

# Barbecue Economics

Be Your Neighborhood Expert on Demand, Supply and the Free Market

Dick Gillette

# .

Smashwords Edition

Copyright 2012 Dick Gillette

License Notes: This ebook is licensed for your personal enjoyment only. This ebook may not be re-sold or given away to other people. If you would like to share this ebook with another person, please purchase an additional copy for each person you share it with. If you're reading this book and did not purchase it, or it was not purchased for your use only, then you should return to Smashwords.com and purchase your own copy. Thank you for respecting the hard work of this author.

# Table Of Contents

Foreword

Introduction

Chapter I – Basic Principles

Things We Want Are Scarce

Humans Are Rational

Decisions Are Made At The Margin

People Respond To Economic Incentives

Everything Has An Opportunity Cost

Chapter II – Microeconomics

Markets

How Markets Work

Demand

Elasticity Of Demand

Supply

Price Determination

Rent Control Laws

Elasticity Of Supply

Supply Of Labor

Minimum Wage Laws

Drug Price Controls

Maximizing Firm Profits

Chapter III – Macroeconomics

Gross Domestic Product

The Business Cycle

Classical Economics

Consumption, Saving, And Keynes

Supply-Side Economics And The Laffer Curve

Rational Expectations

Economic Equilibrium

Chapter IV – Fiscal Policy

Taxes

Spending

Borrowing

Chapter V – Monetary Policy

Money

The Federal Reserve

Chapter VI – Regulation

Lyme Disease And Government

Air Pollution

Commercial Licensing

Auto Mileage Standards

Commercial Banking

The Titanic

Chapter VII – Jobs and Income

Creating Jobs

Concentration Of Income

Chapter VIII – Foreign Trade

The Basics

China

Chapter IX – Cronyism: Enemy Of The Free Market

Government

Corporations

Millionaires

Labor

Chapter X – Reflections

Appendix

Glossary of Terms

About the Author

# Foreword

This is a book about economics, but it is not an economics book. To really learn economics, consult any number of books written by highly qualified economists. My experience is business, and my formal training in economics is now decades old. I undertook this project to counter the growing quantity of misinformation and un-economic reasoning that passes for wisdom in today's conversation.

Nor is it a political book. The words Democrat and Republican appear in just two paragraphs of the entire book. No living politician's name appears anywhere, except as a source.

It is simply a book about economics, how prices and wages are determined in the market, how businesses seek to maximize profits, and how these forces influence the well-being of our economy. I hope to present just enough of the topic so that readers will have a basic command of the vocabulary and can understand how economic decisions are made, and their likely outcomes. Think of it as barbecue economics, the kind that will impress your neighbors at the block party.

The need for economic literacy has never been more acute. Politicians untrained in economics rely on talking points contrived by untrained political staffs. The press generally has little understanding of economic principles, usually just repeating the talking points of their preferred politicians. In truth, given its centrality to society, the lack of economic understanding by public figures is shocking. Economics is a challenging field of study, but there are a few basic principles that informed people should know and use when forming policy opinions, and they are not difficult to understand. The first goal of this book is to help you master them.

Economic study is based on a fundamental truth: as human beings, our wants exceed our resources. Who doesn't crave that new car, that new video system, the ticket to the Broadway show? For that matter, who wouldn't like to have more free time to spend with their family or learn to play the piano? There is just not enough money and free time to go around. Economists refer to this unfortunate truth as a condition of scarcity. Economics is the study of how people deal with scarcity.

When things are scarce, trade-offs must be made. If your budget is tight, and you want the new car, you will have to give something else up; you can't afford everything. Maybe you will give up your vacation this year, or maybe you will cut your entertainment budget. Whatever you decide, it will sting a little.

Bartenders in 19th century American saloons offered free lunches to patrons who would come in and buy a glass of beer. The profit from that one glass of beer, of course, was not enough to cover the cost of the lunch, but the bartenders were sure that, once the lunch was in front of them, their patrons would drink more beer. And just to clinch it, they made the lunch out of saltines, sardines, and other salty snacks. The profit from all those beers more than made up for the cost of the lunch so, in the end, there really was no free lunch for the patrons. It was all marketing fluff. There are no free lunches in economics either.

Lawmakers lose sight of this. Difficult decisions don't get you reelected; it's bringing home the bacon that counts. So, they reallocate our resources at the margin, a little here, a little there. Each program sounds worthwhile; who could be against saving the (fill in the blank)s? There seems to be no over-arching set of rules that guides their actions.

Our lawmakers know something is wrong. They see a federal budgeting process falling apart, and deficits and government debt mounting ominously. Their constituents complain about spending money beyond our means. A basic understanding of the principles of accounting leads them to resolve to "pay for" all of the new programs they put in place. They seem to believe that, so long as they can find revenues to cover the expenses, the problem is solved. In doing so they lose sight of the real problem, which is that government spending has an economic cost that "paying for" does not eliminate.

Economists and accountants view the world from different perspectives. To accountants, cost is generally defined as the payment of money. Thus, if a new government program requires an expenditure of $1 billion, an accountant would call that expenditure its cost. To an economist, the cost of the program is what is given up to collect the $1 billion. How might the billion dollars have been otherwise employed, and what effect would that have had? Most lawmakers think like accountants.

In addition to being an economics primer, have a second goal for the book. It is often pointed out that the American free market system is responsible for building the most prosperous society the world has ever known. This is true by almost any measure. Yet, well-intentioned voices in society argue that the free market is nothing more than a manifestation of raw, human greed and unfair to the vast majority of our citizens. From the time of the Robber Barons of the 19th century through today these voices have multiplied and are responsible for legislation that diminishes the freedom of and, therefore, the efficiency of markets.

The argument against free markets is misplaced. The free market is a place where all of us, if we understood the options, would prefer to go to conduct our business. The market is "free" because each of us can choose to go, or not go, whenever we want, and we know that when we get there we can generally expect to find a broad selection of sellers competing for our business. In addition to providing a wide range of choices of things to buy, the market assures us that, by placing sellers in competition with one another, none of them will have undue influence over the prices and terms available. And the unlimited opportunity for sellers to earn more of your dollars by innovating and creating better products can only exist in a free market.

Consumers have the real power in a free market. Consumers have the money, and without their money, sellers cannot survive. And consumers own one of the most important resources that all manufacturers need to make a profit - their own willingness to work. Freedom of choice - the ability of consumers and sellers to decide what is best for each of them without coercion of any kind - insures that a free market is the most efficient way to allocate resources known to man.

If this description of a free market is counter to your experience, it is likely not because the free market has failed, but rather because the influence of powerful interests has made the market less free. The essence of a free market is competition, and every participant is naturally motivated to try and push the odds a little more in their favor. Businesses petition legislators to protect them against the ravages of competition. Labor unions petition legislators to advantage their members relative to employers and other workers. Environmental groups petition lawmakers to curtail commerce to return to a more pristine state.

Luigi Zingales, professor of economics at the University of Chicago, has written that, while everyone benefits from a free and competitive market, no one has a strong incentive to _keep_ the system competitive and the playing field level. "True capitalism," Zingales says, "lacks a strong lobby." The second objective of this book is to provide a voice for the free market.

The book has several sections, but two sections - Microeconomics and Macroeconomics - are the guts of economic theory. These are likely to give the uninitiated some pause. Do not lose hope; the rest of the book is quite user-friendly.

I am grateful to the many superb economists at the University of Chicago who sparked my lifelong interest in the field as a student at the University's Booth School of Business. One measure of the academic energy that permeated the school was that we rarely read textbooks; instead, we read scholarly papers that our professors, and others, had recently published, representing advances in the science that textbooks were just too slow to capture. It was, and continues to be, a truly creative and exciting environment.

I would also like to tip my hat to the editorial page of _The Wall Street Journal_ , which has consistently supported free market principles with sharp analysis and commentary for the forty or more years that I have read it. Theirs is an invaluable contribution to the conversation. Kudos also to publications like _National Review_ and _The_ _Weekly Standard_ and to organizations like the American Enterprise Institute, the Heritage Foundation, and the Competitive Enterprise Institute for their high quality work on behalf of the principles of economic freedom.

Finally, I am grateful to my wife for encouraging me, a first-time author, to write this book, to my daughters for containing their disbelief when told about it (jk), and to all of them for helping me design and edit it. This was definitely a family affair. Thanks, girls.

# INTRODUCTION

" _A citizen cannot at the same time be free and not free."_ \- Frederic Bastiat

An economic system is a set of laws, rules, and traditions that governs the exchange of money for goods and services by members of society. Only two pure forms of economic system exist. The first is one in which decisions about what goods to supply to the market, what goods to buy, and what prices to charge and pay, are made by millions of people and businesses in freely negotiated transactions every day - a free market system. The other is one in which those decisions are made by a government elite, with only a broad understanding of the needs of the marketplace - a managed economy.

A free market system allows all parties - consumers, merchants, producers - to participate on equal footing with all the others. No single party has undue influence over the others, and all transactions are entered into willingly, based on the self-interest of each party. Since business activities in a free market require the investment of privately owned capital, the term "capitalism" has come to be closely associated with a free market, and the term "free market capitalism" is often used. We consider this to be synonymous with free market.

In a sense, the term free market is a straw man; no fully free markets exist today. The Heritage Foundation publishes an Index of Economic Freedom each year, based on extensive research of nearly 180 countries ranked according to their degree of economic freedom. Hong Kong and Singapore are at the top, followed by Australia, New Zealand, and Switzerland. The U.S. ranks tenth. The most visible example of a directed market in the 20th century was the former Soviet Union. Currently, North Korea occupies the bottom of the freedom list.

Most economic systems fall somewhere between the extremes - mixed economies. In a mixed economy, like the United States, relatively free markets exist in certain sectors, while the rest of the economy operates with greater degrees of government involvement. The role of government is, ostensibly, to balance the influence of market participants to keep the market free.

There isn't much argument among economists today over which system is best. The collapse of the Soviet Union and the extreme poverty and lack of economic growth in places like North Korea and Cuba pretty much put that question to rest. In the Soviet economy, agencies prepared massive five-year plans, directing where every knife, fork, and spoon would be produced, in what volumes, and with what materials, and what their selling prices would be. This bureaucratic system proved incapable of supplying consumers with the quality and variety of products they desired at prices they could afford. This failure, and the government's excessive allocation of its scarce capital to weapons production, combined to impoverish the nation and doom it to failure. No credible defense of the Soviet system can be made today, and even its closest relative, The People's Republic of China, has moved beyond a closely managed economy to a more free market orientation.

By the same token, there can be little argument that U.S. economic history validates the principle of a free market. The U.S. has created more wealth, and distributed its benefit more widely than any nation in history.

A logical question, then, is what is the optimal mix of free market and government involvement in a modern economy? To be sure, the recognition and protection of private property and the respect for contracts is critically important to the functioning of a free market, and these functions can only be performed by a competent legal system overseen by the government. Most of us agree on the need for some kind of social safety net for the unfortunate among us. And most of us support government action in areas where the free market does not function well, such as pollution. The extent to which government should be involved beyond areas like these is an open question.

Nineteenth century French political economist, Frederic Bastiat, addressed this question in his pamphlet, "The Law," published in 1850. In it, he argued for a strong legal system, saying

Law is justice. And it is under the law of justice — under the reign of right; under the influence of liberty, safety, stability, and responsibility — that every person will attain his real worth and the true dignity of his being. It is only under this law of justice that mankind will achieve — slowly, no doubt, but certainly — God's design for the orderly and peaceful progress of humanity.

But Bastiat feared the consequences of an ambitious and uncontrolled law. He accepted the reality of man's basic nature to seek the easiest, least painful way to satisfy his needs. And he recognized that this innate drive of man to seek shortcuts caused the "fighting at the door of the Legislative Palace" by men seeking favors, which he witnessed firsthand as a member of the Assembly. "Here I encounter," he wrote, "the most popular fallacy of our times. It is not considered sufficient that the law should be just; it must be philanthropic... These two uses of the law are in direct contradiction to each other. We must choose between them. A citizen cannot at the same time be free and not free."

Bastiat's concern is as relevant today as it was one hundred sixty years ago. A mixed economic system with a bias toward freedom clearly seems to be the best way for society to reach its economic potential, but a government that commandeers too much of the wealth will undermine that effort. The principles of economics will help us understand why this is true. Bastiat's way of drawing the line is as clear as any; that is, once the government is used for more than the protection of private property rights, it has gone too far.

We are well over that line today. Indeed, Bastiat's line in the sand may well be an anachronism. The U.S. economy is so complex, with so many vested and conflicting interests, that the idea of returning to a fully free market, the kind of environment that created such massive wealth, can be no more than a dream. We must, instead, seek a balance. It would be useful, however, to understand the direction in which we are headed; too far in one direction, we know, is certain failure. When people are not sure of the direction of policy, they view the future with uncertainty, and uncertainty generally puts a damper on economic growth.

In the pages that follow we will introduce the basic principles of economics. We will show how these principles operate in the context of a free market and in that of our mixed economy. We will illustrate how the forces of people seeking the easy path to success create imbalances that distort the market. We hope at the end to have given you a clearer view of the economic impact of the choices we make, and a sufficient vocabulary to join the debate.

For those who like to view a map before setting sail, we elaborate here on the Table of Contents, which you may have skimmed. We even grade each section for difficulty - SC for Sunny and Calm, LWE for Light Winds Expected, and BDH for Batten Down the Hatches - not so you know which ones to skip, but rather how long it will be before the weather clears. We understand that some of the material is challenging, and we have always liked how our dentist keeps reminding us that "it's almost over."
Chapter I - Basic Principles covers, well, the basic principles behind economic theory - SC.

Chapter II - Microeconomics describes how the factors of supply and demand interact to determine prices in a market, and provides some examples from real life - SC/LWE. The final section shows how businesses analyze their costs to try and maximize their profits - BDH, but important!

Chapter III - Macroeconomics shows how entire economies, like the U.S., operate, with a particular focus on how living standards are determined - SC/LWE/BDH.

Chapter IV - Fiscal Policy describes taxes, spending, and borrowing - LWE.

Chapter V - Monetary Policy examines the role of money and trade policy - SC/LWE.

Chapter VI - Regulation looks at how several forms of government intervention in the economy affect our economic health - SC.

Chapter VII - Jobs and Income discusses job creation and distribution of income - SC.

Chapter VIII - Foreign Trade describes the basis for importing and exporting and uses the example of China to explore currency and trade issues - SC.

Chapter IX - Cronyism: Enemy Of The Free Market provides examples of how our markets are manipulated to serve special interests and the resulting impact on economic growth \- SC.
Chapter X - Reflections - Now to the block party.

# Chapter I - Basic Principles

**THINGS WE WANT ARE SCARCE**

If you ask someone to name something that is always and everywhere available, they will likely name the air. It is abundant, exists everywhere on earth and, best of all, it is free. But what else is like air? What else is so abundant that there is always more of it than people want? Not Super Bowl tickets, not diamond earrings, not even pizza. No matter what we want, there is never enough of it to get it for free. Virtually everything we want is scarce. In the late 1990's, information technologists told us that internet bandwidth was so abundant we could never use all we have. Have you tried downloading a movie on your smart phone lately?

**Scarcity** is the condition of unlimited wants in a world of limited resources. Economics is the study of how people deal with scarcity, and economists assume what most of us already know, that people have more wants than they have money to satisfy them.

Scarcity moves economists to focus on trade-offs and how decisions are made about which choices to make. You can have the new car or the island vacation, but you can't have both, at least not right now. Producers of goods also face this conundrum when deciding what and how much of their products to produce. Economists have developed a graphical way of expressing this conundrum; it is called a **possibility frontier** , shown in Figure 1. In this example, the subject is the production of automobiles, so the graph is called a production possibility frontier. It could also be used to illustrate an individual's consumption possibilities - their budget - or other trade-offs. The point is that, in making a decision to trade one opportunity for another, one must consider what they are giving up as well as what they are gaining.

This fictional car company makes two types of vehicles: a pick-up truck and a sedan. The company's plant is only so big, so its finance department has calculated how many of each type of vehicle it is able to produce under this constraint. Figure 1 shows the company could produce one million sedans if it produced no pick-ups, and it could produce 750,000 pick-ups if it produced no sedans. The line between those two points defines the company's production possibility frontier. Any point along the line will inform management the optimum mix of vehicles they can make. Since they have both types of vehicles to sell, the company's location on the frontier is not at either extreme, but somewhere in between, say, Point A, where they produce 500,000 sedans and 375,000 pick-ups. They cannot produce at the level of Point B, because it is located outside their possibility frontier. If they produce fewer vehicles, as at Point C, they are underutilizing their plant. In reality, of course, automobile companies must make much more complex calculations involving multiple dimensions to map out their production possibility frontier, but that is a job for a computer, not a simple graph.

The reason to introduce the possibility frontier at this point is to underline the fact that, in the real world, resources are scarce, which puts limits on potential outcomes and forces people to make choices. We will return to it later when we discuss international trade.

**HUMANS ARE RATIONAL**

Economics is a social science, not like physics or chemistry, which deal in concrete, observable, and repeatable phenomena. The goal of economics is to understand and develop models of how people behave so that they can be used to forecast the possible outcomes of various business and economic policies. As a science, economics has evolved over the past two hundred fifty years into a highly quantitative subject, and economists seek to mathematically prove their theories with as much rigor as physicists.

However, no one can predict what each of 300 million people will do under a given set of circumstances. For this reason, economists must make assumptions about how the population will act. In some cases, they are able to break it down into sub-groups, such as younger people and older people or people with jobs and those without jobs. In most cases, they will make what are called **simplifying assumptions** to characterize the behavior of the groups they are modeling.

A key simplifying assumption economists make is that people are rational, that when confronted with financial choices, they will act in broadly predictable ways to achieve their goals. In this context, "rationally" means that they will consider the relevant information and analyze it to determine the best outcome. For example, when buying milk at the supermarket, we usually have two or three choices. We can select the highest priced brand, the one that advertises on national TV. It is produced by a large company that has been in business for decades. We might also select a medium-priced brand, which is produced by a well-known, local dairy. It doesn't have the implied quality of the highest price brand, but it has been successful in our market. Finally, we could select the brand that has the supermarket's own name on it. It is the lowest-priced milk on the shelf.

We have several things to consider when deciding which carton of milk to buy. We can consider our preference for buying a well-known, national brand. We know that company has been producing milk for more than a half-century, and must have detailed protocols to insure the quality of its product. The fact that it has been in business for such a long time suggests it is a safe buy. It does cost more than the other brands, but it comes in a sturdy plastic bottle. Whatever our final choice, it will have been made rationally, considering relevant facts and deciding which are most important to us.

Unfortunately for economists, not all decisions we make are rational in a classical sense. How can we evaluate, for example, paying a premium for a golf ball that is used by one of our favorite professional golfers? We know that all pro golfers try many different kinds of balls to select the brand that suits them best. We also suspect, however, that golf ball manufacturers pay the golfers to use their brand as a marketing tool. Is our golf game so good that we can tell the difference between balls? If we pay a premium price for a certain brand of ball because a certain pro uses it, one could argue that is not a rational decision; instead, it may be an emotional decision, one made to satisfy an inner longing to relate to that golfer, and to be seen as being like them. As humans, we are sometimes motivated to manage our peers' perceptions of us. In fact, 18th century Scottish philosopher/economist Adam Smith identified the human need for approval by others as an important motivating factor in their economic decisions.

To deal with emotional motivations that may interfere with a rational economic choice, Smith developed the idea of **utility**. He argued that individuals make decisions that will maximize the utility, or feeling of well-being, that they will gain through their purchase. So, if hitting a golf ball with a famous name on it is very important to you, then paying a premium price is not an irrational decision. It may not be the same decision another might make, but it is rational in the context of your own preference for utility.

We suggested earlier that economists assume an individual's decisions are not only rational, but are made with their own best interests in mind. This latter idea was examined closely by Adam Smith in his book, "An Inquiry into the Nature and Causes of the Wealth of Nations." Smith's book became the basis of economic study for decades, and its basic principles are recognized just as relevant today as in 1776, when the book was published.

Smith believed that a free market for goods and services - one where buyers and sellers met freely and determined an exchange fair to both - was the best way to build national wealth and improve the condition of the poor. In thinking about the nature of free markets, he realized that it embodied an important paradox; it enabled a producer concerned solely with their own self interest to contribute, unintentionally, to the general welfare of society. He reasoned that, in order for the seller of a good to be successful, he must provide a benefit to the buyer equal, in the buyer's mind, to the price of the good. If he did not, the buyer was free to move on to the next booth in the market, and he would fail to make the sale. If this pattern were repeated too often, Smith observed, the seller would have to adjust or would surely go out of business.

At the same time, the buyer who found a benefit at the next booth and was happy with the result would help boost that seller's sales, so that his business would grow and prosper. Other merchants would take note of their neighbor's success and try to emulate it. If they were very talented, they might discover even better ways of satisfying customers. This allowed them to take their capital from its current use and invest it in their new ideas, a process that Austrian economist Joseph Schumpeter famously named **creative destruction**. In this way, repeated thousands of times across hundreds of markets, the welfare of society was increased, all because producers were trying to be more successful. Smith wrote,

"Every individual is continually exerting himself to find out the most advantageous employment of whatever capital he can command. It is his own advantage, indeed, and not that of the society, which he has in view. But the study of his own advantage naturally, or rather necessarily leads him to prefer that employment which is most advantageous to society."

Since benefitting society was not the underlying goal of the producer, Smith considered it to be a sort of natural force. He called this force the **invisible hand** of the market, a phrase that has endured in economic thought and become synonymous with Smith himself.

An example from real life: When you set up your lemonade stand as a kid, you thought one dollar was a good price for a small cup. Why? Well, a dollar was a lot in those days, and you figured you'd be pretty happy with a bunch of them in your pocket. Good enough for you, but not for your customers, who waved as they sped by the stand.

If you were really ambitious, after awhile you probably began to ask yourself what was wrong with your business model. It couldn't be the quality of the lemonade; you hadn't sold any. It couldn't be the lack of visibility; the artwork on your banner was terrific, and all the passersby were waving. The weather was hot and humid, making everyone thirsty. Then it struck you - maybe the price was too high. So, you cut the price in half, and people began to stop and buy. The money rolled in.

Why did you lower the price? Was it because you felt sorry for the people who didn't buy your lemonade? They looked so thirsty. No. You lowered the price solely because you wanted to make some money. You were a little bummed that you weren't going to make as much money as you had thought, but you figured something was better than nothing. (As we get deeper into economic theory, you'll learn that you might well have made more money at the lower price, because many more people wanted lemonade at that price.)

By lowering your price, lots of thirsty people were able to quench their thirst. By taking that action in your own self-interest, both you and your customers were better off. Actions like yours, spread across hundreds of millions of transactions every day between and among businesses and individuals, make society better off. This is how the invisible hand of the market benefits all of us.

It is fashionable in some circles to decry the lack of fairness inherent in free market capitalism. The argument is that consumers are forced by big corporations to pay too much for their goods, and that the corporations unfairly reap excessive profits. This is supposedly because these corporations are motivated not by the welfare of society, but rather by their own narrow self interests. This fact alone should be enough, it is argued, to consider a more enlightened form of economic system, one in which society has the power to influence how producers do business.

Smith would agree that corporations are driven solely by the desire to make profits but would argue this is perfectly appropriate, since they could not succeed if their self-interest failed to provide a benefit to society. Such a benefit included not only the value of the products they sold, but also the wages they paid to those who helped make them.

Indeed, it is more likely that the detractors of free market capitalism are reacting not to the operation of a free market, but rather to the operation of a market that has been put out of kilter by an imbalance of self-interests. Our government makes continual changes in the rules of the market in an attempt to keep the market fair for all parties. In the 19th century, for example, large companies succeeded in dominating their markets so completely that they became the only significant employer in a region. As a result, the market for labor was pushed out of balance in favor of the employers. Workers went on strike, violence often resulted, and it was necessary for government to intervene in order to re-balance the market. Laws were passed to protect employees, and unions were granted greater rights to give workers more market power to offset the power of their employers. A constant theme of this book is to point out restrictions that are placed on markets by those with the power to do so, and the resulting economic effects.

**DECISIONS ARE MADE AT THE MARGIN**

A second assumption economists make about human economic behavior is that people make decisions at the margin. This is to say that economic decisions are always made with the next, or marginal, action in mind. One tries to decide which car to buy; it is the next car they will be buying, so it is a decision made at the margin. Or a producer weighs whether to expand their production facility; their primary concern is how much more income, marginal income, they will make as a result of the improvement, not what the plant cost originally. Economics is about the future, not the past.

Note: Do not confuse economists' use of the term marginal with the colloquial term "marginal decision," which the rest of us often use to designate a decision that is on the border between good and bad. In economics, marginal always refers to the next decision to be made or the next action to be taken, without a subjective inference.

An example might be helpful. Suppose you and your family go out for dinner at an all-you-can-eat restaurant. Since you are paying a flat rate for the dinner, you are determined to eat all you can to be sure you get your money's worth. You go through the line and pile your plate high with food. Satisfied, you return to your seat and devour the contents of the plate. With that, your hunger is mostly satisfied, but you return to the line and bring back a second plate piled high with more food, which you also finish. The thought of a third plate is not quite as appealing at this point, but you return to the line. This time your plate is only half full when you sit back down. Gamely, you dig in.

You have just demonstrated the economic law of **diminishing marginal utility**. Each successive plate, the marginal plate, brings you less satisfaction - utility - than the one before. Your total utility increases - you are happy you had the extra plate, which provided you with useful nutrition - but it increases in smaller increments. In other words, your marginal utility diminishes with each additional plate. At some point in the evening there will be no additional utility to you from the food and, even though it is free (you paid a fixed price), you will stop eating altogether.

Or, suppose you have a job stuffing newspapers into protective plastic sleeves for home delivery. Your employer has only one machine to dispense the sleeves, but she believes she can increase her productivity if she hires another worker. You and the second worker get along fine, and things go pretty smoothly, so smoothly that your employer thinks she can do even better with yet a third worker. At some point along this path, there will be too many workers to work on that single machine, and they will begin bumping into each other, tripping over one another, jamming the machine by pulling the sleeves out too fast, pinching their fingers, and so on. You are witness to what economists call the **diminishing marginal productivity of labor**. At some point, the productivity of a new hire working with the single dispensing machine is less than the one hired before.

Economists encounter this phenomenon constantly. The reason is scarcity. Your utility for more food diminishes because you have no more room in your stomach - scarce stomach space. The marginal productivity of labor diminishes because there is only one machine to use. Often, this is a short term phenomenon; tomorrow, for example, you will be hungry again. Likewise, if your employer bought more machines, the marginal productivity of the workers would increase. At some point, however, she will either run out of capital to buy new machines, or she will saturate her market and have no reason to buy more machines, and the law of diminishing marginal productivity of labor will re-assert itself.

Later, we will examine what a businessperson does with this understanding to help maximize their profit.

**PEOPLE RESPOND TO ECONOMIC INCENTIVES**

A third assumption economists make about individual and corporate behavior is that they respond to economic incentives. On a very basic level, we could all agree that if someone offered us $10 to give them directions to the theater, most of us would give them the directions. Worker compensation, of course, is based on this principle; how many of us would work without a monetary incentive? And we love sales. Some people just won't shop until a sale is advertised.

Corporations respond to incentives even more eagerly, sometimes, than individuals. If a company is running short of cash, one action it can take is to urge its corporate customers to pay their bills sooner. To provide incentive, it may offer a discount to those corporations who pay within a certain time period, say, ten days. Most customers will compute the discount and compare it with their borrowing cost. If the comparison is favorable, they will pay early and take the discount.

Not all incentives are equally valuable. The intent of a bonus system is to encourage workers to go the extra mile for their employer, to provide a level of effort and quality of work over and above the expectation for their wage or salary level. Some employees go for it aggressively because the utility of that extra money is very high; others may not value it as highly and do less additional work.

The strength of the response to a bonus incentive, of course, will vary with one's assessment of the likelihood of receiving it. Employers find that, if the expectation of performance is too high, incentives can have little effect. In the same way, many people don't buy lottery tickets because they think the odds against them are too high. Nevertheless, if needs are limitless, and the resources to meet those needs are scarce, incentives are a useful way to motivate people and induce them to change their behavior.

**EVERYTHING HAS AN OPPORTUNITY COST**

One of the most important concepts in economics is **opportunity cost**. Imagine for the moment you were offered a free vacation trip to Hawaii. The only caveat with the offer is that the trip must be taken in the third week of May.

In thinking about whether to accept the trip or not, you first check your calendar to see if that week is available. You find that you have scheduled an important sales trip that week, during which time you had hoped to close several large sales. It had been a challenge to put the trip together, since each of the people you would be seeing is very busy and difficult to pin down. As a result, it might be another six months before you could reschedule the trip. In the interim, it is likely your competitors will be calling on those same people, and you might lose some of the sales you would otherwise have made.

In short, if you accept the opportunity to take the trip, you will incur a cost in the form of lost or deferred sales. Economists would say that the opportunity cost of the trip is the sales contracts you will lose. Every choice in life has an opportunity cost; it is the value of the thing you choose _not_ to do. Remember, scarcity requires trade-offs.

In some cases an opportunity cost is easy to quantify. Imagine that you have invested a sum of money in the stock of a company that pays reliable dividends each quarter. Currently, those dividends represent a 3% return on your investment. One day you receive a call from your advisor telling you about a new investment that offers a return of 7%. To make that investment, you will be forced to sell the stock of the dividend-paying company. Your opportunity cost of making the new investment is equal to 3%, the return you will be giving up to make the investment. Doing the analysis, you realize that the new investment only offers a 4% return advantage to you, because you must subtract your opportunity cost of 3% from the projected return of 7% to fairly judge the opportunity.

Often opportunity costs are harder to asses. The original example of the free vacation is one of those. How can you know how many sales you will lose if you reschedule the trip? What is the cost to you of the sales commissions you would have received during the vacation week? They are deferred at least six months, so the interest you could have earned by depositing them in your savings account is gone. Many people, confronted with such complex problems, would never attempt to quantify the opportunity cost, but it is important to recognize that the "free" trip is not free of cost. Remember, there is no such thing as a free lunch.

Chapter II - Microeconomics

**Microeconomics** : the study of how producers and consumers interact to determine the prices, quantities, and quality of goods that will be available in the market.

**MARKETS**

Transactions of interest to economists take place in markets, physical or virtual places where buyers and sellers meet to trade with one another. Physical markets offer face-to-face meetings, as in grocery stores, for example. Virtual markets are those where trades are made through a communications medium, such as the internet.

A key requirement for a market is the presence of multiple buyers and sellers. This is so that a single buyer or seller cannot unduly influence what transpires there. For example, the stand along a country road where a farmer is selling his crops is not a market, as economists would see it, because there is only one seller present. In these cases, the farmer can often set prices without regard to the price of the same goods in the supermarket. They are sometimes called farmers' markets, but they are really just a farmer's store offering one variety of each commodity. Hence, buyers are not able to choose among various varieties to find the one that best suits their needs at a price they like.

The farmer's stand at the side of the road does not meet the test of a market, but if an economist encountered several such stands in a small geographic area, they might consider each stand to be a seller in that larger area, and call the entire area a market. Hence, each farmer could be said to be offering his products into the market, since the presence of other sellers nearby would force him to keep his prices competitive. Note, however, that many of the farmer's customers are people just driving through to some other location who are unlikely to stop and return to a stand they had already passed to get a lower price on corn. In this sense, the individual farmer still has some ability to dictate prices at his stand. (Note, also, that the farmer sells most of his crops to large, wholesale buyers with whom he has absolutely no influence, so don't be too upset over the driver's seat the farmer sits in by the side of the road.)

Markets are classified as freely, or perfectly, competitive, partially competitive, or not competitive at all depending on the structure of the industry being considered. Economists think of markets for agricultural products and natural resources, for example, to be **purely competitive**. In each of these markets a large number of producers offers undifferentiated products, that is, each one's product is identical to another's. In markets like these, producers have no pricing flexibility; they are said to be **price takers** , meaning they must take the price offered in the market or sell very little product, since consumers would buy from the vendor with the lowest price.

As raw commodity products are converted into finished products for the consumer - apples into applesauce, for example - the markets shift from being fully competitive to being only partially competitive. Economists call this type of market **monopolistically competitive**. This shift happens for a couple of reasons. First, the number of firms producing applesauce is much smaller than the number of apple growers, so the actions of any single producer could affect the market price.

The second reason a market is only partially competitive, as economists see it, is that the products sold are differentiated from one another in some way. One vacuum cleaner boasts a circular suction mechanism the others don't have. One desk lamp can be turned on by clapping your hands. One toothpick is round, another is flat. As insignificant as the difference might be, it offers the manufacturer a chance to convince consumers that their product is better than the others. The hope is that a better product will sell at a higher price, and the producer will make a couple more pennies.

