James D. Gwartney, Richard L. Stroup, Dwight R. Lee, Tawni H. Ferrarini, Joseph P. Calhoun, Randall K. Filer

Джеймс Д. Гвартни, Ричард Л. Строуп, Дуайт Р. Ли, Тауни Х. Феррарини, Джозеф П. Калхун, Рэндалл К. Файлер

Common Sense Economics

What Everyone Should Know About Personal and National Prosperity

Экономика здравого смысла

О личном и общественном благополучии для всех и каждого

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Cover Page

Imprint

Preface

Part 1: Twelve Key Elements of Economics

Element 1.1: Incentives Matter

Element 1.2: There Is No Such Thing as a Free Lunch

Element 1.3: Decisions Are Made at the Margins

Element 1.4: Benefits of Trade

Element 1.5: Transaction Costs Matter

Element 1.6: Prices Create Balance

Element 1.7: Profits Are a Guide to Productivity

Element 1.8: Incomes Come From Usefulness

Element 1.9: Value Creates Income and Wealth

Element 1.10: There Are Multiple Sources of Progress

Element 1.11: The Usefulness of the “Invisible Hand”

Element 1.12: Unintended Consequences Create Problems

Part 2: Seven Major Sources of Economic Progress

Element 2.1: The Legal System

Element 2.2: Competitive Markets

Element 2.3: Sensible and Limited Regulation

Element 2.4: Efficient Capital Markets

Element 2.5: Monetary Stability

Element 2.6: Prudent Fiscal Policy

Element 2.7: Free Trade

Part 2 Final Thoughts

Part 3: Ten Key Elements of Economic Thinking About Government

Element 3.1: Protect Rights and Produce Limited Goods and Services

Element 3.2: Regulate Monopolies

Element 3.3: Mitigate Market Failures

Element 3.4: Understand Political Pressures

Element 3.5: Adopt Rules to Limit the Influence of Special Interests

Element 3.6: Avoid Excessive Spending and Deficits

Element 3.7: Avoid Subsidies Not Based on Economic Logic

Element 3.8: Watch out for Inefficiencies Even From Useful Subsidies

Element 3.9: Central Planning Has Never Worked

Element 3.10: Competition and External Anchors Are Key

Part 3 Final Thoughts

Part 4: Twelve Key Elements of Practical Personal Finance

Element 4.1: Discover Your Comparative Advantage

Element 4.2: Increase Your Value to Others

Element 4.3: Budget Your Spending and Saving

Element 4.4: Finance Wisely

Element 4.5: Two Ways to Get More out of Your Money

Element 4.6: Plan for the Unexpected

Element 4.7: The Power of Compound Interest

Element 4.8: Diversify Your Assets

Element 4.9: Realize No One Can Consistently “Beat the Market”

Element 4.10: Match the Length of Your Investments to the Timing of Your Needs

Element 4.11: Reduce Your Risks

Element 4.12: Use Insurance to Protect Yourself

Part 4 Final Thoughts

Concluding Thoughts and Acknowledgments

Footnotes

Readings Featured in the Elements

The Power of Incentives

The Road Not Taken

Opportunities and Costs

Markets and Marginalism

Specialization and Wealth

Sacrificing Lives for Profits

I, Pencil, My Family Tree

Creating Jobs vs. Creating Wealth

What Is Seen and What is Not Seen

Gross Domestic Product—What is it and how is it measured?

Private Property and Opportunity Costs

Running Out of Agricultural Land

Censoring Pleas for Help

Markets and Freedom

Unfair Competition with the Sun

Not Yours to Give

Politics and Foreign Trade

Energy Production versus Conservation

Social Cooperation and the Marketplace

A Case for Constitutional Reform in Ukraine

Suggested Additional Readings

Glossary

About the Authors

Academic Advisory Committee

Subject Matter Experts

Translation Teams

Imprint

COM­MON SENSE ECO­NOM­ICS
What Every­one Should Know About Per­son­al and Na­tion­al Prosper­ity
Re­vised for Cent­ral and East­ern Europe and the Former So­viet Uni­on
JAMES D. GWART­NEY
Flor­ida State Uni­versity
RICHARD L. STROUP
North Car­o­lina State Uni­versity
DWIGHT R. LEE
South­ern Meth­od­ist Uni­versity
TAWNI H. FER­RAR­INI
North­ern Michigan Uni­versity
JOSEPH P. CAL­HOUN
Flor­ida State Uni­versity
RAN­DALL K. FILER
Hunter Col­lege & the CUNY Gradu­ate Cen­ter
“Com­mon Sense Eco­nom­ics: What Every­one Should Know About Per­son­al and Na­tion­al Prosper­ity” by James D. Gwart­ney, Richard L. Stroup, Dwight R. Lee, Tawni H. Fer­rar­ini, Joseph P. Cal­houn and Ran­dall K. Filer.
First pub­lished 2020.
Eco­nom­ic Fun­da­ment­als Ini­ti­at­ive, 110 Jabez Street 1060, Ne­wark, New Jer­sey NJ 07105, USA.
Re­vised for Cent­ral and East­ern Europe and the Former So­viet Uni­on
from the third edi­tion of “Com­mon Sense Eco­nom­ics: What Every­one Should Know About Wealth and Prosper­ity”
by James D. Gwart­ney, Richard L. Stroup, Dwight R. Lee, Tawni H. Fer­rar­ini and Joseph P. Cal­houn.
Copy­right © Eco­nom­ic Fun­da­ment­als Ini­ti­at­ive
This work is li­censed un­der a Cre­at­ive Com­mons At­tri­bu­tion-NonCommercial-NoDerivatives 4.0 In­ter­na­tion­al Li­cense (CC BY-NC-ND 4.0).
The text of the li­cense is avail­able at https://creativecommons.org/licenses/by-nc-nd/4.0/
At­tri­bu­tion Non Com­mer­cial No De­riv­at­ives
ISBN 978-1-952729-00-3

Preface

The au­thors of this book want you to live a suc­cess­ful and ful­filling life.
We also want you, and every oth­er in­di­vidu­al, to live in an en­vir­on­ment
that al­lows and en­cour­ages every­one to reach their max­im­um po­ten­tial.
We be­lieve that ac­com­plish­ing these goals re­quires both lead­ers and cit­izens in gen­er­al to un­der­stand the ba­sic prin­ciples of eco­nom­ics.
Eco­nom­ic de­cisions and policies af­fect each of us in al­most every as­pect of our daily lives, of­ten in ways we do not fully com­pre­hend.
We are con­tinu­ally amazed by the de­gree of eco­nom­ic il­lit­er­acy among politi­cians and voters.
Bad eco­nom­ics is dan­ger­ous every­where, but is es­pe­cially com­mon, and harm­ful, in de­vel­op­ing and post-com­mun­ist trans­ition eco­nom­ies.
The fun­da­ment­al pur­pose of the Com­mon Sense Eco­nom­ics pro­ject is to make the key un­der­stand­ings of our pro­fes­sion ac­cess­ible to all.
Be­cause time is valu­able, we have craf­ted this pub­lic­a­tion in a way that min­im­izes the re­quire­ment to learn new terms,
mem­or­ize for­mu­las, or mas­ter in­tric­ate de­tails im­port­ant only to pro­fes­sion­al eco­nom­ists.
Rather, we fo­cus on the fun­da­ment­al in­sights of eco­nom­ics that really mat­ter—those that will help you make bet­ter choices,
im­prove your un­der­stand­ing of our in­creas­ingly com­plex world, and live a more sat­is­fy­ing life.
Re­gard­less of your cur­rent know­ledge of eco­nom­ics, this book will provide you with im­port­ant in­sights.
We have tried to make it con­cise, thought­fully or­gan­ized, and read­er-friendly.
As the work’s title sug­gests, we be­lieve that the ba­sic prin­ciples of eco­nom­ics primar­ily re­flect com­mon sense.
The work puts these prin­ciples to work, demon­strat­ing their power to ex­plain real world events.
We aim to help you un­der­stand why some na­tions prosper and oth­ers do not.
The polit­ic­al pro­cess is ex­amined and dif­fer­ences between gov­ern­ment and mar­ket al­loc­a­tion in­vest­ig­ated.
Even ad­vanced stu­dents of eco­nom­ics and busi­ness will be­ne­fit from our ef­forts to pull to­geth­er the “big pic­ture.”
You can tem­por­ar­ily set aside the com­plex for­mu­las, soph­ist­ic­ated mod­els, and tech­nic­al math­em­at­ics of the pro­fes­sion
and con­cen­trate on the eco­nom­ic prin­ciples that at­trac­ted you to eco­nom­ics in the first place.
The ma­ter­i­als are de­signed to provide a strong found­a­tion, es­pe­cially for stu­dents
who may not take an­oth­er eco­nom­ics course as well as for the gen­er­al pub­lic who want an in­sight into the work­ings of the world around them.
It is writ­ten to be ap­pro­pri­ate for sec­ond­ary school stu­dents, for uni­versity stu­dents
in fields oth­er than eco­nom­ics (such as law or journ­al­ism), and, es­pe­cially, for all cit­izens.
Be­cause the Com­mon Sense Eco­nom­ics team is anxious to share these ma­ter­i­als with in­struct­ors,
we can of­fer work­shops de­signed to en­hance the abil­ity of in­struct­ors to make the best pos­sible use of our ma­ter­i­als.
If you would like more in­form­a­tion on these activ­it­ies, please con­sult our web­site at http://www.econfun.org.
Thirty years after the fall of the Ber­lin Wall, many are ques­tion­ing the pace and dir­ec­tion of the trans­ition.
It is es­pe­cially im­port­ant that cit­izens of the re­gion are not sucked in by the false prom­ises of “il­liber­al demo­cracy” or “state cap­it­al­ism.”
Many in­di­vidu­als sac­ri­ficed their time, their ca­reers, and even their lives
to se­cure the bless­ings of polit­ic­al and eco­nom­ic free­dom to this re­gion. We ded­ic­ate this book to those her­oes of liberty.

Part 1: Twelve Key Elements of Economics

Eco­nom­ics
The study of how in­di­vidu­als, gov­ern­ments, busi­nesses, and oth­er or­gan­iz­a­tions make choices that af­fect the al­loc­a­tion and dis­tri­bu­tion of scarce re­sources

The Twelve Key Elements

  1. Incentives mat­ter: Changes in be­ne­fits and costs will in­flu­ence choices in a pre­dict­able man­ner.
  2. There is no such thing as a free lunch: Goods are scarce and there­fore we have to make choices.
  3. De­cisions are made at the mar­gin: If we want to get the most out of our re­sources,
    op­tions should be chosen only when the mar­gin­al be­ne­fits ex­ceed the mar­gin­al cost.
  4. Trade pro­motes eco­nom­ic pro­gress.
  5. Trans­ac­tion costs are an obstacle to trade.
  6. Prices bring the choices of buy­ers and sellers into bal­ance.
  7. Profits dir­ect busi­nesses to­ward pro­duct­ive activ­it­ies that in­crease the value of re­sources, while losses dir­ect them away from waste­ful activ­it­ies that re­duce re­source value.
  8. People earn in­come by provid­ing oth­ers with things they value.
  9. High liv­ing stand­ards res­ult from the pro­duc­tion of goods and ser­vices people value, not from just “hav­ing a job.”
  10. Eco­nom­ic pro­gress comes primar­ily through trade, investment, bet­ter ways of do­ing things, and sound eco­nom­ic in­sti­tu­tions.
  11. The “in­vis­ible hand” of mar­ket prices dir­ects buy­ers and sellers to­ward activ­it­ies that pro­mote the gen­er­al wel­fare.
  12. Too of­ten long-term con­sequences, or the secondary effects, of an ac­tion are ig­nored.

