by importing goods created using non-union foreign labor. Consumers and foreign workers gain from this trade, but union monopolists are left out in the cold – at least in their capacity as sellers of labor, anyway.

The environmentalist link to BL Is forged by the trendy recourse to the theory of man-made global warming, which pinpoints the atmospheric release of carbon dioxide as the culprit. The environmentalist mania for reducing individual and corporate “carbon footprints” has provided a pretext for BL, on the presumption that less transport must mean less carbon usage. Not only is this an unsound generalization, it is also wildly impractical. Even the most powerful socialist dictatorship would not possess the necessary knowledge to calculate the carbon footprints of the hundreds of thousands of goods and services produced and consumed by billions of humans, let alone to successfully coordinate economic life in such a regime. The problems posed are those of “buy American” increased exponentially. And, of course, all this assumes the correctness of the initial theory.

BL is BS

BL pretends that economic problems can be reduced to a crude level and solved with reference to simple geography. But the only valid points made by the BL program are already automatically incorporated into the data transmitted by the free, competitive price system. Meanwhile, that price system also integrates a vast amount of additional subtle and complex data that BL does not even begin to contemplate. Thus, BL not only represents an attempt to reinvent the wheel – it reinvents it square.

In sum, then, BL veers between meaningless platitude and hard-core protectionism. Sliced either way, it is baloney. BL is BS, a victory of style over substance in the great politically correct tradition of the left wing.

DRI-438: Oh, Yeah? Prove It!

One of the unique American strains of thought is pragmatism. Confronted by a problem or a matter in dispute, the ancient solution was to rely on tradition or religion to settle it. The founding of America changed this. Our enshrinement of freedom and discovery of economic growth gave us a practical bent. We didn’t take someone’s word on faith or follow tradition blindly. We looked for demonstrable answers.

This has been characterized in various ways. Harry Truman said, “I’m from Missouri and you’ve got to show me.” Economist Donald McCloskey expressed the same basic insight differently but with equal bluntness by posing the “American question:” “If you’re so smart, why aren’t you rich?”

Economics provides a logic of choice. Many illuminating implications can be developed from it. Below, we use them to test the truth or falsity of conventional thinking. In each case, a nugget of conventional thinking is subjected to a classic American test of skepticism.

When somebody says something outrageous, a reflex response is: “Oh, yeah? Prove it!” This becomes more than mere reflex when economics suggests that a valid burden of proof can be placed. We do this below. “Oh, yeah? Prove it!” (hereinafter, OYPI) is the challenge we issue to convention, using economic logic as our engine of proof. In each case, a familiar claim is followed by the OYPI challenge that, if taken up, could prove or disprove it.

Employment Discrimination Against Women By Men

#1: “Women earn a mere 77 cents for every dollar earned by men. This ‘gender gap’ is the result of discrimination exerted upon women by men.”

OYPI: Hire women, in order to profit risklessly from the productivity differential implied by the “gender gap.” The word “discrimination” implies that women receive less monetary remuneration for equally productive work effort. This means that employers can automatically earn more profits for a given less of output than competitors (who practice discrimination against women), simply by hiring women.

Of course, the source of riskless profits from female hires cannot last indefinitely. The profits earned by the firms that hire women will attract attention and imitation from other firms. Even if we assume that the misogynistic obsession with discrimination continues to overshadow any desire or need to earn profits, financial capital will still flow to the firms that do hire women. Those firms will expand. Eventually, the wages and salaries of women will be bid up. As long as any differential unrelated to productivity remains, the process of female hires and bidding up of women’s compensation will continue. The “equilibrium” position is the outcome toward which a competitive market will gravitate and the only one consistent with long-run stability. It will produce one of two possible results. Either wages and salaries for separable, identifiable groups of people will be equal, or they will differ according to variations in productivity between the groups or differential hiring costs associated with the groups.

Since exponents of discrimination theory insist that there are no systematic productivity differences between men and women – as opposed to differences between individual men and women – they are insisting, in effect, that riskless profits lie on the table waiting to be scooped up by employers who hire women.

The reflex response of discrimination theorists (DTs) might be that males (hard-core DTs would probably refine this to “white males”) pervade and dominate higher echelons of business. First and foremost, this is false – there are some female CEOs and numerous large and small businesses headed by women, such as the multi-billion real-estate empire founded by Barbara Corcoran. Even more to the point, women control an estimated 51% of the nation’s wealth. Presumably, they would be delighted to bankroll a venture that would earn supra-normal profits by exploiting the under-utilized talents of women in business. Techniques might be as simple as employing women for hourly wages or as complex as backing a fund that owns shares of female-headed businesses.

If discrimination theorists really, truly believe their own claims with their whole hearts and souls, they will cheerfully put their money where their mouths are, even to the extent of mortgaging their net worth. If they succeed in earning the riskless, supra-normal profits whose potential is implied by their claims, they have proved their case. If not, they have proved themselves wrong.