A third type of market is one in which a handful of producers offer relatively expensive or sophisticated products, such as computers or commercial airplanes. Economists call markets like this **oligopolistic**. The number of competitors in these markets is limited by the large capital requirements to enter the business. One might first think that such conditions would be ripe for exploitation of the consumer but, in fact, most oligopolistic markets are fiercely competitive, and it is not unusual for one of the competitors to go out of business from time to time due to financial losses.

The supreme example of this is the airline industry. Despite limited competition on their routes, airlines have failed to ever provide attractive returns to their owners. In fact, over the past sixty years, the airline industry has cumulatively lost nearly $75 billion. Warren Buffett, one of the world's most successful investors, summed up many investors' feelings about the airline industry by saying that "if a farsighted capitalist had been present at Kitty Hawk, he would have done his successors a huge favor by shooting Orville down."

Other examples of oligopolistic industries include railroads, automobiles, cell phone service, and aluminum smelting. All of these require large amounts of capital to enter, making them **capital intensive** industries. Such industries must produce at very high levels to provide adequate returns to their investors, which limits the number of companies the business can support.

The fourth type of market is a **monopolistic** market. Most of us are familiar with the term monopoly, which refers to a market having just a single provider of a good or service. Electric utilities are monopolies, as are water companies. Companies like these are called natural monopolies, because the cost of bringing wires and water pipes to every house in a market is too high for more than one company to survive. Imagine if two companies connected water pipes to every house in their market, and consumers were indifferent between the two. Each company's pipes would only be half full, which would provide insufficient revenue to each company to make a profit. Industries like these are also capital intensive and need to keep their pipes nearly full all the time in order to provide an acceptable return to their investors.

A monopoly is able to raise its prices without concern of a competitor coming in and taking their customers by charging a lower price. This ability offers the opportunity of making **monopoly profits**. Natural monopolies are normally regulated by the government to protect individuals from having to pay too high a price for an essential service. This is not only good for consumers, but it is also the most efficient use of capital in those industries and is, thus, accepted by economists as an appropriate interference by government in the market. However, a monopolistic market does not fit our definition of a free market, which requires multiple sellers, and we will not devote any more attention to monopolies.

**HOW MARKETS WORK**

" _Nobody ever saw a dog make a fair and deliberate exchange of one bone for another with another dog."_ \- Adam Smith

Early economists like Adam Smith sought to understand how an economy worked and what general principles guided its operation. Smith identified two types of economies, one that is controlled by a monarch, and one that is very loosely controlled by the natural urge of men to trade with one another. He called trading a natural urge of men noting, tongue in cheek, that no other animal is known to consciously trade among themselves. This natural tendency to trade gives rise to the phenomenon described earlier as the invisible hand of the market, which creates the unique situation whereby trades routinely occur with each participant walking away satisfied. He called this a free market. Smith explained that the primary players in a free market consisted of producers of goods[1], on one hand, and consumers of goods[2] on the other. He observed that the obvious role of consumers in the market was to buy goods from producers.

Smith's insight was that, in order for producers to make their goods, they needed to buy what he called the **factors of production** \- labor, land and raw materials - and these factors were in the hands of the consumer. The consumer, himself, provided labor, and owned the land, or much of it, and the raw materials that typically came from the land. Smith concluded that the consumer was not in any way subservient to the producer, but that the parties enjoyed a naturally equal stature in the market. Smith described a model of how the market worked that is depicted in Figure 2.

The model shows a circular flow of resources and goods between the consumer and the producer that Smith argued was the essence of a functioning and free economy. In the model, consumers are shown supplying the factors of production - labor, land, and materials - to producers, who convert these into finished goods for sale back to individuals (solid lines). In return, each pays the other for their goods and services (dashed lines). One of Smith's themes was that producers and consumers are part of a complex web of interdependence, such that each group relies on the other to satisfy their own needs. It is the invisible hand of the market that causes this interdependence to benefit society.

We will now turn to the topics of demand and supply. Demand sheds light on a consumer's desire to purchase a good, and supply highlights the conditions necessary for a producer to make and offer goods for sale.

**DEMAND**

Suppose you decide to go out for lunch. You drive over to the local sandwich shop to buy a hoagie sandwich (mysteriously also known as a grinder, hero, submarine, wedge, poor boy, etc.) and find the price of the sandwich is $5. You would consider buying one at that price, but you noticed a flyer at the newsstand outside quoting a price of $4 at a different shop. At that price, you think you might buy two sandwiches and give one to your friend.

On your way to the second shop, you pass a third shop advertising hoagies in the window at $3 apiece. It occurs to you that, at that price, you could buy three sandwiches, eating one, giving one to your friend, and popping the other in the fridge, all for less than the cost of two sandwiches at the first shop. You might find that deal especially attractive. The prices and the choices you would make at each price are shown in Figure 3. Economists call this table your **demand schedule** for hoagies.

You could plot these values on a two-dimensional graph and connect the points with line AC as shown in Figure 4. This graph and those that follow show the relationship between two variables, in this case quantity and price.[3] It shows that when the price of a hoagie is $5, you would only want one but, at a price of $4, you would buy two, and so on. It is simply a visual representation of the demand schedule.

Once several points are plotted, we can confidently connect them with a line to estimate the quantity demanded at any price along the line. For example, at a price of $4.50, we estimate the demand for hoagies would be midway between 1 and 2, or 1 1/2.

This is what economists call a **demand curve**. The number of hoagies you would buy - the "quantity demanded" - is expressed on the horizontal axis of the graph, and the price per sandwich is shown on the vertical axis. (Note: many of the relationships that economists graph in this way are not linear, but would more accurately be drawn as curved lines; hence, the term "demand curve." Where possible, however, we use the economist's convention of showing them as straight lines.)

The demand curve we have drawn is downward sloping - it starts from a high point on the left and slopes down to a lower point on the right. By inference we could extend the line a bit farther, as shown. This visually represents what is known as the **Law of Demand** , which can be stated as follows: As the price of a product or service declines, the quantity consumers demand (would like to buy) increases, and conversely, as the price increases, the quantity consumers demand decreases. Economists call this a law because a) it seems perfectly obvious to most of us, b) it has been demonstrated to hold in countless transactions since the beginning of time, and c) no one has been able to show that the opposite is true, i.e., that when the price of a product goes up, people want more of it.

Regarding the last point, it is true that some people seem to prefer higher priced products, even if there is no difference in quality between them and a lower priced one. The luxury goods market relies on this fact, and the advertising industry helps bring it about. However, when shopping for a luxury automobile, most people would still prefer to pay less for the same car.

The Law of Demand applies not only to consumer demand for finished products, but also to the demand that producers have for the factors of production - the raw materials, labor, and capital - they need to produce their products. Each of these factors is also a scarce good. Producers must bid in the markets to acquire each of them, and none of them is available for free. In fact, nearly everything that producers and consumers want is scarce and, thus, the Law of Demand applies to them all.

What explains the Law of Demand? Economists identify two conditions where a price change can cause a change in the quantity demanded. The first is called the substitute effect. If the price of a product increases, consumers will naturally search for acceptable substitute products at lower prices. For example, restaurants specializing in Italian food range from expensive, white table cloth establishments to the less expensive, red-and-white checkered plastic tablecloth variety. If the owner of an expensive Italian food restaurant raises his prices, some of his customers will decide to patronize the less expensive one around the corner. The lower priced restaurant provides a substitute, or competitive venue for his more price-sensitive customers, and the quantity of his dinners demanded will drop, i.e., he will lose some business.

The substitute effect applies in producer markets as well. Manufacturers are constantly looking for lower priced goods and services to substitute for the ones they are currently using. This gives them room to make a little more profit, at least until the competition copies their initiative. Metal office furniture did not replace furniture made of wood because it was more aesthetically pleasing or of higher quality. It replaced wooden furniture because it was an acceptable substitute and it was cheaper.

A related condition might be called the complementary effect, which involves two different products. Complementary products are those that are typically purchased to go with another product. Hot dogs and buns are complementary products; when hot dogs get more expensive, people will buy fewer of them, and the demand for buns will decline as a result.

A more subtle example might be music purchased through iTunes and the iPods that play the music. If the price of music were to drop, consumers would want to buy more of it. People who formerly did not buy music on iTunes would start to do so, and they would also buy iPods to listen to it. So, the demand for iPods would increase along with the demand for music on iTunes. The reverse would happen if the price of music became more expensive. iTunes and iPods are complementary products.

The second condition that can lead to a change in demand is called the income effect. When a consumer's income changes, it affects their overall purchasing power. A person who has received a raise in salary will have more money to spend, and they will likely use some of that raise to increase their purchases of a number of products or services.

These two effects - the substitution and income effects - can be analyzed separately, but generally both operate at the same time. A decrease in the price of a substitute product, for example, will make that product more attractive to buyers (the substitute effect), and by saving the extra money, buyers' overall purchasing power has increased, enabling them to buy more products (the income effect).

**ELASTICITY OF DEMAND**

All demand curves do not have the same shape, or slope. The nature of demand varies among products according to whether they are necessities or frivolous goods and whether they have readily available substitutes. These factors determine what is called the **elasticity** of demand. Goods that are not necessities and have many substitutes, like caviar (sardines, guacamole, veggies dipped in ranch dressing, etc.) are said to have relatively high elasticity of demand.

This means that a small change in the price of caviar can induce a larger change in the quantity demanded. In Figure 5, as an example, when the price of caviar falls from $4 per bottle to $3.75 per bottle, the quantity demanded increases from 10 million bottles to 11 million bottles. Because the percentage change in the price, 6% ($4 - $3.75 = $0.25 / $4 = 0.06 x 100 = 6%), is less than the percentage change in the quantity demanded, 10% ($11 million - $10 million = $1 million / $10 million = 0.10 x 100 = 10%), the demand for caviar is said to be elastic, and the demand curve is flatter than the one for hoagies. (Sorry for the math; that's as bad as it gets.)

Alternatively, when the price of a necessity such as bread changes, the opposite occurs. Bread has few substitutes, and most of us require it in our diets. It is also a relatively small portion of our budgets, so we are not quite as sensitive to a large increase in the price. In Figure 6, the price of bread increases from $2 per loaf to $2.50 per loaf, and the quantity demanded falls from 20 million loaves to 19.6 million loaves. The price has changed by 25%, but the quantity demanded has changed only 2%, so the demand is said to be inelastic, and the curve is more vertical.

Elasticity of demand is a subtle but useful concept. It helps people in business decide whether or not to change the price of their product, for example, because if one knows the elasticity of demand, they can estimate how much a change in price will affect the sales of the product. Pricing decisions are made continuously by producers in order to adjust to market and competitive conditions and try and maximize their profits. Experienced managers can often determine these relationships by intuition and experience, but the elasticity of demand for their product is the basis of their calculation.

**SUPPLY**

Now, let's look at how the supply of products and services[4] on the market is determined. Demand focuses on the consumer of goods; supply focuses on the producer of those goods. Supply is the other side of the transaction. The question is how does the producer decide what quantity of his goods to produce and put into the market? How does he determine to meet the demand?

Consider our favorite sandwich shop. The owner of the shop is selling 100 hoagies a day at his price of $3 per sandwich. If you told him he could sell his hoagies at $4, he might ask his sandwich maker to work overtime so he could sell 150 a day. At a price of $5, the owner might decide to hire another sandwich maker so he could sell 200 a day. When we put these values into a table like the one below, it gives us the **supply schedule** for this shop.

Plotting the values in this schedule on a graph describes the owner's **supply curve** (Figure 8). As with the demand curve, the supply curve is not a straight line at all points along the line, but we have focused on that section of the curve that is basically straight.

The points define a curve that is upward sloping, starting at the lower left and moving toward the upper right of the graph. This, of course, represents the **Law of Supply** , which can be stated as follows: As the price of a product or service increases, the quantity that producers are willing to supply will increase and, conversely, as the price falls, the quantity they wish to supply will fall. Economists consider this to be a law because, like the Law of Demand, a) it seems obvious that producers would want to supply more product to the market if they could get a higher price, b) this relationship has been demonstrated through centuries of trade, and c) no one has been able to demonstrate that its opposite is true, i.e., that when the price goes up, producers supply less to the market.

In fact, the Law of Supply is perhaps more straightforward than the Law of Demand. Recall that consumers can allow feelings and emotions to enter into their buying decisions, which can complicate the process of creating a demand schedule. Producers, on the other hand, are assumed to be driven only by money, and the utility they receive from any sale can presumably be measured solely in dollars and cents. If we put ourselves in the position of the producer, it is difficult to imagine wanting to sell less to people who are willing to pay more or, conversely, wanting to sell more to those only willing to pay less.

Supply schedules are also elastic or inelastic. A producer is either more or less willing to supply products to the market depending on how his costs at each level of production will affect his profits. If raw material prices go up, he may be less willing to supply product unless he is able to make some other adjustment to offset the increase in costs.

**PRICE DETERMINATION**

Most of us believe that a producer, by putting a price tag on their product, actually determines the price for that product. The media frequently support this impression when they vilify industries like Big Oil and Big Pharma for profiting unjustly at the expense of the consumer. However, the answer to the question, who sets the price, is not as obvious as it might appear.

To answer it, we need to plot our demand and supply curves on the same graph and examine their interaction. The curves shown in Figure 9 represent aggregations of the individual demand and supply curves we derived for hoagies. We literally add the individual curves for each consumer and each supplier in the market together to create curves that represent the entire market. The reason we do this is because the curves for individual consumers and suppliers are not necessarily identical. For example, while one consumer may want to buy a sandwich at $3, another may feel that $2.50 is the appropriate price. To determine the demand for sandwiches in the entire market, therefore, each of their preferences must be accounted for.

Likewise, not every sandwich maker will want to supply their sandwiches at the same price. Some will have large, bustling shops where they are able to employ several people to make sandwiches at a relatively low cost. Others will be one-person shops where the owner has to not only make all the sandwiches, but also buy all the ingredients, make the coleslaw, slice the tomatoes, take phone orders, and keep the books. His cost per sandwich is likely to be higher than the larger operation, and he would, therefore, prefer to charge a higher price to cover that cost. At a higher price, he will likely sell fewer sandwiches than his competitor, which, unless he makes some changes, will insure that he remains a one-person shop.[5]

When the demand and supply curves for the entire market are plotted, there is a point where the curves intersect (Figure 9). This happens because the demand curve is downward sloping and the supply curve is upward sloping; they really can't miss! The point of intersection defines the equilibrium price for hoagies; at this point, consumers are willing to buy the quantity of sandwiches that producers are willing to sell at a price acceptable to both. Economists call this the point of **market equilibrium**. The widely varying prices we observe in the market suggest some of the hoagie-makers have found a niche market that prefers their sandwich to others. If all sandwiches were exactly the same, however, the market would move toward the equilibrium price.

This takes us back to the question, who actually sets the market price? The wonderful thing about a free market is that trades are only made if both sides are satisfied. If a consumer is not satisfied with the price for a good or service, they can Google another supplier and get another quote. When enough consumers are not satisfied with the price quoted, one supplier, at least, will lower their price in order to make a sale. And if this price is still too high for most consumers, another supplier will lower the price one more notch, and so on until enough consumers and suppliers are satisfied that all of the suppliers' goods are sold. So the answer to our question is that the seller does not determine the price of a good in a free market; the price is "set" by the market itself, by the preferences of consumers and the competitiveness of sellers.

This process is easy to see if we think about the retail gasoline market. It is rare to find one or more of the four stations at an intersection offering their gas at more than a penny or two different from the others. This is not, as some might suppose, because the stations are in collusion to maintain high prices but, rather, because none of the stations wants to lose sales to a lower priced station. In a competitive market like gasoline, it is very difficult for a group of stations to maintain prices above the equilibrium price, because when a nearby station sees an opportunity to increase its sales by pricing below the group, the discipline within the group will soon break down, and prices will drop. (This is true even in the largest cartel in the world, the Organization of Petroleum Exporting Countries - OPEC - where some of the smaller producers in the group are tacitly permitted to offer their oil below the stated price in order to maintain their production volume. Even some who are not permitted to lower their prices do so anyway.)

A freely competitive market is the most efficient way for buyers and sellers to signal their preferences. Suppose the equilibrium price of gasoline in March is $3.50 per gallon. Experts predict unusually warm summer weather so, expecting more people to drive on their vacation, producers decide to increase the supplies of gas they deliver to their retail stations. In this case, the supply curve for gas would shift to the right (Supply 2) as shown in Figure 10, indicating there is more supply available at each price than before. If that warmer weather fails to arrive, however, and consumers drive fewer miles than producers had expected, the market would experience a surplus of gasoline.

Now, the demand and supply curves cross at a new, lower equilibrium price of $3.35 per gallon. When this occurs, those holding the surplus are forced to lower their prices to induce greater demand for their surplus gas. Other stations must follow this drop in price to avoid losing customers. In time, the cheaper gas will get rid of the surplus and, as the supply curve moves back to the left, the market price will return to its old equilibrium level. Note, however, that this error by producers cannot be undone, and they will have lost $0.15 per gallon by over-supplying the market.

The same process operates if demand changes. Suppose the summer weather is even hotter than producers had anticipated, causing consumer demand to jump. The demand curve in Figure 11 would shift to the right, indicating a greater demand for gas at each level of supply. It now intersects the supply curve at 55 million gallons. Since the current supply is only 50 million, the equilibrium price rises to $3.60 to reflect the shortage of gas. Consumers will have to pay more for their vacations and, because of the increase in price, some consumers will decide to stay home. The higher price effectively allocates the available gas to those who value it most. When weather conditions return to normal, the demand curve will shift back to the left to the equilibrium quantity of 50 million gallons.

Note that, in each case, there is a loser. When the market is oversupplied, producers will have to cut back production, and jobs may be lost, at least for a time. When the market is under-supplied, some consumers will not be able to pay the extra price and will have to reduce their driving. Markets not at equilibrium create inefficiencies, and markets permanently out of balance due to outside interference impose enduring costs on society.

Smith recognized that this process of the market finding the right price could take some time. He introduced the idea of two prices, a **natural price** and a **market price**. The natural price, he said, was the price that would result in "normal" returns to both labor and capital. A normal return to capital - a **normal profit** \- was one sufficient to keep a firm in business, but not so large as to encourage other firms to enter the business. Smith's natural price, then, was the equivalent of what we have called competitive market equilibrium.

The market price, on the other hand, was the price actually required to clear the market on a given day, that is, to purchase the full quantity of goods brought to market by producers. The market price is affected by short term imbalances between supply and demand, like the surpluses and shortages described above.

Think about farm products, which are generally available throughout the year. A heavy winter storm may curtail truck transportation for several days or longer, causing deliveries to be delayed. Consumer demand for food products, however, is constant, so a storm delay will cause a temporary shortage of product in the market (i.e., demand is greater than supply). Those food companies most in need of certain commodities will be willing to pay more to secure their supplies; thus, the market price will rise above the natural price. In the same manner, when the harvest is bountiful and storage space is at a minimum, the market price may temporarily fall below normal until this imbalance is eliminated.

**RENT CONTROL LAWS**

How can we use the knowledge of demand, supply, and price determination in our own world? Consider price controls. Periodically, when the price of an essential good or service seems to be getting out of line, people call for government to do something about it. One of the most appealing proposals is always to control the price. It is appealing because it sounds so darn logical.

In 1920, concerned about the multitude of returning soldiers and the effect they were having on the housing market, the city of New York approved the Emergency Rent Laws to control the cost of renting. The problem was that rents were rising so rapidly that some renters, whose leases were about to expire, could not afford the higher level of the renewal and would, thus, have to vacate their apartment. This was deemed to be unfair to the renters, so the law stipulated that, once a person's rent was set in a rental agreement, that rate could not be increased, ever. The mayor of New York argued that "the law of supply and demand should not apply so far as the renting situation is concerned." At the urging of Governor Al Smith, the law expired in 1929.

During World War II, the federal government had the same concern about apartment shortages and rapid rent increases, so they passed a rent control law applicable to a number of large cities. This law remained in effect from 1943 - 1948, at which time the federal government turned over responsibility of oversight to the states. New York was one of the few states that picked it up, and rents have been controlled continuously in New York City ever since.

As microeconomists, we can quickly see what is wrong with trying to ignore the laws of supply and demand. If the rent of apartments is artificially held below the equilibrium price, two things will happen. First, people not in the rental market will begin to find it more attractive, and will enter the market to take advantage of the below-market rents. At the same time, people supplying rental units to the market will tend to invest free funds in other areas where the profits are better, and the supply of apartments will start to drop. Demand will increase and supply will decrease, but since the price mechanism that would normally resolve that problem is not allowed to work, a shortage is created. No law can be passed that will prevent this, short of a government take-over of the industry.

Apart from economic incoherence, there are two major problems with rent control laws. The first is a constitutional question. The Fifth Amendment to the Constitution provides that "no person shall be . . . deprived of life, liberty, or property, without due process of law; nor shall private property be taken for public use, without just compensation." Legal scholars can argue over whether a rent control law, which deprives the landlord of revenue he would otherwise have received, is a "taking" under the Constitution, but most fair-minded people would see it that way. Legal scholars have, in fact, argued this point, and an appeal to the U.S. Supreme Court has resulted in the Court asking New York City and the tenants to respond, indicating the possibility the Court will consider the appeal.

The second problem with government interfering in the pricing of rental units is that, as costs rise, landlords will no longer have sufficient funds to maintain their properties, and the quality of the housing stock declines. Like any business, real estate owners have regular expenses that must be covered. Eventually, units under rent control (not all units are included in the law) run short of cash, and the landlords start deferring maintenance. A hole in the roof is not repaired right away, and water starts to leak into the apartments. The plaster starts to deteriorate. The kitchen appliances break. Window panes crack. The air conditioning unit fails. And when an unanticipated repair is needed, the necessary cash reserves will not be available to pay for it. Eventually, some landlords just walk away from their properties rather than put any more money into them. The South Bronx in New York is crowded with empty, dilapidated apartment buildings for just this reason.

Is there a better way to address a social problem like a shortage of lower priced apartments if it is, indeed, a problem? A guiding principle of economics is that a social problem should be addressed by all of society, not just a small subset. If the residents of New York believe the city should supply below-market rentals to the public, they should agree to a tax that will cover the rental shortfalls, and pay that amount to the landlords. This will spread the burden fairly, and provide incentive for landlords to maintain their buildings. Since the rental market would be free to work as renters and landlords would like it to work, shortages would disappear, and the quality of the housing stock would improve.

Rent control, like any price control scheme, is a disruptive economic action that upsets the efficient working of a free market and results in a less efficient allocation of resources. Although controls may be embraced by the people they benefit, their burden usually falls, unjustly, on the nearest likely candidate rather than on the appropriate parties.

**ELASTICITY OF SUPPLY**

As mentioned earlier, the supply of products in the market varies depending on the producers' ability to bring additional product to market cost-effectively. If the price of gasoline increases, it is difficult for producers to bring much more gas to the market, at least in the short term. Refineries normally run around the clock, so there is not much extra capacity to produce more fuel. And there are only so many trucks and pipelines to transport gas to the market, so delivering a lot more in the next week or two is difficult. The supply of gasoline, therefore, is highly inelastic relative to price; a big change in price will not draw very much more gas to the market in the short term.

Contrast this with the supply schedule of Apple's iPhone. When it was first introduced, the iPhone was priced at $599. Apple quickly found that the demand at that price was not nearly what they hoped, so they dropped the price to $399 after a couple of weeks. At this price, iPhones flew off the shelves, and Apple produced and sold many more than it had initially expected. The supply of iPhones was found to be highly elastic with regard to price.

What is the difference between the two products? One of the major differences is the amount of capital that must be invested to increase the supply and the time required for that investment to result in greater quantities. To begin producing oil from a deepwater lease, a producer must invest a couple hundred million to map the site and drill an exploratory well or two to find out if there is enough oil to continue the development. If the wells are successful, they must rent a drill ship at a quarter of a million per day and spend another couple of billion to fabricate a production platform. From start to finish, it will take a few billion dollars and four-to-five years to begin production. Thus, while a short term jump in prices might lead producers to crank their existing production up a little higher, they are not able to bring significant new supplies to market for a long time.

In the case of iPhones, it would probably take Apple six-nine months to build a new plant and bring a much larger supply to market. In the meantime, the company will likely have excess capacity in their existing plants to bring more supply to the market in the near term.

Other factors affecting the elasticity of supply are factors that affect producers' costs, such as labor and raw materials. Any time profit margins are under pressure, producers must consider whether increasing or reducing their production will improve their bottom line. Knowing the elasticity of supply for those resources helps them make those decisions.

**SUPPLY OF LABOR**

Smith defined three elements necessary to produce goods for sale - land, labor, and raw materials - and called them the factors of production. Later economists expanded the idea of land to include machinery and equipment, and this factor was renamed **physical** **capital** (not to be confused with "money," which is used in the financial and accounting worlds). Economists now consider a fourth factor to also be essential for production, and that is entrepreneurial skills, the ability to bring the other factors of production together in a way that will produce profits. Such skills are called **human capital**.[6]

The factors of production, like finished goods, have their own supply curves. Nearly all supply curves are upward sloping, like those we have seen. There is an exception, however, to the straight line supply "curve" that is worth examining, the supply curve for labor. The supply of labor is determined by those supplying the labor, that is, people like us. Our desire to supply labor (i.e., work for pay) is a function of the wage we can get for our labor. Figure 12 shows the quantity of labor we may be willing to supply, shown in hours/week (the horizontal axis), plotted against the wage rate per hour. Notice that, at relatively low levels of pay, most of us would like to supply more labor as long as our wages grow. This is perfectly consistent with the Law of Supply and an upward sloping supply curve.

However, as our wages increase and we become more comfortable with our financial future, our interest in working harder begins to wane, and we begin to value our free time more highly. We are no longer interested in working longer hours for a modest wage increase, and the wage we require begins to increase more rapidly. At some number of hours worked, we are making so much money that we actually start offering less time for the wage offered. After all, who wants to work so many hours that they have no time to enjoy life? Economists would say that the opportunity cost of working the marginal hour has become too high, and the value of our free time exceeds the marginal value of working.

The result is a supply curve that is shaped like a boomerang. You might wonder where the curve goes beyond what is shown. We could speculate that it eventually extends all the way back to the zero point on the horizontal axis, where wages become so high that we are not willing to work at all. But this is nonsensical; who would pay us that much to not work? We will leave it to the economists to solve this problem. We show this labor supply curve for two reasons. The first is to illustrate that, indeed, not all relationships in economics can be fairly represented by straight lines; considerations of costs and benefits at the margin often lead to more complex analysis. The second reason is to foreshadow a similar kind of curve we will encounter when we take up the subject of taxes.

**MINIMUM WAGE LAWS**

The plight of the poor has been a concern for economists since the 18th century. It was one of the primary reasons that philosophers like Smith and others began to think about economics. Unfortunately, that concern is still with us. One of the many ways government addresses the problem has been through the minimum wage law, setting a minimum hourly wage that all employers must pay. Smith, himself, acknowledged the need for a "subsistence wage" to cover the basic needs of the labor force, but argued that the market would naturally supply such a wage so as not to cause a drop in the supply of labor. He believed that population was, to some extent, self-regulating depending on the standard of living.

Advocates of the minimum wage now call the subsistence wage a "living wage." How does one determine what a living wage is? What is the "living" requirement of Fred Jones or Sarah Smith? It would be hard enough to determine that about your close neighbors, and virtually impossible to determine it for the other 150 million people in the labor force. Nevertheless, many are persuaded that the market will not provide a living wage and feel that we, as a society, need to intervene.

What does economics have to say about a minimum wage? Economists would look at the demand and supply curves for labor. They know that, if the price of labor is arbitrarily increased above the equilibrium wage, two things will happen: one, the quantity of labor demanded by firms will drop and, two, the quantity of labor supplied to the market will rise. Thus, there will be more workers looking for jobs and fewer jobs available than before. Figure 13 shows graphically what happens.

In this example, the typical demand and supply curves for entry level positions indicate an equilibrium wage of $5 per hour, Point A on the graph, meaning that for firms to be able to fill their 5,000 open positions, they will have to offer no less than this wage.

Now, suppose the government dictates a minimum wage of $5.50 per hour for entry level positions. At this level, the firm's costs go up, and some of the available jobs disappear. The firms decide they can reorganize their existing operations to cover the work that needs to be done, and their demand for workers drops by 400 jobs, Point B on the graph.

At the same time, the extra $.50 per hour has encouraged 500 more workers to enter the job market, Point C. The result is a surplus of 900 workers (5,500 - 4,600) and 900 people are now unemployed, the 400 the firm did not hire and the 500 willing to work at the higher wage. The imposition of the minimum wage, above the equilibrium wage, has increased unemployment.

This is a pretty straightforward analysis, and, as we determined earlier, these are _laws_ , not theories. However, economists have tried to study the actual effects of increases in the minimum wage, and the results do not convince all skeptics. Some show a clear increase in unemployment, while others show, at most, a modest increase. Most economists agree that at least some unemployment is created, as the economic laws suggest, but argue over the amount and whether it is significant.

This highlights the challenge that economists face in dealing with the real world. How does one generate reliable data that will isolate the effect of a change in one factor from all the other factors that influence the market? If, for example, the increase in minimum wage became effective just as the economy was heading into a recession and unemployment was beginning to increase, how could one conclude that it was solely the increase in the minimum wage that led to the increase in unemployment? This is just one of many situations that could cloud the data and make it difficult to draw useful inferences. The country could just as well be pulling out of a recession, or even a temporary slowdown, with unemployment declining, which would also tend to overshadow the effect of the minimum wage increase. We will see even more complex problems than this when we get to macroeconomics.

When the data for a study are inconclusive, some economists are moved to draw conclusions based on their political beliefs. This is definitely counter to the ethic of the profession; as scientists, economists believe they should confine their conclusions to the data. However, politicians constantly look to the profession for guidance, and the temptation to try and fill that need with opinion is strong. One should be cautious when considering guidance from an economist who writes op eds in the newspaper. They should be clear about what part of their writing is based on peer-reviewed studies and analysis of real data and what part is based on opinion, no matter how educated it may be.

If one couples solid economic theory with reliable data, however, one can develop a reasonable opinion about the effect of the minimum wage. In 2007, Congress increased the minimum wage from $5.15 to $7.25 per hour, a 41% increase, over two years. In the summer of 2011, the Labor Department reported that a smaller share of teens, 16-19 years old, were working than at any time since 1948, when records were first kept; only 24% of teens had a job, compared to 42% as recently as 2001. A 2010 study by William Even of Miami University and David Macpherson of Trinity University found that, as a result of the $2.10 increase in the minimum wage, teen employment dropped 6.9%, and for teens not having finished high school, employment dropped 12.4%.

Not having a job denies teens the chance to learn some of the key lessons of the labor market - getting to work on time, how to run a machine, how to dress and behave - which could affect their entire careers. The shame is that Congress could consider other steps to achieve the effect of a living wage that would cause little or no unemployment. It is estimated that roughly three-quarters of those receiving the minimum wage are, in fact, teenagers. Congress could establish a lower minimum wage of, say, $4.00 for them, since they are usually single and living at home and, therefore, do not have the same need for a living wage as a family does. This would significantly increase teen employment and get a lot more off the street and into the work force.

The remaining one-quarter of minimum wage earners fall primarily into two categories: those who are the sole providers for a family, and those for whom their wage is the second income in their household. It would be reasonable, and less costly to society, to make a direct payment to those supporting a family solely on the minimum wage. This could be done in conjunction with other support programs already in place, such as food stamps and medical care, to insure that the worker had effective access to a living wage, whatever that amount might be.

Some might object on the grounds that this payment would require an increase in taxes and, thereby, dampen economic activity. However, the cost of the minimum wage is ultimately absorbed by the rest of us anyway, either through higher prices for the products we buy, or lower investment by companies, leading to lower wages in the future. (We will discuss these effects in more depth when we look at macroeconomics.) Government price interference in the labor market deprives people of work. That's just economics. The question as to why legislators would take action so obviously counter to economic theory will find a partial answer when we address cronyism in government.

**DRUG PRICE CONTROLS**

Major shortages of two critical cancer drugs currently have brought attention to a more widespread problem involving both generic and branded drugs. Awi Federgruen of Columbia Business School highlights a record of 267 drug shortages in 2011, up from 58 in 2004. Most of the 2011 shortages remain unresolved. The number of generic drug manufacturers in the U.S. has dropped from 26 in 1967 to only six today.

Supply disruptions are common, often based on shutdowns for reasons of quality and safety. At the same time, Federgruen found that major pharmaceutical makers have failed to invest in the technology and quality-control improvements that would reduce the risk of shutdowns, despite the Federal Drug Administration's regularly issued guidelines for best practices.

Government price controls on generic drugs are the primary culprit, especially for those purchased by Medicare and Medicaid. Low prices cause manufacturers to exit the market, increasing the risk that a shutdown will have a major impact on supply. Low prices also limit the capital firms have to make needed investment in better technologies.