Introduction

Life is about choices, and economics is about how in­cent­ives af­fect those choices and shape our lives.
Choices about our edu­ca­tion, how we spend and in­vest, what we do in the work­place,
and many oth­er per­son­al de­cisions will in­flu­ence our well-be­ing and qual­ity of life.
Moreover, the choices we make as voters and cit­izens af­fect the laws or “rules of the game,”
and these rules ex­ert an enorm­ous im­pact on our free­dom and prosper­ity.
To choose in­tel­li­gently, both for ourselves and for so­ci­ety gen­er­ally, we must un­der­stand some ba­sic prin­ciples about
how people choose, what mo­tiv­ates their ac­tions, and how their ac­tions in­flu­ence their per­son­al wel­fare and that of oth­ers.
Thus, eco­nom­ics is about hu­man de­cision-mak­ing, the ana­lys­is of the forces un­der­ly­ing choice, and the im­plic­a­tions for how so­ci­et­ies work.
The eco­nom­ic way of think­ing in­volves the in­teg­ra­tion of key con­cepts into your thought pro­cess.
The fol­low­ing sec­tion presents twelve con­cepts that are cru­cial for the un­der­stand­ing of eco­nom­ies,
and why some coun­tries grow and achieve high in­come levels while oth­ers stag­nate and re­main poor.
You will learn such things as the true mean­ing of costs, why prices mat­ter, how trade fur­thers prosper­ity,
and why pro­duc­tion of things that people value un­der­pins our stand­ard of liv­ing.
In the sub­sequent parts of the book, these con­cepts will be used to ad­dress oth­er vi­tally im­port­ant top­ics.

Element 1.1: Incentives Matter

Changes in benefits and costs will influence choices in a predictable manner.

All of eco­nom­ics rests on one simple prin­ciple: Changes in in­cent­ives in­flu­ence hu­man be­ha­vi­or in pre­dict­able ways.
Both mon­et­ary and non­mon­et­ary factors in­flu­ence in­cent­ives. If something be­comes more costly, people will be less likely to choose it.
Cor­res­pond­ingly, when the be­ne­fits de­rived from an op­tion in­crease, people will be more likely to choose it.
This simple idea, some­times called the ba­sic pos­tu­late of eco­nom­ics,
is a power­ful tool be­cause it ap­plies to al­most everything that we do.
People will be less likely to choose an op­tion as it be­comes more costly. Think about the im­plic­a­tions of this pro­pos­i­tion.
When late for an ap­point­ment, a per­son will be less likely to take time to stop and vis­it with a friend.
Few­er people will go pic­nick­ing on a cold and rainy day. High­er prices will re­duce the num­ber of units sold.
At­tend­ance in col­lege classes will be be­low nor­mal the day be­fore school hol­i­days.
In each case, the ex­plan­a­tion is the same: As the op­tion be­comes more costly, less is chosen.
Sim­il­arly, when the pay­off de­rived from a choice in­creases, people will be more likely to choose it.
A per­son walk­ing along the street will be more likely to bend over and pick up a Euro or a Dol­lar than a cent.
Stu­dents will at­tend and pay more at­ten­tion in class when they know the ma­ter­i­al will be on the exam.
Cus­tom­ers will buy more from stores that of­fer low prices, high-qual­ity ser­vice, and a con­veni­ent loc­a­tion.
Em­ploy­ees will work harder and more ef­fi­ciently when they are re­war­ded for do­ing so.
All of these out­comes are highly pre­dict­able and they merely re­flect the “in­cent­ives mat­ter” pos­tu­late of eco­nom­ics.
This ba­sic pos­tu­late ex­plains how changes in mar­ket prices al­ter in­cent­ives in a man­ner that works to co­ordin­ate the ac­tions of buy­ers and sellers.
If buy­ers want to pur­chase more of an item than pro­du­cers are will­ing (or able) to sell, its price will soon rise.
As the price in­creases, sellers will be more will­ing to provide the item while buy­ers pur­chase less, un­til the high­er price brings the amount de­man­ded and the amount sup­plied into bal­ance.
At that point the price sta­bil­izes.
What hap­pens if it starts out the oth­er way: if sellers want to sup­ply more than buy­ers are will­ing to pur­chase?
If sellers can­not sell all of their goods at the cur­rent price, they will have to cut the price of the item.
In turn, the lower price will en­cour­age people to buy more—but will also dis­cour­age pro­du­cers from pro­du­cing as much,
since it is less at­tract­ive to them to sup­ply the product at the new, lower price.
Again, the price change works to bring the amount de­man­ded by con­sumers into bal­ance with the amount pro­duced by sup­pli­ers.
At that point there is no fur­ther pres­sure for a price change.(1)
For ex­ample, bad weath­er raised the prices of peaches in the U.S. state of Geor­gia in the sum­mer of 2014, for­cing a price in­crease of 180% com­pared to the pre­vi­ous year.
Des­pite the huge in­crease in price, con­sumers did not com­plain.
Why? When the high­er prices made it more costly to pur­chase peaches,
most con­sumers eas­ily sub­sti­tuted oth­er fruits for peaches, either totally or par­tially,
and made their winter jam re­serves from pears or quinces in­stead.
Fur­ther­more, as buy­ers re­acted to high­er peach prices, so did sellers. The farm­ers sup­ply­ing peaches planted new trees.
Oth­er farm­ers cut down their apple and pear orch­ards and planted peach trees in­stead.
Even­tu­ally, after two years (when the newly planted trees be­came fruit­ful) the price of peaches fell as sup­ply ex­pan­ded.
In­cent­ives also in­flu­ence polit­ic­al choices.
There is little reas­on to be­lieve that a per­son mak­ing choices in the vot­ing booth will be­have much dif­fer­ently than when mak­ing choices in the shop­ping mall.
In most cases voters are likely to sup­port polit­ic­al can­did­ates and policies
that they be­lieve will provide them with the most per­son­al be­ne­fits, net of their costs.
They will tend to op­pose polit­ic­al op­tions when the per­son­al costs are high com­pared to the be­ne­fits they ex­pect to re­ceive.
For ex­ample, seni­or cit­izens have voted nu­mer­ous times against can­did­ates and pro­pos­als that would re­duce their pen­sion be­ne­fits.
Op­pos­i­tion to pro­posed re­duc­tions in pen­sion be­ne­fits is widely blamed for the poor show­ing of the United Rus­sia party in Rus­sia’s Septem­ber 2018 gubernat­ori­al elec­tions.
Sim­il­arly, polls in­dic­ate that stu­dents are strongly sup­port­ive of edu­ca­tion­al grants to col­lege stu­dents.
There’s no way to get around the im­port­ance of in­cent­ives. They are a part of hu­man nature.
In­cent­ives mat­ter just as much un­der socialism as they do un­der capitalism.
In the former So­viet Uni­on, man­agers and em­ploy­ees of glass plants were, at one time, re­war­ded ac­cord­ing to the tons of sheet glass they pro­duced.
Be­cause their rev­en­ues de­pended on the weight of the glass, most factor­ies pro­duced sheet glass so thick that you could hardly see through it.
As a res­ult, the rules were changed so that the man­agers were com­pensated ac­cord­ing to the num­ber of square meters of glass pro­duced.
Un­der these rules, So­viet firms made glass so thin that it broke eas­ily.
Sim­il­arly, when quotas for the num­ber of shoes were set for Pol­ish factor­ies
which were, in turn, provided with too little leath­er, is it any won­der that there was a glut of chil­dren’s shoes on the mar­ket?
Some people think that in­cent­ives mat­ter only when people are greedy and selfish.
This is un­true. People act for a vari­ety of reas­ons, some selfish and some char­it­able.
The choices of both the self-centered and al­tru­ist­ic will be in­flu­enced by changes in per­son­al costs and be­ne­fits.
For ex­ample, both the selfish and the al­tru­ist­ic will be more likely to at­tempt to res­cue a child in a shal­low swim­ming pool than in the rap­id cur­rents ap­proach­ing Det­ti­foss wa­ter­fall.(2)
And both are more likely to give a needy per­son their hand-me-downs rather than their best clothes.
Even though no one would have ac­cused the late Al­bani­an, Moth­er Teresa, of greed­i­ness, her self-in­terest caused her to re­spond to in­cent­ives, too.
When Moth­er Teresa’s or­gan­iz­a­tion, the Mis­sion­ar­ies of Char­ity, at­temp­ted to open a shel­ter for the home­less in New York City, the city re­quired ex­pens­ive al­ter­a­tions to its build­ing.
The or­gan­iz­a­tion aban­doned the pro­ject. This de­cision did not re­flect any change in Moth­er Teresa’s com­mit­ment to the poor. In­stead, it re­flec­ted a change in in­cent­ives.
When the cost of help­ing the poor in New York went up, Moth­er Teresa de­cided that her re­sources would do more good in oth­er areas.(3)
Changes in in­cent­ives in­flu­ence every­one’s choices, re­gard­less of the mix of greedy, ma­ter­i­al­ist­ic goals on the one hand
and com­pas­sion­ate, al­tru­ist­ic goals on the oth­er, which are driv­ing a spe­cif­ic de­cision.

Element 1.2: There Is No Such Thing as a Free Lunch

Goods are scarce and, therefore, we have to make choices.