And if they refuse to take up the challenge, it will mean that they don’t really believe their own rhetoric and all their talk of discrimination against women was a sham designed to obtain through deception what women could not earn through their own efforts.

Supra-Normal Profits Earned by Big Oil Companies

#2: “Big oil companies continually earn obscene, windfall, record profits by gouging American consumers, charging exorbitant prices for oil and oil-derivative products.

OYPI: Buy shares of publicly traded big oil companies in order to recoup real income by earning the obscene, windfall, record profits in the form of dividends and capital gains. No American citizen can fail to notice periodic bemoaning of oil-company profits by news media. These lamentations note “record” profits of firms such as Exxon/Mobil and lavish pay for executives.

Since most of the biggest oil companies are publicly traded, the indicated course of action would be for detractors to buy “a piece of the rock” by purchasing shares of the offending companies. This would tend to more-than-offset any dip in real income associated with higher oil prices.

Broadly speaking, there are two possible outcomes of these projected purchases. One possibility is that the oil companies do indeed possess the market power to realize the monopoly profits claimed by critics. If so, these profits would be passed on pro rata to those critics, who are now shareholders. Of course, the critics would not be obligated to retain them. They could distribute them to the poor, invest them in programs to support alternative energy or donate them to the government, at their discretion.

The second possibility is consistent with the decades of analysis devoted to oil companies by the economic specialty known as industrial organization. Economists know that it is absurd to evaluate profits, market power and structure in terms of absolute dollar magnitudes. For most of the last 30 years, ExxonMobil has been the largest private company in the world. In order to provide a competitive rate of return on the gigantic volume of investment capital advanced by its owners, the firm has had to earn a huge volume of profit. That huge volume of profit, however, delivers a rate of return to its investors that is satisfactory but hardly spectacular. Critics who take themselves seriously enough to buy shares will discover this homely truth, doubtless to their chagrin.

While this may be unfortunate from the standpoint of somebody who expects to get rich quick, it could hardly be any other way. The rate of return on any investment depends on the price paid for the asset. Any asset that promises a stream of above-average profits will be avidly pursued. This will drive up the asset’s price until the asset’s rate of return is no longer supra-normal in magnitude but instead merely commensurate with the risk taken in generating the profits. The jargon term economists use to describe this state of bare sufficiency is a “normal profit.”

All this is second nature to economists but journalists betray no sign of familiarity with it. Obscene Profit Theorists have dominated the popular landscape since the 1970s. If journalists and activists believe their own stories and op-eds, their logical course of action is to buy shares in companies such as Exxon/Mobil. Their professional code of fidelity to truth demands that they then report the results of their purchases to their readers.

If they actually receive the supra-normal, monopoly profits that they claim the oil companies are earning, they can document this via their rates of return on financial statements and increases in their net worth. If not, they can print retractions of their long-running vilification campaigns against big oil.

And if they ignore the challenge, they will have to explain why they passed up a simple opportunity to make money and make their case at the same time.

The Ostensible Advantages Enjoyed by Illegal Immigrants

#3: “Illegal immigrants receive free health care and welfare benefits. Their children are entitled to in-state (or free) tuition rates for education. They are treated better than native-born citizens.”

OYPI: Renounce American citizenship, cross the border and re-enter illegally. Live as an undocumented alien and meticulously document the daily facts of that life.

The premise behind much opposition to immigration – whether legal or not – is that the sum of entitlement benefits available to immigrants exceeds that attainable through work as a low-skilled worker. Indeed, some claim that illegal immigrants receive a larger real entitlement income than do native-born American citizens.

This belief, coupled with the corollary belief that immigrants cross the border with comparative ease and legal impunity, creates a stylized narrative of immigration with two key conclusions. First, immigrants come here for leisure, not work. Second, their benefits come at our expense; immigration is a net cost that makes us worse off than we would be in its absence. (Immigration opponents often insist that they oppose illegal immigration while approving, or at least tolerating, legal immigration. This is why we preserve the legal distinction here, even though there is no economic difference between the two.)

This narrative is hotly disputed by supporters of immigration, particularly economists. Given this, it would seem that Anti-Illegal-Immigrationists (AIIs) could not only prove their case but increase the living standards of the poor among their ranks by assuming the identity of the illegal immigrants they deplore.

If things go as the AIIs anticipate, they will have refuted the pro-immigration claims of their opponents. They will have powerful evidence to support a ban on immigration, or a reform of the practice. Of course, this would require a certain amount of work and intestinal fortitude on their part, but if they really, truly believe their own words, the sacrifice would be modest and the potential gain would be significant. After all, they needn’t work, since their central conclusion is that immigrants can earn more than a subsistence living simply by living off the fat of the land.