In the case of vaccines, for example, the Centers for Disease Control and Prevention pays the lowest price for generic vaccines it can negotiate. Their clout as a unit of the federal government gains them an average discount of 40% off private sector prices. Manufacturers have limited influence when a buyer the size of the government is involved. If you want to be in the business, you basically have to take what they are willing to pay. And it is not difficult to see that private buyers' profits will suffer by having to pay a much higher price than the market would normally determine. In 2006, the government's own National Vaccine Advisory Committee named price controls as the primary reason for the troubling disappearance of suppliers.

**MAXIMIZING FIRM PROFITS**

" _The diminution of profit is the natural effect of... prosperity." -_ Adam Smith

So far we have focused on the interaction of consumers and producers in a marketplace. We have said that consumers make decisions about what to buy and how much to pay based on the utility they expect to receive from the purchase. To round out our look at microeconomics, we need to see how firms make decisions about how much to supply to the market and what price to ask. These decisions are made based not on utility but, you guessed it, profit. Producers and their investors want to make a lot of money.

The profits of large corporations are a frequent topic of media coverage, particularly when they are going up. We can comfortably rely on the media to let us know the enormous size of oil company profits when gas prices are rising at the pump. Some are convinced that corporations are the enemy of the people, draining our pockets at every opportunity. If you ask such people how much of their revenues corporations put back into the economy, they will probably throw out some lowball estimate like 5%. In fact, those greedy corporations pay out fifty-five cents of every dollar of sales to their employees, on average, in wages and benefits. Look at the National Income Accounts to verify that wages and benefits of $8.6 trillion represent 55% of GDP. So we should look at how firms seek, selfishly, to maximize their profits, how that benefits society, and whether it is possible for any company to reap extraordinary profits over the long term.

As a starting point, we all know that profits are produced only when a firm's revenues exceed its costs. Smith believed that a firm would not survive over the long term without providing its owners what he called a **normal return** on their investment. He defined normal as an amount to cover the use of the money, its **rental rate** , and an amount to reflect the uncertainty of getting the money back, the **business risk**.

Smith wrote that in a perfectly competitive market, the owners of capital would move their capital from one firm or one industry to another until they felt it was earning a normal return. Recall that, in a perfectly competitive market, products are undifferentiated from one another - they are effectively, if not actually, commodities - so producers in these markets are price takers. In a world like this, Smith's comment quoted above is almost invariably true; the greater the level of prosperity in the economy, the tougher it is for firms to out-fox the consumer.

Today's commercial world is quite different than the one Smith observed. Firms have been able to differentiate their products and, in some cases, protect those differences with patents. Those who can create products that consumers "must have" can sometimes make a greater than normal profit, what economists call an **economic profit**. An economic profit, of course, is what skeptics would call an excess profit.

Economists accept that firms can earn economic profits, but usually only for a short period, one just long enough for consumers and competitors to adjust. Economists do not believe that, in a free market, many firms are able to earn above-average profits over the long term; this would imply a market power that few firms can maintain. We will touch on such situations later.

Now, however, we turn to the costs of a firm, the only element of its business it can truly control. We look at costs to understand how a producer makes a profit, and how it decides to produce more or less. We start with one of Smith's great insights, an important principle called the **division of labor**. Smith introduced this idea in "Wealth of Nations" by noting that when a complex manufacturing process was split into smaller segments, the productivity of the workers was seen to improve significantly.

Smith describes the work of the pin maker, an activity that he observed could be divided into eighteen discrete steps. A single person with little experience and no special equipment, he says, could scarcely make one pin per day. Another maker whose plant he studied, with ten workers and the use of moderately advanced machinery, easily produced around twelve pounds of pins per day. At four thousand pins to a pound, the twelve pounds amounted to forty-eight thousand pins, or about forty-eight hundred pins per worker per day. He concluded that, by cutting this particular job into smaller, more specialized pieces, one was able to increase the productivity of his labor force by a factor of forty-eight hundred. This process represents what economists call the **increasing marginal productivity of labor** , the idea that, by adding an employee, each employee can become more productive. There is a limit to this effect, which we will examine later.

The source of this significant improvement is familiar to us today. It would take one person performing eighteen different functions a very long time to learn and improve their technique in all of those functions. In contrast, those workers who can specialize in fewer functions are able to work much faster and with less waste. Also, more specialized workers do not need to stop what they are doing and start doing something else nearly as often as the single worker. This allows them to devote more of their time to production and less to putting a tool away, getting a drink of water, hitting the head, reading the bulletin board, and setting up another process. Smith asserts that this advantage is larger than it might at first appear, noting that,

A man commonly saunters a little in turning his hand from one sort of employment to another. When he first begins the new work he is seldom very keen and hearty; his mind, as they say, does not go to it, and for some time he rather trifles than applies to good purpose. This habit of sauntering and of indolent, careless application... renders him almost always slothful and lazy...

Any reader who has ever worked in a large factory with lower-skilled laborers knows what Smith was talking about. He was not judging such men. He was simply describing what he observed.

The division of labor, then, is an old idea, but it is as pertinent today as two hundred fifty years ago. In the 1970's, a young consulting firm called the Boston Consulting Group ("BCG") developed strategic plans for large corporations. One of their key analytical techniques involved charting a manufacturing company's unit costs of production over a period of time. A successful firm, they observed, was one whose cost per unit steadily declined. They called the graph of the firm's unit production costs their **experience curve** , by which they meant that, as the firm produced the same product over and over - deepened their experience in the process - it learned better how to reduce manufacturing costs and pull the cost curve downward. Figure 14 illustrates an experience curve, where unit costs of production decline as volume produced increases. This enabled the firm to lower the price of its product and gain more customers, which deepened their experience even more, leading to yet lower costs in a sort of virtuous cycle. The experience curve builds directly on Smith's concept of the division of labor. Within 15 years, BCG became one of the largest management consulting firms in the world.

Now we will show how Smith's principle affects a firm's costs. A word of warning: this part of microeconomics is a little more complex than we have seen so far, and some of the terminology may be unfamiliar. We hope the graphs aid your understanding but, if not, you can always call us.

A firm's costs can be thrown into two "buckets:" those that must be paid regardless of the firm's revenues, things like rent, heat, electricity, depreciation charges on equipment, and salaries of white collar employees; and those that are tied to the production of goods, such as plant labor and raw materials. The first bucket is called **fixed costs** , because the amount is fixed at a specific level regardless of production levels. The second bucket is called **variable costs** , because their amount varies with the volume of production. These two categories of cost make up the firm's **total costs** of operation.

Economists are particularly interested in just a slice of costs, i.e., the cost of producing the next item. It should not surprise you that this is called the firm's **marginal cost** of production, the variable costs of producing one more item. Managers must know their marginal cost to decide whether or not to actually produce that item and supply it to the market. Think of it this way. If you are deciding whether to knit one more pair of socks for sale, you don't care what the pair you knit last week cost. You want to know if you can cover the costs of knitting _this_ pair. If you found that the price of wool had doubled, you might determine that you would lose money selling them at the market price, and decide not to knit them. This is why the marginal cost is important in business.

As with demand and supply, economists create curves to display how costs behave when production volume[7] changes. In Figure 15, the label on the vertical axis is "cost per unit." Unit here means a single item, so the cost per unit is the marginal cost. The marginal cost curve is u-shaped. The reasons for this shape are important to understand.

A decline in a firm's marginal cost means that the cost of making the next unit is less than the cost of making the previous one. Why would the marginal cost decline? The answer is increased productivity due to the division of labor. Think about Smith's pin maker. He perceives a very large demand for pins and believes he can create a profitable business if he keeps his costs low. He knows his costs will not be low if he does not utilize the latest production technology, which requires that he invest in tools and machinery. In the early days of his business, his sales are only large enough to hire one worker, and his machinery sometimes sits idle. During this period, his marginal costs of production might be represented by point A on the graph.

It happens, however, that this guy can sell pins, and soon his sales increase to a level where he can afford to hire a second worker. Now each worker can focus on running one-half of the equipment and, because of this division of labor, each one will become more productive than the single employee by producing more pins per hour. With this, the firm's marginal cost of production - the cost to make the next unit - declines from its initial level, to a point marked B on the curve. This increasing marginal productivity of his labor force will continue until the point where the newest worker just gets in the others' way, point C on the graph. At this point, the firm's marginal productivity per worker has reached its peak.

One might conclude, having reached this point of maximum productive efficiency, that the firm should stop hiring more workers and enjoy its success. Bad decision. In order for the firm to maximize its profit, this is not the time to stop making product. That point can only be determined by considering the price the firm can get for its pins. The economic rule is that the firm should continue supplying the market, i.e., producing and selling product, until the marginal revenue for the next sale is equal to the firm's marginal cost for making that pin.[8] They will not be operating at peak efficiency, but they can still make more money. This may be easier to understand by looking at Figure 16.

One might expect the market demand curve to represent the marginal revenue available at a given volume. This is true for the overall market; however, since an individual producer in a purely competitive market only "sees" one price - the market price - his marginal revenue curve is horizontal. No matter how much or how little he produces, he will get the same price for his production.

The graph shows that the firm should produce 1,075 units. This is where its marginal revenue and marginal cost are the same (Point A). At this point, the firm's profit, which is determined by multiplying the quantity sold by the price received (1,075 times $1.70 = $1,827.50) is maximized. It is easy to see that any quantity less than 1,075 sold at $1.70 will produce less profit.

OK, so the firm makes money at the margin, but profits are based on total costs, you say, not just variable costs. To determine whether the firm will be able to cover _all_ of its costs, including both variable and fixed costs, we must now examine another measure - the firm's **average total cost**. A firm's average total cost is simply the firm's total costs (variable and fixed costs) divided by the quantity of product sold. This, again, measures cost per unit of production. Figure 17 shows how average and marginal costs are related.

We start with the same u-shaped marginal cost curve as on the prior graph. At point A, average total cost (designated ATC on the graph) is greater than marginal cost. This is because, at low production quantities, the firm's fixed costs per unit are high relative to its variable costs.

A simple numerical example might help. Imagine you have just opened your sock shop and sold your first pair for $15. The wool in those socks cost you $2.50, and you determine your time in knitting them was worth $7.50, so your marginal cost was $10.00. Your only other cost is the rent on your shop, your fixed cost, which is a steal at $20 per month. Your operating results, then, are a loss of $15 ($15 revenue - $10 marginal + $20 fixed). Since you sold just one pair of socks, your average total cost is $30 / 1, or $30.

What happens if you sell two pairs of socks? Your marginal costs are two times that for one sale, $20.00, and your rent is still $20. Since you only received $30 for the two pairs, you still lost money, but the loss is lower - $10 vs. $15. And your average total cost is now $40 / 2, or $20 vs. $30.

Now, back to Figure 17. At point B, average cost per unit benefits from the drop in marginal cost (see increasing marginal productivity of labor above). In effect, the lower marginal cost "pulls" the average cost down in the same way that a grade of "C" in a college course pulls down a "B" average.

As marginal costs reach their low point and start to increase, average cost continues to decline as long as the marginal cost remains below it. (Even a C+ pulls a B average down.) At point C, however, marginal cost rises above the average cost, which stops the decline in average cost. From point C on, the rising marginal cost is pulling the average cost back up (as an A in a course pulls up a B average).

What we see here is the genesis of Smith's invisible hand. In purely competitive markets firms are price takers and seek to maximize their profits by keeping costs as low as they can. And by pursuing this strategy the firms will unintentionally deliver the greatest benefit to their customers, a product sold at the lowest price possible. If the price were any lower, firms could not cover their marginal costs. At this point, the least efficient of the firms would reduce their production, supplying less product to the market. This would move the market supply curve to the left. One or two firms might go out of business.

Thinking about supply and demand analysis, we know that a supply curve that moves to the left will intersect the demand curve at a higher price. (Go back to Figure 10 to visualize this.) The shortage of product supplied to the market would cause buyers to increase the price they were willing to pay in order to secure their needed quantities. For a brief period, the remaining producers might enjoy greater than normal profits, but this would attract other producers to enter the market to join the profit party. The economic profits would be eliminated as the newer producers cut their prices to get into the market, and supplies would be pushed back up to their prior level, i.e., the supply curve shifts back to the right. At that point, the price would be just high enough for the firms supplying the quantity demanded to cover their costs again.

The point of this complicated description is to show that in a perfectly competitive, free market, no firm can achieve economic (above normal) profits over the long term (although CEO's who acknowledged that would be fired by their boards). To review, a perfectly competitive market is one with multiple buyers and sellers, where no individual participant can influence the price, and it is a market where each firm's product is like every other firm's. Profit maximization for firms in such markets is achieved at the point where marginal revenue, marginal cost, and average total cost meet, Point A on Figure 18.[9]

In Smith's time, this analysis described nearly all commercial activities, because most products were commodities. In developed economies, where more value is added to basic commodity products, a lower percentage of trade is carried out under these conditions. We will turn, therefore, to how a large portion of trade is carried out in advanced economies, and its effect on firm profits.

Earlier we described the nature of a monopolistically competitive market. These are markets where there are fewer producers still supplying a large number of consumers, and in which the competitors' products are differentiated from each other. Examples of such markets are packaged consumer goods (e.g., food, health and beauty aids), clothing, and most retail businesses. Nearly every product with a brand name is considered to be differentiated from competitive products.

How does the profit maximization strategy for firms in these markets differ from that in perfectly competitive markets? Well, the general rule that firms should supply such markets to the point where their marginal costs equal their marginal revenues still applies. The difference is that, because their products are differentiated, firms in this type of market have some latitude in their pricing. They might be called **price makers**. The degree of latitude depends on the extent to which their products are considered uniquely different from those of their competitors.

Consider the market for breakfast cereals. You might consider one firm's raison bran to be just like another's. However, one producer might offer a flake that is has more fiber than the others, or a raison with a unique taste of sweetness, or an extra shot of Vitamin A. To the extent this producer can convince you of the benefits of these features, they may be able to charge another nickel for their cereal. As a result, the demand curve they face is not horizontal, but rather, downward sloping, as shown in Figure 19.

Recall that a downward sloping demand curve means that a buyer has choices - substitute products are available \- and when the price-to-value ratio for one product gets out of whack, they are likely to buy a substitute. This puts a limit on what producers can charge.

Unfortunately for the producer, while he can offer his products at the price indicated by the demand curve, his marginal revenue will be less than the price. The proof of this is simple math, but we will spare you the mental pain. It is based on the fact that, each time a producer lowers his price, he must sell _all_ of his production at that lower price and, thus, loses revenue he would have gained by selling less product at a higher price. The elasticity of demand for the product (Figures 5 and 6) will help him decide the best course of action.

In Figure 19, the marginal revenue and cost curves intersect at a quantity of 650 units. This is the profit maximizing level of production. (Note that this intersection is not at the lowest point on the marginal cost curve although, in this case, it is close.) However, the actual market price is defined by the demand curve, so the 650 units can be sold at a price of $4.00 each. This appears to offer the producer an opportunity to make an economic profit, but we must consider whether he is covering is total costs to make that determination.

Figure 20 illustrates how economic profits can be made. In this case, the producer's average total costs intersect the quantity sold at Point A, below the price. The difference between Points A and B defines the economic profit available at the quantity of 650 units. The actual profit can be mathematically determined by finding the area of the shaded rectangle, which is $0.75 times 650, or $487.50. If the average total cost curve moved to the right so that it intersected the demand curve at Point B, we would have a situation similar to the purely competitive example, where the price per unit equals the average total cost per unit, and a normal profit is made.

Just as in a perfectly competitive market, the producer in this market has strong incentive to keep his costs as low as possible to try and capture that economic profit. And because he has only limited influence on the price he can charge, the consumer, again, is usually a winner.

We opened this section on corporate profits with a quote from Adam Smith, that in a healthy, free market, the natural tendency is for producers' profit margins to decline, even the most profitable companies. This is true because, as long as there is an economic profit to be made in an industry, new producers will be attracted to it, which will increase the supply relative to demand and cause the price to drop. At some point, all of the excess profits will be consumed by the lower price.

We believe this is valid in the kind of market Smith experienced. We also believe the tendency for profit margins to decline is valid in monopolistically competitive markets, where branded products are sold. However, we know that the name Apple has come to your mind, and you find it hard to believe Apple doesn't make economic profits. We suppose if any company could make an economic profit today it would be Apple.

However, reflect for a moment on Apple's history. They were a shooting star in the 1980's with their slick personal computers, but Microsoft outsmarted them by selling their operating system to any and all computer makers, and Apple's market share began to sink. So dire did the situation become that the board fired the founder, Steve Jobs, in 1985. Only after he returned, in 1996, did iPod, iTunes, iPhone, and iPad launch Apple into the ranks of legend.

The question is, what i-device is next? And how many more are there? No doubt there are many more in planning stages, but Apple's only chance of continuing to earn economic profits is if the streak of winners goes on. The day it delivers a product that bombs, its stock market value will drop significantly and, without truly heroic efforts, a new company will take its place in the heavens. In that event, Apple will evolve into a company like Sony (remember the Walkman?), or Sharp, or Panasonic who make high quality, commodity consumer electronics and struggle to earn normal profits.

Apple is a great company, and we wish them nothing but continued success. Indeed, some companies have been able to dominate their markets for long periods of time, companies like Eastman Kodak, General Motors, Polaroid, Motorola, and, in its day, F.W. Woolworth, all industry leaders. However, these companies have all lost their former dominance, and some have gone bankrupt. Those who continue to lead their industries over long periods of time, the Procter and Gambles, IBMs, and Harley Davidsons, have only done so through continual innovation and reinvestment, and sometimes drastic changes in their products and business models, which have cannibalized some of those economic profits.

Free markets are brutally competitive. Highly paid executives lose years of sleep worrying about their competition. Over the long haul, it is difficult to see how consumers are not winners in these heartless markets. We hope this exposure to the economics behind the stories will help you see why this is true.

# Chapter III - Macroeconomics

" _[The] annual produce of the land and labour of any nation can be increased in its value by no other means, but by increasing either the number of its productive labourers, or the productive power of those labourers ..." —_ Adam Smith

Macroeconomics is the study of the economic behavior of an entire society, whose goal is developing useful guidance for public policy-makers. A primary goal of macroeconomics is to identify the best way to promote healthy growth in the economy to raise the standard of living for all members of society.

Smith's "Wealth of Nations" has become a classic because it was the first comprehensive analysis of an entire economy. Smith understood that it was the growth of an economy, not its actual size, that enabled an increase in the standard of living. "It is not the actual greatness of wealth, but its continual increase, which occasions a rise in the wages of labor," he wrote. He cited the example of the young American economy. America, he said, was growing much faster than the much larger British economy, and because of this, its wage levels were significantly higher. For example, in the years just before the Revolution, he estimated that wages in New York were three times those in Britain.

Smith's circular flow model of the economy (Figure 2) forms the basis of what became known as **classical economics** , the foundation of modern economic study. Some believe that Smith's greatest contribution to the science of economics was his articulation of this circular flow model, which provided the framework for study of both individual markets for products, commodities, labor and capital, and for the economy overall. The term **macroeconomics** to describe the economics of growth came into wide use in the mid-20th century.

**GROSS DOMESTIC PRODUCT**

The Bureau of Economic Analysis of the Department of Commerce maintains detailed accounts of income and expenditures throughout the economy. Called the National Income and Product Accounts, they allow a computation of the total of goods and services actually produced each year; this is called the **Gross Domestic Product** , or GDP. When divided by the number of people in a society, it is a measure of the standard of living for that society (GDP per capita).

GDP is defined as the market value of all goods and services produced and sold domestically during the year. It is also sometimes referred to as the **National Income** , since the profits of all businesses and the wages and income of all individuals add to the same number as GDP. (It's simple math, trust me.) Either way, it is a convenient measure of economic activity for the year. If GDP is growing, it indicates the economy is relatively healthy; if it is shrinking, the reverse is true. Over time, GDP traces a variable path, with a period of growth above the average, followed by a period of below average growth, as illustrated in Figure 21. This pattern is referred to as the **business cycle**. The business cycle is a natural result of economic growth, since growth does not occur in a smooth, predictable way. More about this later.

Economists compare the current value of GDP to its value a year earlier to track the business cycle. Over the sixty years between 1947 and 2007, our GDP grew at a 3.5% average annual rate. During an expansion in the business cycle, GDP can grow upwards of 5%-7% a year, and during a recession, it typically declines between 2%-3% a year.[10] Fortunately, our growth spurts are longer than our hiccups, resulting in positive GDP growth over time.

The growth of the U.S. labor force is about 1%. Economic theory holds that GDP growth is equal the growth of the labor force plus the growth in **productivity** in the economy. Growth in productivity, or **output per man-hour** , is what enables an increase in our standard of living. Productivity growth, discussed below, is made possible by capital investments in labor saving technologies as well as through growth in human capital.

The broad elements of GDP are shown in Figure 22. Consumption, the things we buy and consume each year, is the largest component, 71% of GDP. This includes the value of all durable goods like automobiles and furniture; non-durable goods like food and clothing; and services like medical care and education. As the wealthiest nation in the world, U.S. consumption is a larger percentage of GDP than any other country.

Private investment, that is, the purchase of capital equipment by industry, construction, and changes in business inventories, equals 13% of GDP. Single-family home building is included in this category.

Government purchases, including both federal and state governments, equal 20% of GDP. This account does not include amounts spent by the federal government on transfer payments like Social Security and Medicare, which do not represent the production of new goods and services.

Net exports reflect U.S. exports minus imports, and have a relatively minor effect on GDP, minus 4% in 2011. Exports are counted because they reflect production of goods and services in the U.S. Imports, which are goods and services produced in other countries, are excluded.

GDP is calculated in both nominal - today's dollars - and real values, based on 1982 prices. Nominal GDP, of course, includes the effect of inflation and is, thus, not very useful in measuring changes in purchasing power over time. For that, real GDP is used. Real GDP compares apples of 2011 with apples of 1982.

To adjust from nominal to real values, a **GDP deflator** is employed. Here's how it works. The Bureau of Labor Statistics determines a "market basket" of 300 goods and services representing its estimate of what the average four-person household buys on a monthly basis. The basket includes the basics - groceries, gasoline, washing machines, video equipment - as well as estimates of monthly housing cost. The Bureau then goes into the market to get actual prices paid for each item during the month. By comparing the cost of this month's basket with last month's, or last year's, a percentage change in the cost of the basket is calculated. This percentage, the **Consumer Price Index** ("CPI"), is used to relate the current GDP back to 1982 dollars to reflect the real value of GDP. Real GDP is the figure most commonly used by economists and is the one used in media reports.

**THE BUSINESS CYCLE**

As suggested earlier, markets do not all grow at the same rate. Older markets with stable demand - think hammers and nails - tend to grow not much faster than the population grows, less than 2% per year. Newer markets offering new technologies - smart phones, for example - can grow very much faster. The economy is a mix of both old and new products, and the entire range of products in between. When exciting new products come to market, their faster growth can cause the economy to grow a little faster than it would in their absence. Our economy is filled with all kinds of products at various stages of growth and attractiveness, all growing, or declining, at different rates. It stretches logic to think that this delicious mix is going to track a steady course month after month, year after year. Economic growth is a bumpy road.

Some markets enjoy even greater growth than logic might suggest. Consider the housing industry. During the recession of 2000, the Fed had pushed interest rates lower than they had been in decades, and maintained those levels even after many observers claimed it was time for them to be raised. Banks were pressured by government to make mortgages available to people with credit ratings below their normal standards. House prices began to rise due to the lower interest rates, making them appear to be a smart investment, so people started buying houses, often not to live in, but to re-sell after the price had gone up some more. Home builders stepped up their activities. Of course, home building is a competitive industry that requires very little initial capital, so more homes were started than normal as everyone tried to profit from the increased demand. And investment bankers created a new form of security from all of the new mortgages and began to sell them to large institutions around the world. This opened a huge new pool of mortgage money for the market. The price of housing responded accordingly, causing more people to get in for the ride, which lasted until 2007. The end was not pleasant.

It seems there are elements of over-optimism and greed in most of us. It was not only Wall Street bankers profiting from the mania; many of your neighbors were speculating as well. Who wants to get left behind in a rising market? In the late 1990's, the opportunity was internet companies, fueled by venture capitalists. In the late 1980's, it was office buildings and big box retail stores, with the money pouring in from savings and loan associations. In the late 1970's, it was oil and gas wells fueled with bank loans. In 1637, it was tulip bulbs in Holland. All of these apparently attractive markets became bubbles, which fell to earth with a loud bang.

Do you see a pattern here? Free markets are very good at allocating capital to the most attractive investments, but free markets are "run" by individuals, who are sometimes very good at fooling themselves. Recessions occur when the market mistakenly allocates more capital to a market than its demand will support. When it finally becomes obvious that the "game" is over, those who got in too late lose a lot of their capital as prices drop. The industry slows down, people lose their jobs and can't be reabsorbed into the rest of the economy right away. Businesses that served the industry in question suddenly lose sales and must let go of some of their employees. General industry sees that it will lose sales due to the unemployment, and takes steps to protect their own profits, which usually include buying less inventory and laying people off. Uncertainty about the future creates a general funk in the economy, and growth slows, then goes negative. If GDP declines for two consecutive three-month periods (two quarters), the economy is officially in recession.

At this point, the public cries out for help, comfortable that their elected representatives know the right levers to pull to do something about the sad state of affairs. Those levers often focus on redistributing the people's wealth through stimulus spending, and injecting more money into the economy through the Federal Reserve. Many economists believe that interventions like these actually amplify business fluctuations rather than quell them. They argue that by the time a recession is officially claimed and government has had a chance to hash out a rescue approach, the economy has already started its recovery. Government stimulus efforts at that point cause economic overheating, creating conditions for the next bust.

Actually, left to its own devices, a free market will cure itself and return to equilibrium. All that is needed is for the capital that was over-invested in the high-flying industry to be re-deployed into more realistic opportunities. Some of the capital, of course, was lost, so this re-deployment cannot happen overnight. But the laws of supply and demand eventually take over and lead this capital to more promising investments. As this happens, new jobs are created, unemployment begins to decline, and public confidence in the future starts to return. Consumers buy more automobiles and washing machines, and the production lines fill up again. This "bounce" from the floor of recession normally occurs quite rapidly; nature abhors disequilibrium. Recessions, like bubbles, will self-correct pretty much on their own.

**CLASSICAL ECONOMICS**

Critics claim that free market capitalism causes poverty. Others, taking the historical perspective, claim that poverty is the natural state of man, and actually has no cause. Poverty, they say, is what you get in the absence of growth. We know that a free market drives growth. So how do we untangle this knot?

Economic growth is not automatic. Prior to the late 18th century, economic growth was almost nil. A poor French peasant in the third century B.C. was about as well off as a poor French peasant in the 17th century A.D. When pressed, most economists pick the year 1776 as the turning point in economic fortune. Not only did Adam Smith publish his breakthrough economic study that year, but James Watt invented the steam engine. The steam engine made it possible to automate factories and provide far better transportation, kick-starting the Industrial Revolution. And, of course, the United States, the Petri dish of capitalism, was born in 1776.

Much of the work of the early economists was aimed at finding a way to improve the condition of the poor. The English Poor Law of 1601 established outright grants to the poor financed by local property taxes, but the problem of poverty was not diminished. In fact, by the 18th century, some believed poverty was getting worse. A proposal was made in early 19th century England to consolidate the local grants and income supplements to the poor into a nationwide program run by the central government.

Thomas Malthus, an Anglican priest, believed these programs were ineffective and, in fact, counterproductive. His celebrated series of essays entitled _An Essay on the Principle of Population_ appeared between the years 1798 and 1826, and laid out his reasoning.

Malthus created an economic model - a simplified "picture" of how economic growth might occur - that assumed that humans were naturally inclined to increase their numbers over time, and that this increase in population would inevitably result in a shortage of food. The reason was, he argued, that population grows much faster than the available food supply. The effects of this shortage would be most severe on the poor, whose health was weak to begin with.

In addition, the increase in population would cause an oversupply of workers, and their wages would decline even as the price of food was increasing. When this distress spread throughout society, women would begin to rein in their fertility and farmers would spend more time in the fields to increase the food supply. Eventually, Malthus argued, the population and the food supply would come back into balance, or equilibrium, putting the people back to the same level of prosperity as before.

This model held no hope for improving the standard of living. The cycle, Malthus predicted, would endlessly repeat itself, and provide no improvement in the conditions of the poor. In fact, because of the increase in population, all it would do, he predicted, was increase the number of poor people.

For advancing this pessimistic outlook, Malthus was branded the "gloomy parson." His later work, and that of his followers, caused Thomas Carlyle to call economics the "dismal science." In fact, Malthus' analysis of the limits to economic growth is not accepted by economists today, but his model set the standard for analysis, and it became the central focus of macroeconomic study after his death.

The model offered what came to be called an **aggregate production function** , line AC in Figure 23, a method of determining what Malthus called the total "means of subsistence" available to a society. This established the standard of living for the society. Malthus' model used food production as a proxy for total goods and services produced in the economy each year. Food being the major product of the economy and the critical resource for the poor, this seemed a logical way to measure the means of subsistence. (The modern-day equivalent, of course, is GDP.) He related this measure to the total population, and started with the proposition that, the greater the population, the greater the means of subsistence available to society. This caused line AC to rise steeply at first.

Further, Malthus suggested that each addition to the population would add slightly less to the means of subsistence than the one before. This is because he assumed that most of the land appropriate for growing food was already in cultivation. Thus, each new worker had slightly less productive land available to him than those who were already farming, putting an upper limit on the amount of food that could be economically produced. We characterized this earlier as the diminishing marginal productivity of labor, and it is represented by the curved shape of line AC: each increase in population brings forth a slightly smaller increase in corn.

As to population growth, Malthus assumed that birth rates were relatively insensitive to economic conditions. He believed, rather, that the number new babies was a function of the "passion between the sexes," and basically subject to laws of nature. He did assume, however, that death rates were related to economic conditions. Thus, disease and pestilence could take a heavy toll, especially under conditions of food shortage. Under extreme conditions, Malthus considered it possible, and likely, that the population would actually decrease before recovering.

Line AB in Figure 23 represents the level of the means of subsistence required to maintain zero population growth. Malthus was saying that at P', more food was being produced than necessary (the vertical distance between the two lines), and this abundance would cause the population to grow. At P", food resources were below the level required to maintain the population, which would cause the population to decline. Ultimately, equilibrium would be reached at P, a point at which population growth was eliminated and available resources returned to subsistence level.

Later economists expanded on Malthus' use of land as the only productive resource available to society. The industrial revolution was in its infancy, but production of other products besides food was beginning to increase and improve living standards. Economists reasoned, as suggested earlier, that the production function in Malthus' model should include the tools and equipment used in this production. The term **capital** was used to describe these newly described factors of production.

Thinking about resources in this way opened new avenues of thought. One was the realization that capital, unlike the land in Malthus' model, could be increased. Thus, if capital were to grow as fast as population, each new worker would have the same amount available to him as those already working, and his marginal productivity would not decline. In a world of constant productivity, society's standard of living would tend to stay steady. This enabled economists to modify Malthus' model in a way that allowed for growth in population without the dire effects described by Malthus. In fact, if capital could be made to grow faster than population, the model predicted an even higher standard of living. Importantly, this model, like Malthus', predicted an equilibrium condition, but one much more optimistic. This model is the precursor to what later became known as **neoclassical economics** , which forms the basis of most macroeconomic study today. Figure 24 shows the basic neoclassical model of growth.

The model is based on the use of capital to increase the productivity of workers, which is shown on the vertical scale as output per worker. It is assumed that this can be increased as the ratio of capital to labor, the horizontal scale, is increased. The production function, AP, shows that relationship. Line AI indicates the amount of investment required to maintain a given capital/labor ratio. The actual amount of investment that will be forthcoming is defined by the line AS, the savings or investment function. The vertical distance between AP and AS measures the amount of current production that is consumed in the year produced, while the vertical distance between AS and the horizontal axis is the amount of current production that is saved or invested for the future.

At I', savings are higher than is required to maintain the capital/labor ratio. This "excess" savings causes the capital/labor ratio to increase. At I", savings are insufficient to maintain the capital/labor ratio, and the ratio declines. Position I is the equilibrium condition where savings are sufficient to maintain the ratio. The important difference between this and the Malthus model is that at equilibrium, even with no growth in capital or output per worker, it is still possible for the population to grow and a reasonable living standard to be maintained.

**CONSUMPTION, SAVING, AND KEYNES**

The neoclassical model introduced the critically important **savings function** seen in Figure 24. The savings function, sometimes also referred to as the **consumption function** , recognized that a nation's annual income is allocated to either savings or consumption such that, if the percentage of income allocated to one is increased, the percentage allocated to the other is decreased. In other words, more money used to buy goods today means that less money is saved for the future. This, again, is simply mathematics. Likewise, more money saved for the future means less consumption today. However, the unexpected result of higher saving and lower consumption today leads to increases in wages and consumption in the future. This is because the higher savings leads to investment in capital goods that improve worker productivity in the future.