Car­toon of a man and his dog on a leash. The man says to the dog: “I hope you ap­pre­ci­ate that each ‘walk’ costs $175 of my bil­lable time.” The dog thinks to him­self: “I hope you ap­pre­ci­ate that I am your only friend.”
The real­ity of life on our plan­et is that pro­duct­ive resources are lim­ited, while the hu­man de­sire for goods and ser­vices is vir­tu­ally un­lim­ited.
Would you like to have some new clothes, a lux­ury boat, or a va­ca­tion in the Swiss Alps?
How about more time for leis­ure, re­cre­ation, and travel?
Do you dream of driv­ing your brand-new Porsche into the drive­way of your ocean­front house?
Most of us would like to have all of these things and many oth­ers!
However, we are con­strained by the scarcity of re­sources, in­clud­ing a lim­ited avail­ab­il­ity of time.
Be­cause we can­not have as much of everything as we would like, we are forced to choose among al­tern­at­ives.
There is “no free lunch.” Do­ing one thing makes us sac­ri­fice the op­por­tun­ity to do something else we value.
This is why eco­nom­ists refer to all costs as opportunity costs.
Many costs are meas­ured in terms of money, but these too are op­por­tun­ity costs.
The money you spend on one pur­chase is money that is not avail­able to spend on oth­er things.
The op­por­tun­ity cost of your pur­chase is the value you place on the items that must now be giv­en up be­cause you spent the money on the ini­tial pur­chase.
But just be­cause you don’t have to spend money to do something does not mean the ac­tion is cost­less.
You don’t have to spend money to take a walk and en­joy a beau­ti­ful sun­set, but there is an op­por­tun­ity cost to tak­ing the walk.
The time you spend walk­ing could have been used to do something else you value, like vis­it­ing a friend or read­ing a book.
It is of­ten said that some things are so im­port­ant that we should do them without con­sid­er­ing the cost.
Mak­ing such a state­ment may sound reas­on­able at first thought, and may be an ef­fect­ive way
to en­cour­age people to spend more money on things that we value and for which we would like them to help pay.
But the un­reas­on­able­ness of ig­nor­ing cost be­comes ob­vi­ous once we re­cog­nize that costs are the value of for­gone al­tern­at­ives (that is, al­tern­at­ives giv­en up).
Say­ing that we should do something without con­sid­er­ing the cost
is really say­ing that we should do it without con­sid­er­ing the value of the al­tern­at­ives.
When we choose between mu­tu­ally ex­clus­ive (but equally at­tract­ive) al­tern­at­ives, the least-cost al­tern­at­ive is the best choice.
The choices of both con­sumers and pro­du­cers in­volve costs. As con­sumers, the cost of a good, as re­flec­ted in its price,
helps us to com­pare our de­sire for a product against our de­sire for al­tern­at­ive products that we could pur­chase in­stead.
If we do not con­sider the costs, we will prob­ably end up us­ing our in­come to pur­chase the “wrong” things
—those goods and ser­vices not val­ued as much as the oth­er items we might have bought.
Pro­du­cers face costs, too—the costs of the re­sources used to make a product or provide a ser­vice.
For ex­ample, the use of re­sources such as lum­ber, steel, and sheet rock
to build a new house takes re­sources away from the pro­duc­tion of oth­er goods, such as hos­pit­als and schools.
High costs for re­sources sig­nal that the re­sources have oth­er highly val­ued uses, as judged by buy­ers and sellers in oth­er mar­kets.
Profit-seek­ing firms will heed those sig­nals and act ac­cord­ingly, such as seek­ing out less costly sub­sti­tutes.
However, gov­ern­ment policies can over­ride these sig­nals.
They can in­tro­duce taxes or sub­sidies to gain fa­vor with po­ten­tial sup­port­ers by lower­ing the prices
that emerge in free and open markets.
But such policies re­duce the abil­ity of mar­ket in­cent­ives to guide re­sources to where con­sumers ul­ti­mately, on bal­ance, value them most highly.
A clas­sic ex­ample oc­curred in Geor­gia between 1991 and 1994.
The gov­ern­ment froze bread prices at a be­low mar­ket level, res­ult­ing in con­sumers stand­ing in queues that could stretch for more than a kilo­met­er.
The day price controls were re­moved,
shops were all of a sud­den well stocked and there were no queues!
A sim­il­ar phe­nomen­on also from Geor­gia oc­curred in 2006
when a pipeline de­liv­er­ing gas from Rus­sia ex­ploded, res­ult­ing in a huge in­crease in de­mand for heat­ing ker­osene.
To pre­vent “price gouging,” con­trols were im­posed on ker­osene, again res­ult­ing in long lines un­til prices were freed and al­lowed to rise to the mar­ket-clear­ing level.
Politi­cians, gov­ern­ment of­fi­cials, and lobbyists of­ten speak of “free edu­ca­tion,” “free med­ic­al care,” or “free hous­ing.”
This ter­min­o­logy is de­cept­ive. These things are not free.
Scarce re­sources are re­quired to pro­duce each of them and al­tern­at­ive uses ex­ist.
For ex­ample, the build­ings, labor, and oth­er re­sources used to pro­duce school­ing could in­stead pro­duce more food, re­cre­ation, en­vir­on­ment­al pro­tec­tion, or med­ic­al care.
The cost of the school­ing is the value of those goods that must be sac­ri­ficed.
Gov­ern­ments may be able to shift costs, but they can­not elim­in­ate them.
When gov­ern­ments want to en­cour­age people to save for their re­tire­ment, a massive ad­vert­ising pro­gram typ­ic­ally proves in­ef­fect­ive, but a tax-de­ferred sav­ings ac­count of­ten works.
Op­por­tun­ity cost is an im­port­ant concept. Everything in life is about op­por­tun­ity cost.
Every­one lives in a world of scarcity and there­fore must make choices.
By look­ing at op­por­tun­ity costs, we can bet­ter un­der­stand the world in which we live.
Con­sider the im­pact of op­por­tun­ity cost on work­force par­ti­cip­a­tion, the birth rate, and pop­u­la­tion growth—
top­ics many would con­sider out­side the realm of op­por­tun­ity-cost ap­plic­a­tion.
Have you ever thought about why wo­men with more edu­ca­tion are more likely to work out­side the home than their less edu­cated coun­ter­parts?
Op­por­tun­ity cost provides the an­swer.
The more highly edu­cated wo­men will have bet­ter earn­ing op­por­tun­it­ies in the work­force, and there­fore it will be more costly for them to stay at home.
The data are con­sist­ent with this view.
In 2014, in Ukraine, more than 70% of wo­men in the labor force aged fif­teen to sixty-four with a second stage of ter­tiary edu­ca­tion were em­ployed, com­pared to 62% of their coun­ter­parts with only in­com­plete ter­tiary edu­ca­tion and 40% of the wo­men with up­per sec­ond­ary school­ing.(4)
Just as eco­nom­ic the­ory pre­dicts, when it is more costly for a wo­man not to work out­side the home, few­er will choose this op­tion.
Ex­hib­it 1: Em­ploy­ment-to-Pop­u­la­tion Ra­tio by Gender (Pop­u­la­tion Aged 15–64) in Ukraine, in per­cent
Two graphs show­ing the em­ploy­ment-to-pop­u­la­tion ra­tio by gender for 15–64-year-olds in Ukraine, ex­pressed in per­cent. The first graph is a line chart show­ing the em­ploy­ment to pop­u­la­tion ra­tio by gender between 2000 and 2014. Em­ploy­ment rates for wo­men var­ied little, at just over 50% in 2000, reach­ing a peak of 55% in 2013 and re­du­cing to just over 50% in 2014. Em­ploy­ment rates for men av­er­aged just over 60%, reach­ing 65% in 2008 and 2013. The em­ploy­ment rates for men were more volat­ile com­pared to wo­men. The second graph is a bar chart show­ing em­ploy­ment rates by gender and edu­ca­tion level for 2014. Edu­ca­tion levels ranged from primary or pre-primary through to the second stage of ter­tiary edu­ca­tion. For both genders, those who had achieved the second stage of ter­tiary edu­ca­tion had the highest rates of em­ploy­ment. Re­gard­less of edu­ca­tion level, men had high­er rates of em­ploy­ment than wo­men. The in­form­a­tion source is the 2014 La­bour Force Sur­vey.
Source: Labor Force Sur­vey 2014.
What do you think hap­pens to the birth rate as an eco­nomy grows and earn­ings rise?
Time spent on house­hold re­spons­ib­il­it­ies re­duces the time avail­able for mar­ket work.
As earn­ings rise, the op­por­tun­ity cost of hav­ing chil­dren and rais­ing a large fam­ily in­creases.
There­fore, the pre­dicted res­ult is a re­duc­tion in the birth rate and slower pop­u­la­tion growth. The real world re­flects this ana­lys­is.
Dur­ing the past two cen­tur­ies, as the per cap­ita in­come of a coun­try in­creased, a re­duc­tion in the birth rate and a slow­down in pop­u­la­tion growth soon fol­lowed.
Moreover, this pat­tern has oc­curred in every coun­try.
Even though there are wide­spread cul­tur­al, re­li­gious, eth­nic, and polit­ic­al or­gan­iz­a­tion­al dif­fer­ences among coun­tries,
the high­er op­por­tun­ity cost of hav­ing chil­dren ex­er­ted the same im­pact on the birth rate in all cases.
Op­por­tun­ity cost is a power­ful tool and it will be ap­plied again and again throughout this book.
If you in­teg­rate this tool into your thought pro­cess, it will greatly en­hance your abil­ity to un­der­stand the real-world be­ha­vi­or of con­sumers,
pro­du­cers, busi­ness own­ers, polit­ic­al fig­ures, and oth­er de­cision-makers.
Even more im­port­ant, the concept will also help you make bet­ter choices.

Element 1.3: Decisions Are Made at the Margins

If we want to get the most out of our resources, options should be chosen only when the marginal benefits exceed the marginal cost.

If we are go­ing to get the most out of our re­sources, ac­tions should be un­der­taken
when they gen­er­ate more be­ne­fits than costs, and re­jec­ted when they are more costly than the be­ne­fits de­rived.
This prin­ciple of sound de­cision-mak­ing ap­plies to in­di­vidu­als, busi­nesses, gov­ern­ment of­fi­cials, and so­ci­ety as a whole.
Nearly all choices are made at the mar­gin. That means that they al­most al­ways in­volve ad­di­tions to
(or sub­trac­tions from) cur­rent con­di­tions, rather than “all-or-noth­ing” de­cisions.
The word “ad­di­tion­al” is a sub­sti­tute for “marginal.”
We might ask, “What is the mar­gin­al (or ad­di­tion­al) cost of pro­du­cing or pur­chas­ing one more unit?”
Mar­gin­al de­cisions may in­volve large or small changes.
The “one more unit” could be a new shirt, a new house, a new fact­ory,
or even an ex­pendit­ure of time, as in the case of a Uni­versity or Col­lege stu­dent choos­ing among vari­ous activ­it­ies.
All these de­cisions are mar­gin­al be­cause they in­volve con­sid­er­a­tion of ad­di­tion­al costs and be­ne­fits.
People do not gen­er­ally have to make “all-or-noth­ing” de­cisions, such as choos­ing between eat­ing or wear­ing clothes.
In­stead they com­pare the mar­gin­al be­ne­fits (a little more food)
with the mar­gin­al costs (a little less cloth­ing or a little less of something else).
In mak­ing de­cisions in­di­vidu­als don’t com­pare the total value of food and the total value of cloth­ing, but rather they com­pare their mar­gin­al val­ues.
Fur­ther, we choose op­tions only when the mar­gin­al be­ne­fits ex­ceed the mar­gin­al costs.
Of course some goods are “lumpy.”
It is easy to buy a little more food and a slightly smal­ler dwell­ing unit, but hard to add half a child in mak­ing fer­til­ity de­cisions.
Even in such goods, the mar­gin­al prin­ciple ap­plies. Par­ents can in­vest more or less in child qual­ity
(i.e. in in­vest­ments such as ex­tra tu­ition, mu­sic classes etc. which par­ents be­lieve will in­crease a child’s suc­cess or hap­pi­ness in life).
Con­sumers can sub­sti­tute mar­gin­ally lower qual­ity cars when auto prices rise (or hold on to their cur­rent car longer).
The fact that hous­ing of­ten de­term­ines the schools that chil­dren at­tend cre­ates an es­pe­cially prob­lem­at­ic is­sue for fam­il­ies when gov­ern­ment policy forces chil­dren to go to the school closest to their home rather than of­fer­ing par­ents a choice of schools ac­cord­ing to the school’s qual­ity and their chil­dren’s needs.
Things are even less sub­ject to free choice in coun­tries such as China,
where res­id­en­tial loc­a­tion (and as­so­ci­ated school­ing) is highly con­trolled by the gov­ern­ment.
Sim­il­arly, a busi­ness ex­ec­ut­ive plan­ning to build a new fact­ory will con­sider
wheth­er the marginal benefits of the new fact­ory (for ex­ample, ad­di­tion­al sales rev­en­ues) are great­er than the marginal costs (the ex­pense of con­struct­ing the new build­ing).
If not, the ex­ec­ut­ive and the com­pany are bet­ter off without the new fact­ory.
Ef­fect­ive polit­ic­al ac­tions also re­quire mar­gin­al de­cision-mak­ing.
Con­sider the polit­ic­al de­cision of how much ef­fort should go into clean­ing up pol­lu­tion.
If asked how much pol­lu­tion we should al­low, many people would re­spond “none”—in oth­er words, we should re­duce pol­lu­tion to zero.
In the vot­ing booth they might vote that way. But mar­gin­al think­ing re­veals that this would be ex­traordin­ar­ily waste­ful.
When there is a lot of pol­lu­tion—so much, say, that we are chok­ing on the air we breathe—
the mar­gin­al be­ne­fit of re­du­cing pol­lu­tion is quite likely to ex­ceed the mar­gin­al cost of the re­duc­tion.
But as the amount of pol­lu­tion goes down, so does the mar­gin­al be­ne­fit—the value of the ad­di­tion­al im­prove­ment in the air.
There is still a be­ne­fit to an even clean­er at­mo­sphere (for ex­ample, we would be able to see dis­tant moun­tains or swim in a clean­er river),
but this be­ne­fit is not nearly as valu­able as pro­tect­ing our lungs.
At some point, be­fore all pol­lu­tion dis­ap­peared, the mar­gin­al be­ne­fit of elim­in­at­ing more pol­lu­tion would de­cline to al­most zero.
As pol­lu­tion is be­ing re­duced, the mar­gin­al be­ne­fit is go­ing down while the mar­gin­al cost is go­ing up, and be­comes very high be­fore all pol­lu­tion is elim­in­ated.
The mar­gin­al cost is the value of oth­er things that have to be sac­ri­ficed to re­duce pol­lu­tion a little bit more.
Once the mar­gin­al cost of a clean­er at­mo­sphere ex­ceeds the mar­gin­al be­ne­fit, ad­di­tion­al pol­lu­tion re­duc­tion would be waste­ful. It would simply not be worth the cost.
To con­tin­ue with the pol­lu­tion ex­ample, con­sider the fol­low­ing hy­po­thet­ic­al situ­ation.
As­sume that we know that pol­lu­tion is do­ing €100 mil­lion worth of dam­age, and only €1 mil­lion is be­ing spent to re­duce pol­lu­tion.
Giv­en this in­form­a­tion, are we do­ing too little, or too much, to re­duce pol­lu­tion? Most people would say that we are spend­ing too little.
This may be cor­rect, but it doesn’t fol­low from the in­form­a­tion giv­en.
The €100 mil­lion in dam­age is total dam­age, and the €1 mil­lion in cost is the total cost of cleanup.
To make an in­formed de­cision about what to do next,
we need to know the mar­gin­al be­ne­fit of cleanup and the mar­gin­al cost of do­ing so.
If spend­ing an­oth­er €10 on pol­lu­tion re­duc­tion would re­duce dam­age by more than €10, then we should spend more.
The mar­gin­al be­ne­fit ex­ceeds the mar­gin­al cost.
But if an ad­di­tion­al €10 spent on an­ti­pol­lu­tion ef­forts would re­duce dam­ages by only one euro,
ad­di­tion­al an­ti­pol­lu­tion spend­ing would be un­wise.
People com­monly ig­nore the im­plic­a­tions of mar­gin­al­ism in their com­ments and votes but sel­dom in their per­son­al ac­tions.
Con­sider food versus re­cre­ation. When viewed as a whole, food is far more valu­able than re­cre­ation be­cause it al­lows people to sur­vive.
When people are poor and liv­ing in im­pov­er­ished coun­tries, they de­vote most of their in­come to se­cur­ing an ad­equate diet.
They de­vote little time, if any, to play­ing golf, wa­ter ski­ing, or oth­er re­cre­ation­al activ­it­ies.
But as people be­come wealth­i­er, the op­por­tun­ity cost of ac­quir­ing food de­clines.
Al­though food re­mains vi­tal to life, con­tinu­ing to spend most of their money on food would be fool­ish.
At high­er levels of af­flu­ence, people find that at the mar­gin—as they make de­cisions about how to spend each ad­di­tion­al euro—food is worth much less than re­cre­ation.
So as Swedes be­come wealth­i­er, they spend a smal­ler por­tion of their in­come on food and a lar­ger por­tion of their in­come on re­cre­ation(5).
The concept of mar­gin­al­ism re­veals that it is the mar­gin­al costs and mar­gin­al be­ne­fits that are rel­ev­ant to sound de­cision-mak­ing.
If we want to get the most out of our re­sources,
we must un­der­take only ac­tions that provide mar­gin­al be­ne­fits that are equal to, or great­er than, mar­gin­al costs.
Both in­di­vidu­als and na­tions will be more pros­per­ous when their choices re­flect the im­plic­a­tions of mar­gin­al­ism.