It seems only fair, though, to point out that the AIIs claims are somewhat inflated. Begin with the border passage itself. If the crossing is as easy as AIIs claim, how can smugglers command a four-figure fee for conveying illegals into the U.S. from Mexico? Why do so many illegal immigrants risk their lives crossing deserts and rivers? Why do hundreds lose their lives annually in the process? Well, we needn’t speculate on the answers to these questions, because AIIs will soon supply them from first-hand experience.

Another point on which AIIs can enlighten us is how illegal immigrants can hope to receive welfare benefits for which they do not qualify. The bureaucratic red tape that must be cut prior to receipt of federal cash or in-kind benefits is legendary. Illegal immigrants are legally ineligible for them. It is true that hospital emergency rooms must treat all applicants, whether citizens or not. But recipients are presented with a bill, and the hospital is just as entitled to collect from illegals as from citizens. Moreover, since illegal immigrants are actually somewhat more likely than low-skilled citizens to hold a job and earn income, the chances of collecting from illegals are probably better.

Receipt of low- or no-tuition public education is not a differential advantage for immigrants; it merely means they have a shot at the same lousy education as American citizens. Of course, it is true that illegals do not pay many of the taxes paid by Americans, such as income and property taxes. But they also do not receive many of the services and benefits we enjoy.

It should be noted that even if AIIs should turn out to be wrong about the relative advantages of illegal status, their acceptance of the OYPI challenge should yield highly useful information. One of the few demonstrable Congressional accomplishments of recent years was welfare reform in the 1990s. But that reform affected only one of the six categories of welfare benefits. It is probably a very bad idea to sever the link between receipt and payment of medical and educational services, both for Americans and immigrants. The OYPI challenge would shed additional light on these matters.

The most dramatic effect of this OYPI challenge would result if AIIs should take up the gauntlet only to die of thirst in the Mexican desert or suffocate crammed in the back of a truck full of illegal immigrants. Not only would they fail to prove their argument, they would fail to survive. But they would not die as hypocrites, but as honest men, however misguided.

On the other hand, if they refused to take up the challenge, they would remain alive. And they would live the rest of their lives with the realization of their own hypocrisy.

The Demand that Companies Pay Living Wages and Provide Health-Care Benefits

#4: “Companies should give their employees generous packages of health-care benefits and pay a ‘living wage.'”

OYPI: Form a company organized around the policy of industry-leading health-care benefits and guaranteeing wages and salaries sufficient to enable purchase of specified market baskets of goods and services.

For many years, left-wing commentators have opined that the “social responsibility” of business demands that companies meet certain threshold levels and forms of compensation to employees. Provision of health insurance and the offer of a “living wage” are the two best-known indices of this degree of compensation.

Certain axioms are planted deep within these demands. These are seldom, if ever, made explicit. The most fundamental is that companies can survive after meeting these standards. The presumptive basis for this claim is that worker productivity will rise sufficiently to offset any increased costs to the firm arising from the necessity to incur higher payroll costs or pay higher wages.

If adherents of Social Responsibility Theory (SRT) really believe this, then their course is clear. They shouldn’t wait around for business owners or managers to succumb to their persuasive arguments. Instead, SRT adherents should start businesses and do exactly what they demand of currently-existing businesses.

Provide generous health-care benefits to all employees. Pay a “living wage” to everybody, regardless of what employees earn currently.

SRT is perhaps the preeminent example of what the great black economist Thomas Sowell calls “volitional economics.” That is, our actions are governed not by constraints imposed by market prices and quantities but rather by our wishes. If we want a certain outcome to result, all we have to do is aim directly at that outcome, and it will eventuate. The failure to achieve it is attributable directly and simply to our unwillingness to try for it.

If we really and truly believe in SRT, then we should demand of SRT adherents what they demand of us. They should have to start businesses and live by the rules they craft for our use. After all, nobody has a stronger incentive to bring about the outcomes demanded by SRT than its own followers. If they can’t do it, it’s safe to assume that the job can’t be done.

If that is the case, it will be because businesses do not exist for the express purpose of providing real income for employees. A business is merely an intermediary between input suppliers and consumers; it allows the former to specialize in their highest-productivity occupation and the latter to receive goods in final form instead of dealing with each input supplier and then assembling the good themselves.

In order to maximize their real income, consumers want to buy each good they consume at least cost. Consumer demands discipline business behavior, forcing businesses to cut costs to the bone. This means that businesses pay wages and salaries based on the employee’s productivity, not on the employee’s needs or wants. In a competitive market, a business that based its hiring and employment decisions on fuzzy-minded notions of generosity rather than on the constraints of market prices and wages would go broke.

The consumers who ruthlessly punish any business that increases wages or benefits in excess of productivity are the same people who yearn for wage or benefit hikes. In effect, consumers are saying, “Raise my real income, but don’t you dare do the same for other people.” Of course, this is a logical contradiction. But every worker is also a consumer; everybody benefits from the cost consciousness created by marketplace competition.

SRT adherents do not believe this, or at least pretend not to. Which gives us the right to confront them with the classic American rebuttal: Oh, yeah? Prove it! Start your own company and practice what you preach. If you succeed, you have made your case. If you fail, your argument fails with you.