This is a critically important idea to grasp. The model assumes that, when workers have more capital to work with, they are able to produce more with the same effort. This increase in their productivity improves their employers' profits. Employers, wanting this happy state to continue, can afford to and are willing to pay higher wages to keep these more productive employees working. In turn, workers use their higher salaries to increase their consumption. In effect, lower consumption today leads to greater consumption in the future. Delayed gratification is critical to economic growth.

A second step in the process is what happens to other workers, those who have not contributed to the increase in productivity. As higher paying jobs are created, a number of workers with lower wage jobs are attracted to them. This increase in supply of workers for the higher paying jobs creates a shortage of workers in lower wage jobs. To keep their production lines running, employers of the lower wage workers have to increase their wages to keep them at work. _In this manner, even lower wage earners benefit from the increase in productivity from higher capital investment_.

John Maynard Keynes, the British economist who published his major work, "The General Theory of Employment, Interest and Money" in 1936, was one of the most influential economists of the 20th century. Among his most lasting contributions was his theory about the optimal role of the federal government during low points in the business cycle. He focused on the idea of aggregate demand, essentially the demand curve for the entire economy, represented by GDP. He reasoned that, when aggregate demand in the economy was too low (i.e., during recession), government could speed economic recovery by injecting more money into the economy so that people would boost their consumption. This increase in consumer spending would cause businesses to order more inventory to meet the larger demand, and soon the economy would get itself back on track. Keynes recommended a combined increase in government spending and lowering of taxes to achieve this effect. Both actions would put more money in the consumer's pocket. The government would clearly have to incur a budget deficit to accomplish it by borrowing the shortfall in revenues, which Keynes said could be repaid in following years.

Keynes counseled President Roosevelt during the Depression and is credited with strongly influencing the direction of the New Deal. His influence on economic policy continues, despite the fact that most economists believe history has proven a key part of his theory wrong, the part that recommends increased government spending during a recession. Perhaps the reason it survives is that it advocates an interventionist role for the government in the private economy, which is useful to the arguments of a specific strain of politicians. Another reason may be that the very act of the government intervening in this way has been popularly dubbed economic "stimulus," a vaguely medical-sounding term connoting life support or a drug injection of some kind. How could anyone be against stimulus for a sick economy? When frustrated citizens call upon government to "do something" to speed recovery from a recession, stimulus seems like a great solution, doesn't it?

An important feature of Keynes' stimulus model is the so-called **Keynesian multiplier**. Keynes attempted to predict the degree of stimulative effect of an extra dollar put into a consumer's hand by the government. He assumed that, if the extra dollar were spent at a clothing store, for example, the store owner would use some of the dollar to pay her employee. In turn, the employee might use the extra money to buy a new hat. The hat maker would use some of that money to order new inventory. And so on. In this way, Keynes reasoned that the single dollar would have a multiplier effect on GDP, being spent many times and contributing to economic growth. In the $787 billion stimulus package passed by Congress and signed by the President in 2009, administration economists estimated the value of the multiplier to be 1.5 times, meaning that spending $787 billion would actually add almost $1.2 trillion to GDP.

The multiplier effect described by Keynes is no longer accepted by most economists. Some question whether the multiplier works at all. Others, like Nobel Prize-winning University of Chicago economist Merton Miller in his 1976 book, "Macroeconomics: A Neoclassical Introduction," acknowledge the existence of a multiplier effect, but claimed that the multiplier was not predictable as Keynes had argued, and that its value could, in fact, be positive, negative, or zero. Robert Barro of Harvard University has subsequently reinforced Miller's findings. A negative multiplier means that every stimulus dollar would actually _subtract_ from GDP.

The mathematics of the multiplier are complex and beyond the objectives of this book. However, it seems that with all the discussion about what happens to that new, "stimulating" dollar, the question of where the dollar came from is overlooked. That dollar can only get into the government's hands in one of three ways: taxes, borrowing, or creating new money. We will show later that the economic effect of any of these methods is to dampen economic activity. Let's assume, however, that the money comes from people's taxes. The question is why does a dollar taken from one person's pocket and put into another person's pocket suddenly acquire extra energy, becoming $1.50?

Assuming there is a reasonable answer to that question, an even more challenging question arises: If the government can magically grow $1.00 into $1.50 during a recession, why can't it do the same thing all the time? In fact, why don't we just give our money to the government so that they can give it to somebody else and turn it into $1.50? This is a much better return than private industry can provide. The whole idea sounds vaguely similar to the alchemists of the Middle Ages claiming they could turn lead into gold. Color us skeptical.

Alan Blinder, professor of economics at Princeton and former Fed governor, presents the most sensible Keynesian approach today. He agrees that dropping money from airplanes is not a wise approach to stimulating the economy. Instead, he advocates a narrow stimulus aimed at infrastructure projects - roads and bridges - which are truly investments in future productivity. The funds would not come from the public's pockets today but, rather, through borrowing so that, in the short term, the stimulus would be "cost free." Research at the University of Chicago supports the proposition that narrowly targeted stimulus efforts may, indeed, have a short term growth effect.

So far, so good. However, our political system has shown itself totally incapable of implementing such a well-targeted program. The $787 billion (later increased to $840 billion) stimulus package of 2009, which was promoted as funding "shovel ready" infrastructure projects, is largely written off today as a failure. The money was not distributed nearly as quickly as was hoped, and well under $100 billion actually went to anything that could be considered an investment in future productivity.

Instead, millions of dollars were spread across hundreds of projects in each congressional district and every department of government. Take a look at recovery.gov to learn how the money has been spent. And if after going there you need a chuckle, read _Stimulus Checkup: A Closer Look at 100 Projects Funded by the American Recovery and Reinvestment Act_ , published in December, 2009, by Senators Coburn and McCain. It is truly marvelous how imaginative our legislators are. Unfortunately, dinner cruises, golf courses, puppet shows, and stimulus road signs were never likely to create much growth.

A further criticism of Keynes' work relates to his formulation of a consumption function. Keynes' approach to this problem was to assume that, as a person's income increased, their consumption would also increase, but at a slower rate. Keynes wrote in his General Theory:

" _The fundamental psychological law, upon which we are entitled to depend with great confidence both_ a priori _from our knowledge of human nature and from the detailed facts of experience, is that men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income."_

This assumption became controversial among many economists, who preferred to leave psychological laws to psychologists, and who could find no "facts of experience" that supported the thesis. In fact, historical data refuted it. By the early 1950's it had become clear to most economists that attempting to explain consumption behavior based on current income alone was doomed to fail. It fell to two of America's most esteemed economists, Milton Friedman and Franco Modigliani, to develop the theory of consumption that underlies most economic study today. Friedman's work came to be called the **permanent income hypothesis** and Modigliani's, similar to Friedman's, the **life-cycle hypothesis.**

The life-cycle hypothesis argues that the amount of money a person spends[11] is a function of the total resources available to them at that time. Those resources include both their current income and an estimate of their current wealth. It also assumes they would like to avoid large changes in consumption from year-to-year, or from their years of employment to their retirement years, through the use of **income smoothing**. A good example of income smoothing would be student education loans, which help a student bridge the income gap between high school and a good career. Thus, the hypothesis states that a person's consumption in any year is proportional to their total wealth (including income and savings) at the start of that year, with the factor of proportionality being equal to the total number of years remaining in their life. All of this, like most of macroeconomic study, is based on some serious math, which we do not intend to explore.

The difference between this and Keynes' hypothesis is subtle, but significant. Keynes assumed that, no matter how great one's income might be, their propensity to consume declines as their income grows. The life-cycle hypothesis, on the other hand, assumes that an individual bases their current consumption not only on their income, but also on their estimate of their remaining lifetime earnings potential, the present value of which is their current wealth. As their income grows, so too does their estimate of their lifetime earnings potential, and as they approach retirement, they may judge their wealth high enough that they can continue to consume at their earlier proportion, or an even greater proportion, rather than at lower rates, as Keynes asserted. This new approach made a big difference in how economists see the future and is now in wide use in the profession.

**SUPPLY-SIDE ECONOMICS AND THE LAFFER CURVE**

A significant contribution to macroeconomic study was made by economist Arthur Laffer in 1974. An economics professor at the University of Chicago, Laffer famously outlined his idea on a napkin at a dinner with supporters of Ronald Reagan's presidential bid.

Up to that time, and continuing to today, every tax bill proposed in Congress had to be "scored" by the Congressional Budget Office. It is the CBO's job to express a non-partisan opinion on the financial impact of the bill. Thus, for example, if a bill calls for an increase in the tax rate of 5%, CBO accountants would simply add another 5% to the projected tax revenues to forecast the new revenue figure. This same method is employed no matter the form or amount of the tax change. If the tax rate is to be increased by 25%, forecast revenues are increased by 25%. This is referred to as "static" analysis.

At one point during the dinner, Laffer drew a curve on a napkin to illustrate why static analysis was irrelevant. It looked something like the drawing in Figure 25.

Here is how he explained it. The graph plots the amount of tax revenue the government receives against tax rates. Starting with tax rates at 0% and 100% on the graph, he argued that tax collections would be zero at each level. At 0%, this is easy to accept - no tax, no revenue. At a 100% tax rate, he claimed, revenues would also be zero, since no one would work only to give it all up in taxes. With those two points plotted on the graph, it followed mathematically that there must be some point between 0 and 100 that represents the maximum revenue possibility. In Figure 26, which is only an example, that number is $260,000 at a tax rate of 50%. Any tax rate higher, or lower, than 50% would yield less revenue.

To an accountant, this was heresy. Laffer's view was that tax revenues were not static, as the CBO assumed, but rather were dynamic, a function of the actions of workers, who could alter their behavior in the face of a change in taxes. This implied that, at some tax rate, some of those workers would decide that paying the extra tax made the extra work not worth the effort.

Laffer's curve invited a firestorm of criticism in the econo-political world. His theory is not the easiest to prove historically, because the data are difficult to sort out from the many factors that influence tax collections. The tax on long term capital gains, however, is relatively isolated from other economic events, and it is useful to see what happened to revenues from the tax between 1967 and 2007. Figure 26 shows the percentage increase in average capital gain tax revenues paid to the IRS for the five years following a cut in the rate, as compared to the average taxes paid for the two years prior to the cut. In 1980, for example, the rate was cut from 30% to 20%, and average revenues increased 89% for the following five years. As shown, tax revenues increased significantly after each of the three tax cuts.

The period between 1967 and 2007 also saw two _increases_ in the long term capital gains tax rate, as shown in Figure 27. In each case, average tax collections dropped in the five years following the rate increase, also consistent with Laffer's theory. The drop in average revenues was 36% and 37%.

Laffer pointed out that the capital gains tax is a "voluntary" tax, voluntary in the sense that a gain is only taxed when the capital asset is sold. An investor will generally only sell a stock and recognize a gain if it makes economic sense. If, after paying the gains tax, an investor would be in a less favorable position than if she just continued holding the stock, she will often choose not sell it. This has the undesirable effect of locking capital gains up in stocks that might better be sold and the money reinvested. "Unlocking" such gains contributes to the flood of new taxes after the rate is dropped.

Laffer's drawing became known as the "Laffer curve" and became a central focus of the new **supply-side economics** and Ronald Reagan's presidential campaign in 1980. Supply-side economics developed in response to the failure of Keynes' theory that an economy in recession needed a boost in demand, a stimulus. Many economists coalesced around the idea that what a sick economy really needed was greater investment and production, which would create jobs and lead to greater consumption. Investment, it was argued, would provide the supply of goods at low enough prices to boost demand, and the way to achieve it was to cut taxes and ease costly regulations on business. Reagan's Republican challenger for the nomination, George H.W. Bush, famously called it "voodoo economics" in one of their televised debates.

Laffer took no credit for the theory, saying it came from his readings of Keynes and an obscure, Tunisian philosopher of the 14th century, Ibn Khaldun. It might better be called the Mellon curve after Andrew Mellon, Secretary of the Treasury under Presidents Coolidge and Hoover. As Amity Schlaes records in her book, "The Forgotten Man, A New History of the Great Depression," Mellon strongly believed that lower income tax rates would produce more revenue. In Coolidge's first term, Mellon succeeded in cutting the top rate from 50% to 25%. The effect on the economy was impressive: real wages grew 16% between 1923 and 1929, and unemployment dropped from 5% to 2%. Even with the lower tax rate, Mellon was able to reduce the national debt from $24 billion to $16 billion.

Most, though not all, economists accept the logic of the Laffer curve. The argument in the profession is primarily over what the rate should be to collect the greatest amount of tax, the maximum revenue point on the curve. No doubt the curve is different for different types of taxes, and given the difficulty in isolating the outcomes of changes in various economic variables, that argument will doubtless go on for awhile. One observation about the data in Figures 26 and 27 is incontrovertible; from the first tax rate increase in 1970 to the final tax rate decrease in 2003, average capital gain tax revenues have increased roughly ten-fold while the tax rate declined from 35% to 15%. Sometimes, you just have to accept the obvious.

**RATIONAL EXPECTATIONS**

Theories like the life-cycle hypothesis and supply-side economics foreshadowed a new area of macroeconomic study, the idea that the actions of individuals were more complex than economic models had so far considered. In the case of the life-cycle hypothesis, the complexity was that aggregate individual behavior might be, at best, a modestly helpful concept because all individuals are not in the same financial position and could not be expected to act in lock-step. The Laffer curve and supply-side economics are based on the idea that taxes are voluntary, and that the wrong tax policy will cause taxpayers to take unpredictable actions to avoid them. Soon, other economists began to offer an even more startling idea, that individuals were not robots who could be expected to act in a predictable fashion time after time. Since the idea behind economic modeling is to be able to predict the how economic players will behave, this apparent unpredictability of human behavior was troubling.

The 2011 Nobel Prize in economics was awarded to Thomas Sargent of New York University and Stanford's Hoover Institution. Sargent and his mentor, 1995 Nobel Prize winner Robert Lucas of the University of Chicago, were perplexed by the performance of the economy in the 1970's. Using traditional Keynesian logic, the Fed was following policies aimed at reducing the unemployment rate to 4% by increasing inflation to 4%. (We will go deeper into this logic when we talk about the Federal Reserve.) A touch of inflation was supposed to trick business into thinking that demand for their products was increasing and induce them to hire more employees. What happened, instead, was that unemployment and inflation both grew to 9% by the end of the decade, and the economy entered a cycle that was termed "stagflation," indicating stagnant economic growth with high inflation. Stagflation became such a problem under the presidency of Jimmy Carter that it resulted in his losing re-election to Ronald Reagan in 1980.

Sargent, Lucas, and John Muth hypothesized that the economy was not so easily tricked as Keynesian theory predicted, and that it could "learn" the behavior of government policy. Thus, when employees saw unemployment rising, they expected the Fed to inflate the currency as it had before. In response to this signal, the workers adjusted their wage demands upward. Recalling supply and demand laws, a higher price for labor would lead employers to cut back on employment, so the Fed's policy actually caused more unemployment. The three economists coined the term **rational expectations** to describe this behavior, and a new school of macroeconomic thought was launched.

Rational expectations adds a human dimension to macroeconomic models. It recognizes that workers and companies are not just pieces on the government's chess board, but thinking, reasoning beings. They are able to learn from experience and modify their behavior to better their chances of "winning the Fed's game" the next time around. Once the Fed takes a policy action, its expected results are incorporated into the public's experience base, and that action would not work the same way again. Rational expectations is a further attempt to understand how government should react to downturns in the business cycle. Many believe we are far from that understanding and that government actions during a recession, as mentioned earlier, may actually cause greater volatility of economic swings rather than less.

**ECONOMIC EQUILIBRIUM**

A critical element of economic modeling is the concept of equilibrium. In microeconomics we saw how demand and supply for a product determines a price point acceptable to both parties in a trade, the equilibrium price. As Smith pointed out, actual market prices are not always at equilibrium. When product surpluses and shortages exist, suppliers must lower their prices, or consumers must be willing to pay more, to bring the market back into balance. In a free market, this process happens automatically.

In the market for securities, an old saw warns that "nothing goes to the sky," meaning that even if a stock goes up faster than the overall market, it must at some point peak in value. The fact is that, as the price of a good or security goes higher, an increasing number of people think it is too high. In securities and commodities markets, those people may sell the security short (by borrowing it from a party that owns it), then buy it back later when it goes lower. After returning it to the investor they borrowed it from, they have made a profit by selling at a high price and buying at a lower price. This is the same result promised by the old maxim to buy low and sell high. It's just that the actions are reversed. The action of short sellers facilitates security prices reflecting the sentiments of both bulls and bears.

So, too, in macroeconomics we have seen how the early economists developed models that reached an equilibrium condition. Malthus, for example, assumed that, when the population became too large relative to the land available to support it, malnutrition and disease would gradually bring the population back down to a sustainable level.

Smith provided a simple explanation. He said that a position of equilibrium in the economy would be attained when each type of good is sold at its natural price, and when the factors of production - labor, land, and capital - are paid at their normal rate. In this situation, there would be no incentive for producers to move resources to other uses, and the economy would be in balance.

Scientists studying the natural world perceive this phenomenon. Chemists combine two stable materials that instantly react, change form, and result in a new compound. During the reaction the mixture is unstable, but nature finds the new equilibrium.

On a broader scale, the sun exerts gravitational pull on the planets which, un-countered, would cause them to be consumed by the sun's heat as they were pulled closer to it. However, the centrifugal force acting on the planets as they circle the sun counters the sun's gravity. At some point, equilibrium is achieved, a stable orbit is established, nature is satisfied, and we don't crash into the sun.

Free market economies are subject to a similar natural force. As they experience shocks that cause them to break out of equilibrium, there is a natural reaction on the part of their various components that tugs them back. At equilibrium, industry is at its maximum efficiency for a given level of capital, and the economy is producing a stable, or steadily growing standard of living.

What is this force that brings free markets back into equilibrium? It is the pursuit of self-interest by individuals and firms, the invisible hand of the market. It is the result of a level economic playing field, on which neither individuals nor firms have an unfair advantage, and which encourages all players to continue playing the game.

On a macroeconomic scale, it is the sum of the actions of all the players that drives the economy toward equilibrium. Since all transactions in a free market are, by definition, satisfying to both parties, the sum total of this satisfaction works to keep the economy in balance. If people are not satisfied, they take some action to work around the problem, and eventually find satisfaction. The consumer is able to find satisfaction because a new or different producer sees the opportunity and finds a way to make it work to his advantage as well. In "Economic Harmonies" Bastiat says "All men's impulses, when motivated by legitimate self-interest, fall into a harmonious social pattern."

The market for agricultural commodities offers a simple way to describe the equilibration process. Imagine you are a farmer in 1950 and, having harvested all of your corn and soybeans by the end of October, you haul your crops to the local grain elevator and sell them at whatever price she is offering that day. You know that the price of corn and soybeans is usually lowest in the fall because all crops are harvested in October and, hence, come to market at the same time. The supply is suddenly very large relative to the current demand. You take the price the elevator offers you; hopefully, it is enough to pay off your bank loan and leave enough to buy seed and fertilizer next spring.

At this point the grain elevator has an advantage over you and your neighboring farmers because she can hold the crop until prices begin to increase later in the winter and spring. This inherent advantage of the grain elevator - the ability to buy at the lowest price and sell at possibly higher prices later - is not lost on people with capital to invest, and soon another elevator opens nearby to try and reap some of that reward.

At the same time, you realize that the structure of the industry in 1950 is stacked against you. In order to avoid having to sell your crop at the low, fall prices, you run some numbers and decide it would be worthwhile to build a silo to hold your grain, just as the elevator does. This added flexibility helps keep the playing field level between you and the elevator, and the elevator's profit margin starts to decline. Now some of that profit can stay in your pocket instead of going to the elevator.

With all of these adjustments - your new silo and a competitive grain elevator - the market finds its way back to equilibrium, where you can choose when to sell your crops to get the best price, and the grain elevator's excess profit margin (her economic profit) is whittled back down to normal.

This is important because when government intervenes in the economy, it alters the natural process. Imagine, for example, that you had gone to the government to complain that the elevator was ripping you off. They would hold hearings, undertake a study of the grain elevator business, and, recognizing that it was possible your elevator was making "unfair" profits, they might set a policy that no grain elevator could make more than some percentage profit. Or, they might set a minimum price for the elevator to pay you for your crops.

What would be the result of the government's new policies? Since the government can't know the appropriate level of profit the elevator should earn (that can only be determined in the marketplace from negotiations between buyers and sellers), their new price controls are likely to work in either your or the elevator's favor. In effect, one of you will be extra happy with the arrangement, while the other will feel unfairly treated. Left alone to pursue your own solution, on the other hand, both you and the elevator would feel you were receiving fair treatment in your trades.

In addition, other investors would decide not to build a competitive elevator now, because the "excess" profits they had seen would have been regulated out of the business. As a result, they would continue investing their capital in a less attractive business - the one from which they would have taken the capital to build the new elevator - and earn a lower return than they might have in the new venture. So, capital remains invested in a lower profit business, the grain elevator's cost of doing business will go up to cover the paper work to report to the government, and the marketplace has a harder time deciding which particular business they want to invest in, farms or elevators or neither? Government intervention, in short, garbles the price signals that a free market sends to insure optimal allocation of labor and capital, and economic efficiency is reduced.

This completes the picture of how an economy can grow and create opportunities for employment and a better standard of living for all its citizens. Our discussion has limited itself to economic growth models in a free market system. We will now turn our attention to the three major tools government can use to manage the economy, potentially reducing the freedom of markets to operate as Smith envisioned: fiscal policy, monetary policy, and regulation.

# Chapter IV - Fiscal Policy

Fiscal policy describes the steps taken by government to manage its revenues and expenses. Revenues are raised through taxing and borrowing. Expenses are primarily programs for defense and social welfare established through legislation. The balancing of revenues and expenses makes up the government's fiscal policy.

**TAXES**

_"There is no art which one government sooner learns of another than that of draining money from the pockets of the people."_ \- Adam Smith

Government's management of its financial affairs through taxing and spending is called **fiscal policy**. In 2011 the federal government spent $3.6 trillion, and took in $2.3 trillion in taxes, resulting in a deficit of $1.3 trillion. To make up the deficit, the $1.3 trillion was borrowed. Said another way, we borrowed 40% of everything we spent.

Taxes are the government's primary source of revenue. To begin, we should state that, if one's goal is to grow the economy to improve society's standard of living, taxes should be lower, not higher. All accepted economic models make this assumption, because a dollar removed from the private economy results in both lower consumption and lower savings. Recalling the neoclassical growth model, a) lower consumption - fewer dollars spent by consumers - hurts short term growth and increases unemployment, and (b) lower savings - fewer dollars put aside - reduces capital investment, which constrains worker productivity in the future, pressuring wages and leading to lower consumption in the future. GDP just can't grow as fast as it otherwise would.

Terry Arthur, in an article for the Adam Smith Institute, has a different way of explaining the effect of taxes. Consider merchants in two countries, he writes, trading with each other. One country imposes a tariff on its imports. The tariff makes that good more expensive and, thus, reduces the amount the other merchant can buy. That, of course, is the purpose of the tariff, to reduce the trade.

Now consider a tariff on a good that is "exported" to Maine from Texas. The tariff will reduce the trade in the good, lowering economic activity, just as it will in cross-border trade. In fact, geographic boundaries are irrelevant to the argument. A tariff is simply a tax on trade, no matter where it occurs. If the tax is assessed on a specific good, like a tariff or excise tax, the good becomes more expensive and requires more of your income to buy. If the tax is a tax on your income, the cost of the good remains the same, but you have less buying power after paying your tax. The effect of either action is that buying the good takes more of your disposable income than it would without the tax. Your "trade" will decline because of the tax.

What happens to the demand for the good imported from Texas? If a Mainer can't afford to buy a Texas barbeque sauce, and no other sauces are available to meet her need, she might choose make it herself. By making it in her own kitchen instead of buying it, the Mainer has reduced trade in the good, which lowers GDP growth (and puts a couple of Texas sauce-makers out of work.)

The range of goods and services that are either made at home, or provided by the homeowner rather than an outside supplier, is extensive: if a taxi to work is too expensive, one might ride a bike; if a gardener is too expensive, one might mow their own lawn; if a new TV is too expensive, one can hang onto the one she has. Each of these decisions by consumers reduces trade and lowers economic activity.

Arthur points to a secondary effect of the decision to do things at home. By adding to the things an individual has to do, a tax reduces the economic benefit of specialization that results from the division of labor. Instead of consolidating barbeque sauce production at a Texas plant to achieve the economies of specialization, the production is spread among a number of Maine households, the owners of which are already loaded with tasks to complete. The homeowner will be less efficient at making the sauce, because she will be interrupted by phone calls, the baby crying, picking up her son at his forestry competition, and a host of other distractions. In addition, she will have to go through the whole process again each time she wants the sauce, unless she is able to can her own sauce for storage, another job better done at economic scale. Thus, by forcing an activity back into the home, a tax causes the affected industry to operate less efficiently overall. Economists call this a **deadweight loss** , indicating a cost to society from the less efficient process.

Note, too, that by reducing the sales of the sauce-maker, the tax reduces the profit on which the sauce-maker's income tax is computed. The lost tax is not recovered by taxing the homeowner, because she isn't required to report her self-entrepreneurial activity to the IRS. In this sense, a tax can become its own cannibal. Taxes, tariffs, fees, all these reduce trade and GDP growth.

Some are surprised to learn that the government's primary source of revenues is the personal income tax. As shown in Figure 28, personal income taxes provide 47% of the government's total revenue. Politicians and pundits rail endlessly about the corporate tax code, and not without good reason. The corporate tax code is a purposely dense labyrinth filled with gifts to various industries, even individual companies, painstakingly negotiated between highly paid corporate lobbyists and members of Congress to be sure that money and votes flow in the "appropriate" directions. The entire process is "crony capitalism" at its worst. As you can see, however, business taxes are only one-sixth the size of personal income taxes; individuals through income and social security taxes are where the money is.

Some argue that the existence of both a personal and corporate income tax is counter-productive, and advocate abolishing the corporate tax altogether. The reason for this is simple: since individuals own the corporations (either directly or through mutual funds and retirement fund investments on their behalf), corporate income is really taxed twice, once at the corporate level, and once again when corporate earnings are distributed to individuals as dividends.

At this writing, the tax rate on corporate earnings is 35%, while the tax rate on dividends for individuals is 15%, although some are proposing to raise this to the full personal tax rate. If corporations pay out one-third of their earnings in dividends today, this means the _effective_ tax rate on corporate earnings is closer to 45%, i.e., after the dividends have been taxed again at the individual level. At the proposed new level of dividend taxes, the combined rate would be closer to 60%.

In practice, corporations take advantage of loopholes in the tax code that allow many of them to reduce their actual taxes below 35%, so the effective tax rate on dividends is below 45%. This and hundreds of other nuances in the tax code make it very difficult to create logical policy, because it is impossible to know what unintended effects a change in policy will have. This is one of a number of strong arguments for simplification of the tax code.

Income taxes impose costs on society over and above the actual taxes collected. The time required for both corporate and individual tax compliance is estimated by the Department of Treasury to exceed 7 billion hours. This is the equivalent of nearly four million workers working 40-hour weeks for a year, with two weeks off. In effect, one of every thirty-five people you pass on the way to work is a full time tax preparer. At the average employer cost for civilian workers of $29.72 per hour reported by the Bureau of Labor Statistics, the latest annual cost of compliance with the tax code was $227 billion, split roughly 50-50 between corporations and individuals. In view of the much higher hourly billing rates of tax professionals, this estimate is well below the true cost.

Two-hundred thirty billion dollars is actually a lot of money. Each dollar spent to comply with the increasingly complex tax code is a dollar not spent for a vacation or invested in a new machine, and this cuts into the growth of GDP. For this reason, and for reasons of simple fairness, many advocate a flat tax, in essence a single percentage applied to all income with no deductions. Such a tax could be computed in far less time and filed on a single sheet of paper. Various proposals suggest varying tax rates, but they tend to cluster in the range of 15-20%.

Opponents of a flat tax argue it is a regressive tax, meaning that it affects lower income taxpayers more than upper income taxpayers. America has historically used a progressive tax rate schedule where rates increase at higher levels of income. We will not engage the argument over tax fairness - progressive and regressive - which involves far more subjectivity than economists can bear. Most flat tax proposals offer two rates rather than a single rate for this reason, and also include income floors below which income would not be taxed at all. However, as long as politicians insist on the flexibility to create special tax deductions for their favored constituents, our tax code will continue to be mindbogglingly complex, unfair, economically inefficient, and unbelievably costly.

CAPITAL GAINS

Federal tax rules define a capital gain as the positive difference between what is received from the sale of a capital asset and its original cost. (A _negative_ difference between the two would be a capital loss.) A capital asset is any investment that is purchased for the purpose of earning a positive return. The most common capital assets are stocks, bonds, and other financial instruments, as well as "hard" assets like real estate. A person's home is also considered a capital asset even though most people don't buy their homes to make money. The current tax on capital gains is the same as the dividends tax, 15%.

Taxing capital gains poses a couple of problems. The first is that, during periods of inflation, one might have to report a gain on the sale of an asset that had actually produced a loss. Let's say you buy a stock in 2005 for $500. Five years later the value of your stock has risen to $600. You have apparently gained $100 on your investment. However, because inflation was 5% each year, the value of the $600 is only $470 in 2005 dollars[12]. So, instead of a gain, you have actually lost $30 in purchasing power on your original investment ($470 - $500 = -$30).

To add insult to injury, if you sell the stock at the $600 price, the IRS will charge you a 15% tax on the $100 gain you didn't get, or $15. So your total loss on the investment is $45 ($30 + $15 = 45).

The general public doesn't pay much attention to this problem, probably because capital gains are not forefront in their minds. The taxation of imaginary gains, however, is economically highly inefficient, and those who think about it would likely agree it is a shameful scam Congress has perpetrated on us.

From an economist's point of view, capital gains taxes present a different problem. Recall that growth in GDP is only possible if the productivity of labor grows. Productivity can grow simply from people working harder, but when was the last time you popped out of bed and resolved to work harder?

The most direct way to improve labor productivity is to provide it more capital to work with - more tools, better technology. The general rule is that, if you tax something, you will get less of it. This is the direct result, of course, of the demand-supply relationship for capital. Taxing capital reduces the return one can earn by investing it, and thereby reduces the amount of investment capital that people are willing to supply to the market. A series of papers presented by Kevin Hassett of the American Enterprise Institute and Alan Auerbach of the University of California showed that raising taxes on dividends increases the cost of equity capital and lowers asset prices, harming consumers while hindering firms' ability to grow and provide more jobs. The same is likely true of taxing capital gains.

TAXES ARE VOLUNTARY

Income taxes, like capital gains taxes, are voluntary. If you want to pay lower income taxes, you can move to a different tax jurisdiction, you can elect not to work as hard and reduce your taxable income, or you can employ any number of options to "shelter" your income from taxes. California is one of the highest taxed states in the nation. Four million more people have _left_ the sunny State in the last twenty years than have moved in.

There are other, less extreme options one has to "manage" their tax liability than moving. For example, if you are to be paid a bonus at the end of this year, you can ask your employer to defer paying the bonus until January of next year. In this manner, your taxable income for this year is reduced and, thus, your tax will be lower. Of course, you will have to pay the extra tax _next_ year, but you have been able to use the money for a full year to your advantage. Furthermore, since you can defer next year's bonus until the following year, you can essentially borrow the one year's taxes from the IRS indefinitely, interest free.

A progressive tax system holds another truth: the higher the tax rate, the more a deferral of the bonus is worth in tax savings. If your bonus is $1,000 and the tax rate is 10%, you would save $100 in taxes. If the tax rate is increased to 20%, your savings would be $200. At a tax rate of 50%, your savings becomes real money - $500. At this level, more people are likely to look for ways to reduce their taxes.

During the 60' and 70's, when income tax rates were high, a number of firms were formed to help high income tax payers reduce their tax obligations. Called the **tax shelter** industry, these firms would find investment opportunities in areas like real estate and oil and gas production that would create large accounting losses in the early years of their operation. The investment would be structured as a partnership for tax purposes so that the losses could be passed through to the individual investors. They, in turn, would deduct these losses from their taxable income to lower their tax liability. Eventually, it was forecast that the investment would prove profitable to offset the early losses; the structure of the investment would simply have pushed these profits into the future.

Over time, the demand for such investments became so strong that some firms began to package and sell investments that had almost no chance of producing profits in the future. Still, they sold like hotcakes because in many cases the value of the tax deduction was enough to provide the tax payer a reasonable return. Thus was spawned an entire industry whose primary purpose was to build lousy projects that wealthy people could buy to shelter their income from taxes. What a country!

TAX FAIRNESS

Periodically, politicians and the media like to go after the "fat cats" in society, those people at the top of the income ladder. They claim that the rich don't pay their fair share of taxes. This activity generally follows the business cycle; when unemployment is high, it is most convenient to try and find a scapegoat. During the relatively brief recession of 1989-1990, these fortunate people were characterized as uncaring, spoiled folks who liked to indulge themselves with their luxury yachts. In 1990, Congress passed a 10% luxury tax on the purchase of a boat over $100,000 to try and make these people pay their fair share in hard economic times.