Element 1.4: Benefits of Trade

Trade promotes economic progress.

The found­a­tion of trade is mu­tu­al gain. People agree to an ex­change be­cause they ex­pect it to im­prove their well-be­ing.
The mo­tiv­a­tion for trade is summed up in the state­ment: “If you do something good for me, I will do something good for you.”
Trade is a win-win trans­ac­tion. This pos­it­ive-sum activ­ity per­mits each of the trad­ing part­ners to get more of what they value.
There are three ma­jor sources of gains from trade.
First, trade moves goods from people who value them less to people who value them more.
Thus, trade can in­crease the value of goods even when noth­ing new is pro­duced.
For ex­ample, when used goods are sold at flea mar­kets, or through ser­vices such as Craigslist (or its loc­al vari­ants such as list.am),
the ex­changes do not in­crease the quant­ity of goods avail­able (as new products do).
But the trades move products to­ward people who value them more.
Both the buy­er and seller gain, or oth­er­wise the ex­change would not oc­cur.
People’s pref­er­ences, know­ledge, and goals vary widely.
A product that is vir­tu­ally worth­less to one per­son may be a pre­cious gem to an­oth­er.
A highly tech­nic­al book on elec­tron­ics may be worth noth­ing to an art col­lect­or but val­ued at hun­dreds of dol­lars by an en­gin­eer.
Sim­il­arly, a paint­ing that an en­gin­eer cares little for may be cher­ished by an art col­lect­or.
Vol­un­tary ex­change that moves the elec­tron­ics book to the en­gin­eer and the paint­ing to the art col­lect­or will in­crease the be­ne­fit de­rived from both goods.
The trade will in­crease the wealth of both people and also their na­tion.
It is not just the amount of goods and ser­vices pro­duced in a na­tion that de­term­ines the na­tion’s wealth, but how those goods and ser­vices are al­loc­ated.
Second, trade makes lar­ger pro­duc­tion and con­sump­tion levels pos­sible be­cause it al­lows each of us to spe­cial­ize more fully in the things that we do best re­l­at­ive to cost.
When people spe­cial­ize, they can then sell these products to oth­ers.
Rev­en­ues re­ceived can be used to pur­chase items that would be costly to pro­duce them­selves.
Through these ex­changes, people who spe­cial­ize in this way will pro­duce a lar­ger total quant­ity of goods and ser­vices than would oth­er­wise be pos­sible.
Eco­nom­ists refer to this prin­ciple as the law of comparative advantage.
This law ap­plies to trade among in­di­vidu­als, busi­nesses, re­gions, and na­tions.
The law of com­par­at­ive ad­vant­age is just com­mon sense.
If someone else is will­ing to provide you with a product at a lower cost than you can provide it for your­self
(keep in mind that all costs are op­por­tun­ity costs), it makes sense to trade for it.
You can then use your time and re­sources to pro­duce more of the things for which you are a low-cost pro­du­cer.
In oth­er words, pro­duce what you pro­duce best, and trade for the rest.
The res­ult is that you and your trad­ing part­ners will mu­tu­ally gain from specialization and trade,
lead­ing to great­er total pro­duc­tion and high­er in­comes.
In con­trast, try­ing to pro­duce everything your­self would mean you are us­ing your time and re­sources to pro­duce many things for which you are a high-cost pro­vider.
This would trans­late into lower pro­duc­tion and in­come.
For ex­ample, even though most doc­tors might be good at re­cord keep­ing and ar­ran­ging ap­point­ments,
it is gen­er­ally in their in­terest to hire someone to per­form these ser­vices.
The time doc­tors use to keep re­cords is time they could have spent see­ing pa­tients.
Be­cause the time spent with their pa­tients is worth a lot, the op­por­tun­ity cost of re­cord keep­ing for doc­tors will be high.
Thus, doc­tors will al­most al­ways find it ad­vant­age­ous to hire someone else to keep and man­age their re­cords.
Moreover, when the doc­tor spe­cial­izes in the pro­vi­sion of phys­i­cian ser­vices and hires someone who has a com­par­at­ive ad­vant­age in re­cord keep­ing,
costs will be lower and joint output lar­ger than would oth­er­wise be achiev­able.
Third, vol­un­tary ex­change al­lows firms to achieve lower per-unit costs by ad­opt­ing large-scale pro­duc­tion meth­ods.
Trade makes it pos­sible for busi­ness firms to sell their out­put over a broad mar­ket area
so they can plan for large out­puts and ad­opt pro­duc­tion pro­cesses that take ad­vant­age of economies of scale,
as happened after 1989 when juices from Mol­dova entered the glob­al mar­ket.
Such pro­cesses of­ten lead to sub­stan­tially lower per-unit costs and enorm­ous in­creases in out­put per work­er.
Without trade, these gains could not be achieved.
Market forces are con­tinu­ously real­loc­at­ing pro­duc­tion to­ward low-cost pro­du­cers (and away from high-cost ones).
As a res­ult, open mar­kets tend to al­loc­ate products and re­sources in ways that max­im­ize
the value, amount, and vari­ety of the goods and ser­vices that are pro­duced.
China is a per­fect ex­ample of a con­trolled eco­nomy whose cit­izens, after it joined the glob­al trad­ing sys­tem in 1995,
were able to take ad­vant­age of the sig­nals giv­en by trade and com­par­at­ive ad­vant­age
to lift lit­er­ally bil­lions of people (in both China and oth­er coun­tries in the re­gion) out of poverty.
The im­port­ance of trade in our mod­ern world can hardly be ex­ag­ger­ated.
Trade makes it pos­sible for most of us to con­sume a bundle of goods and ser­vices far bey­ond what we would be able to pro­duce for ourselves.
Can you ima­gine the dif­fi­culty in­volved in pro­du­cing your own hous­ing, cloth­ing, and food,
to say noth­ing of com­puters, tele­vi­sion sets, dish­wash­ers, auto­mo­biles, and tele­phones?
People who have these things have them largely be­cause their eco­nom­ies are or­gan­ized in such a way
that in­di­vidu­als can co­oper­ate, spe­cial­ize, and trade.
Coun­tries that im­pose obstacles to ex­change—either do­mest­ic or in­ter­na­tion­al—re­duce the abil­ity of their cit­izens to achieve gains from trade and to live more pros­per­ous lives.
It is true that a dy­nam­ic glob­al eco­nomy will mean shifts over time in the jobs in any one coun­try.
Eco­nom­ists al­most uni­ver­sally agree that the prop­er re­sponse is to fa­cil­it­ate work­ers mov­ing to new jobs rather than shut­ting off im­ports.

Element 1.5: Transaction Costs Matter

Transaction costs are an obstacle to trade.

Vol­un­tary ex­change pro­motes co­oper­a­tion and helps us get more of what we want. However, trade it­self is costly.
It takes time, ef­fort, and oth­er re­sources to search out po­ten­tial trad­ing part­ners, ne­go­ti­ate trades, and close the sale.
Re­sources spent in this way are called transaction costs,
and they are an obstacle to the cre­ation of wealth. They lim­it both our pro­duct­ive ca­pa­city and the real­iz­a­tion of gains from mu­tu­ally ad­vant­age­ous trades.
Trans­ac­tion costs are some­times high be­cause of phys­ic­al obstacles,
such as oceans, rivers, and moun­tains, which make it dif­fi­cult to get products to cus­tom­ers.
In­vest­ment in roads and im­prove­ments in trans­port­a­tion and com­mu­nic­a­tions can re­duce these trans­ac­tion costs.
In oth­er in­stances, trans­ac­tion costs may be high be­cause of the lack of in­form­a­tion.
For ex­ample, you may want to buy a used copy of the eco­nom­ics book as­signed for a class,
but you don’t know who has a copy and is will­ing to sell it at an at­tract­ive price.
You need to track down someone will­ing to sell a used copy: the time and en­ergy you spend do­ing so is part of your trans­ac­tion costs.
In still oth­er cases, trans­ac­tion costs are high be­cause of reg­u­lat­ory obstacles,
such as taxes, li­cens­ing re­quire­ments, government regulations, price con­trols, tariffs, or import quotas.
Re­gard­less of wheth­er the road­b­locks are phys­ic­al, in­form­a­tion­al, or polit­ic­al,
high trans­ac­tion costs re­duce the po­ten­tial gains from trade.
People who help oth­ers ar­range trades and make bet­ter choices re­duce trans­ac­tion costs and pro­mote eco­nom­ic pro­gress.
Such spe­cial­ists, some­times called middlemen, in­clude cam­pus book­stores,
real es­tate agents, stockbrokers, auto­mobile deal­ers, and a wide vari­ety of merchants.
Many be­lieve that middle­men merely in­crease the price of goods and ser­vices without provid­ing be­ne­fits.
If this were true, people would not use their ser­vices.
Trans­ac­tion costs are an obstacle to trade, and middle­men re­duce these costs. This is why people value their ser­vices.
The gro­cer, for ex­ample, is a middle­man. (Of course, today’s gi­ant su­per­mar­ket re­flects the ac­tions of many people,
but to­geth­er their ser­vices are those of a middle­man.)
Think of the time and ef­fort that would be in­volved in pre­par­ing even a single meal
if shop­pers had to deal dir­ectly with farm­ers when pur­chas­ing ve­get­ables, cit­rus grow­ers when buy­ing fruit, dairy op­er­at­ors if they wanted milk or cheese,
and ranch­ers or fish­er­men if they wanted to serve beef or fish.
Gro­cers make these con­tacts for con­sumers, place the items in a con­veni­ent selling loc­a­tion, and main­tain re­li­able in­vent­or­ies.
With prop­erly func­tion­ing mar­kets, the ser­vices of gro­cers and oth­er middle­men re­duce trans­ac­tion costs sig­ni­fic­antly,
mak­ing it easi­er for po­ten­tial buy­ers and sellers to real­ize gains from trade.
These ser­vices in­crease the volume of trade and pro­mote eco­nom­ic pro­gress.
Later, we will dis­cuss how im­per­fect mar­kets may arise,
such as when gov­ern­ment or tech­no­logy gives a mono­poly priv­ilege to an in­di­vidu­al or firm.
The dangers of a single, or monopoly, sup­pli­er are es­pe­cially evid­ent in the case of vi­tal nat­ur­al re­sources such as when one coun­try is the only source for an­oth­er’s nat­ur­al gas or oil.
In re­cent years, tech­no­logy has re­duced the trans­ac­tion costs of nu­mer­ous ex­changes.
With just a few swipes on a touch screen, buy­ers can now ac­quire in­form­a­tion about po­ten­tial sellers of al­most every product.
Apps are routinely used to shop for movies, cloth­ing, and house­hold goods,
loc­ate a hotel room, ob­tain tick­ets for a ma­jor con­cert or big foot­ball game, and even hail a taxi.
These re­duc­tions in trans­ac­tion costs have in­creased the volume of trade and en­hanced our liv­ing stand­ards.