And if you ignore the challenge, you have deliberately passed up the chance to prove yourself right.

The OYPI Challenge

The common denominator linking each OYPI challenge is the fact that the popular assertion implies an opportunity for making money is being overlooked. In order to defend the assertion, it is necessary to show the existence of this opportunity by seizing the opportunity and making the money. If this cannot be done, then the assertion is disproved – to the extent that any statement can be disproved.

And if the challenge is ignored, that means that the authors of the statement didn’t really believe it. They were trying to gain by lying.

DRI-473: Digital Replaces Film – the Technological Tradeoffs

Economics often seems like a foreign language to the general public, whose grasp of the subject is uneasy at best. Raising the topic of technology illustrates this vividly. The general public’s attitude toward technology fluctuates between wide-eyed wonder and stark paranoia. Economic theory treats it as a parameter – something whose boundaries are tentatively fixed, but allowed to vary conceptually for purposes of analysis. Empirically, economists acknowledge it as the key process behind human progress.

The public intuitively realizes that technology is good, but has a hard time explaining exactly what is good about it. The closest they can come is by citing scientific breakthroughs like the polio vaccine or new products like cell phones. They are sure that it has a downside, though. For one thing, we never can tell when technology will rampage out of control through humanity’s ranks like a maddened bull loose in an antique store. And everybody knows that machines create unemployment by taking jobs formerly held by people.

Economists view the workings of technology in the context of production. Anything product or process than enables us to get more output from the same quantity of inputs (or the same amount from fewer inputs) is a technological improvement. Real-life innovation seldom makes breakthroughs – innovation proceeds in painfully slow, incremental steps. A 2% annual improvement in total factor productivity would be phenomenal. Over many decades, this steady pace of industrial progress has attained our miraculous modern standard of living.

The displacement of workers by machines is not a disaster and does not create unemployment, per se. It frees up human beings to produce more output in relatively labor-intensive sectors. Our life today would be unthinkable in the absence of the substitution of capital for labor that began at the dawn of the Industrial Revolution. Unemployment results from friction created by minimum-wage laws, labor union restrictions, prevailing-wage laws, direct and indirect disincentives to employment created by affirmative action and quota legislation, anti-discrimination statutes, payroll and other taxes and the myriad of other measures allegedly intended to protect the worker. Thus, economists evaluate the ultimate effects of technology by gauging its impact on the volume of goods available for consumption.

There is a tradeoff demanded by technology. It comes not in the form of employment but rather in the quality of consumption. This point of theory cries out for a concrete example. As it happens, we are experiencing it today in America’s leading export industry and artistic gift to the world – the movies. Film – the physical medium of motion pictures for over a century – is being replaced by digital technology.

The Decline of Film and the Rise of Digital

For almost a century, Americans have gone to the movies as a cherished form of popular entertainment. The term “movie” is short for motion picture, a medium that began with the magic lantern shows of the 19th century and evolved into the flickers and shorts around the turn of the century. At first, the movies were silent. When technology developed a way to synchronize the projection of a picture with an accompanying sound track, they began to talk.

Now looked upon as art, movies became “film,” as in “film critic,” “film society” and “film festival.” The word came from the physical stock upon which the photographed movie was developed and printed – silver-nitrate film with 35-millimeter width. (16-millimeter film was a cheaper substitute, manufactured in non-nitrate form – which turned out to be an advantage.) Nitrate film stock possessed ideal viewing qualities, as attested to by older cinephiles today. When perfectly preserved, old black-and-white films are visually stunning.

Unfortunately, nitrate film also had serious drawbacks. First, it decomposed into sludge over decades unless carefully held in cool, dry conditions. (Today’s storage caves are ideal.) Second, nitrate films were highly flammable. Over the years, thousands of films produced by old-line Hollywood studios have perished in fires, along with numerous warehouses and a few employees as well. Even movie theaters experienced occasional fires.

Around 1950, the big studios switched to acetate (“safety”) film. Celluloid film has remained the medium of movies ever since. Until the advent of digital technology, that is.

With the rise of computers and digital technology, the movie business reached a watershed. It became possible to photograph a movie using technology analogous to that used to make home videos. This had revolutionary implications for both the production and the exhibition of motion pictures.

Digital Economies in Motion-Picture Production

Formerly, motion pictures were photographed by craftsmen using sophisticated cameras and the film was rushed to labs for development. On large studio production, the day’s efforts (“dailies”) might be available for viewing late the same night. Re-takes of scenes considered unsatisfactory were scheduled later in shooting – or postponed until after production. Eventually, the rough cut of the film was submitted to an editor or “cutter” for tailoring into a finished product – a process that might take weeks or months to complete.

Today, the movie is shot using digital equipment and stored in a computer. The footage is available to immediate viewing and editing. This not only simplifies and streamlines the editing process but also allows immediate re-takes. The amount of time and money saved thereby is vast.