Seems reasonable enough, but if the legislators had bothered to draw up a simple demand-supply diagram, they would have seen that, since increasing the tax has the same effect as increasing the price of the boat, the increase in price would lead to a drop in demand... but they didn't. As a result, boat sales dropped 42% between 1989 and 1992, thousands of boat workers became unemployed, and a number of boat builders went out of business. Instead of collecting the luxury tax, the government lost the income taxes of those who had to close their doors, and began paying unemployment benefits to the newly unemployed. Congress repealed the tax in 1993.

The silliness is back. Instead of luxury yachts, this time the offenders are those who own private planes; they are referred to as "millionaires and billionaires." The government learned its lesson from the yacht fiasco, however, and hasn't sought to tax private planes; they are going for the whole income pie. Again, the high earners are being asked to pay their "fair" share, this time with an increase in their marginal tax rate.

We should digress a moment to clarify the difference between an _average_ tax rate and a _marginal_ tax rate. The progressive design of our tax system divides the entire range of income into seven brackets. The lowest tax bracket is 10%, which is applied to income under $8,500. Income between $8,500 and $34,500 is taxed at 15%, shown in Figure 29. The next bracket is 25%, and the top bracket, 35%.

Each taxpayer's income is taxed, first, at the lowest rate, then, if his income exceeds the first bracket, the incremental, or marginal, amount is taxed in the second bracket. And so on up the ladder. Thus, a person's average tax rate is a combination of all the rates in the brackets in which his income falls. The average tax rate is mathematically always lower than the marginal tax rate because it includes tax computed at the lower rates as well. People with economic tendencies usually look to the marginal tax bracket, because that defines the rate at which the next dollar of income will be taxed.

In support of a tax increase on millionaires and billionaires, the "top 1%" for short, came the aforementioned Warren Buffet, one of the most astute investors of all time, one of the richest people in the world, and one considered to be of the highest integrity. Buffet went public with the fact that, in 2010, his average tax rate was less than that of his secretary, and wondered how that could be fair. Buffet said his tax rate was only 17%, while his secretary's was 23%. People were shocked to hear of this apparent inequity, and the call to raise taxes on the top 1% grew louder.

Consider the facts. In 2010, Buffet paid $6,938,744 in federal income and withholding taxes, representing 17.4% of his taxable income. No doubt his secretary's taxes were quite a bit lower than his. The reason for the different average tax rates is simple. Aside from his $100,000 annual salary, most of Buffet's income came from dividends and capital gains on his investments. The tax rate for both was 15%, so most of his income was subject to this lower tax rate. Most of his secretary's income was salary and taxed at her personal income tax rate, not the capital gains tax rate. If she filed singly, for example, and her taxable income was between $78,000 and $164,000, her marginal tax rate was 28%, which would have put her average tax rate somewhat lower. Buffet's comparison with his secretary is like comparing apples to oranges, but it makes terrific press.

It should also be noted that, for those who believe Buffet's low tax rate is unjust, Buffet's wealth did not just appear out of nowhere. Buffet started his career with very little wealth, but through intelligence and hard work, was able to build a substantial fortune. As this process unfolded, he paid tax on whatever salary he received at the personal tax rate. In addition, the many businesses that he acquired and helped to grow paid taxes on their income, so that his interest in these companies has also been taxed. Some hold to the principle that the same activity should only be taxed once. Taxes on dividends and capital gains violate that principle.

The argument over whether the top 1% pay their fair share of taxes will, no doubt, continue. Figures released by the CBO in 2011 shed some light. The data show the average federal tax rates for various income groups. Figure 30 breaks the taxes into two parts: a) income taxes and, b) income taxes plus Social Security and Medicare taxes.

As should be expected, given the progressive nature of our tax system, each of the income groups paid a higher tax rate than the group below it. The real headline is that the top 1% of earners paid _six times_ the rate of the bottom 20% on their combined income and payroll taxes.

The income tax rate for the bottom 20% is negative due to so-called refundable tax credits, a provision in the tax code by which those taxpayers who did not earn enough to pay federal tax are entitled to receive money "back" (over and above any withholding taxes returned) from the IRS. It is, in effect, a negative income tax. The figure means that the other three income groups subsidized that amount on behalf of the bottom group.

Progressivity was embodied even in the first income tax assessed in 1913, which had tax rates from 1% - 6% of income. To amplify the distribution of the current tax burden shown in Figure 30, analysts have broken the actual amount of taxes paid by each of various income levels. The data are shown in Figure 31.

In 2008, the top 1% of earners actually paid 38% of the total taxes collected. The next 9% paid an additional 33%, meaning that the top 10% of taxpayers paid more than 70% of all the taxes. That's a pretty progressive result.

Also of note is that the bottom 50% of earners paid only 3% of taxes. Some have argued that such a skewed distribution of income taxes represents a danger to society. If the bottom 51% of taxpayers came to owe no taxes, then a politician able to dominate that 51% could perpetuate a tax code where her constituency could, essentially, collect government services at the exclusive cost of others. A democracy financially supported by a minority of its citizens, it is argued, is a democracy that cannot stand. A sense of shared sacrifice and civic duty is critical to maintaining a cohesive society.

In the ongoing debate over who, or what "class," should give up the most to solve our budget deficit problem, the "Buffet Rule" has taken center stage. Some propose that the wealthy should pay no less than 30% of their income in taxes regardless of how the tax law is written. The administration proposes to add $500 billion in additional spending each year for the next ten years, and claims that the minimum tax on the top 1% will be of great help in financing those expenditures. The actual numbers, however, show that the new tax, and other proposed measures to tax the rich, will provide less than 30% of the added spending. The other 70% will be borrowed.

The reason to pay attention to such proposals is that the manner in which the government covers its expenses matters. Taxes on capital, and those who provide it, make the accumulation of capital less attractive. Capital can be moved to other countries to seek a higher return, or can be parked on the sideline to see how the economy plays out. Some argue that more can be allocated to consumption, helping the economy in the near term. The life-cycle hypothesis, however, would argue that shrinking capital reduces the holder's estimate of her future wealth, and would have the opposite effect.

As to the issue of fairness, how does one define the idea in such a way that it can be a useful guidepost for government action? Is it unfair that Buffet pays a lower tax rate than his secretary while, at the same time, paying more than 100 times the taxes she paid? How many more times his secretary's taxes does he have to pay for it to be fair? Lawrence Lindsay, former Federal Reserve governor, calculates that the relative tax burden of the top 5% of wage earners as compared to the other 95% has increased from three-to-one in 1980 to almost six-to-one today. How much more gold do we think there is in that goose?

**SPENDING**

The other side of fiscal policy is government spending. The government normally runs a deficit, meaning that it spends more than it takes in. It doesn't plan to do so or, if it does, it doesn't see it as a continuing state of affairs. Nevertheless, post-New Deal governments always seem to find extra things to spend money on, and run over budget by the end of the year. These deficits usually aren't very big, and they tend to bounce up and down from year-to-year and, on rare occasions, actually turn into a surplus. So, the debt required to cover the deficits over the years has risen steadily, but at a relatively modest pace.

The situation today is different. Following the very serious recession of 2008-2009, the government felt compelled to dust off their out-of-date Keynesian text books and try to stimulate the economy. Most economists recognize that the economy can't be stimulated in the same way that, say, a heart attack victim can be "defillibrated" back to life, but the stimulus image is a powerful one, and when the public is calling for the government to do something, stimulating has a nice ring to it.

As a result of its various forms of stimulus, the current government has raised the ante on deficit spending. Where government spending normally consumed about 20% of GDP, it now consumes 24%, the highest since 1946. It has been at that level for more than three years, despite the fact that the stimulus was supposed to have been a one-time jolt. The graph in Figure 32 shows the spending and revenue of the government since the year 2000.

This graph clearly shows the departure of current fiscal policy between 2008 and 2011 from the norm, and how a one-time stimulus of $800 billion turned into an apparently permanently higher level of government spending. Our intent is not to question the need for a given level of government spending; it is simply to underline the economic effects. These are two-fold.

First is the observation, already made, that the more money extracted from the private economy to serve public needs, the less money is available to create new private capital. Lower private capital formation means less prosperity in the future. We are in the position of appearing to revive the patient, while our action is actually shortening his life.

The second effect of running constant and growing deficits is that the debt needed to fund it becomes so large that our foreign creditors start to worry about our ability to repay it. When debt was a smaller percentage of our wealth, one never considered whether the U.S. was "good for it," so it is difficult for some to appreciate the threat posed by our ballooning debt.

**BORROWING**

Governments have borrowed money since before records have been kept; it is in their DNA. The colonies were deeply in debt after the Revolutionary War, a war nearly lost for lack of funds. Government debt is normally measured against the annual income of the economy, GDP. When Alexander Hamilton converted the colonies' debts to U.S. government obligations in 1788, the amount stood at around 35% of the new nation's GDP. The debt was fully paid off by the 1830's.

The next round of government borrowing was used to finance the Civil War which, again, brought the debt up to 35% of GDP. This debt was mostly retired by the turn of the century. World War I required another dose of borrowing, moving the debt back up again to 35% of GDP. This was cut to around 20% of GDP by the late 1920's. During the Depression, President Roosevelt's economic stimulus caused the debt to surge to 40% of GDP just prior to World War II. This was the first time that any significant debt had been issued for purposes other than funding a war.

Governments, like all of us, are inevitably confronted with unplanned needs, and since they have no natural source of savings to rely on, borrowing is the only feasible solution. From an economist's point of view, borrowing money poses a couple of problems. One is the simple fact that it must be paid back. When our national debt was considered manageable, few worried about paying it back; the growth in the economy, it was felt, would take care of it. Now, however, our debt is at levels that concern our creditors, and we must take a stab at paying some back. The fact is that whatever good may come from using borrowed money, that good is reversed when the money is paid back.

The second, and more serious, problem with borrowing is that it is not free. Interest must be paid on bonds on a regular basis. If the bonds are paid off at maturity, the interest obligation has been a finite, though real, burden. Today, however, bonds are paid off simply by issuing new bonds to raise the cash needed to pay off the old debt.

In this manner, we manage our bond debt somewhat like an individual manages their credit card debt. Credit card lenders make money by collecting interest on loans, so they really don't want the loan principal paid off. To encourage borrowers to keep their loans outstanding, they came up with the seductive idea of requiring only a minimum payment each month. The minimum payment typically includes a very small amount of the principal, often as low as 1%, with the rest being interest. Those borrowers who elect to pay only the minimum payment each month will probably not live long enough to actually pay back the loan, but they will surely pay a lot of interest.

Now, imagine the government issues a $1,000 bond payable in twenty years with annual interest at 5%. Since no bond principal is retired prior to its maturity, the total interest paid is equal to one year's interest at 5% ($50) times 20 years, or $1,000. If the loan is paid at maturity by issuing another $1,000 bond for twenty years, then an additional $1,000 of interest will be paid. Forty years from the first date of issuance, the government has paid twice the value of the bond in interest, and they still haven't repaid the debt. Since this is the way we are managing our bond debt, one could imagine paying four, five, ten times the amount of the bond in interest. This gets pretty expensive.

The interest has to be paid. It can be paid in one of three ways: by raising taxes, by borrowing more money, or by printing money. We know how raising taxes affects economic growth. Borrowing money to pay interest gets us back into the credit card spiral. And some say that inflating the currency by printing more money to pay interest is little more than legal larceny. Thus, no matter how we look at it, borrowing money is far from costless, and by shifting those dollars from producers to less productive uses, it results in lower economic growth now, or in the future, or both.

We have not been out of debt since World War I, and the debt is beginning to grow at an alarming rate. The federal debt held by the public[13] as a percent of our GDP has fluctuated just below 40% up until 2008. Since 2008, it has risen to 70% and is expected to keep growing.[14] This is the statistic focused on in the press concerning the troubles in Greece, Spain, and other European economies. As a result of figures like these and the government's apparent inability to control them, the rating on U.S. debt securities has been lowered from A to A- by Standard & Poor, an unimaginable insult to the strongest economy on earth.

# Chapter V - Monetary Policy

**Monetary policy** is action taken by the Federal Reserve Bank to manage the supply of money in circulation and, more generally, to create conditions favorable to economic growth.

**MONEY**

Control of the supply of money in the economy presents government with a second major tool to influence economic development. If not enough money is available to handle the commercial needs of the country, economic activity will slow, and GDP will weaken. If too much money is in circulation, inflation will follow. This cuts our purchasing power and leaves us less money for consumption and savings, also putting downward pressure on GDP. Since economic growth is the interest of macroeconomists, how the supply of money is managed is crucial to their studies.

Smith defined a person's wealth as a function of his ability to acquire goods and services, and since most goods and services are produced by the labor of others, wealth was a measure of one's ability to "command," or purchase, that labor. The value of any commodity, therefore, was equal to the quantity of labor it enabled one to command. He wrote "labor... is the real measure of the exchangeable value of all commodities."

Labor, unfortunately, cannot easily be exchanged for all the goods and services needed by today's workers. To do so would require each worker to provide discreet amounts of labor to each supplier of goods. One might have to sweep the floor of the pharmacy, for example, to buy a bottle of aspirin. This is clearly an inefficient way to convert the value of labor into a good or service.

Commodity money was developed to solve this problem. One might bring their mutton to the market, for example, to pay for a month's worth of provisions, a barter transaction. Older societies used a variety of commodities to transfer value in this way, such as cattle, sheep, salt, sugar, tobacco, and dried codfish. Smith wrote that, in one Scottish village, nails were the currency at the time of his writing.

Eventually, as societies became more diverse and the types of products more numerous, it became difficult for some to acquire the preferred commodity. Not everyone raised cattle or could get their hands on dried codfish. For this reason, people gravitated toward the use of metals as a means of exchange. Metals were more compact than cattle and, thus, easier to bring to market. They were durable, didn't spoil, and could be passed around the market indefinitely. Unmarked bars of metal were first used, but they needed to be weighed and assayed to assure they contained the proper quantity of metal, an effort that took a merchant a lot of time. As a result, countries began to stamp the bars to assure their authenticity, which ultimately gave way to minting coins.

Thus it evolved that, instead of receiving a cow for their labor, a commodity with actual value in use, workers began to receive pieces of metal, having virtually no value in use. One can't eat gold or wear copper. In either case, according to Smith, the value of the commodity was determined by the amount of work done to possess it.

Money, like any other commodity, had a value, but it also had a characteristic that other commodities did not: its value could fluctuate for reasons other than the amount of labor required to acquire it. Government had the power to create money to add to that already in circulation. Suppose a cow could be exchanged for 100 English pounds on a given day. Now imagine that, overnight, the government doubled the supply of money in circulation. What happens to the price of the cow? The law of supply says that, if the supply of money increases and the demand remains constant, the value of the money, its price, will fall. The value of the cow, i.e., the amount of labor required to raise it, remains the same, but since the value of money has fallen, it will take more of the "new" money to buy the cow. The new price will depend on the elasticity of demand for cows, but it will clearly be higher than yesterday's price.

With examples like this, Smith added a new dimension to our understanding of money: **inflation**. The cow now has two values, a real value and a nominal value. The **real value** of the cow remains the amount of labor needed to raise it and bring it to market. One might think of it as the "intrinsic" value of the cow. The **nominal value** of the cow is the money required to buy it, its market price. The two are different because the supply of money has been increased, depressing its value. When the supply of money rises faster than the real values of goods and services in the economy, inflation is the result. (By the same token, when the supply of money contracts, i.e., **deflation** occurs, its value rises. This happens seldom, and often with dire consequences.)

Governments love inflation. They learned that they could borrow money to cover their costs today, inflate the currency by circulating more money, and pay the debt back in the future with "cheaper" money. In other words, England could borrow 500 pounds today, issue more money to reduce the value of the pound, and pay the debt off with 500 pounds that might have a real value of, say, 400 pounds. Most agree this is unfair, and some today call it unconstitutional in the U.S., violating the "takings" clause of the Fifth Amendment. The Fifth Amendment states that "private property shall not be taken for public use, without just compensation." Inflation, which is caused by the government, takes real value from private citizens for public use, that is, to pay off government debt, and there is certainly no compensation.

Before the use of paper money, sovereigns would inflate the currency by reducing the quantity of metal in their coins. It was the government equivalent of putting water back in the vodka bottle so your dad didn't know you'd had a drink. For this reason, inflation is considered a hidden tax on the public.

Inflation is a wonderful thing for borrowers. For lenders, however, receiving payment on debts with less purchasing power than the money originally lent is not such a good thing; when the borrower (i.e., the government) is responsible for the shortfall, some consider it immoral.

Western Europe eventually gravitated to gold as the metal of choice for its money. Gold had many advantages as money, but also some disadvantages. When a gold bar or coin was presented for payment in the market, a time-consuming exercise to determine the actual quality of gold was required to be sure the merchant was getting her price. A practice developed by which a worker could leave his gold at the bank and receive a certificate evidencing his claim on that gold. Local merchants, who would know the bank's standing, began to accept such certificates, which were just claims on the gold instead of the gold itself. The merchant was confident that, if he ever needed to possess the gold, he could present the certificate to the bank, and it would be handed over. And with that confidence, it became unnecessary for him to do so, and the certificates began to circulate as money.

Later still, banks began to issue notes rather than gold certificates, which could be exchanged for gold. This practice worked well in local markets, but when a note from a bank a hundred miles away was presented, merchants were loathe to accept them because they didn't know the bank and didn't want to take the risk the note would not be paid. Gradually, central governments took control of the money supply and issued their own notes, still backed in varying degrees by gold. This facilitated trade on a broader scale and contributed further to growth in the standard of living.

**THE FEDERAL RESERVE**

" _The Great Depression of the United States is a testament to how much harm can be done by mistakes on the part of a few men when they wield vast power over the monetary system of a country."_ \- Milton Friedman

The U.S. Federal Reserve System (the "Fed") was created in 1913 to take over bank supervision and manage the money supply. This was in response to bank panics that had disturbed the economy throughout the late 1800's and, most recently, the Panic of 1907. At that time, widespread unwillingness by banks to meet their depositors' immediate demands for cash during a run on several large banks led to the establishment of a National Monetary Commission to determine a forward-looking solution to the problem.

The U.S. was then operating on a partial **gold standard** , meaning that only about 10-20% of the total money supply was held in gold, with the remainder being held in the form of cash and bank demand deposits[15], which could theoretically be exchanged by the depositors for currency at any time. The Commission recommended the establishment of the Federal Reserve System to act as a source of liquidity for commercial banks that were facing withdrawal demands in excess of their currency reserves. In other words, it would make loans to banks that were experiencing a run on their deposits. In addition, it would have regulatory and supervisory authority over the national banking system.

Popular jargon holds that the Fed can print money. This is not technically true. The U.S. Treasury prints money to replace worn out bills. The creation of new money is accomplished by the Fed in a different way, by buying government securities held by commercial banks. To pay for the securities, the Fed makes a deposit into the bank's reserve account with the Fed. This deposit is then available to the bank to make loans. When loans are made, the money supply grows.

The establishment of the Fed was broadly supported by the working classes as well as the bankers, and by both political parties. Originally, Fed currency was convertible to gold at any Federal Reserve Bank at a price of $35 per ounce. The requirement to convert currency into gold at a fixed price was intended to limit the Fed's power to inflate the currency. If the dollar began to lose its purchasing power because the Fed created too much money, people would seize the opportunity to convert their less valuable dollars into gold at $35 per ounce, and the Fed would experience a run on its gold. Think of it this way - if someone offered you $100 in cash and asked if, instead, you would like an ounce of gold that was worth $100, you would probably say, No thanks, I'm fine. However, if someone offered you $90 in cash or $100 of gold, you'd no doubt take the gold. The requirement for the Fed to maintain convertibility of dollars into gold at a fixed price, thus, acted as a restraint on its creation of excess money.

For this reason, people in some quarters, including University of Chicago Nobel laureate, Milton Friedman, have called for a return to the gold standard. This, they argue, would put an end to the continual devaluation of the dollar we have experienced over the years. In 2011, for example, it took $5.83 to buy an item that cost $1.00 in 1970, an annual rate of increase of 4.3%. Over this same period, real GDP increased at a 3.1% annual rate. In effect, prices have grown faster than our income, the classic definition of inflation.

For purposes of measurement, the Fed defines money as the sum of currency in circulation plus the value of demand deposits in banks. The U.S. banking system, like any advanced banking system, operates on what is called a **fractional reserve** basis. This means that, when you make a deposit at the bank, instead of putting all of your money into its vault, the bank lends some of your money to someone else, leaving it with only a "fraction" of your entire deposit - its cash reserve - in its hands. Thus, if you were the bank's only depositor and came back the next day to withdraw your full deposit, the bank would not have enough cash on hand to honor your request. It would, instead, be forced to seek payment of the loan it made to be able to return all of your money.

When economic conditions were favorable, bank depositors generally trusted their banks to honor their obligations. However, when the economy slowed down and people lost their jobs, the demands on banks for cash withdrawals increased. During such times it was more difficult for banks to call in their loans to retrieve their customers' cash, because their borrowers were also facing financial pressure. If, during such a period, a bank's customers found cause to question their trust in the bank, more and more of them would go to the bank to withdraw their cash. This sometimes led customers to "panic," and a run on the bank would begin. The bank run caused the bank's reserves of cash to fall to the point where they were unable to honor their customers' requests, and bank officials were forced to close their doors.

Note that, during a bank run, the financial condition of the bank is not necessarily affected; a run on deposits has no effect on the quality of its loan portfolio. It can expect to be able to collect the loans when due and have sufficient funds to meet all withdrawal requests eventually. A major reason for creation of the Fed was to have a source of cash available for such banks to carry them over a run on deposits. The Fed was specifically chartered to be able to lend cash to commercial banks during a financial crisis.

No sooner was the Fed established than World War I broke out, and much of the world abandoned the gold standard. What followed is described by Friedman in his book, "Capitalism and Freedom", published in 1962. He traces the severe economic contractions of 1920-21, 1929-33, and 1937-38 to acts of commission or omission of the Fed, saying that severe contractions like these would have been much milder under our earlier banking and monetary arrangements. Friedman concludes that "the quantity of money, prices, and output was decidedly more unstable after the establishment of the Reserve System than before."

Friedman's extensive study of Fed records led him to conclude that, were it not for the Fed's failure to provide sufficient liquidity to the economy after 1929, the Great Depression would not have been nearly as severe as it was. He notes that the peak of economic activity was reached months before the stock market crash and that, even with a modest shrinkage in the supply of money over the next two years, the economy was showing signs of recovery later in 1930.

In November of 1930, a number of banks failed, causing a run on other banks. In December, one of the largest commercial banks in the country, the Bank of the United States, failed and was closed. Most people, even in the United States, took the bank's name to mean that it was a government entity and, therefore, its failure caused great concern about the health of the banking system. Bank runs continued in the first quarter of 1931, but began to taper off before the quarter was over.

The conversion of large amounts of bank deposits into cash during this period had the effect of shrinking the supply of money in the economy. This was due to the fractional reserve operation of the banking system. Under this system, bank deposits that are loaned out lead to an increase in deposits in either the lending bank, or other banks where the proceeds of the loan are deposited. A fraction of those loans can also be loaned out, so that one deposit leads to a cascade of new deposits throughout the banking system. The effect of this is to increase the supply of money in the economy. When the reverse happens and deposits are converted to cash for depositors, the money supply contracts.

Friedman found that neither the banks' need for additional liquidity nor the decline in the money supply was addressed by the Fed during this period. Soon, another string of bank runs caused the money supply to drop even further. Then, in September of 1931, England went off the gold standard, and the Fed experienced greater than normal exchanges of dollars for gold. Hoping to slow the loss of gold, the Fed decided to take more money out of the economy by increasing the **discount rate** , the interest rate it charges on loans to commercial banks.

The run on the Fed's gold was stopped, but the reduction in liquidity in the domestic system sparked another, even more serious run on the banks. Between August, 1931 and January, 1932, roughly one out of ten U.S. banks was forced to close, and bank deposits, the largest component of the money supply, dropped another 15%. Only in 1932 did the Fed take decisive action by injecting $1 billion into the banking system, but by that time the damage had been done. After a brief hiatus, bank runs picked up again, ultimately leading to the Banking Holiday of 1933, when all banks were officially closed for one week to try and calm things down.

Between July, 1929 and March, 1933, Friedman determined that the money supply had fallen by one-third. This imposed a tremendous burden on the ability of people to engage in commerce - imagine what happens to commerce if the money supply falls to zero - adding to unemployment and extending the depth of the depression. Friedman concludes that, if the Fed had taken steps to stabilize the money supply sooner, the economic slowdown would have been shorter and far milder.

The Fed consists of twelve regional Federal Reserve Banks, and is governed by a Board of Governors comprised of seven individuals nominated by the President and confirmed by the U.S. Senate. The President appoints the Chairman and Vice Chairman of the Board of Governors, but the Board operates independent of the government to insulate the Fed from political pressures. This independence is believed by some to be an important feature of our system. A study of central banking systems by Alberto Alesina and Lawrence Summers in 1993 showed that, the greater the degree of independence of the central bank from government control, the lower that country's inflation rate over time. In that study, only the central banks of Switzerland and Germany were judged to be more independent than the Fed.

In reality, however, the Chairman of the Fed, who exercises great influence over its policies, owes his job to the President. In addition, Congress calls him to committee meetings regularly and can, in this manner, place significant pressure on Fed policies. It is difficult, under these conditions, for the Chairman to remain independent from political pressures, and he must be tempted from time to time to steer the Fed in a direction that does not adhere strictly to economic considerations. In Friedman's view, this would be the worst of both worlds: too much decision-making power concentrated in too small a group of people, and even their too narrow perspective is subject to political pressure.

The Fed's mandate regarding monetary policy is to influence monetary and credit conditions in the economy to pursue maximum employment, stable prices, and moderate long term interest rates. It is argued, however, that two of these mandates are conflicting, that the actions needed to reduce unemployment and control inflation are in direct contradiction. Recall how Keynesian economic policies in the 1970's resulted in both high inflation and high unemployment. The rational expectations school finds compelling evidence that such policies had been used too often and that the market learned to adjust to expected Fed action even before it was implemented.

This ambiguity of mandate is at work today as the Fed tries to help some economic sectors to the distress of others. The Fed is keeping interest rates near zero, in large part, to encourage people to buy homes with low-rate mortgages, thinking that recovery in the housing market is the critical factor in boosting the economy. However, consider the impact of such low interest rates on retired people who have converted their stocks to fixed income investments so they can count on a steady stream of interest payments. Much of this investment has returned almost nothing over the past three years, and the Fed has announced it will keep interest rates near zero for the next three years. That's six years of receiving very little income on one's life savings, which will be devastating for many. In fact, after adjusting for inflation, their return has been negative. The Fed's action on interest rates is simply transferring wealth from savers to borrowers. Do we really want an unelected body making decisions like that?

Many economists, including Friedman and Stanford University professor John Taylor, argue the Fed should narrow its goal to that of simply keeping the money supply growing at a constant rate. This will remove judgment from its hands and allow the capital markets freedom to move capital to where it is most needed. They believe the market will always have a more equitable and economically efficient answer than even the smartest individual.

# Chapter VI - Regulation

Government regulations are put in place for a number of reasons, some valid, some not. George Stigler, a University of Chicago economist and Nobel laureate, observed that the agencies charged with enforcing regulations often developed such close ties with the industries they were regulating that their decisions seemed biased in their favor. Stigler developed a theory called **regulatory capture** , which describes cases where this occurs and the rationale behind it.

The major explanation, of course, is that complying with regulations costs industry billions of dollars every year. The administration claims that regulations cost only $62 billion annually, while a detailed study for the U.S. Chamber of Commerce found $1.7 trillion in annual costs. The answer must lie somewhere in the middle, which would be a disturbingly large number. These costs are corporate expenditures to modify certain activities, measure the results, and report all of this to their agencies. It is money not available for capital expenditures or hiring new workers or paying dividends to shareholders. Regulatory costs are a deadweight loss to the economy.

Thus, it is in the best interests of the corporations to make nice with their regulators. It is no longer legal for them to buy gifts, but they do their best to make their regulators know how much they love them. Over time, it becomes difficult for the regulator to be positioned against their industry "friends," so they become "captured." This is not uniformly true, but it is a well-documented phenomenon. And the economic effect, of course, tilts the playing field toward the corporation and away from the consumer.

**LYME DISEASE AND GOVERNMENT**

" _It is the highest impertinence and presumption, therefore, in kings and ministers, to pretend to watch over the economy of private people, and to restrain their expense, either by sumptuary laws, or by prohibiting the importation of foreign luxuries. They are themselves always, and without any exception, the greatest spendthrifts in the society."_ \- Adam Smith

There is a little-known malady concentrated in the Northeast U.S. called Lyme disease. First discovered near the town of Lyme, CT, Lyme disease is a bacterial invasion transmitted by the tiny brown tick, aka the deer tick. These little bugs are much smaller than the more familiar wood ticks that you may encounter on your dog; in fact, they are about as large as the head of a pin. The tick is transported by the deer population, which brings it out of the woods and into your garden or back yard. The tick's bite is usually, though not always, accompanied by a circular reddening of the skin that may last for a few days. One may also experience light flu symptoms such as headache, muscle aches, and fatigue. The tick bite is painless, and the tick falls off soon after the bite, so one is often not aware of being bitten. A treatment with a heavy dose of antibiotics soon after the bite is normally successful.

For those unlucky enough not to have discovered the bite or know its source, the story can be quite different. Over time, the bacteria find their way deep into the nervous system, where antibiotics have a harder time reaching them. At this stage, one can suffer from a variety of symptoms including arthritis, partial paralysis of the facial muscles, numbness, meningitis, fatigue, severe headaches, sleep disorders, memory loss, and irritability. A subset of sufferers can develop life-threatening disorders of the lungs, nervous system, and heart. Untreated, the disease can go on for years. Lyme disease is something you want to catch early, before it becomes a real problem.

So it is with many government interventions in the free market; if you don't make plans to end them when their goal has been achieved, they become entrenched deep in the bureaucracy and grow like bacteria. Farm programs come to mind; with corn prices at all-time highs, why is it, again, that farmers need relief?

Another example is The Low Income Home Energy Assistance program, or Liheap. Created in the 1981 to help the very poor keep their homes heated as energy prices were spiking, it now has its own lobbying group, the National Energy Assistance Directors' Association. The American Gas Association supports its goals so that, today, Liheap subsidizes air conditioning as well as heat. (Air conditioners use electricity that is largely produced by natural gas-fired power plants called "peaking" plants.) Even though the need for energy assistance disappeared by 1985, Liheap is now a permanent part of the budget.

The government sector is not motivated by profit or measures of efficiency - seldom is one evaluated on how much of the people's money they have saved - but, rather, by the desire to do the people's work, to adopt the mission of a particular agency and seek ways to achieve that mission. Often, no doubt, one is encouraged to find ways to expand the mission, believing that this is the intent of the people or, simply, that it is the right thing to do. And, as in the private sector, a public sector employee may seek to elevate their stature by increasing the size and importance of their domain. Over time, the expanded mission becomes part of the original mission, is included in the budget, and requires more employees to carry out. The agency grows like deeply embedded bacteria, causing headaches, sleep disorders, memory loss, and irritability among the rest of us, especially at tax time.

Government efforts also result in some remarkable outcomes. One of the most unusual regulatory edicts we have found comes from the European Union. As the London _Telegraph_ reported: "A meeting of 21 scientists in Parma, Italy, concluded that reduced water content in the body was a _symptom_ (emphasis added) of dehydration and not something that drinking water could subsequently control." As a result, "producers of bottled water are now forbidden by law from making the claim [that water hydrates] and will face a two-year jail sentence if they defy the edict." Dry martini, anyone?

In this section, we take a look at a few of the many activities of government that encroach on the free operation and efficiency of the market, potentially limiting opportunities for economic growth.

**AIR POLLUTION**

Private property is essential to the operation of a free market. People and firms acting in their own _self_ interest give rise to the invisible hand, which results in voluntary transactions satisfying both parties.

Economists have noted an interesting twist on this, which they call the **tragedy of the commons**. Public parks, beaches, and roadways - common areas - seem habitually scarred by discarded beer cans, donut wrappers, Big Mac boxes, and more. Economists believe this happens because, the parks being publicly-owned, no single individual is responsible for their cleanliness. Instead, we are all responsible, which gives many of us an excuse to litter, knowing that someone else will clean it up. This is the tragedy of the commons, selfishness gone berserk. Private property, or private stewardship, is one answer to the tragedy of the commons.

Economists call the money that municipalities must spend to clean up their parks and highways a **social cost**. A social cost is a cost borne by society, regardless of who might have been responsible for it. Prior to the Clean Air Act of 1970, many companies disposed of pollutants into the air and nearby rivers and streams. In some cases, this resulted in poisoning the nearby environment and human beings who contacted the pollutants. Poisoned environments must be cleaned up, and poisoned humans must seek medical help. Both of these activities usually result in someone other than the responsible party footing the bill. These are the social costs of pollution.