Element 1.6: Prices Create Balance

Prices bring the choices of buyers and sellers into balance.

Mar­ket prices will in­flu­ence the choices of both buy­ers and sellers.
When a rise in the price of a good makes it more ex­pens­ive for buy­ers to pur­chase it, they will nor­mally choose to buy few­er units.
Thus, there is a neg­at­ive re­la­tion­ship between the price of a good or ser­vice and the quant­ity de­man­ded.
This neg­at­ive re­la­tion­ship is known as the law of demand.
For sellers, the rise in the price of that product brings ex­tra rev­en­ue that makes them will­ing to sup­ply more of it.
Thus, there is a pos­it­ive re­la­tion­ship between the price of a good and the quant­ity pro­du­cers will sup­ply.
This pos­it­ive re­la­tion­ship is known as the law of supply.
The law of de­mand is so uni­ver­sal that eco­nom­ists have been search­ing un­suc­cess­fully for dec­ades to find a mean­ing­ful ex­cep­tion.
However, it is help­ful to re­mem­ber that, while the law of sup­ply is true most of the time, there are ex­cep­tions.
For ex­ample, a col­lege stu­dent works (sup­ply­ing labor) to pay her tu­ition. Now ima­gine that her wage (the price of selling her labor) rises.
If that en­ables her to pay for her uni­versity costs with few­er hours of work, she might choose to cut back on the amount of labor she sup­plies so that she has more time to study.
Eco­nom­ists of­ten use graph­ics to il­lus­trate the re­la­tion­ships among price, quant­ity de­man­ded, and quant­ity sup­plied.
When do­ing so, the price of a good is placed on the ver­tic­al y-axis
and the quant­ity per unit of time (for ex­ample, a week, a month, or year) on the ho­ri­zont­al x-axis.
Us­ing ice cream as an ex­ample and the Geor­gi­an Lari (GEL) as the cur­rency,
Ex­hib­it 2 il­lus­trates the clas­sic de­mand and sup­ply graph­ic. The de­mand curve in­dic­ates the vari­ous quant­it­ies of ice cream con­sumers will pur­chase at al­tern­at­ive prices.
Note how the de­mand curve slopes down­ward to the right, in­dic­at­ing that con­sumers will pur­chase more ice cream as its price de­clines.
This is merely a graph­ic rep­res­ent­a­tion of the law of de­mand.
The sup­ply curve in­dic­ates the vari­ous quant­it­ies of ice cream pro­du­cers are will­ing to sup­ply at al­tern­at­ive prices.
As Ex­hib­it 2 il­lus­trates, it slopes up­ward to the right, in­dic­at­ing
that pro­du­cers will be will­ing to sup­ply lar­ger quant­it­ies at high­er prices.
The sup­ply curve provides a graph­ic rep­res­ent­a­tion of the law of sup­ply.
Ex­hib­it 2: De­mand, Sup­ply, and Equi­lib­ri­um Price
A clas­sic de­mand and sup­ply graph il­lus­trat­ing the quant­ity of ice cream which con­sumers are will­ing to buy and pro­du­cers will­ing to sup­ply at a cer­tain price. The price is dis­played on the ver­tic­al y axis and the quant­ity is dis­played on the ho­ri­zont­al x axis. The equi­lib­ri­um price, which is where the sup­ply and de­mand curves meet, is at 5 Geor­gi­an Lev per liter of ice cream. In oth­er words, at a price of 5 Geor­gi­an Lev per liter, the quant­ity of ice cream which con­sumers are will­ing to pur­chase is equal to the quant­ity which pro­du­cers are will­ing to sup­ply.
Now for a really im­port­ant point: The price will tend to move to­ward a level, GEL 5 per liter of ice cream in our ex­ample,
that will bring the quant­ity de­man­ded into equal­ity with the quant­ity sup­plied.
At the equilibrium price of GEL 5, Geor­gi­an con­sumers will want to pur­chase 15 thou­sand liters of ice cream per day,
the same quant­ity that ice cream pro­du­cers are will­ing to sup­ply.
Price co­ordin­ates the choices of both con­sumers and pro­du­cers of ice cream and brings them into bal­ance.
If the price is high­er than GEL 5—for ex­ample, GEL 7.5—pro­du­cers will want to sup­ply more ice cream than con­sumers will want to pur­chase.
At the GEL 7.5 price, pro­du­cers will be un­able to sell as many units as they would like.
In­vent­or­ies will rise and this ex­cess sup­ply will lead some pro­du­cers to cut their price to re­duce their ex­cess in­vent­or­ies.
The price will tend to de­cline un­til the GEL 5 equi­lib­ri­um price is reached.
It is easy to see, then, that if the price is above the equi­lib­ri­um, mar­ket forces will push the price down to­ward equi­lib­ri­um.
Cor­res­pond­ingly, if the price of ice cream is less than GEL 5—for ex­ample, GEL 2.5—
con­sumers will want to pur­chase a lar­ger quant­ity than pro­du­cers are will­ing to sup­ply.
This gen­er­ates ex­cess de­mand and will place up­ward pres­sure on price and it will tend to move back to­ward the equi­lib­ri­um of GEL 5.
The choices of buy­ers and sellers will be con­sist­ent with each oth­er only at the equi­lib­ri­um price and the mar­ket price will grav­it­ate to­ward this level.
The auc­tion sys­tem on eBay il­lus­trates the op­er­a­tion of de­mand and sup­ply in a set­ting that is fa­mil­i­ar to many.
On eBay, sellers enter their re­serve prices—the min­im­um prices they will ac­cept for goods;
buy­ers enter their max­im­um bids—the max­im­um prices they are will­ing to pay.
The auc­tion man­age­ment sys­tem will bid on be­half of the buy­ers in pre­de­ter­mined mon­et­ary in­cre­ments.
Bid­ding en­sues un­til the trad­ing peri­od ex­pires or a per­son agrees to pay the stated “Buy it Now” price.
Ex­change oc­curs only when buy­ers bid a price great­er than the seller’s min­im­um ask­ing price.
But when this hap­pens, an ex­change will oc­cur and both the buy­er and seller will gain.
Though some­what less vis­ible than the eBay elec­tron­ic mar­ket, the forces of de­mand and sup­ply in oth­er markets work sim­il­arly.
The height of the de­mand curve in­dic­ates the max­im­um amount the con­sumer is will­ing to pay for an­oth­er unit of the good,
while the height of the sup­ply curve shows the min­im­um price at which pro­du­cers are will­ing to sup­ply an­oth­er unit.
As long as the price is between the max­im­um the con­sumer is will­ing to pay and the min­im­um of­fer price of a seller, po­ten­tial gains from trade are present.
Moreover, when the equi­lib­ri­um price is present, all po­ten­tial gains from ex­change will be real­ized.
Thus, con­sumers will tend to pur­chase only units that they value more than the ac­tu­al price.
Sim­il­arly, pro­du­cers will sup­ply only units that can be pro­duced at a cost less than that price.
When the equi­lib­ri­um price is present, units will be pro­duced and pur­chased as long as the value of the good to con­sumers ex­ceeds the cost of the re­sources re­quired for its pro­duc­tion.
The im­plic­a­tion: Mar­ket prices not only bring the quant­ity de­man­ded and quant­ity sup­plied into bal­ance,
but they also dir­ect pro­du­cers to sup­ply those goods that con­sumers value more than their cost of pro­duc­tion. This holds true in any mar­ket.
Of course, we live in a dy­nam­ic world. Through time, changes will oc­cur that will al­ter the de­mand and sup­ply of goods and ser­vices.
Factors such as con­sumer in­come, prices of re­lated goods, the ex­pect­a­tion of a fu­ture price in­crease, and the num­ber of con­sumers in the mar­ket area will in­flu­ence the mar­ket de­mand for a good.
Changes in any of these factors will al­ter the amount of a good con­sumers will want to pur­chase at al­tern­at­ive prices.
Put an­oth­er way, changes in these factors will cause a change in de­mand, a shift in the en­tire de­mand curve.
It is im­port­ant to dis­tin­guish between a change in de­mand—a shift in the en­tire de­mand curve,
and a change in quant­ity de­man­ded—a move­ment along a de­mand curve as the res­ult of a change in the price of the good.
(Im­port­ant note to stu­dents: Fail­ure to dis­tin­guish between a change in de­mand and a change in quant­ity de­man­ded is one of the most com­mon er­rors in all of eco­nom­ics.
Moreover, ques­tions on this top­ic are fa­vor­ites of many eco­nom­ics in­struct­ors. Wise stu­dents will take this note ser­i­ously.)
Ex­hib­it 3 il­lus­trates the im­pact of an in­crease in de­mand on the mar­ket price of a good.
Sup­pose there is an in­crease in con­sumers’ in­come or a rise in the price of frozen yogurt, a com­mon sub­sti­tute for ice cream.
These changes will in­crease the de­mand for ice cream at all prices, caus­ing the de­mand curve to shift to the right from D1 to D2.
In turn, the stronger de­mand will push the equi­lib­ri­um price of ice cream up­ward from GEL 5 to GEL 7.
At the new high­er equi­lib­ri­um price, the quant­ity de­man­ded by con­sumers will once again be brought into bal­ance with the quant­ity sup­plied by pro­du­cers.
Note, the in­crease in de­mand (shift in the en­tire de­mand curve)
will res­ult in an in­crease in the quant­ity sup­plied from 15 thou­sand to 20 thou­sand, a move­ment along the ex­ist­ing sup­ply curve.
A re­duc­tion in con­sumer in­come or lower frozen yogurt prices would ex­ert the op­pos­ite im­pact.
These changes would re­duce the de­mand for ice cream (shift the de­mand curve to the left), lower the price, and re­duce the equi­lib­ri­um quant­ity ex­changed.
Ex­hib­it 3: An In­crease in De­mand Leads to a High­er Price
A clas­sic de­mand and sup­ply graph il­lus­trat­ing the im­pact of in­creased de­mand on product price. The price is dis­played on the ver­tic­al y axis and the quant­ity of units on the ho­ri­zont­al x axis. In­creased de­mand leads to an in­crease in prices and in the quant­ity sup­plied; the new equi­lib­ri­um moves right and up­ward, cor­res­pond­ing with a high­er price and a high­er quant­ity traded.
Now let’s turn to the sup­ply side of a mar­ket.
Changes in factors that al­ter the per-unit cost of sup­ply­ing a good will cause the en­tire sup­ply curve to shift.
Changes that lower per-unit costs (for ex­ample, an im­prove­ment in tech­no­logy or lower prices for the re­sources used to pro­duce the good)
will in­crease sup­ply, caus­ing the en­tire sup­ply curve to shift to the right.
In con­trast, changes that make it more ex­pens­ive to pro­duce the good
such as high­er prices for the re­quired in­gredi­ents or high­er taxes im­posed on the pro­du­cers will re­duce sup­ply, caus­ing the sup­ply curve to shift to the left.
Sup­pose there is a re­duc­tion in the prices of cream and milk, in­gredi­ents used to pro­duce ice cream.
What im­pact will these re­source price re­duc­tions have on the sup­ply and mar­ket price of ice cream?
If your an­swer is that sup­ply will in­crease and the mar­ket price de­cline, you are cor­rect.
Ex­hib­it 4 il­lus­trates this point with­in the de­mand and sup­ply frame­work.
The lower prices of cream and milk will re­duce the per-unit cost of pro­du­cing ice cream,
caus­ing the sup­ply curve to shift to the right (from S1 to S2).
As a res­ult, the equi­lib­ri­um price of ice cream will de­cline from GEL 5 to GEL 3.
At the new lower price, the quant­ity de­man­ded will in­crease and once again equal the quant­ity sup­plied at 20 thou­sand liters per day.
Note: The in­crease in sup­ply (the shift of the en­tire curve)
lowered the price of ice cream and in­creased the quant­ity de­man­ded—a move­ment along the ex­ist­ing de­mand curve.
If changes oc­curred that in­creased the cost of pro­du­cing ice cream (for ex­ample,
high­er prices for the in­gredi­ents), the res­ults would be just the op­pos­ite:
a de­crease in sup­ply (shift to the left), in­crease in the price of ice cream, and a re­duc­tion in the quant­ity ex­changed.
Ex­hib­it 4: An In­crease in Sup­ply Leads to a Lower Price
A clas­sic de­mand and sup­ply graph il­lus­trat­ing the im­pact of an in­creased sup­ply on product prices. The price is dis­played on the ver­tic­al y axis and the quant­ity of units on the ho­ri­zont­al x axis. Lower per unit costs will shift the sup­ply curve to the right, in­creas­ing the quant­ity sup­plied and re­du­cing prices; the equi­lib­ri­um point moves right and down­ward, cor­res­pond­ing with a lower price and a high­er quant­ity traded.
Mar­ket ad­just­ments like the ones out­lined here will not take place in­stant­an­eously.
It will take time for both con­sumers and pro­du­cers to ad­just to the new con­di­tions.
In fact, in a dy­nam­ic world, the ad­just­ment pro­cess is con­tinu­ous.
The im­pact of changes in de­mand and sup­ply, and factors
that un­der­lie shifts in these curves, are cent­ral to the un­der­stand­ing of the mar­ket pro­cess.
De­mand and sup­ply ana­lys­is will be util­ized again and again throughout this book.