Sophisticated editing is still a fact of movie life. Now, however, it is mostly done in order to create and insert “computer-generated effects.” Where formerly the dictates of filming an epic movie might have demanded a “cast of thousands,” now people and things can be digitally inserted into the movie to simulate reality. Special effects were used in movies virtually since their origins, but today their scope and sophistication is unparalleled. Again, the time and money saved is enormous.

Digital Economies Motion-Picture Exhibition

The impact of digital technology is just as great on the exhibition of movies as on their production. Today, a movie shot on celluloid film stock must be printed, then transported inside a protective metal shipping canister to every single theater showing the film. The average cost per-print is approximately $1,500. In contrast, the average cost of a digital movie disk is about $150 per copy.

Assume, for illustrative purposes, that the releasing studio will show the film in all 4,000 multiplex theaters nationwide. The total costs per-movie would then be $6,000,000 for celluloid film and $6,000 for the digital disk. Assume an annual industry output of about 200 films. (Although the six major studios produce a smaller total, independent filmmakers make a significant number of films that are released by the studios, who absorb the exhibition costs.) These rough estimates let us comprehend the figures cited by Gendy Alimurung in LA Weekly‘s article “The Death of Film,” which gives annual industry film-print costs of approximately $850 million and delivery costs of $450 million. In a typical year, around a billion dollars would be at stake in a choice between movie media.

The Triumph of Digital; the Demise of Film

For the movie studios, the superiority of digital over film is decisive. But motion-picture exhibition has been geared toward film for a century. Until recently, each theater had a projection booth containing a film projector, into which the physical film was deposited. That projector was operated by a projectionist, who was often a member of a craft union.

In the last ten years, that picture has changed dramatically. The movie studios have begun to subsidize the cost of switching theaters to digital projection, which requires substituting computer technology for film projectors. That runs anywhere from $70,000-$150,000 per screen. The subsidy takes the form of a “virtual-print fee” paid by the studio to the theater for each new digital release over the next ten years. The changeover relieves theater owners of a considerable portion of their labor costs by reducing the number of people needed to show films and eliminating the need to pay wages inflated by union scale.

There is a downside to the transition. Studios will refuse to distribute films from their vaults to theaters that do not make the transition or, more precisely, will make them available only in digital format. Since studio vaults are the principal source of films for revivals, festivals of classic films and repertory houses that specialize in showing older films, this will confront old-line theaters with a Hobson’s choice. Either they must cut their ties to film or risk losing their source of supply altogether.

In the event, digital is winning the battle. By the end of 2012 digital will replace film as the dominant mode of film exhibition. In another three years, film exhibition is projected (no pun intended) to become scarce.

The Real Tradeoff of Technological Innovation

Based on the above, the superiority of digital to film may seem clear-cut. In fact, there are key tradeoffs involved in the transition. But they are not the ones felt by producers, or directors who prefer to work with film, nor by exhibitors who are squeezed by the major studios. They are not really felt on the supply side of the market at all.

The tradeoffs are experienced by consumers of movies. They are the people left out of account in most descriptions of the digitization of motion pictures. Yet movie fans are the ones that the movies are produced for in the first place. Consumers are the yardstick by which economists gauge the value of economic activity.

When movies switched from nitrate film to acetate, the studios were clear winners. They saved on the costs of safeguarding and preserving films. It was movie fans who had to put up with the slight diminution in quality of their viewing experience. As it happened, the era (beginning about 1950) coincided with a trend toward more grit and realism in movies, which probably cushioned the effect of the loss in visual beauty.

Today, digital projection is less sharp and realistic than celluloid film. Movies simply don’t look the same as they used to. Because more movies today cater to the youth market and depend on special effects and fantasy, the loss of sharpness and realism may not be felt as keenly as it might otherwise.

But adults clearly do not find the motion-picture experience as enjoyable as they once did. That shows up in declining theater attendance compared to the heyday of movies in the 1930s and 1940s, when average weekly movie attendance exceeded half the total population of the country. Today, it barely reaches 10% of total population. Of course, that trend began long before the advent of digitization. But the popularity of classic film in venues like cable TV’s Turner Classic Movies channel suggests that the adult demand for film is alive and well; it deserves its say in the battle over digitization.

In addition to the apparent tradeoffs, others lurk beneath the surface. Alimurung notes many of them in the LA Weekly piece. Superficially, digital technology seems permanent. A film is inherently mortal; tiny pieces of the film chip off with each showing, producing wear and tear that will ultimately necessitate preservation and reconstruction if the film is to survive. In contrast, a digital movie is not a physical object, but rather data stored on a computer – seemingly a permanent entity.