Determining the source of pollution is not a simple task. To be sure, if a firm pours contaminated liquids onto its own property and they seep into a neighbor's property, the neighbor would have standing in court to sue for damages. But who is able to sue for liquids poured into a stream and carried hundreds of miles downstream? Those damaged might not know the source of the pollutants, even if they could be isolated from all the other pollutants that had been added to the stream along the way. Air pollution presents the same kind of challenges. Economists agree that only government has the necessary authority to take up this challenge.

The government has a number of options available to intervene in the market and correct inequities like this. One solution is to tax the polluters and give the money to those damaged by the pollution. This would provide an elegant financial solution but would be costly to administer. And, of course, the question of where the pollution came from would always be argued in court.

If the polluting companies were taxed, they would pass the cost of the tax on to consumers by increasing their prices, shifting the cost to people who buy their products. This would mean that only the consumers of, say, children's plastic toys would incur the cost of the tax on toy factories, giving rise to what economists call the **free rider** problem. In this example, a free rider is anyone who benefitted from the tax without having to pay it, that is, people who don't buy children's toys.

Taxing pollution, however, does not eliminate it. A second way to handle the social cost of pollution is to make it go away by requiring polluters to install pollution control equipment. This reduces the pollution and the damage it might cause, reducing the social cost going forward. This is the approach taken for power plant operators, for example, who are directed by the Environmental Protection Agency ("EPA") to install such equipment.

This solution, too, raises questions, among the most important being how much of the pollution should be abated? No process will control every last molecule, so what leeway should be granted?

In this area, we call on the law of diminishing marginal returns for illumination. Recall that, when a producer adds employees to try and capture more business in the market, each new employee adds a little less value than the last, demonstrating the diminishing marginal productivity of labor. The same is true in the field of pollution abatement. Capturing the first 50% of a stack pollutant, for example, might involve simply putting a screen in the flue. Getting the next 35% might involve installing a bag house, a more elaborate form of screening, and more expensive. So, the cost of the second solution is larger, while the amount captured, 35%, is smaller. Capturing the last 15% is often prohibitively expensive. In economic terms, the cost per particle of pollution abated goes up. Economists say this represents the diminishing marginal return received from an extra dollar spent on pollution control.

Late in 2011, the EPA issued a final regulation concerning mercury emissions from coal-fired power plants. The EPA had been studying the issue for more than ten years and had sought input from interested parties and the public. The rules required power plants that burn coal to adopt the so-called Maximum Available Control Technology to reduce mercury emissions by 90% by 2015. Roughly 40% of the nation's coal-fired power plants would be affected. EPA estimated this would cost the affected utilities around $10 billion per year in operating costs, save 4,200 - 11,000 lives and generate $37 - $90 billion in health benefits each year.

The rules were aimed primarily at the oldest coal burning plants still in service, since those had the least investment in modern pollution control technologies. One analyst claimed that installing the required hardware at these plants would cost $130 billion, on top of the $10 billion in annual operating costs estimated by the EPA. Others calculated the annual operating costs at closer to $30 billion per year.

Many of the power companies stated they would have to shut a number of plants down, because the added investment could not be justified for the older plants. The North American Electric Reliability Corporation estimated 25% of all existing coal-fired capacity could be lost due to the shutdowns. This, in turn, created concern about possible power black outs under extraordinary load conditions, such as very hot weather, storm damage, and so on. Industry experts claimed the closure of these plants could cost more than one million permanent jobs, including coal mining, transportation and ancillary industries.

Health experts claimed the EPA's health benefits estimate was far too high. Most media outlets reported 11,000 lives would be saved, ignoring the actual estimate of 4,200 \- 11,000.

And so the battle lines were drawn. The basic issue was whether the potential benefit to society justified the expenditure on new equipment and the cost of possible power outages. The facts in the case were elusive, and advocates on both sides of the argument advanced their own views of the relevant facts to support their arguments. Forecasting costs and benefits in such complex systems is not a straightforward exercise, as it depends on the assumptions made about costs and benefits. Reasonable people can disagree on assumptions, and different assumptions can lead to widely varying results.

The following facts published by the Department of Energy (the "DOE") seemed to be indisputable. Mercury exists naturally in the environment, in air, water, rocks, trees and earth. Each year some 5,500 tons of mercury are emitted into the atmosphere worldwide from both human and natural sources such as volcanoes and forest fires. All coal-fired power plants in the U.S. are responsible for less than 1% of this amount; some experts say it is below 0.5%.

Historical levels of mercury emissions in the U.S. had been measured by analyzing peat deposits from Minnesota. This analysis showed that emissions increased ten-fold between the late 19th century and 1950, but that by 1980, they had declined to half of the 1950 level. Separate studies in Sweden and the United Kingdom also indicated that mercury emissions had peaked by 1960.

A more recent study, commissioned by the DOE, showed that mercury emissions continued to fall during the 1990's, measuring all U.S. emissions at 242 tons in 1993 and less than 160 tons by the end of the decade. The primary reason was that EPA had already begun to regulate mercury emissions during the 1990's, and required 90% reductions from incinerators for municipal waste, hazardous waste, and hospitals. Mercury emissions from batteries, paint, and fungicides were also lowered.

The greatest point of difference seemed centered on the EPA's claimed health benefits. The opposition cited a study from the National Health and Nutrition Examination Survey, a unit of the Centers for Disease Control. The study showed that mercury blood counts in women declined between 1999 and 2008 to well below the safe level called for by the EPA itself.

The EPA was specifically concerned about possible neurological damage to fetuses. A study of mercury concentrations in more than 6,800 people published in the New England Journal of Medicine suggested there would be much less risk than EPA claimed. The study, led by Darius Mozaffarian, MD, associate professor of cardiovascular medicine at Brigham and Women's Hospital and Harvard Medical School, found concentrations of mercury at 0.25 micrograms per gram of material sampled, well below Mozaffarian's estimate of the lower limit of safety for pregnant mothers and infants, 0.40 micrograms per gram.

The EPA also claimed the new regulations would prevent 4,700 heart attacks annually, primarily by avoiding contaminated fish. Dr. Mozaffarian, also a cardiovascular expert, said, "For the average consumer who's worried about mercury in fish, our study suggests that cardiovascular toxicity should not be a concern."

Of greater concern, however, was EPA's claim of saving 4,200 - 11,000 lives annually. 11,000 is a very big number of deaths - nearly one-third of the total deaths from automobile accidents and three-quarters of the total deaths from homicide. If mercury emissions from coal plants are causing this number of deaths each year, this is a health problem of significant proportions.

Dr. Anne Smith, PhD., consultant with NERA Economic Consulting, found EPA's claim puzzling and performed an analysis of how this number was derived. In her technical commentary of August, 2011, she concluded that EPA was actually claiming _zero_ saved lives from reducing mercury. The 4,200 - 11,000 lives range was an estimate of the lives to be saved through a related effect of the abatement: the reduction of particle air pollution, a substance already regulated by EPA and safely under its proscribed limits. In addition, Dr. Smith explains that the statistical methodology used to forecast the number was problematic, and that, at a minimum, the lower limit of deaths - 4,200 - should be lowered to zero, since EPA had not claimed that even one life was lost last year from this pollution source.

The benefits attributed solely to mercury abatement by EPA relate to possible neurological problems avoided in children _in utero_. In considering the many negative effects, EPA concluded it was possible to avoid an average loss of IQ points among these children equal to two thousandths (0.002) of one point. This was calculated to be worth $6.1 million. So, instead of saving actual lives from the mercury abatement, EPA was really aiming to save IQ points, a total of 511 IQ points in the entire country, in fact, at a cost of $10 billion per year. That's around $19.6 million per IQ point, implicitly valuing the life of a person with a 110 IQ at $2.2 billion.

This vignette about mercury emissions raises a number of important questions. How is the public to learn the truth of a matter like this, when it is so complex, overlaid with political agendas, and poorly covered in the media? Government agencies deal with such matters on a regular basis. Are they truly analyzing data in an unbiased and transparent manner? Aren't taxpayers entitled to that? And economics cautions that the last bit of pollution abated, having the least amount of societal risk relative to prior abatements, is also the most costly. As a society, is it a wise use of our limited funds to eliminate such a minimal risk, knowing that most of every dollar extracted from the private sector will lower our standard of living without significantly improving our health?

**COMMERCIAL LICENSING**

Legislators have an unending desire to make things better for the rest of us. Governments at all levels - federal, state, and local - engage in this, and the scope of their ambitions ranges from the seemingly insignificant to the obviously overweening. Each such interference touches a free market and makes it less free by reducing the choices of its participants. And by favoring one group or cause, they invariably limit another, because government programs operate by taking from pocket number one to fill pocket number two.

One of the simplest and most widespread forms of government regulation is the licensing of commercial vendors, from bug killers to hair clippers to nail cutters. Years ago a news story told of a young black woman who had developed a superior skill at weaving corn rows into her friends' hair. She became so well known that neighbors came to her house and began to pay for her service, and she became a successful entrepreneur. When the local government learned of her business, it decided it must be licensed as a hair salon, charged her a one-time fee with annual renewals, required her to install sinks and a toilet for the sole use of the patrons, and generally made it so expensive for her to qualify that she folded up her tools and went out of business. Another town recently forced a young girl to license her lemonade stand.

The wacky stories about over-reaching licensing are endless, but they shouldn't mask the harmful economic effects. Ostensibly to protect the public from unscrupulous, unclean, unqualified providers, the effect of these license requirements is to limit the choice of suppliers available to the public. Licenses cost money, which can prevent potential suppliers from even applying. Most require some type of qualification - tests or courses - which raise the cost of entering the business. Continuing education requirements add to a business's ongoing costs.

An example reported in _The Wall Street Journal_ from Chicago is illustrative of the wider issues. Operation of a food truck offers people with very little capital the opportunity to practice their culinary skills without leasing retail space and, of course, offer consumers a quick meal on the run. Who is harmed by food trucks? Restaurants are. Hence, food trucks in Chicago are limited by law to a sales period between 10 AM and 10 PM, saving breakfast business for the restaurants. Under a new ordinance passed by the City Council in 2011, food trucks are no longer allowed to operate within 200 feet of a place selling any food, including a Starbucks or 7-11. This rules out most locations in the city's "Loop" business district. To improve compliance, the regulation requires each truck to install a GPS device at their own expense allowing their positions to be monitored centrally. If a truck is trying to cheat a little, tickets are issued automatically. How's that for free enterprise?

By limiting the number of potential suppliers, commercial licenses reduce the supply, causing the supply curve for vendors to shift to the left. Economists know that when a market supply curve shifts to the left, the equilibrium price for that good or service goes up. It is in the economic interest of the public to have as many suppliers of services as possible, precisely because this results in greater competition and lower prices. Municipalities enact license laws, of course, to collect the fees, and to protect Joe the barber by shrinking the supply of barbers. In turn, Joe supports his councilman's reelection campaign. It works out pretty well for everybody, except us.

Are all these licenses really necessary? Do they prevent fraud and deception? Do they insure better quality work? Aren't lousy vendors pretty quickly identified and squeezed out of business? Are we really better off knowing that the person shining our shoes in the airport is licensed?

Commercial licensing sounds reasonable enough, but it denies individuals, often those on the lowest rungs of the economic ladder, the opportunity to support themselves with the skills they have acquired. The result is often increasing unemployment, contributing to other social problems. And licensing limits the number of options available to us to satisfy our needs, raising their prices, reducing our choices, and lengthening wait times.

**AUTO MILEAGE STANDARDS**

A particularly feckless and invasive form of regulation was the federal government's attempt to reduce the consumption of gasoline following the Arab oil embargo in 1973. Examining various options, Congress decided to force the auto industry to carry its water. It imposed Corporate Average Fuel Economy ("CAFÉ") standards in 1975 whereby each auto maker was ordered to sell a mix of high-mileage and low-mileage cars such that the average gas mileage of all cars sold would not exceed 18 miles per gallon. Penalties were assessed for failure to meet the standard.

A more complete control of an industry is difficult to imagine. The result was that auto makers had to design new, smaller cars to meet the standard, cars that the public had not indicated it wanted. In order to induce the public to buy more of the small cars, the manufacturers had to make them as inexpensive ("cheap") as possible and, even then, profit margins had to be cut to meet the quotas.

A couple of unexpected reactions to the CAFÉ standards occurred. First, they opened the door to Japanese car makers to sell more of their higher quality small cars in the U.S. at competitive prices to the U.S. makers' lower quality vehicles. This was a door the U.S. auto makers did not need to have opened, although it certainly benefited U.S. consumers. Second, the National Highway Safety Administration found that deaths in auto accidents occurred at a higher rate in small cars than in large. Their initial estimate was that 1,300 to 2,600 highway deaths would result each year from the sale of the smaller cars that the law effectively mandated.

U.S. auto companies, of course, were not naïfs at the negotiating table. They assured that light trucks (pick-up trucks) were not included in the initial law and were assigned lower mileage standards in ensuing modifications, and that four-wheel drive trucks had lower requirements than two-wheel drive trucks. If you have ever wondered why four-wheel drive "sport-utility vehicles" (i.e., fancy trucks) replaced station wagons, now you know.

The idea of forcing an industry the size of the auto industry to re-invent half of its business to achieve a social goal is surprisingly bold, even for a politician. Apart from the loss of profit, the ongoing costs of administration are a drag on productivity. If the goal was to reduce consumption of gasoline, a simple increase in the gasoline tax would have done the trick and had the advantage of spreading the cost across the entire user base. Is it possible that no one in government wanted to take the political heat of being honest with the voters about who would bear the ultimate cost?

**COMMERCIAL BANKING**

The commercial banking industry is the most highly regulated industry of all. Three agencies - the Fed, the Comptroller of the Currency, and the Federal Deposit Insurance Corporation - have oversight authority over all federally chartered banks. And, of course, all banks are subject to review by the Securities and Exchange Commission. Imagine having to report to four regulators. The banks made serious mistakes in mortgage lending during the recent past and, as a result of the backlash, now have a fifth and sixth regulator courtesy of the Dodd-Frank bill. The attitude of government seems to be, if four agencies can't do the job, heck, let's try six.

Sometimes even two regulators are too many. Kirsten Grind, in her book "The Lost Bank" about the failure of Washington Mutual Bank ("WaMu") in September of 2008, reveals a turf battle over which agency should actually be running the show. As a savings and loan association, WaMu was regulated by the Office of Thrift Supervision ("OTS") but its holding company was overseen by the Fed and the Federal Deposit Insurance Corporation ("FDIC"), which guaranteed its consumer deposits. The OTS, since it oversaw the much smaller savings bank industry, apparently felt it needed to flex its muscle in the whirlwind of activity prior to WaMu's failure. Thus, on the morning of September 27, we find the FDIC privately approving the sale of WaMu's holding company to J.P. Morgan Chase, and in the evening of the same day, the OTS seizing the bank itself and putting it in receivership. In serious situations like this, it would seem especially helpful to know who's on first.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 created the new Financial Stability and Oversight Council, and established the Bureau of Consumer Financial Protection. Wouldn't it make more sense to examine why the first four failed in their duties and then fix them rather than create a monumental new law to lay on top?

Dodd-Frank duplicates most of the regulatory authorities of the Fed, and adds hundreds of new regulations to oversee hedge funds, insurance companies (though they are already regulated by the States), credit rating agencies, non-bank financial companies, even the Federal Reserve itself, a regulator regulating a regulator. The bill is sure to add significantly to the cost of providing financial services, but some say it fails to accomplish the one thing that most agree is needed, the elimination of the **moral hazard**[16] of having banks that are "too big to fail" and will, thus, continue to represent a danger to the stability of the banking system.

One of the distorting effects of the bill is just coming into focus. Additional limits and reporting requirements on banks are affecting smaller banks more drastically than the mega-banks that created our recent problems. The smaller banks are the ones that support medium and smaller businesses, but Dodd-Frank will raise their operating costs and make it difficult for them to continue performing this essential function. Why, since these banks had virtually zero involvement in the mortgage loan scandals, are they having yet another layer of regulation loaded on them?

The need for a new bureau to protect consumers from financial providers is also unclear. Clearly the average consumer is at a knowledge disadvantage when dealing with financial services providers. One needs a decent math skill and a patient mind to navigate the fine print of such arrangements. Existing financial regulators have taken useful steps in forcing providers to make their proposals easier to understand; consider the extensive disclosure requirements already imposed on credit card companies and mortgage lenders.

Consumers might well have benefitted from counsel when presented with the very complex mortgage loan proposals of the last decade, but is this reason to expand regulation of all forms of consumer financial services providers? So-called omnibus bills like Dodd-Frank allow legislators to toss in all kinds of unrelated restrictions to please special interest groups, each of which raises costs on business and creates market distortions. In our view, such laws should be, well, illegal.

**THE TITANIC**

One of the problems with relying on government to solve societal problems is the subtle shift in responsibility that occurs from those having the most relevant information to those who are farther removed from the market. Chris Berg, a fellow at the Institute of Public Affairs in Melbourne, Australia, writes that the Titanic carried only enough lifeboats to save half of its passengers and crew, which was in full compliance with British Board of Trade regulations. This 20 year-old law required that all ships in excess of 10,000 metric tons carry 16 lifeboats; the Titanic was more than 46,000 tons and, in fact, carried 4 more boats than required at the direction of the ship's owner.

Why was the regulation in place? Several reasons. First, it had been forty years since the last serious loss of life at sea, and newly-built ships were much safer than the older ones. Second, it was commonly felt that the purpose of lifeboats in that age was to ferry passengers of a stricken vessel to nearby vessels to escape danger. Atlantic shipping included many more ships than in the past, and it was not uncommon for two or three ships to be within rescue distance of a ship in danger. The idea that lifeboats would have to be used to carry all of the passengers at one time had begun to fade into history. Had the Titanic sunk more slowly, as was considered the norm for larger, safer ships, seven ships could have been on the scene in time to effect the rescue.

In short, shipbuilders and owners assumed that the Board of Trade's experts were on top of the situation and that their regulations could be relied upon. In fact, the Board of Trade's post-accident inquiry documented a conversation between the head of the shipyard that built the Titanic and its owner in which the shipyard recommended that the ship carry 48 lifeboats. The owner declined this recommendation at the time in order to see what the legal requirement was, but he did authorize the shipyard to develop full designs to carry 48 boats if it was required. In the end, the issue was not extra cost but simply what the board required.

Governments find it easy to establish regulations, but are not always good on follow-through. Responsible agencies often lose sight of the original purpose of the regulations they are charged with overseeing, get bogged down in the minutiae of regulation and lose the big picture. The highly paid staff of the SEC failed to act against Bernie Madoff and his $50 billion Ponzi scheme despite warnings from private sources years before it failed. They were so concerned about the health of commodity trading firm MF Global that they actually placed paid employees in the company's offices to oversee its operations, this a full year before the company lost $1.6 billion of its customers' money and declared bankruptcy. The Fed's own staff economists reported that the housing market was overvalued by 20% in 2005, yet the Fed took little notice and kept interest rates low, feeding more fuel into the blazing housing market. Regulatory minimums often become practical maximums because they relieve private sector managers of the burden of reason and thought about their own business.

Do we ever consider how pervasive government influence is in the markets we use every day? Of course, we are all subject to the tax code, which makes us subservient to the government for at least a few months of the year and, as we have suggested, taxes introduce market imbalances.

Industries of all kinds are subject to regulation. One of the more bizarre examples was the Justice Department's armed raid on one of the leaders in Big Music, the Gibson Guitar Company, in 2011. Federal agents closed the company's plant, sent everyone home, and seized all of the company's Madagascar ebony. They charged the company with violating the Lacey Act, which requires buyers of, in this case, ebony to certify its legal harvesting all the way back to the tree. In Gibson's case, the company had acquired the wood legally as certified by the government of Madagascar, but the Justice Department argued that Gibson not only needed to abide by the laws of Madagascar, but also to determine whether those laws were valid and enforced. Gibson settled with Justice at a cost of over $500,000, in addition to the costs of its business disruption.

Gibson, of course, should know the laws that pertain to its business, but one wonders if the laws will ever stop coming. The Code of Federal Regulation, which records the actions of government agencies, is measured by the number of inches of shelf space the fifty volumes occupy in the Library of Congress - 304 inches, a little over 25 feet. Many of us hold the conceit that our institutions, businesses and citizens are largely free from government control. It turns out that our market isn't nearly as free as we think and, in some cases, it is really quite expensive.

# Chapter VII - Jobs and Income

**CREATING JOBS**

Job creation is the topic _du jour_. Government claims it can create jobs, even though it has no resources of its own, and business is informed that it is their social responsibility to invest more of their resources to create new jobs. There are few subjects about which we hear more inane babbling from the political class than job creation.

What does it mean to "create" a job? What, exactly, is a job? In Smith's model, a job is the exchange of labor for money; importantly, the money is generated by the fruit of that labor in the form of product sales. Labor is employed to produce something of value. So, a "real" job is one where value is created by combining an employee's labor with an employer's capital. A "real" job is sustainable through the product of the work, that is, when the return to capital is adequate, labor is continuously employed. The job is self-financing and creates its own permanence.

Smith noted that some jobs were "unproductive of any value" and resulted in no marketable product. He cited, specifically, the sovereign and all the officers of justice and war who served under him, including "the whole army and navy," as being "unproductive labourers." Their service, however honorable, had to be supported by the industry of others. "In that same class must be ranked," he noted, "some of the gravest and most important, and some of the most frivolous professions: churchmen, lawyers, physicians, men of letters of all kinds; players, buffoons, musicians, opera-singers, opera-dancers, etc." Colorfully, he added, "Like the declamation of the actor, the harangue of the orator, or the tune of the musician, the work of all of them perishes in the very instant of its production."

In what way, then, can the sovereign - the government - actually create a job? The government has no capital to combine with labor. The government has no wealth. It can only raise money by taking it from the rest of us. If the government takes a dollar from your pocket and gives it to someone else, how does the economy benefit? The dry cleaner who would have gotten the dollar from you will now not get it. Nor will the supplier of plastic bags to the dry cleaner gain the benefit they otherwise would have. Someone else will. Where is the creation of value? Most government jobs do not add to the productive capacity of the economy, and no wealth is created.

Clearly, then, it is misleading to say that government creates jobs. All the government really does is to take from you to pay your neighbor. But note how politicians use the word "create," which subtly elevates the act of taxing to something far more noble. It's as if the National Science Foundation had discovered how to clone a job in a test tube. There is absolutely no creation involved when the government redistributes money and calls it a job.

That said, many in government believe it is their responsibility to create employment opportunities which, in their view, is the same as creating a job. A major mandate of the Federal Reserve is to manage the level of unemployment in the economy, which they can supposedly do by changing the level of interest rates. Unfortunately, as we have seen, the Fed has two mandates in its charter concerning unemployment and interest rates that are in direct conflict. If a job is defined as an activity that will contribute to GDP, private sector jobs are those we should be encouraging.

**CONCENTRATION OF INCOME**

Not to be philosophical, but the essence of humanity is diversity or lack of "sameness." We are all physically different, to be sure. Even identical twins are not exactly alike. We are all born with or soon develop different levels of intelligence, aptitude, curiosity, aggressiveness, energy, social skills, and so on. As we get older, we form unique definitions of a successful life, from the purely monetary to the highly spiritual. Economists might say we all have different utility functions, meaning that each of us sees the world in different ways and reacts in unique, sometimes unpredictable ways to its various stimuli.

Differences in income are an inevitable result of this diversity in a free market; some of us value money, and have the aptitude to acquire it, more than others. Indeed, it is this energy and the freedom to exercise it that powers a free economy. Diversity of income is assumed in our Constitution, which guarantees equality of opportunity but not of results. Some of us just have greater skills at imagining the needs of consumers and acting upon that vision and, in a free market, can be rewarded accordingly. This is not to glorify this state of affairs, simply to acknowledge it.

Nevertheless, inequality of income, as diversity of income is popularly known, is now used as a political slogan to marshal the votes of those who don't have as big a piece of the pie as they might like. Not long ago analysts began using income data to demonstrate that income was becoming more concentrated in our economy, that, in effect, the rich were getting richer and the poor, poorer. Of course, anything that smacks of an aristocracy in the U.S., given our history, is highly distasteful.

In this section, we will make two points. The first is that a healthy, free market economy grows through the extraordinary efforts of a relatively small number of people, and their creation of personal wealth is what enables all members of society to advance. In fact, one might _expect_ to find the income of the top 1% growing faster than that of the other 99%, but it should also be true that the income of the other 99% is growing. Producers in a free economy do not generally become wealthy by taking wealth away from others, but rather by giving it to others in the form of needed products, jobs and dividends. In this way, both the top 1% and the other 99% benefit.

The second point is that, when we speak about concentration of income, we must recognize that, over time, it does not all go to the same individuals. The make-up of the top 1% is constantly changing, as some people achieve new levels of wealth, while others' fortunes are in decline. This point goes to the idea of class warfare, which some like to wield as a political tool.

Concern over class in America is informed largely by the experience of Europe, and particularly, England. There, a permanent aristocracy consolidated its hold on wealth and privilege in the early Middle Ages. The reason is that in England's feudal society, as Smith describes, the king relied heavily on the owners of large estates to send him soldiers when his kingdom was threatened. They, the regional noblemen who lived in the imposing castles, were, thus, the true source of the king's power, and it was imperative that they retain influence over their own vassals and serfs.

However, if the Lords and Barons, upon their death, distributed their estates widely to their children, the estates would gradually be broken into pieces. At some point, they would be so small that the heirs would lose influence over their vassals and no longer be able to send the soldiers needed by the crown. This was unacceptable to the king, so the practice of primogeniture was established. Under primogeniture a nobleman's estate passed directly to his oldest heir so that the estate would remain large and maintain its control over its farms and villages.

In England, this gave rise to the landed aristocracy, which maintained its position of wealth and influence for centuries. The younger male children, deprived of their fathers' treasure, often went into the clergy, the military, or the political realm, thereby remaining in public positions of respect and influence. It was this concentration of power that the framers of the Constitution sought to prevent in America. They believed that citizens should be free to advance in society based solely on the merit of their achievements, not simply the miracle of their birth.

Of course, primogeniture is not practiced in the United States. To be sure, America has produced its share of family fortunes - of Rockefellers, Fords, Carnegies, Mellons, and Vanderbilts - that have carried on for several generations. In most cases, however, the originator of the wealth distributed his estate among all of his heirs, as well as to charity and community improvement. Thus, what began as very large concentrations of wealth in America are steadily being diluted among growing numbers of heirs.

Furthermore, while the old fortunes fade, the dynamic nature of our economy ensures that new ones are always being created. Any societal influence that heirs of older estates may maintain in America is constantly challenged by these new arrivals - the financial wizards, the web entrepreneurs. Thus, it cannot fairly be said that any form of permanent aristocracy, or upper class of enduring influence like that of earlier England, exists in America. This is not to say that certain groups of wealthy people don't hang out and play polo together, creating the aura of aristocracy, just that it doesn't matter very much to the rest of us.

The data series that originally raised the flag of increasing concentration of income was an Office of Management and Budget study based on Census figures that divided households into five equal income groups called quintiles. The trend over the prior thirty years, indeed, showed the high income quintile claiming a larger share of the total income than the low income quintile.

Scrutiny by a number of economists found the analysis to be flawed. The Heritage Foundation, for example, pointed out the series did not include non-wage income like the value of employer-provided health care, Medicare and Medicaid payments, income taxes, and the broad range of government benefits such as food stamps, health, and housing benefits provided to the poor. These increase the effective income of lower income earners to a greater extent than the higher ones.

In addition, the original study compared _household_ income as opposed to _individual_ income. Since top quintile households happen to be larger than those in the lowest quintile, the top quintile included many more wage earners, boosting its share of the income for that reason alone.

Adding all of these factors to the analysis significantly reduced the measured differential between the top and bottom quintiles.

The most recent OMB study has made many of the needed adjustments, but still shows a wide and growing disparity in income. The usefulness of the study, however, suffers from several other flaws. One of them is the failure to consider other demographic changes that might explain much of the growing difference in income by quintile.

We know that income varies with age. In 2010, the Bureau of Labor Statistics reports that the average weekly wage for salaried and hourly workers was $747; the figure was $432 for workers in the 16-24 age range, and $860 for those in the 55-64 age range. Thus, any grouping of workers by quintile is likely to include a higher percentage of younger workers in the lowest quintile and a higher percentage of older workers in the highest. If the population were stable with regard to age - if the ages of those in each quintile didn't change over time - then one might argue that OMB's findings were more relevant.

What the OMB analysis ignores is that the median ages in each quintile did, in fact, change over time. Over the same period analysts argue that concentration of income in the top quintile has grown significantly, the baby boom generation has been slowly moving through the labor force like a pig through a python. Referring to Figure 33, when the pig was young, she was only making an average of $432 weekly. Over the years the pig gained new skills and more education so that, by the time she reached the end of her career, her weekly wage had doubled. When she and her friends retire, their premium wage will go with them, and the average wage in the oldest quintile will move back more in line with the other quintiles. Thus, the growing inequality in income that is claimed to evidence a "fairness gap" is partly due to a demographic change that is self-correcting.

A second critique of the OMB study questions whether its use of Census income data to uncover a trend in income concentration is valid at all. The beginning Census data set represents a snapshot in time, and is comprised of a randomly selected group of people. The next data set in the series includes another randomly selected group of people. In order to compare these snapshots over time to discern a valid statistical trend, the members should be the same individuals.

The method, in effect, ignores a central feature of our economy, which is the ability of individuals to move from one quintile to another over time, apart from demographic changes. We know this happens because it has happened to most of us as our careers advanced, and we are all familiar with the rags to riches stories that fill the press, whether they be business leaders, movie stars, or sports heroes. The American dream embraces the ability to move up the economic ladder, which we see happening, anecdotally, all around us all the time.

To account for this phenomenon the Treasury Department has conducted studies of two, ten-year time periods - 1979-1988 and 1996-2005 - using income tax returns of the same individuals over each period. The income data are analyzed and grouped into quintiles just like the Census data, but the individuals' movements are tracked so that a true trend can be determined. The results of this analysis present quite a different picture than the OMB studies. The 1996-2005 study examined 97,000 tax returns covering 169,000 individual taxpayers. The results were converted to 2005 dollars to remove the effects of inflation.

The key findings of the study, in the Treasury's words, are

* There was considerable income mobility of individuals in the U.S. economy during the 1996 through 2005 period as over half of taxpayers moved to a different income quintile over this period.

* Roughly half of taxpayers who began in the bottom income quintile in 1996 moved up to a higher income group by 2005.

* Among those with the very highest incomes in 1996 \- the top 1/100 of 1 percent - only 25 percent remained in this group in 2005. Moreover, the median real income of these taxpayers declined over this period.

* The degree of mobility among income groups is unchanged from the prior decade (1987 through 1996).

* Economic growth resulted in rising incomes for most taxpayers over the period from 1996 to 2005. Median incomes of all taxpayers increased by 24 percent after adjusting for inflation. The real incomes of two-thirds of all taxpayers increased over this period. In addition, the median incomes of those initially in the lower income groups increased more than the median incomes of those initially in the higher income group (emphasis added).

The picture painted is one of a bubbling, churning labor market, where more than half the workers change quintiles over ten years, where workers slip down from the heights as easily as climb up, and where economic growth benefits all of the quintiles. Think of the escalators in a busy department store, with customers constantly going up and coming down. This is quite different from the gloomy tale told by OMB figures, which suggest permanent classes of workers huddled around the bottom of a broken escalator, staring glumly at the champagne gala underway above.

The final point of the Treasury Department's study is worth a closer look. It claims that the median incomes of those initially in the lower income groups increased faster than the median incomes of those initially in the higher groups. This finding directly contradicts the claim that the rich are getting richer and the poor, poorer. If it seems impossible for the rich to get richer without the poor getting poorer, remember the neo-classical growth model. In a free economy people become rich by providing greater value to society than others before them. As the wages of workers supplying that greater value rise and that sector attracts more capital, more workers are needed in that higher wage category, creating a shortage of workers to provide life's more mundane necessities. Inevitably this shortage boosts wages for the lower paid workers. This is possible because the new wealth has caused the economic pie to get bigger. Economic growth in a free market is not a zero-sum game.

When President Kennedy campaigned aggressively for cuts in personal income tax rates in 1962, especially for the higher brackets, he declared that "a rising tide lifts all boats." The more pessimistic among us now refer sarcastically to trickle-down economics, as if those of us below the top level must fight for position to receive the wealthy's table scraps. In fact, our system would be better characterized as trickle-down _prosperity_ , because the wealth created by the economy's best performers accrues to the benefit of all. It would be a greater concern if wages in the lowest quintile were actually falling - Malthus returns! - but this is not the case.