Element 1.7: Profits Are a Guide to Productivity

Profits direct businesses toward productive activities that increase the value of resources, while losses direct them away from wasteful activities that reduce resource value.

Busi­nesses pur­chase nat­ur­al re­sources, labor, cap­it­al, and en­tre­pren­eur­i­al tal­ent.
These productive resources are then trans­formed into goods
and ser­vices that are sold to con­sumers.
In a market economy, pro­du­cers will have to bid re­sources away from their al­tern­at­ive uses
be­cause the own­ers of the re­sources will sup­ply them only at prices at least equal to what they could earn else­where.
The pro­du­cer’s op­por­tun­ity cost of sup­ply­ing a good or ser­vice will equal the pay­ments re­quired to bid the re­sources away from their oth­er po­ten­tial uses.
There is an im­port­ant dif­fer­ence between the op­por­tun­ity cost of pro­duc­tion and stand­ard ac­count­ing meas­ures of cost.
Ac­count­ants fo­cus on the cal­cu­la­tion of the firm’s net in­come,
which is slightly dif­fer­ent than eco­nom­ic profit.
The net in­come cal­cu­la­tion omits the op­por­tun­ity cost of as­sets owned by the firm.
While ac­count­ants omit this op­por­tun­ity cost, eco­nom­ists do not.(6)
As a res­ult, the firm’s net in­come will over­state profit, as meas­ured by the eco­nom­ist.
Eco­nom­ists con­sider the fact that the as­sets owned by the firm could be used some oth­er way.
Un­less these op­por­tun­ity costs are covered, the re­sources will even­tu­ally be used in oth­er ways.
A firm’s profit can be de­term­ined in the fol­low­ing man­ner:
Profit = Total Rev­en­ue − Total Cost
The firm’s total rev­en­ue is simply the sales price of all goods sold (P) times the quant­ity (Q) of all goods sold.
In or­der to earn a profit, a firm must gen­er­ate more rev­en­ue from the sale of its product than the op­por­tun­ity cost of the re­sources re­quired to make the good.
Thus, a firm will earn a profit only if it is able to pro­duce a good or ser­vice
that con­sumers value more than the cost of the re­sources re­quired for their pro­duc­tion.
Con­sumers will not pur­chase a good un­less they value it as much, or more, than the price.
If con­sumers are will­ing to pay more than the pro­duc­tion costs,
then the de­cision by the pro­du­cer to bid the re­sources away from their al­tern­at­ive uses will have been a prof­it­able one.
Profit is a re­ward for trans­form­ing re­sources into something of great­er value.
Busi­ness de­cision-makers will seek to un­der­take pro­duc­tion of goods and ser­vices that will gen­er­ate profit.
However, things do not al­ways turn out as ex­pec­ted. Some­times busi­ness firms are un­able to sell their products at prices that will cov­er their costs.
Losses oc­cur when the total rev­en­ue from sales is less than the op­por­tun­ity cost of the re­sources used to pro­duce a good or ser­vice.
Losses are a pen­alty im­posed on busi­nesses that pro­duce goods and ser­vices that con­sumers value less than the re­sources re­quired for their pro­duc­tion.
The losses in­dic­ate that the re­sources would have been bet­ter used pro­du­cing oth­er things.
Sup­pose, in Bul­garia (where the cur­rency is the Bul­gari­an Lev,
BGN), it costs a shirt man­u­fac­turer BGN 20,000 per month to lease a build­ing, rent the re­quired ma­chines, and pur­chase the labor, cloth,
but­tons, and oth­er ma­ter­i­als ne­ces­sary to pro­duce and mar­ket one thou­sand shirts per month.
If the man­u­fac­turer sells the one thou­sand shirts for BGN 22 each, he re­ceives BGN 22,000 in monthly rev­en­ue, or BGN 2,000 in profit.
The shirt man­u­fac­turer has cre­ated wealth—for him­self and for the con­sumer.
By their will­ing­ness to pay more than the costs of pro­duc­tion,
his cus­tom­ers re­veal that they value the shirts more than they value the re­sources re­quired for their pro­duc­tion.
The man­u­fac­turer’s profit is a re­ward for in­creas­ing the value of re­sources by con­vert­ing them into the more highly val­ued product.
On the oth­er hand, if the de­mand for shirts de­clines and they can be sold for only BGN 17 each,
then the man­u­fac­turer will earn BGN 17,000, los­ing BGN 3,000 a month.
This loss oc­curs be­cause the man­u­fac­turer’s ac­tions re­duced the value of the re­sources used.
The shirts—the fi­nal product—were worth less to con­sumers than the value of oth­er things that could have been pro­duced with the re­sources.
We are not say­ing that con­sumers con­sciously know that the re­sources used to make the shirts would have been more valu­able if con­ver­ted into some oth­er product.
But their com­bined choices provide this in­form­a­tion to the man­u­fac­turer, along with the in­cent­ive to take steps to re­duce the loss.
In a mar­ket eco­nomy, losses and busi­ness fail­ures work con­stantly to bring in­ef­fi­cient activ­it­ies—
such as pro­du­cing shirts that sell for less than their cost—to a halt.
Losses and busi­ness fail­ures will re­dir­ect the re­sources to­ward the pro­duc­tion of oth­er goods that are val­ued more highly.
Thus, even though busi­ness fail­ures are of­ten pain­ful for the own­ers, in­vestors, and em­ploy­ees in­volved, there is a pos­it­ive side:
They re­lease re­sources that can be dir­ec­ted to­ward wealth-cre­at­ing pro­jects.
The people of a na­tion will be bet­ter off if their re­sources—their land,
build­ings, labor, and en­tre­pren­eur­i­al tal­ent—pro­duce valu­able goods and ser­vices.
At any giv­en time a vir­tu­ally un­lim­ited num­ber of po­ten­tial in­vest­ment pro­jects are avail­able to be un­der­taken.
Some of these in­vest­ments will in­crease the value of re­sources by trans­form­ing them into goods and ser­vices
that con­sumers value highly re­l­at­ive to cost.
These will pro­mote eco­nom­ic pro­gress. Oth­er in­vest­ments will re­duce the value of re­sources and re­duce eco­nom­ic pro­gress.
If we are go­ing to get the most out of the avail­able re­sources,
pro­jects that in­crease value must be en­cour­aged, while those that use re­sources less pro­duct­ively must be dis­cour­aged.
This is pre­cisely what profits and losses do.
We live in a world of chan­ging tastes and tech­no­logy, im­per­fect know­ledge, and un­cer­tainty.
Busi­ness own­ers can­not be sure what the fu­ture mar­ket prices will be or what the fu­ture costs of pro­duc­tion will be.
Their de­cisions are based on ex­pect­a­tions. But the re­ward-pen­alty struc­ture of a mar­ket eco­nomy is clear.
Entrepreneurs who pro­duce ef­fi­ciently and who an­ti­cip­ate cor­rectly
the goods and ser­vices that at­tract con­sumers at prices above pro­duc­tion cost will prosper.
In con­trast, busi­ness ex­ec­ut­ives who al­loc­ate re­sources in­ef­fi­ciently into areas where de­mand is weak will be pen­al­ized with losses and fin­an­cial dif­fi­culties.
While some cri­ti­cize the busi­ness fail­ures that ac­com­pany the mar­ket pro­cess,
this re­ward-pen­alty sys­tem un­der­lies the prosper­ity that mar­kets provide.
In­ter­est­ingly, many of the en­tre­pren­eurs who ini­tially failed, even­tu­ally suc­ceed in a big way. Steve Jobs provides an ex­ample.
After leav­ing Apple in 1985, Jobs foun­ded neXT, a firm that he thought
would pro­duce the next gen­er­a­tion of per­son­al com­puters.
The com­pany struggled. But, Jobs learned from the ex­per­i­ence.
He re­turned to Apple in 1997 and soon in­tro­duced the iPhone,
the iPad, and oth­er in­nov­at­ive products that suc­ceeded spec­tac­u­larly in the mar­ket­place.
The bot­tom line is straight­for­ward: Profits dir­ect busi­ness in­vest­ment to­ward pro­duct­ive pro­jects
that pro­mote eco­nom­ic pro­gress, while losses chan­nel re­sources away from pro­jects that are coun­ter­pro­duct­ive.
This is a vi­tally im­port­ant func­tion. Eco­nom­ies that fail to per­form this func­tion well will al­most surely ex­per­i­ence stagnation, or worse.

Element 1.8: Incomes Come From Usefulness

People earn income by providing others with things they value.