This comparison is deceptive. With controlled storage, films can last forever if shown on a limited basis. On closer inspection, digital movies are found to be shockingly ephemeral. For one thing, computer formats change frequently, thereby necessitating digital transfer of the movie as well. This might not be too onerous for the most popular movies, but the purpose of movie preservation is the stewardship of a cultural heritage. After all, over half of all films produced are now lost due to decomposition or dislocation. This includes many famous classic films from the silent era. To make matters worse, digital movies physically deteriorate faster than do films, particularly if not shown regularly. To top it off, digital equipment is much more fragile than film projection hardware. The latter can survive for decades; digital equipment tends to be shorter-lived, more fragile and more expensive to replace.

Oh, one more minor detail. Every computer user shudders when remembering how easy it is to blow away a data set. Well, that’s just about how easy it is to destroy a digital movie.

The End of Movies?

The possible implications of these tradeoffs are disturbing indeed. They imply that the short-run attractions of a full changeover to digital technology could – in the long run – eventually destroy the movie business altogether. The costs of frequent changes in formats could eat up the immediate savings of the change, driving theater owners from the market. The costs of digital transfer could make the maintenance of film libraries prohibitively expensive, limiting movies to first-run exhibition and leaving viewers of TCM with nowhere to turn. The market for new movies has become increasingly dominated by movies targeted at the young. Most of these movies do not turn a profit from ticket sales per se, but rather from concessions and merchandising tie-ins.

This is not a scenario of a healthy industry with a bright future. It is possible that the movie business may become – may already be – a dying industry.

The jobs lost thereby would be recovered elsewhere, sooner or later. But the value lost would never be recovered. This is the real cost of technology. It has always been there. The disappearance of hand-crafted goods replaced by assembly-line production, the demise of soda-fountain soft drinks superseded by the bottled variety, the loss of farm-fresh produce in exchange for the ability to feed regions, nations and the world – this is the true price we pay for the rise in our standard of living.

Traditionally, the gain has been well worth the cost. Consumers have been more than willing to sacrifice the slight loss of quality for the huge increases in quantity made possible by technology. Unfortunately, the activities of government today impair the ability of consumers to make an informed choice.

Government Subsidies to Movie Production

For decades, European moviemakers have been subsidized by their national governments. The rationale for this practice has been twofold. First, it has been deemed necessary to offset the “unfair” advantage enjoyed by Hollywood movies, which were generally preferred to the domestic product. Second, it has been justified as a way to preserve national culture, which would otherwise decay and deteriorate. This policy has not produced better European movies, whether evaluated critically or commercially – a fact that has not brought an end to the subsidies.

In recent years, U.S. state governments have significantly subsidized the production of motion pictures. Here, the rationale has been different. It is “economic development.” Ostensibly, motion-picture production has “multiplier effects” on local economic activity that miraculously create economic value that is many times the value expended on the subsidies. Once again, the facts do not conform to the theory behind the subsidies. The Keynesian logic behind the government-expenditure-creates-secondary-multiplier-income-and-employment-gains has conspicuously failed national governments around the world ever since the 1960s. Most recently, it has failed the Bush and Obama administrations, whose stimulus and quantitative easing policies have done little if anything to ease the burden of recession in the U.S. State governments do not possess the power to create money, nor do they possess the fiscal powers of national governments, so there is even less reason, a priori, to expect them to successfully wield this policy instrument even if its theoretical effectiveness were conceded. In reality, there is no evidence that state government subsidies to motion-picture production actually promote economic development.

Subsidies have given us the worst of both worlds. They have made producers dependent on government for survival without giving consumers a better product. The imminence of federal budgetary collapse in Europe, with the U.S. trailing along in the wake, makes it likely that these subsidies will not long survive. This will ill-equip movie producers to respond to the long run challenges posed by digitization of movies.

Rx: Consumer Sovereignty

Is the loss of quality associated with digitization counterbalanced by its advantages? Only consumers can answer that question. But to answer it, they must be asked. That is, they must control the choice between film and digital. Alas, at the very time when the survival of the movie business depends on delivering value to consumers, the attention of movie producers has instead been diverted to short-term considerations – strong-arming theaters into digital conversion and lobbying for government subsidies.

Pharmacists are taught to be on guard against “interaction effects” caused by concurrent ingestion of prescription medications. Movie lovers can only pray that the mix of technological innovation and government subsidies will not prove fatal to their favorite pastime.

Brad Furnish
Chief Economist
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DRI-450: What’s Right – and Wrong – With Economics?

It is obvious to both casual and formal students of the subject that something is rotten with the state of economics. In the physical world, the presence of rot is often evident long before its source is clear. If the economics profession were a barrel of apples, an approaching bystander could sense spoilage from a considerable distance. In these cases, it is just as important not to discard a healthy apple as it is to cull a spoiled one. To help us tell the difference, we need to examine a specimen of each, side by side.

The Concept of Social Cost and the “Coase Theorem”

No better illustration of what is right with economics exists than that of Nobel Laureate Ronald Coase’s famous article, “The Problem of Social Cost,” published in 1960. Coase was writing in opposition to two long- and strongly held beliefs. First was the tradition in the common law of nuisance that required government to assign and enforce property rights to enforce equity. Second, economists have long supported the use of taxes as a means of discouraging producers from imposing costs on third parties.