It is not our claim that there has been no change in income distribution over the past 45 years, only that the change cited by many is based on incomplete analysis that overstates the case, and raises alarm that may lead to economically inefficient solutions. In fact, during favorable economic times, we might _expect_ to see the rich getting even richer as they are rewarded for their particular contributions to rising GDP.

By the same token, preliminary evidence suggests the rich have done less well than others since we went into recession in December, 2007. The IRS reports a significant drop in the number of tax returns with over $1 million in income over this period. It may well be that, when appropriate data are available over a number of economic cycles, we will find that the incomes of very high earners are more "elastic" than those of lower earners. Consider the salesperson, who can earn a bonus of 100% of their salary in good times, but only 10% in bad times. Or think of the small business, which is capable of providing its owner a good living when GDP is growing but is forced to close its doors during a recession. Such variability of income at the higher levels can make residence in the upper quintile less than comfortable, as the Treasury study indicates.

Our hypothesis is that there is an equilibrium point of income distribution in a relatively free economy, below which the higher quintiles will gain income relative to the lower quintiles and, conversely, above which the upper quintiles will lose. It is ludicrous to believe, for example, that the upper quintile could capture 100% of the available income. In this case, there would be no more quintiles; we would all make exactly the same amount of money.

So, similar to the idea behind the Laffer curve, there must be an optimal income distribution for a given economy. Below the optimal level, more potential for growth exists than is being realized, so entrepreneurs are busy trying to harness that potential and getting rich in the process. Above it, not enough capital is available for the size of the labor force, productivity slows down, and unemployment increases.

At the optimal level, the upper quintiles reap the rewards of ingenuity, ambition, and hard work, while the lower quintiles share in those rewards through rising real incomes. The entire economy is working like a Ferrari engine. This optimum condition is a function of those policies that allow the market to allocate capital and labor on a level playing field.

When economists are able to prove this hypothesis, we can perhaps agree on a _scientific_ definition of fairness rather than an emotional one. What is fair is the level of income distribution that allows some individuals to make "obscene" amounts of income, while even the poor are able to increase their incomes and consumption to the maximum degree. Distribution of income is the outcome of policy; it should not be the goal.

# Chapter VIII - Foreign Trade

**THE BASICS**

The economics of U.S. firms trading with other countries - foreign or international trade - is a natural extension of domestic economics, with one obvious exception: it involves two currencies instead of one. The laws of supply and demand still hold, producers and merchants are still driven by the need to minimize their costs, and capital still seeks the most advantageous employment. Decisions about products and locations for plants are now a global exercise, but the economics are basically the same.

Of course, importing and exporting is not quite as simple as selling goods from a plant in Nebraska to a customer in Georgia. Foreign trade involves lots of paperwork, customs duties, bank letters of credit, and a host of other impediments that don't trouble domestic trade, but the fundamental difference is the need to buy, or sell, a foreign currency.

Smith describes foreign trade as the logical outgrowth of a gap in domestic supply. If one could not find what they needed at home, and it was available from a foreign source, then it was logical to tap that source. Otherwise, Smith believed, the tendency would be to keep one's capital within their national market. Capital sent abroad was not available for domestic reinvestment, he felt, which would slow domestic growth. The first significant foreign trade was likely undertaken to buy food that was not available domestically. Trade in metal for arms manufacture no doubt followed closely behind. As economies grew and demand for a wider variety of goods developed, so did foreign trade.

It was left to David Ricardo, an English political economist, to expand on Smith's thinking and clarify the rationale for foreign trade in his 1817 book, "On the Principles of Political Economy and Taxation." Using the example of wine and cloth produced in Portugal and England, Ricardo showed how both countries were better off by trading with each other than they would be without trading, even if Portugal could produce both wine and cloth at lower cost than England. The reason was that Portugal could produce wine more efficiently than she could produce cloth. Thus, Portugal's capital was better employed making wine than cloth, and it was to her advantage to produce more wine for export and import more cloth from England in return.

England's calculation was similar, but in reverse. England could buy both wine and cloth at lower cost from Portugal than she could produce them herself. However she, herself, could produce cloth at lower cost than wine; therefore, it was to England's advantage to devote more of her capital to producing cloth than wine. Since Portugal was interested in importing cloth, the interests of the two countries were perfectly aligned. The result was that each imported the product they were less efficient in producing, but more than compensated for this by producing even more of the one they were more efficient in producing. Each country's capital, then, was more profitably employed than if they had not traded, leading to a greater increase in each country's national wealth. This became known as the law of **comparative advantage**. Economists use a production possibilities frontier to demonstrate comparative advantage. Figure 34 illustrates that, without trade, Portugal, by producing cloth and wine in equal amounts at Point A, was limited by its production possibility frontier. By increasing its production of wine and buying more cloth from England, however, it was able to produce at Point B, pushing its possibilities frontier outward and increasing its standard of living.

In a footnote, Ricardo also used this example of a hat maker and a shoe maker which is, we humbly admit, far more clear than our recounting of the wine and cloth scenario. He wrote

" _Two men can both make shoes and hats, and one is superior to the other in both [activities]; but in making hats, [the superior man] can only exceed his competitor by one-fifth or 20 per cent, and in making shoes he can excel him by one-third or 33 per cent;—will it not be for the interest of both, that the superior man should employ himself exclusively in making shoes, and the inferior man in making hats?"_

Would you want to buy _your_ shoes from a hat maker?

Ricardo's model assumed a perfectly free market for imports and exports. Early on, however, governments came to believe that taxing imports could kill two birds with one stone. First, of course, it would provide a nice source of revenue for the governments, who were in constant need of money to support their adventures at home and abroad. And second, it would protect indigenous industries that might otherwise fail due to cheaper imports. The tax, or tariff, would raise the cost of imports and save domestic jobs. This sounded pretty convincing to the economically illiterate, was surely OK with the protected industries and, not insignificantly, put food on the tables of the political class.

In the early days of the U.S., tariffs were the government's only significant source of revenue to fund an adequate army and navy. Following the War of 1812, more citizens began to appreciate government's defense requirements, and commercial interests began to lobby government to build roads and canals. As a result, the Tariff of 1816 assessed a 30% tariff on imported woolens and linen, 25% on iron, leather, hats and cabinets, and three cents per pound on sugar.

Today, the government uses tariffs strictly to protect domestic industries and jobs from low-priced imports. In 2011, for example, imports of Chinese auto tires were said to be hurting the business of domestic manufacturers. The U.S. manufacturers successfully petitioned government to impose a 35% tariff on imports from China. This despite the fact that the bulk of Chinese imports was in lower grade tires, which the domestic industry had largely stopped producing as their technology advanced. The producers' leverage with government was the saving of jobs in the U.S., in addition to any campaign funding that might be thrown into the mix.

So, if they really don't compete with lower grade Chinese tires, what is the benefit of the tariff to U.S. producers? Well, with the price of low grade tires higher by 35%, they could increase the price of their own tires to maintain a reasonable difference between the two in the market. It is purely a marketing advantage having nothing to do with U.S. jobs. The only loser here is the U.S. consumer, who pays the artificially higher price.

The question is, should government be in the business of protecting U.S. industries from global competition? Those who favor it are called **protectionists,** and those opposed, **free-traders**. Bastiat believed in free trade in the same way that Ricardo did. In his "Economic Sophisms," published in 1845, Bastiat, ironically taking the position of the protectionists, painted a vivid picture of the massive benefits that would accrue to French society if the government were to pass a law protecting the candle making industry. The law would require, wrote Bastiat, the immediate closing of all "windows, dormers, skylights, inside and outside shutters, curtains, casements, bull's-eyes, deadlights, and blinds—in short, all openings, holes, chinks, and fissures through which the light of the sun is wont to enter houses." The sun, he argued, caused the candle makers' plants to be idle half the time and their workers underemployed, and this was profoundly unfair competition because, after all, the sun was free. Who can compete with free? Passing the law would, of course, make the candle makers rich, but it would also contribute to an explosion of demand in the livestock industry for tallow production which, in turn, would stimulate the grain industry to feed the cattle, lead to a large increase in manure for fertilization, and so on. Ultimately, he claimed, there was not one Frenchman who would not benefit from protection from the sun.

Protectionists usually use the fairness argument to support their position, claiming that the offending importer has an unfair access to low cost labor or resources or is unfairly supported by their government. This is called "dumping," as in, exporting subsidized goods into someone else's market to gain market share. Governments often do, in fact, subsidize industries they seek to support through lower taxes or other forms of financial aid, and it is hard to argue that such behavior is fair. Thus, protectionists say, it seems only fair that we should impose a tariff to offset the other side's behavior. The problem is that this often causes the other side to retaliate in some fashion. Usually, the retaliation will affect products that are particularly important to us, so it will be especially damaging. Soon enough, minor issues like these can escalate into full-blown trade wars.

Trade wars go way back. The infamous Smoot-Hawley tariff of 1930 increased U.S tariffs on some 20,000 goods to the highest levels in a century, leading to immediate and severe retaliation by our major trading partners, who were also beginning to suffer from the Depression. U.S. imports and exports dropped by more than 50% in the four years following its implementation. Many point to the Smoot-Hawley tariff as a major contributor to the depth of the Depression.

The U.S. Export-Import Bank ("Exim") was established in 1934 to support trade with the Soviet Union and now provides taxpayer-backed loan guarantees and other services to all U.S. exporters (another case of Lyme disease). It has a lending cap of $100 billion, which is 90% employed, and extended $33 billion in loans and guarantees in 2011, up from $13 billion in 2007. Almost half of Exim's portfolio supports the exports of a single company - Boeing - which raises the questions, why does Boeing get so much, and who pays for this aid to Boeing?

The answer to the first question is probably self-evident. Boeing is our only manufacturer of large commercial aircraft, a significant employer, and important to our balance of trade with other nations. Boeing's argument for support is stronger due to the fact that its only major competitor worldwide - Airbus - is an EU-supported consortium of French and German interests. If Airbus is subsidized, so should Boeing be, goes the argument.

Unfortunately, when Boeing sells its product cheaper to foreign airlines through Exim financing at low rates, domestic airlines are put at a competitive disadvantage. In a letter to Congress in 2012, Delta Airlines estimated that Exim subsidies to Boeing cost U.S. airlines up to 7,500 jobs and $684 million a year.

Free-traders argue that protecting domestic industries through tariffs and other barriers impedes economic development by subsidizing industries that probably shouldn't survive. The subsidy comes from the higher prices that consumers pay for the goods that are protected. In addition, the less efficient use of capital in the uncompetitive industry pulls GDP down from a higher growth track. Free-traders ask, why shouldn't we have free access to the lowest-priced products available? Why should 300 million people be taxed to save 20,000 jobs in a dying industry? Wouldn't it make more sense to take some fraction of the subsidy and retrain the 20,000 workers to find other, more secure jobs?

In 1789, Congress approved a tariff on sugar imports to raise revenue, which tariff was continually extended through 1934. In 1934, the government revamped its approach to protection of the domestic industry by instituting a quota system, which limited the amount of sugar that could be imported each year. Limiting supply is an industry's way to increase its prices. It also began to manage the production of sugar through a processor loan program that put a floor under the domestic price, keeping retail prices higher than they would be under free market conditions.

The effect of the sugar "racket," as it is called, is that U.S. food companies pay about twice the world price for sugar, and that premium is reflected in the prices we pay in the supermarket. This has led to a gradual exodus of U.S. candy manufacturers to Canada and Mexico, where the world price holds, and those manufacturers take the jobs with them. Then, they export the production back into the U.S. A 2006 study showed that, for every sugar production job saved through the sugar program, three manufacturing jobs are lost in the U.S. candy and confectionary industries.

This example highlights the economic price paid due to protectionist trade policies in general. Those policies are in place for only one reason: the big players in industry spend a lot of money, on lobbying and election campaigns, convincing politicians to support them. In the sugar industry, for example, 42% of the benefits of the sugar program go to the top 1% of the growers. Public records indicate the growers in this 1% contribute generously to candidates of both parties. And consumers pay the price.

**CHINA**

Our largest trading partner is The People's Republic of China. In 1985, our trade balance with China - the dollar value of imports (purchases) from China minus the dollar value of exports (sales) to China - was zero, i.e., our imports equaled our exports, $3.9 billion. Between 1985 and 2011, our annual exports to China grew to $92 billion, and our imports grew to $399 billion, indicating a U.S. **trade deficit** with China of $307 billion.

Early economists generally believed that trade deficits were to be avoided, representing the loss by a country of its wealth as it exchanged its money for hard goods. England famously sought to manage its world trade to avoid a deficit altogether. Today, one hears people lamenting the "massive transfer of wealth" from the U.S. to Middle East oil producers. Warren Buffet was quoted in 2006 as saying that the trade deficit was a greater problem for the U.S. than the budget deficit or consumer debt.

Milton Friedman researched trade deficits and surpluses thoroughly and concluded that they didn't pose any real danger for the economy. Throughout the 19th century, for example, the U.S. was a net importer (trade deficit), although trade surpluses were produced beginning around 1870 and continued into the 20th century. This is the case with many younger economies, which need outside capital to build their infrastructure and manufacturing capabilities. It is a normal pattern, in fact, for countries to switch to surpluses as they develop and have a wide range of manufactured goods to sell. Another typical pattern applies to underdeveloped countries with plentiful natural resources needed by the developed world; they are often net exporters even before they have developed an industrial base.

The fact is that trade is a two-way street, good for both parties; otherwise, it wouldn't occur. Trade is, indeed, a transfer of wealth, but in both directions. We exchange money for oil which, by definition, has value equal to what we pay. That oil is used to power our trucks and cars, which transport our goods for sale and get us to work each day. The oil is also used by our chemical industry to make plastics, a lighter, cheaper alternative to metal. Without oil we might have more dollars in the bank, but we would be a much poorer nation.

Furthermore, the dollars we send to the Middle East to buy oil will come home eventually. They will be used to buy goods from U.S. producers, or to make capital and financial investments in the U.S. (The geo-political argument over our dependence on oil from an unstable part of the world, though important, is not an economic question.) The trade deficit with China, however, has captured the attention of the public, so it is worth examining.

China is a totalitarian state that decided some twenty-five years ago to grow its economy through exports, and use the capital that was generated thereby to develop its domestic economy, which was vastly under-developed. Since the government had the power to channel capital in the direction it wanted, a host of labor-intensive manufacturing industries were established. The cost of manufacturing was so low that it didn't take long to develop some good export markets.

It was a clever strategy. China's leaders could see that trying to develop the domestic economy first would take a very long time, since there was not yet a middle class able to buy consumer goods in large quantities. In addition, China had a huge potential work force with a wage level far below developed nations. This work force could be used to produce products cheaply to be sold abroad at competitive prices.

China learned from the Soviet Union's failure that, if they didn't have a market-based system, they would likely follow it down the tube. So they constructed a sort of hybrid economy, which was guided from the top, but which encouraged entrepreneurship and enabled the best talents to rise up and be rewarded. China is, thus, a paradoxically totalitarian free market economy, a unique animal to be sure, and it has been uniquely successful. The fact that there is no religious or political liberty in China, that news is censored and people are tortured and killed for advocating liberty is problematic. History provides few, if any, examples of totalitarian nations that have successfully transformed into free societies without violence, and violence on a Chinese scale is hard to imagine, but that is a topic for another day.

As the biggest consumer on the planet, the U.S. was an attractive target for China's industrial base. And as a capitalist nation, we could be counted on to invest in Chinese manufacturing to try and capture some of the value of their low-cost work force for ourselves. China could then learn modern manufacturing methods from us, "borrow" our intellectual property and patents, and squeeze us out when the time was right. This was arranged by requiring that any foreign investor have a local partner in the business. Eventually, in the absence of a legitimate judicial system, the local partners would take over.

In 1985, the U.S. was recovering from recession, so the timing was good for China to start making its move. The country found willing customers for a wide variety of mundane consumer goods, and it began to make inroads into the industrial markets for simple parts. The quality of manufacturing was good enough for a wide range of products, and the prices were very attractive. Consumers began to see products on retailers' shelves they expected would cost $25, and found they only cost $8.47. The buying began.

The main reason China gets so much attention today relates not to their trading practices, but rather to their monetary policies. In a nutshell, in order for this gift to keep on giving, China needs to keep the value of its currency depressed. With its currency "cheap," other countries' currencies can buy more Chinese goods with the same amount of their currency. Think of it this way: you have a dollar to buy a candy bar that is priced at one dollar, so you can buy one candy bar. If the price of the candy bar is reduced to $.50, you can buy two with the same dollar. This is what happens when a country's currency depreciates in value; its products become cheaper to foreign buyers. China hopes that, by keeping the value of its currency low, its products will remain attractively priced, and its exports will continue to grow.

So how does China go about managing the value of its currency? After all, the market for currencies (also known as the **foreign exchange market** ) is large and very liquid, and it operates on the principles of supply and demand. One could expect it to reflect the true value of any currency.

To answer the question, it helps to review the underlying transaction. U.S. firms want to buy Chinese goods, but China will not accept dollars as payment. The U.S. firms must enter the foreign exchange market and buy the Chinese currency, the Yuan, to pay for the goods. With so many U.S. firms buying Yuan, the market will price the Yuan higher to reflect the increase in demand; the Yuan will be said to "appreciate" against the dollar. This is the exact opposite of what the Chinese government wants to happen, because a more expensive Yuan will make Chinese goods more expensive for U.S. and other foreign buyers.

To solve this problem, China's government orders its central bank to produce more Yuan (out of thin air) and enter the foreign exchange market to buy dollars with the new Yuan. The effect of this is to raise the demand for dollars and reduce the value of the Yuan relative to the dollar. With this "manipulation," China's goods will remain cheap. And this manipulation has some American politicians hopping mad, because it is reducing opportunities for businesses in their own districts to succeed.

China's central bank now owns a lot of dollars that it has no use for. It could stuff them under the mattress, but it will more likely search for an investment to earn a return on the money. How will it decide what securities to select? Its primary concern would likely be safety; it would like securities with very low risk of non-payment, or default. A second concern would be liquidity; it would like to know that it could sell the investments at some rate that would not drive their price down too fast. With $2.5 trillion in U.S. currency, there aren't many options. The obvious choice is U.S. Treasury securities, the safest and most liquid investments in the world.

So China has taken most of its U.S. dollars and invested them in our debt; it now holds around 26% of our publicly-traded Treasury bonds, making it the largest national holder of our bonds. (Japan is close behind.) Some are concerned that we now rely too heavily on these Chinese investments to fund our growing budget deficits. They worry that, if the Chinese changed their investment strategy and started to sell its U.S. Treasury bonds, the value of Treasury bonds would decline precipitously. As a result, we would have to offer much higher interest rates on our new bonds to find willing buyers. In short, our government's ability to fund its budget deficit at today's attractive interest rates, and to issue new bonds to replace those that are maturing, could be severely limited. Those higher interest costs would drive our deficit even higher.

This is a grim picture, but one should also look at it from China's perspective. The Chinese are committed to continuing their rapid growth in exports, and their practice of buying U.S. dollars to keep their currency weak would seem to be an important part of that strategy. They could begin to buy Germany's bonds, or England's, but the European Community is facing its own financial crisis currently, so this seems unlikely. What other investments would meet their criteria? The Japanese economy is struggling, and other, highly rated government securities lack the liquidity to absorb very much of China's dollar wealth. China could, of course, allow the Yuan to appreciate against the dollar to avoid making the problem any bigger, and it has, in fact, allowed moderate appreciation over the past couple of years. Still, China's options are limited.

Tung Chee Hwa, Vice Chairman of the National Committee of the Chinese People's Political Consultative Conference, offers a different slant on the topic in an op ed in the _Wall Street Journal_. He points to a study by Oxford Economics that low-cost Chinese imports have helped keep U.S. inflation low, saving the average household $1,000 per year. In addition, Mr. Tung argues that China's heavy buying of U.S. debt has lowered U.S. interest rates. Both of these arguments are consistent with economic principles.

Furthermore, a good portion of the materials and technology used to produce Chinese goods is sold to them by U.S. companies. A recent study by the San Francisco Federal Reserve Bank indicates as much as 55% of the value of Chinese imports at retail goes to U.S. companies who design, ship, and market those goods.

The fact is that China, as a valued trading partner, needs us as much as we need China. The geo-political implications are nerve-racking, but there seems to be no easy way out of the situation for either of us. This doesn't stop U.S. politicians from decrying China's lack of fairness in their trade relations with us. Their complaint is that, by continuing to keep the prices of their goods artificially low through currency manipulation, the Chinese are robbing U.S. manufacturers of the opportunity to sell more into their market, and they are stealing our jobs, as U.S. firms move their plants to China to take advantage of their low labor rates.

These are the facts today, although there are signs that China's labor costs have risen high enough that manufacturing is beginning to shift to lower cost Asian countries like Viet Nam and Thailand. Furthermore, there is also evidence that some U.S. firms are moving manufacturing back into the U.S. due to logistical issues and the fact that manufacturing technology is advancing so fast that new plants will rely less on labor and more on automation to keep labor costs low. A recent survey by the Boston Consulting Group found more than a third of large, U.S. producers either plan to or are considering transferring some work home from China.

The question of what to do about China's currency manipulation is a political, not an economic one. We should keep in mind that arguments over foreign trade practices have been around ever since governments first became involved centuries ago. With free international trade, such problems would not arise. Capital would flow to the markets that could make the best use of it and, under Ricardo's principle of comparative advantage, the global economy would be better for it.

# Chapter IX - Cronyism: Enemy Of The Free Market

" _The American Republic can endure only until politicians realize they can bribe the people with their own money."_ \- Attributed to Alexis de Tocqueville or Alexander Frazer Tytler

**GOVERNMENT**

_"Government is the great fiction through which everybody endeavors to live at the expense of everybody else." -_ Frederic Bastiat

Cooperation, some call it collusion, between special interests and the government usually results in actions directly opposed to the interests of a free market. We have pointed out that, in competitive markets, buyers have a natural advantage relative to sellers, causing sellers to have to compete for their business. This competition lowers costs and spurs innovation, which keeps workers employed and consumers satisfied. Bastiat argued in "Economic Harmonies" that consumers should logically have greater influence with government than producers. Consumers, after all, have the collective power to boycott a producer, an entire industry, even the government, and virtually shut it down.

However, he went on, it rarely works out that way. Consumers' power is diffused across the population, and mobilizing enough of them to support any given effort is difficult. Producers, being far fewer in number and having significant resources to bring to bear (e.g., lobbyists), enjoy much easier access to government. Their ability to cajole government using this power makes them a more likely partner for government than consumers. In this way, Bastiat claimed, governments are inherently adversarial to the interests of the consumer.

Bastiat's solution to this potential imbalance was to limit the government's range of activities to those involving only justice under the law, and not allow it to enter into areas where the boundaries are less clear. In "The Law" he wrote

If you exceed this proper limit — if you attempt to make the law religious, fraternal, equalizing, philanthropic, industrial, literary, or artistic — you will then be lost in an uncharted territory, in vagueness and uncertainty, in a forced utopia or, even worse, in a multitude of utopias, each striving to seize the law and impose it upon you. This is true because fraternity and philanthropy, unlike justice, do not have precise limits. Once started, where will you stop? And where will the law stop itself?

Keeping the right balance of interests in the market requires constant vigilance by consumers and is the price that must be paid to maintain strong economic growth. A market out of balance is not a very neighborly place.

**CORPORATIONS**

" _People of the same trade seldom meet together, even for merriment and diversion, but the conversation ends in a conspiracy against the public, or in some contrivance to raise prices." -_ Adam Smith

Smith was certainly not a shill for business. He was a fan of competition, and he would have approved of anti-trust laws to reign in collusion. Nevertheless, history shows that scale and power go hand-in-hand in the business world. This has been true in the U.S. for more than a century, as journalist Timothy Carney ably recounts in his book, "The Big Rip-off: How Big Business and Big Government Steal Your Money."

Around the turn of the 20th century, Carney says, the public's concern with the quality of their food was stirred up by Upton Sinclair's description (in "The Jungle") of filthy conditions in the nation's meat packing plants. He painted vivid and disturbing pictures of the various foreign materials that found their way into the products that were sold. It was time, he declared, for government to regulate this morally corrupt industry.

Surprisingly, this seemed like a good idea to the largest of the meat packers. Being no fools, they saw that the extra cost of government inspection could not be easily borne by their smaller competitors, which would give them the opportunity to drive more of them out of business. As a result, their sales and profits would grow even larger. Upton's radical idea played right into the hand of Big Meat.

The second reason the big packers liked the idea of government regulation was they felt that a government seal on their packages would enhance their credibility among consumers and help draw more customers and open new markets. It was, in effect, a government seal of approval, free, also not a bad deal.

All in all, it appeared government regulation could be a boon to their businesses. So, officers of the largest meat packers happily participated in government hearings on the subject, and fully supported the meat inspection scheme that was enacted by Congress in 1908. As the big packers had foreseen, the number of independent meat packing companies declined from more than 1,000 in 1908 to a mere handful today. Unfortunately for the packers, however, industry profits never reflected this seeming near-monopoly power. It turned out that, as far as the customers were concerned, meat was just, well, meat.

In 1907, U.S. Steel, having failed to create a monopoly for itself, saw its margins eroding due to strong competition. Its chairman called a meeting of nearly 50 steel companies in order to try to set prices for their products. All agreed. However, by 1909, smaller producers were cutting prices to increase their business (the invisible hand at work) and further eroding the market shares of the major companies. Andrew Carnegie, himself, publicly favored government control of the industry. By 1911, the Chairman of U.S. Steel told a congressional committee that government should take a significant role in controlling the industry, particularly prices. The Democrats running the committee called his views socialistic and rejected them.

Other major industries also called for more government control. Competition was causing great turmoil in the markets as new companies gained traction and offered more innovative products than the older, larger companies. The larger companies felt threatened, and were naturally keen to explore avenues to reduce the threat. The railroads, like the meat packers and steel companies, were also successful in soliciting government "protection," and yielded major investment and pricing power to the Interstate Commerce Commission.

Carney finds, in fact, that the essence of the Progressive movement at the turn of the century was to conserve the power, influence, and financial success of existing industry leaders. To some extent, it was a reaction to the rough and tumble world of competition, and to the periodic bank panics that roiled the economy and led to the creation of the Federal Reserve. Business leaders began to feel that theirs would be a perfect world if only they could get rid of this annoying instability and competition in their environment. Far from being "progressive," Carney says, the movement was really more of a conservative phenomenon.

The symbiotic relationship between big business and government continued to grow throughout the 1920's and, of course, during the New Deal of the 1930's. World War II brought temporary price and production controls. Wages were also controlled, which created problems for industry in attracting and retaining workers. Government threw industry a bone: to get around wage controls, the government allowed companies to offer health care benefits, which would be tax-free for the employees. This provided companies sufficient flexibility in compensation discussions to dull the effect of the wage controls. Which raises the question, why would the government put wage restrictions in place, only to offer ways around them to industry? This particular corporate benefit, no doubt negotiated in the dead of night among government and corporate cronies, has led to a massive misallocation of resources in the health care industry and contributes to the significant cost increases in medical services we experience today.

The military appetite for armaments was ravenous, and government made sure that industry was well taken care of. In the 1950's, the so-called military-industrial complex became so influential that President Eisenhower was moved to warn society of its darker side.

An important element of President Reagan's platform was to free certain industries from excessive government regulation. Airline ticket prices were subject to government controls, and one would think the airlines would be anxious to be free to use prices to compete more effectively in their various markets; that was certainly the thought behind their deregulation. However, airline CEOs were uniformly opposed to deregulation, because they were afraid of competition.

As an industry, the airlines have been among the most poorly managed industries in the country. Some say that, since the dawn of commercial air travel, airline companies as a whole have not made a nickel of accounting profit. Of course, Reagan was not a strong supporter of cronyism and was determined to put some of these industries back into the free market, so the airline CEOs lost this battle. Airlines generally continue to have profitability problems, but ticket prices for consumers remain remarkably low; during the same period from 2000-2010, ticket prices increased only 4.5% while the general price level rose 27%.

Examples of the failure of government participation in industry are legion. Jimmy Carter's $2 billion Synthetic Fuels Corporation folded in less than five years. Amtrack hasn't earned a profit in four decades. Fannie Mae and Freddie Mac have lost $150 billion of taxpayer money so far. Who knows the future of the Post Office?

In addition, government subsidizes or otherwise supports numerous programs of questionable value to taxpayers. It subsidizes the production of corn-based ethanol to blend with gasoline to the tune of about $6 billion per year, making both fuel and food more expensive. Corn prices have quadrupled due to the higher demand created by the government. The Federal Communications Commission recently approved spending up to $4.5 billion to bring high-speed internet to rural America, a task of which private industry is certainly capable. Industry marketing programs, sponsored by the Department of Agriculture, contribute more than $1 billion annually to support favored industries. Some $8 billion has gone to the likes of Ford, Nissan, and Tesla Motors to fund more fuel-efficient cars, on top of another $2.4 billion to build battery-operated vehicles. Fisker Automotive was granted a $500 million loan from the Department of Energy to build hybrid cars selling for $100,000 each; bet they sell a lot of those. Forty billion dollars of loan guarantees have benefited largely uneconomic renewable energy ventures. Exim Bank is noted by some to be "Boeing's Bank." And on, and on.

All of this largesse falls under the heading of corporate welfare. The Cato Institute took a stab at estimating the value of corporate welfare for the year 2006 and came up with $92 billion. The Wall Street Journal estimates the number could have increased to $200 billion by 2011, including the $80 billion doled out under the 2009 stimulus bill. A government that favors corporate interests and directs funds to favored industries is employing what is known as "industrial policy" which, although it sounds like a neat idea, is an area where government should tread lightly. If a free market is the most efficient way to allocate capital, government "investment" is the wrong policy. As the Wall Street Journal points out, this is an area where Occupy Wall Street and conservatives ought to be able to agree.

Underlying programs such as these is a myth propounded by the Democrat party that Republicans are the party of big business and responsible for all the favors. In fact, big business donates just as much money to Democrat congressional candidates as to Republicans. Study after study shows that the typical large corporation donates about an equal amount of money to both parties' candidates, certainly not indicative of an ideological slant. And various studies have shown that the wealthiest individuals in the country tend to give more to Democrats than to Republicans. Government favoritism, as is only proper, does not discriminate.

Government support programs are highly complex, and the arguments from politicians, sadly, often shed little light on the issues. No one but an experienced and attentive observer can begin to sort them all out. What the public needs to know is some basic principles of economics: that government payments to the favored few come out of the public's pockets, and that money is, therefore, not available for other uses that would more accurately reflect the public's preferences; and that government tariffs to protect certain industries raise the cost of products consumers want to buy, again, taxing the public for the benefit of the few. This constant transferring of money from many pockets to the few creates inefficiencies in the economy that lower real wages and, ultimately, the standard of living. This is pretty basic and broadly accepted economics.

If the economic argument becomes too opaque or complex, consider this: The fact that business would rather seek the comfort of government protection than face unbridled competition in the free market should tell us all we need to know about the effectiveness of a free market system. Businesses, by and large, always favor free markets, except for themselves.

**MILLIONAIRES**

Congress has created, and the federal government manages, a dizzying array of programs designed to distribute money to citizens. If you own a farm, for example, you are eligible to receive grants and cash payments from several government agencies for a number of different actions, or inactions, on your part. Most of us know about the farm bills that pay farmers not to produce certain crops on their lands and/or to produce others. These programs are managed by the U.S. Department of Agriculture ("USDA").

In addition, as a farmer you could qualify for other USDA payments for land and wildlife conservation efforts on parts of your farm not dedicated to crops, or on your five acres in the suburbs. For example, you can be paid for maintaining wetlands through the Wetland Reserve Program ("WRP"), and grasslands through the Grassland Reserve Program ("GRP"), for improving the soil, water, plant, animal, and air resources on your farm through the Environmental Quality Incentive Program ("EQIP"), for maintaining habitats for fish and wildlife through the Wildlife Habitat Incentive Program ("WHIP"), and for restricting land for certain agricultural uses (e.g., growing strawberries) through the Farm and Ranch Land Protection Program ("FRPP"). One could really make a go of this.

Agriculture programs are just the beginning of the riches available to individuals through government programs. In addition to the big ones, Social Security and Medicare, one can: get tax credits for child care expenses, including household expenses (cleaning, cooking, maid services) if any of them are even partly for the benefit of the dependent child, and for adding insulation and energy-efficient windows and skylights to one's house, or solar panels on the roof; get assistance paying heating bills through the Low-Income Home Energy Assistance Program; deduct the mortgage interest on a boat used as a second home as long as it has a galley and a toilet and one spends at least two weeks a year living on it; deduct gambling losses; be eligible for disaster relief from the Federal Emergency Management Agency for uninsured natural and man-made disasters, and flood insurance from the National Flood Insurance Program if one's beach house is washed away; get up to a $7,500 tax credit for buying a new electric or alternative fuel vehicle (television personality John Stossel got a $6,000 golf cart for free under this program, proving that a Princeton education is nothing to sneeze at); get cash awards from the National Foundation for the Arts; and get fellowships and grants from the Department of the Interior, Department of Justice, and the Environmental Protection Agency, to name a few.