People dif­fer in many ways—in their pro­duct­ive abil­it­ies, pref­er­ences, spe­cial­ized skills, at­ti­tudes, and will­ing­ness to take risks.
These dif­fer­ences in­flu­ence people’s in­comes be­cause they af­fect the value of the goods and ser­vices that in­di­vidu­als are will­ing and able to provide to oth­ers.
In a mar­ket eco­nomy, most people who earn high in­comes do so be­cause they provide oth­ers with things they value more than their cost.
If these in­di­vidu­als did not provide valu­able goods or ser­vices, firms (and in­dir­ectly con­sumers) would not pay them so gen­er­ously.
There is a mor­al here: If you want to earn a high in­come, you had bet­ter fig­ure out how to do something that helps oth­ers a great deal.
On the oth­er hand, if you are un­able or un­will­ing to help oth­ers in ways they value, your in­come will be low.
This dir­ect link between help­ing oth­ers and re­ceiv­ing in­come gives each of us a strong in­cent­ive to ac­quire skills,
de­vel­op tal­ents, and cul­tiv­ate habits that will help us provide oth­ers with valu­able goods and ser­vices.
Col­lege stu­dents study for long hours, en­dure stress, and in­cur the fin­an­cial cost of school­ing in or­der to be­come doc­tors, teach­ers, ac­count­ants, and en­gin­eers.
Oth­er people ac­quire train­ing, cer­ti­fic­a­tion, and ex­per­i­ence
that will help them be­come elec­tri­cians, main­ten­ance work­ers, or web­site de­sign­ers.
Still oth­ers in­vest and start busi­nesses. Why do people do these things?
In some cases in­di­vidu­als may be mo­tiv­ated by a strong per­son­al de­sire to im­prove the world.
However—and this is the key point—even people who don’t care about im­prov­ing the world, who are mo­tiv­ated mostly by the de­sire for in­come,
will have a strong in­cent­ive to de­vel­op skills and take ac­tions that are valu­able to oth­ers.
High earn­ings come from provid­ing goods and ser­vices that oth­ers value.
People seek­ing great wealth will have a strong in­cent­ive to pay close at­ten­tion to what oth­ers want.
And even those people who want to im­prove the world need in­form­a­tion on the edu­ca­tion and skills they can ac­quire, which will do the most to make the world a bet­ter place for oth­ers.
This in­form­a­tion is gen­er­ally provided by the earn­ing op­por­tun­it­ies in dif­fer­ent oc­cu­pa­tions.
Some people think that high-in­come in­di­vidu­als must be ex­ploit­ing oth­ers.
But people who earn high in­comes in a well-func­tion­ing mar­ket­place
gen­er­ally do so by provid­ing oth­ers with things they value and for which they are will­ing to pay.
Larry Page and Sergey Brin be­came bil­lion­aires be­cause users found Google bet­ter served their needs than Ya­hoo! or Ask Jeeves.
Pop­u­lar sing­ers provide an­oth­er ex­ample. Bey­on­cé and Taylor Swift each have huge earn­ings be­cause mil­lions en­joy their mu­sic.
The role of a so­ci­ety is to en­sure that the “rules” of the game are fair, not to pre­vent some from win­ning by a large mar­gin be­cause they are good at the game.
Prob­lems arise when early movers lock in tech­no­lo­gies that may even­tu­ally be­come out­dated but hard to re­place.
This trade-off leads to a great deal of pub­lic policy dis­cus­sion that is of­ten more a func­tion of polit­ic­al opin­ion than sound eco­nom­ic ana­lys­is.
Busi­ness en­tre­pren­eurs who suc­ceed in a big way do so by mak­ing products that mil­lions of con­sumers find at­tract­ive.
The late Sam Walton, who foun­ded Wal­mart, be­came one of the richest men in the United States be­cause he figured out
how to man­age large in­vent­or­ies ef­fect­ively and sell brand-name mer­chand­ise at dis­count prices to small-town Amer­ica.
Bill Gates and Paul Al­len, cofounders of Mi­crosoft, be­came bil­lion­aires by de­vel­op­ing a set of products
that dra­mat­ic­ally im­proved the ef­fi­ciency and com­pat­ib­il­ity of desktop com­puters.
Mil­lions of con­sumers who nev­er heard of Walton, Gates, or Al­len be­nefited from their tal­ents and products.
These men made a lot of money be­cause they helped a lot of people.
Such ex­amples of “good cap­it­al­ists” can also be found throughout trans­ition eco­nom­ies.
Per­haps not as well known as Bill Gates, the Czech Pavel Baudiš built Avast into a ma­jor force in cy­ber­se­cur­ity and a for­tune of many bil­lions of dol­lars.
The Pol­ish mech­an­ic Zbig­niew Sosnowski turned a fail­ing state bi­cycle com­pany into Kross,
a ma­jor European maker pro­du­cing over 1 mil­lion bi­cycles a year.
Google “Talk­ing Tom Cat” and you will find a very pop­u­lar set of chil­dren’s videos de­veloped by a young Slov­e­ni­an couple, Izo and Samo Lo­gin,
and sold to a Chinese buy­er for over a bil­lion dol­lars.

Element 1.9: Value Creates Income and Wealth

Production of goods and services people value, not just jobs, provides the source of high living standards.

Con­sump­tion is the sole end and pur­pose of all pro­duc­tion;
and the in­terest of the pro­du­cer ought to be at­ten­ded to, only so far as it may be ne­ces­sary for pro­mot­ing that of the con­sumer.
Adam Smith, An In­quiry into the Nature and Causes of the Wealth of Na­tions, Volume II Glas­gow Edi­tion (In­di­ana­pol­is: Liberty Fund, Inc., [1776] 1981): 660. Also avail­able at: http://www.econlib.org/library/Smith/smWN.html
As Adam Smith noted more than 240 years ago, con­sump­tion is the ob­ject­ive of all pro­duc­tion. But, con­sump­tion comes be­fore pro­duc­tion only in the dic­tion­ary.
In­come and liv­ing stand­ards can­not in­crease without an in­crease in the pro­duc­tion of goods and ser­vices that people value.
Clearly, des­troy­ing com­monly traded goods that people value will make a so­ci­ety worse off.
This pro­pos­i­tion is so in­tu­it­ively ob­vi­ous that it al­most seems silly to high­light it.
But policies based on the fal­la­cious idea that des­troy­ing goods will be­ne­fit so­ci­ety have some­times been ad­op­ted.
In 1933, the United States Con­gress passed the Ag­ri­cul­tur­al Ad­just­ment Act (AAA) in an ef­fort to re­duce sup­ply and thus pre­vent the prices of ag­ri­cul­tur­al products from fall­ing.
Un­der this New Deal le­gis­la­tion, the fed­er­al gov­ern­ment paid farm­ers to plow un­der por­tions of their cot­ton, corn, wheat, and oth­er crops.
Potato farm­ers were paid to spray their pota­toes with dye so they would be un­fit for hu­man con­sump­tion.
Healthy cattle, sheep, and pigs were slaughtered and bur­ied in mass graves in or­der to keep them off the mar­ket.
Six mil­lion baby pigs were killed un­der the AAA in 1933 alone.
The Su­preme Court de­clared the act un­con­sti­tu­tion­al in 1936,
but not be­fore it had kept mil­lions of valu­able ag­ri­cul­tur­al products from Amer­ic­an con­sumers.
Moreover, un­der mod­i­fied forms of the Act,
even today the United States gov­ern­ment con­tin­ues to pay vari­ous farm­ers to lim­it their pro­duc­tion.
While the polit­ic­al de­mands of those be­ne­fit­ing from the policies are un­der­stand­able,
such pro­grams des­troy valu­able re­sources, mak­ing the na­tion poorer.
The United States is not alone in re­spond­ing to polit­ic­al pres­sure to “sup­port” farm­ers at an enorm­ous cost to tax­pay­ers and con­sumers.
The European Uni­on’s “Com­mon Ag­ri­cul­tur­al Policy” is one of the largest and most con­tro­ver­sial parts of the E.U.’s budget.
Farm­ing is not the only in­dustry tar­geted, either. In the United States, the 2009 “Cash for Clunkers”
pro­gram provides an­oth­er ex­ample of politi­cians at­tempt­ing to pro­mote prosper­ity
by des­troy­ing pro­duct­ive as­sets—used cars in this case.
Un­der the Cash for Clunkers pro­gram, car deal­ers were paid between $3,500 and $4,500
to des­troy the older cars that were traded in for a new auto­mobile.
Deal­ers were re­quired to ruin the car en­gines with a so­di­um silic­ate solu­tion, then smash them and send them to the junk­yard,
as­sur­ing that not even the parts would be avail­able for fu­ture use.
The pro­ponents of this pro­gram ar­gued that it would stim­u­late re­cov­ery by in­du­cing people to buy new cars.
But the new cars cost more than used ones, and the price of used ones in­creased be­cause of the de­cline in sup­ply.
As a res­ult, con­sumers spent more on auto­mo­biles
(both new and used) and there­fore less was avail­able for spend­ing on oth­er items.
Thus, the Cash for Clunkers pro­gram failed to stim­u­late total de­mand.
In es­sence, tax­pay­ers provided $3 bil­lion in sub­sidies for new car pur­chases,
while des­troy­ing ap­prox­im­ately 700,000 used cars val­ued at about $2 bil­lion.
Those who could af­ford new cars were sub­sid­ized, while poor people who de­pend on used cars were pun­ished.
And new car sales plunged when the pro­gram ex­pired.
Ger­many in­tro­duced its own scrap­page pro­gram, which has been es­tim­ated to cost tax­pay­ers over $7 bil­lion,
more than twice as much as in the United States.
Sim­il­ar pro­grams ex­is­ted in many East European coun­tries, in­clud­ing Rus­sia and Slov­akia.
In Ro­mania un­der the pro­gram called “Rabla” (the wreck) over 525,000 cars, eight years or more in age, were scrapped for vouch­ers worth up to €1,500.
The pro­gram op­er­ated between 2005 and 2015, and an in­di­vidu­al could turn in up to three older cars for vouch­ers to be ap­plied to­wards new cars.
If des­troy­ing auto­mo­biles is a good idea, why not re­quire own­ers to des­troy their auto­mobile every year?
Think of all of the new-car sales this would gen­er­ate. All of this is un­sound eco­nom­ics.
You may be able to help spe­cif­ic pro­du­cers by in­creas­ing the scarcity of their products, but you can­not make the gen­er­al popu­lace bet­ter off by des­troy­ing mar­ket­able goods with con­sump­tion value.
A more subtle form of de­struc­tion in­volves gov­ern­ment ac­tions that in­crease the op­por­tun­ity cost of ob­tain­ing vari­ous goods.
Coun­tries world­wide spend $30 bil­lion a year on fish­er­ies sub­sidies,
60% of which dir­ectly en­cour­ages un­sus­tain­able, de­struct­ive, or even il­leg­al prac­tices.
The res­ult­ing mar­ket dis­tor­tion is a ma­jor factor be­hind the chron­ic mis­man­age­ment of the world’s fish­er­ies,
which the World Bank cal­cu­lates to have cost the glob­al eco­nomy $83 bil­lion in 2012.
Fur­ther­more, rich eco­nom­ies (in par­tic­u­lar Ja­pan, the United States, France, and Spain),
along with China and South Korea, ac­count for 70% of glob­al fish­er­ies sub­sidies.
These trans­fers leave thou­sands of fish­ing-de­pend­ent com­munit­ies strug­gling to com­pete with sub­sid­ized rivals
and threaten the food se­cur­ity of mil­lions of people as in­dus­tri­al fleets from dis­tant lands de­plete their ocean­ic stocks.
West Africa, where fish­ing can be a mat­ter of life and death for the loc­al people, is be­ing par­tic­u­larly hard hit.
Since the 1990s, when for­eign ves­sels, primar­ily from the E.U. and China, began to fish on an in­dus­tri­al scale off its shores,
it has be­come im­possible for many loc­al fish­ers to make a liv­ing or feed their fam­il­ies.
Politi­cians and pro­ponents of gov­ern­ment spend­ing pro­jects are fond of boast­ing about the jobs cre­ated by their spend­ing pro­grams and they ex­ag­ger­ate pro­gram be­ne­fits.
This makes eco­nom­ic lit­er­acy par­tic­u­larly im­port­ant.
While em­ploy­ment is of­ten used as a means to cre­ate wealth, we must re­mem­ber
that it is not simply more jobs that im­prove our eco­nom­ic well-be­ing
but rather jobs that pro­duce goods and ser­vices people value.
When that ele­ment­ary fact is for­got­ten, people are of­ten misled into ac­cept­ance of pro­grams that re­duce wealth rather than cre­ate it.
The fo­cus on ar­ti­fi­cially cre­at­ing jobs can be ex­tremely mis­lead­ing.
The great early French eco­nom­ist Frédéric Basti­at clearly poin­ted out the fal­lacy in his par­able of the broken win­dow from his es­say
“Ce qu’on voit et ce qu’on ne voit pas” (“What is Seen and What is Un­seen,” 1850):
Have you ever wit­nessed the an­ger of the good shop­keep­er, James Good­fel­low, when his care­less son has happened to break a pane of glass?
If you have been present at such a scene, you will most as­suredly bear wit­ness to the fact that every one of the spec­tat­ors, were there even thirty of them,
by com­mon con­sent ap­par­ently, offered the un­for­tu­nate own­er this in­vari­able con­sol­a­tion—
“It is an ill wind that blows nobody good. Every­body must live, and what would be­come of the glazi­ers if panes of glass were nev­er broken?”
Now, this form of con­dol­ence con­tains an en­tire the­ory, which it will be well to show up in this simple case,
see­ing that it is pre­cisely the same as that which, un­hap­pily, reg­u­lates the great­er part of our eco­nom­ic­al in­sti­tu­tions.
Sup­pose it cost six francs to re­pair the dam­age, and you say that the ac­ci­dent brings six francs to the glazi­er’s trade—that it en­cour­ages that trade to the amount of six francs—
I grant it; I have not a word to say against it; you reas­on justly.
The glazi­er comes, per­forms his task, re­ceives his six francs, rubs his hands, and, in his heart, blesses the care­less child. All this is that which is seen.
But if, on the oth­er hand, you come to the con­clu­sion, as is too of­ten the case, that it is a good thing to break win­dows, that it causes money to cir­cu­late, and that the en­cour­age­ment of in­dustry in gen­er­al will be the res­ult of it,
you will ob­lige me to call out, “Stop there! Your the­ory is con­fined to that which is seen; it takes no ac­count of that which is not seen.”
It is not seen that as our shop­keep­er has spent six francs upon one thing, he can­not spend them upon an­oth­er.
It is not seen that if he had not had a win­dow to re­place, he would, per­haps, have re­placed his old shoes, or ad­ded an­oth­er book to his lib­rary.
In short, he would have em­ployed his six francs in some way, which this ac­ci­dent has pre­ven­ted.(7)
Basti­at prop­erly re­fo­cuses our at­ten­tion on wealth rather than pro­duc­tion.
Cre­at­ing de­mand for new pro­duc­tion by des­troy­ing already ex­ist­ing valu­able as­sets is not an ef­fect­ive way to make a so­ci­ety bet­ter off.