Coase developed a hypothetical example involving two neighboring landowners, a farmer and a cattle rancher. The rancher’s cattle were allowed to roam at will and trampled the crops of the farmer. The traditional legal approach in such cases is for the law to specify the legal rights, remedies and obligations of all parties. For over half of the 20th century, economists followed the lead of A. C. Pigou, who considered such activities to be an external cost; that is, a cost imposed on the farmer by the rancher even though the farmer was not directly involved in the production or consumption of cattle at the wholesale level. In Coase’s example, an additional head of cattle would cause $300 worth of damage to the farmer’s crops.

According to Pigou, the fact that the rancher’s production activities creates costs not just for himself and his business but for a third party makes this case special. The costs felt by the rancher are the private costs of production, while those felt by third parties are the external costs. The sum of both these types of costs is the social cost of production.

According to Pigou, the solution to the problem was to “internalize the externality;” e.g., make the external cost part of the decisionmaking process by levying a tax equal to its magnitude on the production of cattle. He claimed that this would cause ranchers to reduce their production of cattle to an appropriate extent. To continue Coase’s example, suppose that the additional head of cattle returns $200 in revenue to the rancher. The $300 per-unit tax will make it too expensive for the rancher to raise it; thus, cattle ranching will stop short of this level of production.

But Coase demonstrated that this same outcome would occur even without the Pigovian tax. Suppose, for example, the law allows the rancher’s cattle to roam and does not require damages to be paid to the farmer. In that case, the farmer has an incentive to pay the rancher any amount less than $300 in order to prevent the raising of that marginal head of cattle. And the rancher has an incentive to accept any amount greater than $200 in order to forego that production, since he will net more money by doing so. By paying some amount of money between $200 and $300 to the rancher, the farmer can make them both better off than by watching his crops be destroyed by the marginal head of cattle. It is clear that the marginal head of cattle will not be raised.

Alternatively, suppose that the law stipulated that the rancher was liable for damages caused by his cattle. Now the rancher would be forced to pay $300 to the rancher if that marginal head of cattle were raised. But the rancher would earn only $200 from the additional production. So why would he do it? The answer is that he wouldn’t; the result – in terms of cattle raised and crops left undestroyed – would be the same. The assignment of property rights (or a Pigovian tax) affects the distribution of income or wealth between rancher and farmer, but not the allocation of resources between ranching and farming.

Coase’s result has become known as the “Coase Theorem.” (Interestingly enough, it got its name from George Stigler, who advertised the generality of the result and named it in Coase’s honor.)The Theorem says that – under the right circumstances – Pigou’s distinction between private cost and social cost does not exist because there will be no external costs. In practical terms, it argues against using Pigovian taxes to internalize externalities. For one thing, the taxes would distort other markets since it would be necessary to raise the tax revenue by taxing the production or consumption of some other good. And in real life, individuals like farmers and ranchers have a pretty good idea what their actual costs are and have very strong incentives to negotiate to reach the best outcome. But people in government have almost no idea what the particular costs of hundreds of thousands of individual businesses are and have little or no incentive to levy the correct taxes necessary to duplicate the Coase result.

There is one catch to the Coase Theorem, though. The people involved – “rancher” and “farmer” – have to be able to get together and negotiate; those are the “right circumstances” stipulated above. Economists formalize this by saying that “transactions costs are zero.” This is an overstatement, but the costs of successful negotiation must be low enough to make it feasible.

The Coase Theorem and the Bad Apples of Economics

The Coase Theorem (like the work of Ronald Coase in general) is one of the most-often cited of all economic propositions. Professional economists like it because it yields a categorical solution to a wide variety of problems, and the solution is economic in character. They also like it because they find its baggage – the assumption of “zero transactions costs”- very appealing.

This assumption is likewise categorical and precise. It makes the problem at hand easier to deal with. And – this is the heart of the matter – it avoids the complications of not assuming transactions costs to be zero. The existence of positive transactions costs makes the Coase conclusion problematic. In order to resolve the issue, the economist must inquire into the nature and size of transactions costs. This stirs up a hornet’s nest of pesky potential problems. Now the economist has stepped out of his neat, clean, determinate world of mathematical precision and into a messy, dirty, indeterminate world of subjective, qualitative evaluation and argument. Ugh!

The fact that, in reality, transactions costs are never zero hasn’t killed economists’ love affair with the Coase Theorem. It is a lot easier to explain away an assumption made “for purposes of exposition,” “for clarity,” because “economists deal in clean theoretical concepts that allow them to exclude extraneous ideas” or for some nobler academic purpose than it is to grapple with the grubby detail of real-world markets. Data are hard to come by and, even when available, often inaccurate. The public is impatient with qualification and ambivalence. Academic promotion and tenure are dependent on publication, and ambiguity does not dress a submission for success in the world of academic journals.