But that isn't the best part; these programs are all available to all of us, even millionaires. In a study published in November, 2011, entitled _Subsidies of the Rich and Famous_ , U.S. Senator Tom Coburn has gathered information on these and other government grant, payment, and loan programs specifically for those recipients whose adjusted gross income ("AGI") was in excess of $1 million. The information was collected directly from the agencies providing the money, most of which required income information due to eligibility caps in the legislation. In some cases, cooperation from the Internal Revenue Service was required.

We recommend you read the report yourselves to get the full details. The summary in Figure 35 should give us plenty to mull over about the possible influence of millionaires on the political process.

The average annual amount of government payments to millionaires is $1.6 billion. Obviously, the largest payment is from Social Security, a benefit available to everyone who has contributed during their working lives. The system paid $9 billion over six years to between 77,000 individuals in 2007 and 38,000 individuals in 2009 with income over $1 million. In 2009, 1,430 of those 38,000 earned over $10 million. Half of that money came from the taxpayers' own contributions, the other half from their employers. The average Social Security payment to each millionaire was around $30,000 in 2009.

Coburn questions why, when the Social Security system, a social safety net, is headed for failure, millionaires should be collecting any payments at all? That is a political question we will not engage. From an economic point of view, however, the matching contributions by the employers were a tax that reduced their profits. Those funds were taxed when received by the millionaires and not available for investment to improve productivity and future GDP. Like any other tax, they were a drag on the economy.

More interesting, $74 million went to unemployed millionaires, that is, people who showed at least a million dollars of AGI in the same year they received the unemployment benefits. Does anybody really think that makes sense? Again, the money came from a tax on employers, with the same negative effect on economic growth. And, while it doesn't seem a lot of money in the scheme of things, why in the world is _any_ money going to ease the pain of finding a new job to a person who earned over $1 million? How about over $10 million? In 2009, eighteen individuals earning more than $10 million received unemployment payments averaging $12,000.

This is not to criticize millionaires, who were doubtless highly productive to achieve that level of income. No doubt, most of them have no idea they actually received unemployment, since most would have had accountants taking care of their financial affairs, and the accountants are paid to use all legal means to maximize their employers' after-tax income. But a hex on Congress for enabling such behavior.

The farm program opens up an Alice in Wonderland of outrageous findings. For example, a Government Accountability Office examination of the years 2003-2006 found that $49 million was paid to 2,702 farmers having over $2.5 million in adjusted gross income. Two and a half million dollars was actually the cap during those years, so this $49 million was paid by mistake. Seventy-eight percent of the 2,702 farmers listed a metropolitan area as their primary address, nowhere near farmland. They included people like the founder and former executive of an insurance company, who received $300,000, and a part owner of a sports franchise, who received $200,000. Former NBA star Scottie Pippen, of the Chicago Bulls, and Ted Turner, billionaire, also received benefits during this period.

While the USDA is not very good at observing its own limits on payments in its farm programs, it is good at waiving such limits in its various conservation programs. In 2008 and 2009 it paid over $89 million to recipients with adjusted gross income over the $1 million cap in these programs. These payments were made under specific waivers granted for each recipient. Most of the waivers were granted in the Wetland Reserve Program: Ten million of the $89 million was paid to a California investment company for restoring wetlands to protect the Riparian Brush Rabbit; twenty-two million went to a Florida ranch owned by a family company involved in commercial property development in Florida and New Jersey; an additional $31 million was paid to another Florida ranch as part of an $89 million purchase of a conservation easement in the Fisheating Creek Watershed to provide support for the crested caracara, the Florida panther, and the red-cockaded woodpecker.

The real money in Coburn's study is the $114 billion in tax deductions and credits claimed by millionaires from 2006 through 2009, but simplification of the tax code to eliminate many of these deductions is a topic already covered. One does wonder why it was necessary to give millionaires $21 billion in gambling loss deductions, or even $12.5 million in tax credits for buying an electric car.

Coburn argues that this "reverse Robin Hood style of wealth redistribution" is specifically designed to spread government largesse ever wider among the populace to get more people committed to the system. His report claims that nearly half of Americans now receive some kind of benefit from the government; recent reports suggest the share is even higher.

This largesse heaped upon the super-wealthy may, indeed, be a subtle plot by the bureaucracy to raise its importance and extend its influence. This would surely not surprise Monsieur Bastiat. We also wonder, however, the extent to which the millionaires' stature provides access to the right offices, their money having been contributed to the right political campaigns, which results in the odd favor being tossed their way. Certain classes of millionaire make no secret of their connections to the current administration, including Wall Street titans, green energy investors, and Hollywood stars. Should we believe that those connections, similar to connections from sometimes different casts of characters during other administrations, have no monetary value?

**LABOR**

Craft guilds were established in the early Middle Ages to protect the interests of tradesmen. The guilds covered all the trades of the various craftsmen in town, and controlled virtually all aspects of their trade, from the supply of goods allowed into the market to the price of the goods and the supply of labor involved in the trade. Guild members were characterized as masters of their trade. Masters generally provided living quarters for an apprentice, who studied the trade under the master for two to seven years. When he was suitably prepared, the apprentice would produce his own work and present it to the master for his approval - a piece of work for the master, a masterpiece. Once approved, the apprentice was eligible to apply to the guild for membership as a master. In this manner, the guild acted to protect both the trade and its workers, mainly because they were, for all intents and purposes, one and the same.

Since the tradesmen were both business owners and workers, both sides of this divide were protected from outside threats. As a result, although trades and workers were happy, the consumer was left out of the game. These markets were fixed to favor the producer, and the consumer had little power in the market. The transformation of economies from craft to industrial economies obviated the need for guilds and, as they disappeared, so too did any sort of protection for the workers. It took hundreds of years of increasing exploitation of workers by increasingly powerful business owners before that void was re-filled.

The establishment of labor unions in the 19th century provided a counter-balance to the power of big business and, just like any other special interest group, labor set about to increase its share of the economic pie. The early history of unions in the U.S. is filled with dramatic and violent events as unions elbowed their way up to the negotiating tables with their employers. By 1935, they had considerable influence over a relatively small number of workplace issues, but were not the powerhouses they were to become.

The increasing power of unions came in several steps. For example, in 1920 Congress passed the Jones Act, which denied access to U.S. ports by foreign flag vessels engaged only in domestic trade. In other words, a foreign ship could only visit a U.S. port to unload products from abroad, or pick up products intended for export.

The ostensible reason for the Jones Act was to ensure a healthy domestic shipping industry, which was deemed important to U.S. security. If domestic U.S. shipping could be carried out only by domestic ships, it was argued, this would promote domestic ship production. It goes without saying that the ship fitters and steam fitters unions loved the law. In effect, the jobs of ship builders were saved at the expense of jobs in more profitable industries. Macroeconomics tells us that workers who are more productive earn higher wages and help raise the standard of living. The cost to all of us is the loss of this opportunity.

In the depth of the Depression Congress passed the Davis-Bacon Act, which imposed the requirement that all government contractors pay the "prevailing wage" in the market where their projects were undertaken. The law was an attempt to prevent contractors from using workers imported from lower labor cost markets to complete their projects, thereby denying higher paid, local workers the opportunity to get work. But the prevailing wage has turned out to be the prevailing union wage, higher than non-union wages, driving up the cost of federal projects to appease the unions. Laws like this have the same economic effect as taxing the public to subsidize union workers since the higher wages will be passed along to the government as the cost of the project, and the government's payments are made with, of course, taxpayer dollars.

In 1937, General Motors workers went on strike and, instead of marching outside the plants with signs, they just "sat down" on their jobs. In effect, they took possession of the job so that any replacements hired to fill in during the strike were prevented from working. Sit down strikes had been ruled illegal up to this time but Roosevelt, pressured by an economy sinking back into depression, refused to take action against the strikers when requested by GM. And so another slice of power was placed on the unions' plate.

The union shop was enabled by the Taft-Hartley Act of 1947. Taft-Hartley outlawed the so-called closed shop, which required all employees to join a union that successfully organized at a certain employer. Instead, the union shop required that all workers pay dues to the union, even those who chose not to join it. This was only fair, it was argued, since the reluctant workers would benefit from the collective bargaining efforts of the union. They were free riders.

Taft-Hartley also worked out well for union leaders because it meant they collected more dues and gained stature from the money they could accumulate. Some of that money went into union pension funds and could be loaned to their friends and business partners to finance often shaky real estate projects that, nevertheless, put union workers to work. Some of the money was donated to the political campaigns of those who supported union power grabs in Congress. Today, unions are the largest organized source of money in political campaigns, nearly all of which goes to a single political party.

Over time, employers began moving their plants from the industrial Midwest to the southern states, which had not enacted union rules. To encourage this migration, twenty-three states passed so called right-to-work legislation. Under right-to-work, those workers not supporting the union were not required to pay dues. Nothing could be clearer evidence of how a market works; unions had been so successful in pushing wages above the equilibrium price that employers voted with their feet to find more favorable labor markets.

Particularly noteworthy was what happened in the auto industry when foreign manufacturers began to establish plants in the U.S. The Japanese and German car makers built brand new plants in states like Tennessee, South Carolina, and Mississippi, where virtually no industrial unions existed, and were able to employ workers at significantly lower wages than the Detroit auto makers. The demise of U.S. auto manufacturers culminated in the bankruptcies of General Motors and Chrysler in 2009, a classic example of an oligopoly that became complacent in their market leadership. That complacency was evident in the failure of management to recognize changes in consumer tastes and failure to compete effectively with foreign manufacturers. It was equally evident in their loss of power to their unions, which resulted in the unions getting too big a piece of the industry's economic pie.

An example of how far the NLRB has moved from its original position was seen in 2011, when Boeing announced its decision to build a new plant in South Carolina. Boeing, a Seattle company since its founding, had concentrated its manufacturing there, and the union seemed to feel entitled to all new Boeing jobs. Union wage levels in Seattle were high, however, and the company found the labor force in South Carolina, a right-to-work state, willing to work for much lower wages. The company needed to expand its capacity to make its newest plane, so it announced its intention to put the new plant there instead of in its home state of Washington.

Almost immediately, the NLRB announced its intention to investigate Boeing's decision for violations of any labor laws they could find. The union complained that Boeing had proposed the new plant as a threat to the union so that it would soften its demands on Boeing during contract negotiations. On this basis, it would seem that any action that might be proposed that did not go along with the union's views would be subject to review.

The Board's intention to review Boeing's motivation for opening its new plant outside its home state was seen as an unprecedented intervention in the governance of a private concern. If the government was, indeed, capable of denying a company the right to locate as it deemed best for its shareholders, what decisions might not be over-ridden by the government? Could government deny the right of a company to manufacture products overseas so that U.S. workers would not lose their jobs? And if government could direct where new investments are made, why could it not direct what products to produce? We guess a few more sugar mills wouldn't hurt. Fortunately, this mounting crisis was disarmed when Boeing and its union reached agreement on other contract terms.

Perhaps the most insidious form of cronyism exists between unions representing government employees and the government officials who hire the workers. Some might say this relationship is more than cronyism, that it represents blatant conflict of interest. Imagine yourself the mayor of a city sitting down to negotiate with the unions representing your employees. The unions collected dues from their members, and provided enough financial and other support to help you get elected as mayor. Now, you must forget that you owe the union your job, and represent the people of your city against the union in negotiating wage scales, benefits, work rules, etc. How hard are you prepared to negotiate when the union reminds you of the debt you owe them? How much easier it would be to just say yes and push the problem into the future.

Most of us, of course, would not sacrifice our principles just to hold onto a job, but many would, and do. The result of this imbalance of power in favor of public worker unions has been retirement benefit grants often far in excess of those in the private sector where, thankfully, the market is a little more free. The city of Stockton, CA, for example, offers its safety employees a pension paying 90% of the retirees' highest salary with a 2% cost-of-living adjustment for the rest of their lives. And while California state law requires public workers to contribute from 7-9% of their salaries toward their pensions, in the 1990's Stockton agreed with various unions to pay the employees' share in addition to the city's share of 20%. On top of that, Stockton agreed on a generous health benefits retirement package, which it agreed to fund but has never done so. Its unfunded retiree health plan liabilities now exceed $400 million. The city's budget is way out of balance, the police force has been cut 25%, and it has filed for bankruptcy protection.

Two other California cities have followed Stockton's bankruptcy example. Annual pension costs for the city of Syracuse, NY, have risen from $2.1 million in 2000 to $30 million in 2013, a factor of fourteen. Down the road in Rochester, costs will rise by a factor of thirty in the same time frame. There are many more examples.

The solutions are not painless. Raising taxes, as we know, will cause many of those most heavily taxed to move to other localities, and the needed revenues often won't materialize. California has become so dependent on "millionaires and billionaires" for its income tax revenue that downturns in investment markets cause serious tax revenue losses for the state. A fluctuating revenue stream like this is not the best way to manage a payroll. Many states and municipalities are in a revenue death spiral, and will not be able to meet the retiree obligations that were promised at the negotiating table. It is precisely this issue that led the Governor of Wisconsin to sign legislation limiting public sector unions' collective bargaining rights.

Labor unions, like large corporations, are fundamentally interested in their own constituencies. Smith and Bastiat both supported active participation of all parties in a market, accepting that it is the selfish interests of market participants that promote advances in the human condition. Unfortunately, as Zingales points out, few disinterested parties are out on the field to make sure the game is truly fair. We expect government to referee, but once the government becomes a player in the game, all bets are off.

To conclude our discussion of cronyism and its effects on the operation of markets, we again turn to Bastiat. Bastiat believed government, which he called "the law," should only insert itself into free markets to keep the game fair. He described a free market as representing the interests of citizens and their private property, using the word "property" as a proxy.

" _As long as it is admitted that the law may be diverted from its true purpose — that it may violate property instead of protecting it — then everyone will want to participate in making the law, either to protect himself against plunder or to use it for plunder. Political questions will always be prejudicial, dominant, and all-absorbing." - Frederic Bastiat_

# Chapter X - Reflections

" _Self-preservation and self-development are common aspirations among all people. And if everyone enjoyed the unrestricted use of his faculties and the free disposition of the fruits of his labor, social progress would be ceaseless, uninterrupted, and unfailing"_ \- Frederic Bastiat

Our goal has been to illuminate how a free market supports economic growth, and to show how the principles of economics enable it. We focus on economic growth because that is the only condition that allows societies to increase their standard of living and ease the plight of the poor. Economic growth is not automatic. We hope to have given you a sense of how growth occurs, that it is the natural result of free individuals seeking to protect and enhance their own well-being.

We have tried to stick to economic theory and avoid stepping too far into the political mud. Nevertheless, it must be clear that our own view is that policies aimed to keep the market as free as possible are the ones we should support. No market in the world is perfectly free, nor should it be for the reasons we and many others have suggested. However, the U.S. rank on the Heritage Foundation's most recent economic freedom list is now tenth among 179 countries, down from fifth three years ago.

The lost ground in the index last year, according to the Foundation, was due to our increasing debt load, increase in cronyism and business regulations, and lack of progress in reducing protectionist trade restrictions. Concern over the cost of bank compliance with the Dodd-Frank bill was also an issue. We should heed the warning in this trend.

In the introduction we noted the difficulty of determining exactly the right mix of private and government involvement in the economy. How do we know when the balance is off-center? How do we know when government's role has become too overbearing for the good of the economy? GDP growth is the obvious indicator, but there are other, more subtle signs to consider.

One might be the relative attractiveness of public and private sector employment. Traditionally, government jobs paid less than private sector jobs because they did not add to economic productivity. The offset for lower salaries was an unwritten lifetime job guarantee. Recent studies show this balance has changed. Current Office of Management and Budget data show that, including pension and health benefits, government worker compensation is 16% higher than private sector jobs of comparable skill. When jobs that do not add to the nation's wealth are worth more than those that do, something must be out of balance. Perhaps, instead of focusing on the 1% vs. the 99%, economists should be examining concentration of income in the public sector vs. the private sector.

The 2010 Census shows that the Washington, D.C. area nosed out San Jose, CA, with the highest median household income in the nation. Washington's median income was $84,523 versus San Jose's $83,994. This compares with the median of about $50,000 for the nation as a whole. One has to ask, when income in the center of government is higher than that of the most productive private sector market in the country - Silicon Valley - have we gone too far? When unemployment in Washington is 6% while the nation's is over 8%, is the system in balance?

One thing should be clear: when the nation's money and talent are streaming toward the bustling center of government, it can't be a good sign for the free market.

We would argue that a Laffer curve-like relationship exists between GDP growth and the share of GDP consumed by the government. Consider the plot shown in Figure 36.

The GDP growth rate is shown on the horizontal axis and the government's share of GDP through taxation on the vertical. At the zero point, the government plays no role at all in the economy, and GDP growth is zero. This is because for a free market to spur a growing economy, government must at least establish a sound legal system to protect private property rights and the sanctity of contracts and a defense capability to protect us from foreign interference. Additionally, essential government services like police and fire are needed to free productive citizens to pursue their financial goals, and government-built highways and bridges allow commerce to grow more rapidly. Most would agree that government should also intervene in the market to address the social costs of pollution and other tragedies of the common. At these levels of government action, the stage is set for the invisible hand of the market to work its magic.

At the 100% point on the vertical axis, GDP growth would be impossible. Government intervention at this level would smother the market and put us back to a Malthus-type model of economic stagnation.

These two points, as on the Laffer curve, suggest a relationship between GDP growth and government intervention that might look like the one shown on the graph. At very low levels of intervention, the economy can grow at a brisk pace. However, as taxation needed to pay for growing intervention begins to deprive the free market of necessary capital, and as the costs of doing business under ever more complex laws and regulations increase, growth in GDP slows down. At some point on the scale, the market is unable to generate any more energy, and GDP growth turns around, heading back toward the point where government consumes all of the country's resources. (We claim no credit for the graphic representation of this obvious relationship; we'll just call it the Son of Laffer curve.)

Scholars Andreas Bergh and Magnus Henrekson examined this effect differently in a 2010 paper. They found a negative correlation between government size and economic growth, such that when government increases by 10%, annual GDP growth decreases by up to one percentage point. By this analysis, the growth in our government's share of GDP from 20% to 24% over the past three years, an increase of 20%, has trimmed potential GDP growth by up to 2% from the long term average of 3.5%. This indicates potential growth of as little as 1.5%, a troubling 57% reduction. In light of Bergh's and Henrekson's work, the fact that the U.S. economy is growing at an annual rate of less than 2.0% should not surprise us.

It is widely accepted that our government gurus are smart enough to get us out of an economic mess. However, our current economic malaise has been pushed, shoved, and banged over the head by government action. The Fed has pumped so much money into the economy that we are inclined to write them a letter asking for $100 just to see if they would give it to us. We think they might.

Still, the economy has little traction. This can't be the solution. Many economists claim there is not much a government can do in a free society to fix a misallocation of capital that led to recession. Uncomfortable as it may be, we should discard the notion that any of us is better able to channel funds to where they are needed than a free market.

One way to judge a government intervention in the economy is to ask the simple question, how will the consumer benefit? Intervention is almost never needed to protect industry from greedy consumers, it is needed to prevent the market from being tilted toward industry. USDA industry marketing programs, for example, which have come up with such inventive slogans as "Got milk?" and "Pork, the other white meat," spend hundreds of millions to help industries increase their revenues, to what end? Is the consumer better off eating more pork than beef? What is the societal interest being addressed? Do we want the government taking sides in such debates?

Proponents of industry marketing programs argue that helping the industry to increase revenues will save jobs. Are they saying consumers are better off having more farmers raising hogs? If that were the case, they would just pay more for bacon. Why would we use the government's influence to accomplish this? Anyway, jobs gained in hog farming would just cut jobs in cattle farming. There is no net benefit.

Similar questions are front and center in agencies like the Federal Communications Commission, which oversees radio frequency usage, and the Fair Trade Commission, which looks for anti-trust violations. The arguments often center on which industry sector might be harmed by a given development rather than whether consumers are better or worse off. Do we really want the government picking winning technologies? Consumers, not government agencies, generally make the best decisions for consumers. They do it through the market.

Frederic Bastiat's view of free markets is simple but brilliant. In a free market, he said, no one can accumulate capital unless he renders a service to someone else, and those who have capital, even just a little, will not part with it without getting something of equal value in return. In this manner, a society's capital is _always put at the service of other people who do not own it_ , and always to satisfy a desire, good or bad, that those people have. Thus, he concluded, all capital is effectively owned in common, and the greater the accumulation of capital, the more its benefits support the common good.

Consider your average billionaire, at least as the public sees him. In the morning he sets sail on his plush, custom-built 300 foot sailing yacht. The yacht was built by skilled craftsmen, loaded with the most sophisticated electronics equipment, and is maintained and sailed by a crew of four. The building and operation of his yacht created jobs.

Coming ashore, the billionaire heads for a healthy lunch at the country club. The club cost several million dollars to build. It is staffed by an array of kitchen workers, bar-tenders, waiters, cleaning people, and management personnel. Another gang of people are employed to maintain the golf course, which cost nearly $10 million, using precision mowers, fertilizer spreaders and other equipment purchased for the purpose. More jobs are created.

After a round of golf and a $100 tip to the caddie, the billionaire drives his American-built, German luxury car home. As the gate to his driveway swings open, spread before him is a thirty-acre estate with manicured lawns and gardens, tennis courts, swimming pools, and riding trails, the maintenance of which requires a full-time staff of five.

Inside, the maid takes his jacket as he calls to the nanny to see how his youngsters are doing. He finds that one is off to a tennis lesson, while the other is grooming her horse with the stable hand. Polishing off a light dinner prepared by his cook, he resolves to fly his private jet south later that evening to spend a few days at his ocean-side estate. Or was it the ski chalet? Details. He calls his pilot.

And so it goes for the billionaire. We may envy his lavish lifestyle, and grumble that he doesn't deserve it, but there can be no doubt that his wealth is working for society. Ignoring the societal value of the new gizmo he invented, his consumption alone is a valuable resource for his communities. He creates opportunities for those farther down the ladder to provide for their families. His property taxes, more than the cost of a five-bedroom home, provide support for the local schools, even though his children go to private school. He funds the Fourth of July parade and has contributed to the new town tennis courts. And, he has funded a foundation to research childhood diseases. Life in his realm is, indeed, better for his wealth.

Bastiat, like Smith, believed capital is a public good in the sense that the public benefits from its accumulation. Where Bastiat departed from his contemporary, Karl Marx, was his belief that the public should not control it. He understood the perils inherent in an over-reaching government - human nature, cronyism, the tragedy of the commons - and asserted that only through _private_ management can capital provide its maximum social benefit. Marx's nirvana lay right before his eyes, but he couldn't see it.

A final thought: We can choose to employ economic principles or not in confronting society's problems, but we cannot change their effects. When we evaluate the trade-offs we have to make in our self-governance, we cannot alter the fact that, in economic theory, there is a single best solution, one that results in the most efficient use of scarce resources and that will ultimately provide the greatest reward for the most people. Sub-optimal solutions channel resources less efficiently, cut back those rewards, and lead to a lower standard of living than might otherwise have occurred. This was Smith's message more than two centuries ago. It is no less relevant today.

# Appendix

Throughout the book we use graphs as a visual complement to our description of various economic concepts. We do this for two reasons: one, because pictures speak louder than words for some readers and two, to show that economics is, indeed, a science that seeks to explain mathematical relationships between economic variables. It is not voodoo. For those readers not familiar with graphs, we explain here a little about how economists go about their work, and how to read and understand their graphs.

Economists deal with variables, or things that don't stay the same. Examples are prices, costs, ratios, population, measures of economic growth, and so on. Their goal is to find variables that don't change randomly, but rather change in relation to other variables. This enables them to make forecasts, because if they know a value for one variable, they may be able to predict the value of another.

You probably use this type of analysis in your everyday life. For example, you may be interested in finding the gas mileage of your new car, so you take measurements of the gallons of gas you use and the number of miles you drive, and you divide the miles driven by the gallons burned to calculate miles per gallon. You do this a number of times to try and get a good comparison, but you get different results each time.

Puzzled, you could conclude that gas mileage is not related to the number of miles you drive, but that's silly, so you re-examine your data. You find that your measures of miles per gallon seem to cluster around two numbers - 17 mpg and 22 mpg. This sounds like something you saw on the window sticker of the car when you bought it, and you remember it related to whether the car was driven in the city or on the highway. You check your calendar and find that the measurements clustered around 17 mpg were made while you were driving around town, and those clustered around 22 mpg while you were on long trips. Now you might conclude that the auto maker wasn't lying about the car's mileage, and you can predict that the next time you go on a trip, you are likely to get around 22 mpg.

An eager economist might try to take the analysis even further. She could examine the mileage numbers around both 17 and 22 to see if she could relate the differences among them to any other variables. Checking your calendar, she is able to determine that the measurements slightly below 17 mpg occurred between the months of December and March, while those slightly above 17 came in April, May, and June. She could plot these findings on a graph, showing the months of the year, January through December, on the horizontal axis, and the miles per gallon on the vertical axis.

On this graph she would see exactly what we have just described, that miles per gallon are lower in some contiguous months and higher in others. Now she can form a hypothesis, that this car's mileage is worse in the winter and better in the summer, and collect more data to validate it. She would want data from all of the months.

She could go even further and predict that, not just _your_ car, but all cars' mileage is lower in the winter. She would try to validate that hypothesis with data from many cars. A question for the reader: If she collects monthly mileage data from around the country, what will she find? Of course, she won't find as close a relationship between mileage and time of year. Why? Because she collected data from places like Florida and Southern California, where it is summer all year. That data "contaminated" her analysis. When she goes back to eliminate the data from all the warm-weather states, she will have a fairer test of her hypothesis.

Note that this is hypothetical; we have no idea whether mileage is lower in the winter, although we could make the argument. We would have to create more hypotheses about winter driving conditions and how they might affect mileage, then test those hypotheses with real data. Wheels spinning on ice, for example, would likely use more gas. We could hypothesize that the more snowfall a state experiences, the more wheel-spinning would occur. We could plot mileage data and snowfall on a graph, and we might find that, the more snowfall there is in a state, the lower the gas mileage. This wouldn't necessarily prove that the more snow that falls, the poorer one's gas mileage, but it is leading us in that direction. We could take the analysis much further, but will leave that to the economist.

Also note: What we have just "proved" is proof of relationship but not causality. Just because snow and mileage are related does not mean that snow _causes_ lower mileage. This would be like relating the frequency of auto accidents to the hour of the day and, finding more accidents during the day than at night, concluding that daylight causes auto accidents. Clearly this is not a valid conclusion. Something else is at work in that relationship, probably relating to the number of drivers on the road during the day vs. the night. This error in logic is common. There are many other variables that could lead to lower gas mileage when it snows, among them the temperature, longer start times, slower traffic, and so on. Most disagreements among economists occur over logic fallacies, not data.

When economists find relationships between different variables, they pull out their slide rules and see if they can find a mathematical equation that depicts this relationship. For example, they might find that for every value of variable A, variable B equals half that amount. Their equation could be written A = 2 x B.[17] Thus, if they know the value of B and want to predict the value of A, they would simply multiply B by 2, and plot that point on a graph. Repeating the process a few times, they find the points can be connected by a line that visually represents the underlying equation.

Most of the graphs we use will be of this type, equations relating two variables mathematically. Some equations describe relationships that are linear and when plotted, result in a straight line. Others describe relationships that are not linear, resulting in curved lines. When we encounter non-linear relationships, we will try to explain why their plots are curved, because the reasons reveal how economists think and do their work. We hope to convey the ideas clearly without the use of math.

# Glossary

Aggregate production function

Average total cost

Business cycle

Business risk

Capital

Capital intensive

Classical economics

Comparative advantage

Consumer Price Index

Consumption function

Creative destruction

Deadweight loss

Deflation

Demand curve

Demand schedule

Diminishing marginal productivity of labor

Diminishing marginal utility

Discount rate

Division of labor

Economic profit

Elasticity

Experience curve

Factors of production

Fiscal policy

Fixed costs

Foreign exchange market

Fractional reserve

Free traders

GDP deflator

Gold standard

Gross National Product

Human capital

Income smoothing

Increasing marginal productivity of labor

Inflation

Invisible hand

Keynesian multiplier

Law of Demand

Law of Supply

Life-cycle hypothesis

Macroeconomics

Microeconomics

Marginal cost

Market equilibrium

Market price

Monetary policy

Monopolistic

Monopolistically competitive

Monopoly profits

Moral hazard

National Income

Natural price

Neoclassical economics

Nominal value

Normal profit

Normal return

Oligopolistic

Opportunity cost

Output per man-hour

Permanent income hypothesis

Physical capital

Possibility frontier

Price makers

Price makers

Price takers

Productivity

Protectionists

Purely competitive

Rational expectations

Real value

Regulatory capture

Rental rate

Savings function

Scarcity

Simplifying assumptions

Social cost

Supply curve

Supply schedule

Supply-side economics

Tax shelter

Total costs

Trade deficit

Tragedy of the commons

Utility

Variable cost

# About The Author

Dick Gillette learned economics early. As an eighth grader with a morning paper route, he figured out money and banking. His $16 a week placed him in the upper 1% of earners among his friends, enabling him to lend them money to join him at the movies.

Enjoying the finer things that money provided, Dick looked for work wherever he could find it - raking leaves and shoveling driveways, selling sandwiches in the dorm at night, handling scrap at a manufacturing plant, and popping lids at the coke plant in a steel mill.

After serving in the Navy during the Vietnam War, Dick took a job as a business lender at a large bank in Chicago. He moved into management consulting to advise corporations on business strategy. Later, he joined GE Capital to found an oil and gas investing business. Eventually, he went off on his own to work with start-up companies in the clean energy field.

Dick earned a BA in history at Trinity College and an MBA at the University of Chicago. He is currently an instructor in economics and finance at the University of Phoenix. On Mondays, Dick participates in the Everybody Wins! reading program at an urban elementary school.

Follow Dick's blog at www.barbecue-econ.com.

# Endnotes

[1] The terms producer, manufacturer, seller, company, corporation and firm are largely interchangeable in the context of this book. Some economists prefer one, some another. We usually prefer firm, mainly because it is easier to type, but we use others in an attempt to honor the choices of authors we are citing.

[2] Likewise, consumers are also referred to as individuals or buyers. These words all denote the party who is seeking to purchase a good or service.

[3] For a primer on how to interpret graphs, see the Appendix.

[4] Early economists typically used only the word "products" to represent goods and services offered by producers. Modern day economists have found it necessary to add the word "services," since so much of modern economies are comprised of both products and services. Throughout this book we will usually just use the word products to encompass both products and services. It's just simpler.

[5] Do not pity the poor sole proprietor. A free market always offers opportunities for small businesses to improve their prospects. McDonalds started life as a single milkshake shop.

[6] Society's human capital is supplied by educated workers, which is why the quality of education is so important to economic growth. Individual firms are often said to possess intellectual capital, which is the sum of the specific knowledge of its workers and the innovative ideas they have added to improve their firm's competitiveness. This is the same as human capital.

[7] It may be helpful to link the terms "production volume" and "supply." Recall that we are discussing how firms decide how much to produce, which is also the amount they will supply to the market.

[8] This is the way economists express the rule – produce until marginal revenue equals marginal cost. As lay people, we can easily see that, if a producer can't get at least a penny more for his product than his marginal cost, he shouldn't bother to make it. Economists assume we understand that.

[9] The astute reader will ask, if the company only just covers its total costs, how can it be profitable? The answer is that economists include a normal return to investors in their definition of cost – it is the cost of capital. Therefore, a firm that earns its cost of capital is at breakeven in economic terms, but profitable in accounting terms.

[10] These figures are characteristic of the United States. Much higher rates of growth are produced in many developing countries, but as these economies mature, their GDP growth falls back to levels more like those in the U.S.

[11] Economists call this their "propensity to consume."

[12] We have used a mathematical technique called "discounting" to arrive at this number. If you multiply $470 by 1.05 (the inflation rate) for a total of five times (the number of years), your result will be $600.

[13] The federal debt "held by the public" is a smaller figure than our total federal debt. The main difference is the amount of debt purchased directly by the Federal Reserve System, which remains in their vault and out of circulation. The debt held by the public is money the Treasury has actually borrowed from individuals and entities like financial institutions and foreign central banks.

[14] If the debt held by the Fed is counted, the ratio of debt to GDP is around 100%, a figure sometimes used in the press. Essentially, our GDP and our total debt are each about $16 trillion.

[15] A demand deposit is so called because it is payable to the depositor on her demand. We call it a checking account.

[16] Moral hazard is created when the party normally responsible in a transaction is insured against loss by the government. At this point, the party can take on excessive risk to reap high returns without worry about a possible loss. This is called "socializing the risk" while "privatizing the return."

[17] Using algebra to transpose the equation, it could also be written as B = ? x A, or B = A/2.