“Zero transactions costs” and categorical results puts the economist in control. It nourishes his fantasy of being a philosopher king who manipulates reality in behalf of humanity. The uncertainty of positive transactions costs kicks the economist off his pedestal and down into the dirt with ordinary mortals. It is humbling as well as professionally risky.

Why Coase is not a Fan of the Coase Theorem

Ironically, Ronald Coase himself does not approve of the promiscuous resort to the Coase Theorem. That does not mean that he repudiates it; after all, he originated it and defended it in debate against the best minds at the University of Chicago in 1960. But much as Alfred Nobel regretted the uses to which the world put his invention of dynamite, Coase bemoans the fact that the economics profession has misused his Theorem.

Coase analyzed production in a world of zero transactions costs in order to stimulate research into the importance of transactions costs in actual markets – much as a science teacher might contrast an environment of zero gravity with one encumbered by gravitational pull. His emphasis on the subject began a quarter-century earlier with the publication in 1937 of “The Nature of the Firm.” In this, his first major article, he attributed the existence of business firms to the existence of transactions costs.

Why don’t households either produce all goods and services internally or purchase them directly from each other? Because it is usually (though not always) cheaper to organize a good’s production under a single rubric which provides a common source of output. It is the number, size and scope of transactions costs – the “running around” and “arranging” that households would have to do in the absence of business firms – that makes it so.

The last thing in the world Coase wanted was to transport economic theory to an alien planet where there were no transactions costs. Here on Earth, transactions costs are ubiquitous. For that matter, so are “external costs.” When a firm builds a factory, there is every possibility that the ensuing production process will impinge on the lives of others through the creation of effects such as smoke, discharges and noise.

One possibility is that markets may reflect these effects, just as predicted by the Coase Theorem. Another possibility is that the costs of transactions between the business owning the factory and the surrounding inhabitants (and other, more distant, parties) preclude the negotiations necessary to a Coase-Theoretic outcome. But this second set of circumstances does not make a conclusive, or even a prima facie, case for action by government. The high cost of transactions does not bode well for an attempt by uninformed government regulators to change the outcome without imposing costs greater than the benefits available.

As a practical matter, Coase sees “a prima facie case against intervention,” bolstered by “the studies on regulation which have been made in recent years in the United States, ranging from agriculture to zoning, which indicate that regulation has commonly made matters worse… .” But viewing the matter formally, Coase recognizes that assuming zero transactions costs and assuming that positive transactions costs make government intervention mandatory are two different ways of assuming the problem away. If economists study actual markets, they must study transactions costs as an empirical driving force in those markets.

The Costs of Government Action

Foremost among transaction costs is the cost of government action. Throughout the 20th century, economists have taken a weirdly asymmetrical view of the private sector and government. In the example above, the “external costs” cited are commonly viewed as somehow foreign or extrinsic to the production process, as if they could be omitted at will or at whim. Thus, their very presence makes the motives and intentions of the producer suspect. Government is regarded as a benign organic unity, miraculously untainted by self-interest, whose objective function is some inadequately defined conception of aggregative welfare.

Coase casts a gimlet gaze upon the role in which economists have placed themselves. They are the philosopher kings, making government policy on their academic blackboard. “All the information needed is assumed to be available and the teacher plays all the parts. He fixes prices, imposes taxes and distributes subsidies (on the blackboard) to promote the general welfare.”

Alas, “there is no counterpart to the teacher within the real economic system. There is no one who is entrusted with the task that is performed on the blackboard. In the back of the teacher’s mind (and sometimes in the front of it) there is, no doubt, the thought that in the real world the government would fill the role he plays. But there is no single entity within the government which regulates economic activity in detail, carefully adjusting what is done in one place with what is done elsewhere. In real life, we have many different firms and government agencies, each with its own interests, policies and powers.”

Coase derides “blackboard economics,” noting that while government intervention may be costless on the blackboard, it is both highly costly and questionably motivated in reality. Meanwhile, the “external costs” that are singled out so invidiously by economists are part and parcel of production. The real choice we face is how to minimize the costs of production when both external costs and transaction costs are included. To leave them out would be tantamount to rejecting production outright.

Ronald Coase, Centenarian

Ronald Coase was born on December 28, 2010. Although his first seminal article was published in 1937, he didn’t obtain his doctorate until 1951. His crowning work on social cost did not appear until 1960, when he was almost fifty years old. Thus, he was a late bloomer.

His famous articles number barely a dozen. He employs no abstruse mathematical or statistical tools. Yet his standing is that of a giant in the profession.

Coase practices what he preaches. In recent years, he has organized a society to study the markets and institutions of China. His book on the economies of China and Vietnam, whose publication was expected in the summer of 2010 but is still delayed, has been long-awaited by his legion of colleagues and admirers.

Ronald Coase is now well into his 102nd year.