Element 1.10: There Are Multiple Sources of Progress

Economic progress comes primarily through trade, investment, better ways of doing things, and sound economic institutions.

On the first day of an in­tro­duct­ory eco­nom­ics class, we of­ten in­form stu­dents that work­ers in de­veloped coun­tries
such as the United States pro­duce and earn ap­prox­im­ately thirty times as much per per­son today as in 1750.
Then we so­li­cit their views on the fol­low­ing ques­tion: “Why are work­ers so much more pro­duct­ive today than two and a half cen­tur­ies ago?”
Think for a mo­ment how you would re­spond to this ques­tion.
In­vari­ably, our stu­dents men­tion three things:
First, today’s sci­entif­ic know­ledge and tech­no­lo­gic­al abil­it­ies are far bey­ond any­thing ima­gined in 1750.
Second, we have com­plex ma­chines and factor­ies, far bet­ter roads, and ex­tens­ive sys­tems of com­mu­nic­a­tions.
Fi­nally, stu­dents usu­ally men­tion that in 1750 in­di­vidu­als and fam­il­ies dir­ectly pro­duced most of the items that they con­sumed,
where­as today we typ­ic­ally pur­chase them from oth­ers.
Ba­sic­ally, the stu­dents provide the cor­rect ex­plan­a­tion even though they have little or no pri­or know­ledge of eco­nom­ics.
They re­cog­nize the im­port­ance of tech­no­logy, cap­it­al (pro­duct­ive as­sets), and trade.
Their re­sponse re­in­forces our view that eco­nom­ics is the “sci­ence of com­mon sense.”
We have already high­lighted gains from trade and the im­port­ance of re­du­cing trans­ac­tion costs as sources of eco­nom­ic pro­gress.
Eco­nom­ic ana­lys­is pin­points three oth­er sources of economic growth:
in­vest­ments in people and pro­duct­ive as­sets, im­prove­ments in tech­no­logy, and im­prove­ments in eco­nom­ic or­gan­iz­a­tion.
First, in­vest­ments in physical capital (such as tools, ma­chines, and build­ings) and human capital
(edu­ca­tion, skills, train­ing, and ex­per­i­ence of work­ers) en­hance our abil­ity to pro­duce goods and ser­vices.
The two kinds of in­vest­ment are linked. Work­ers can pro­duce more if they work with more and bet­ter ma­chines.
A log­ger can pro­duce more when work­ing with a chain­saw rather than a hand-op­er­ated, cross­cut blade.
Sim­il­arly, a trans­port work­er can haul more with a truck than with a mule and wag­on.
Second, im­prove­ments in tech­no­logy (the use of brain power to dis­cov­er new products and less costly meth­ods of pro­duc­tion) spur eco­nom­ic pro­gress.
Since 1750, the steam en­gine, fol­lowed by the in­tern­al com­bus­tion en­gine, elec­tri­city,
and nuc­le­ar power re­placed hu­man and an­im­al power as the ma­jor source of en­ergy.
Auto­mo­biles, buses, trains, and air­planes re­placed the horse and buggy (and walk­ing) as the chief meth­ods of trans­port­a­tion.
Tech­no­lo­gic­al im­prove­ments con­tin­ue to change our life­styles.
Con­sider the im­pact of per­son­al com­puters, mi­crowave ovens, cell phones, stream­ing pro­grams on TV,
heart by-pass sur­gery, hip re­place­ments, auto­mobile air con­di­tion­ers, and even gar­age door open­ers.
The in­tro­duc­tion and de­vel­op­ment of these products dur­ing the last fifty years have vastly changed the way that we work, play, and en­ter­tain ourselves. They have im­proved our well-be­ing.
Third, im­prove­ments in eco­nom­ic or­gan­iz­a­tion can pro­mote growth.
By eco­nom­ic or­gan­iz­a­tion we mean the ways that hu­man activ­it­ies are or­gan­ized and the rules un­der which they op­er­ate—factors of­ten taken for gran­ted or over­looked.
How easy is it for people to en­gage in trade or to or­gan­ize a busi­ness? The leg­al sys­tem of a coun­try, to a large ex­tent,
de­term­ines the level of trade, in­vest­ment, and eco­nom­ic co­oper­a­tion un­der­taken by the res­id­ents of a na­tion.
A leg­al sys­tem that pro­tects in­di­vidu­als and their prop­erty, en­forces con­tracts fairly, and settles dis­putes is an es­sen­tial in­gredi­ent for eco­nom­ic pro­gress.
Without it, in­vest­ment will be lack­ing, trade will be stifled, and the spread of in­nov­at­ive ideas will be im­peded.
Part 2 of this book will ex­am­ine in more de­tail the im­port­ance of the leg­al struc­ture and oth­er ele­ments of eco­nom­ic or­gan­iz­a­tion.
In­vest­ment and im­prove­ments in tech­no­logy do not just hap­pen.
They re­flect the ac­tions of en­tre­pren­eurs, people who take risks in the hope of profit.
No one knows what the next in­nov­at­ive break­through will be or just which pro­duc­tion tech­niques will re­duce costs.
Fur­ther­more, en­tre­pren­eurs are of­ten found in un­ex­pec­ted places.
Thus, eco­nom­ic pro­gress de­pends on a sys­tem that al­lows a very di­verse set of people to test their ideas to see if they are prof­it­able
and, sim­ul­tan­eously, dis­cour­ages them from squan­der­ing re­sources on un­pro­duct­ive pro­jects.
For this pro­gress to oc­cur, mar­kets must be open so that in­di­vidu­als are free to try their in­nov­at­ive ideas.
An en­tre­pren­eur with a new product or tech­no­logy needs to win the sup­port of only enough in­vestors to fin­ance the pro­ject.
But, competition must be pos­sible to hold en­tre­pren­eurs and their in­vestors ac­count­able for the ef­fi­cient al­loc­a­tion of their re­sources:
Their ideas must face the “real­ity check” of con­sumers who will de­cide wheth­er or not to pur­chase a product or ser­vice at a price above the pro­duc­tion cost.
In this en­vir­on­ment, con­sumers are the ul­ti­mate judge and jury.
If they do not value an in­nov­at­ive product or ser­vice enough to cov­er its cost, it will not sur­vive in the mar­ket­place.
The prop­er role of gov­ern­ment is to en­sure that new and bet­ter products have a chance to com­pete,
not to de­cide which products should be favored.

Element 1.11: The Usefulness of the “Invisible Hand”

The “invisible hand” of market prices directs buyers and sellers toward activities that promote the general welfare.

Every in­di­vidu­al is con­tinu­ally ex­ert­ing him­self to find out the most ad­vant­age­ous em­ploy­ment for 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.
He in­tends only his own gain, and he is in this, as in many oth­er cases,
led by an in­vis­ible hand to pro­mote an end which was not part of his in­ten­tion.(8)
Adam Smith (1776)
Self-in­terest is a power­ful mo­tiv­at­or. As Adam Smith noted long ago, when dir­ec­ted by the invisible hand, self-in­ter­ested in­di­vidu­als
will have a strong in­cent­ive to un­der­take ac­tions that pro­mote the gen­er­al prosper­ity of a com­munity or na­tion.
The “in­vis­ible hand” to which Smith refers is the price sys­tem.
The in­di­vidu­al “in­tends only his own gain” but he is dir­ec­ted by the in­vis­ible hand of mar­ket prices to pro­mote the goals of oth­ers, lead­ing to great­er prosper­ity.
The prin­ciple of the “in­vis­ible hand” is dif­fi­cult for many people to grasp.
There is a nat­ur­al tend­ency to per­ceive that or­derly out­comes can only be achieved when someone is in charge or through dir­ec­tions from a cent­ral­ized au­thor­ity.
Yet Adam Smith con­ten­ded that pur­su­ing one’s own ad­vant­age cre­ates an or­derly so­ci­ety
in which de­mands are routinely sat­is­fied without cent­ral­ized plan­ning.
This or­der oc­curs be­cause mar­ket prices co­ordin­ate the ac­tions of self-in­ter­ested in­di­vidu­als when private prop­erty and free­dom of ex­change are present.
One stat­ist­ic—the cur­rent mar­ket price of a par­tic­u­lar good or ser­vice—provides buy­ers and sellers with what they need to bring their ac­tions into har­mony with the best pos­sible in­form­a­tion on the cur­rent ac­tions and pref­er­ences of oth­ers.
Mar­ket prices re­gister the choices of mil­lions of con­sumers, pro­du­cers, and re­source sup­pli­ers.
They re­flect in­form­a­tion about con­sumer pref­er­ences, costs, and mat­ters re­lated to tim­ing, loc­a­tion, and cir­cum­stances—
in­form­a­tion that in any large mar­ket is well bey­ond the com­pre­hen­sion of any in­di­vidu­al or cent­ral-plan­ning au­thor­ity.
Have you ever wondered why the su­per­mar­kets in your com­munity have ap­prox­im­ately the right amount of milk, bread, ve­get­ables, and oth­er goods—
an amount large enough that the goods are nearly al­ways avail­able but not so large that a lot gets spoiled or wasted?
How is it that re­fri­ger­at­ors, auto­mo­biles, and touch screen tab­lets, pro­duced at di­verse places around the world,
are avail­able in your loc­al mar­ket in about the quant­ity that con­sumers de­sire?
Where is the tech­nic­al manu­al for busi­nesses to fol­low to get this done? Of course, there is no manu­al.
The in­vis­ible hand of mar­ket prices provides the an­swer.
It dir­ects self-in­ter­ested in­di­vidu­als into co­oper­at­ive ac­tion
and brings their choices into line with each oth­er through price sig­nal­ing, as de­scribed in Ele­ment 1.6.
The 1974 No­bel Prize re­cip­i­ent Friedrich Hayek called the mar­ket sys­tem a “mar­vel” be­cause just one in­dic­at­or, the mar­ket price of a com­mod­ity,
spon­tan­eously car­ries so much in­form­a­tion that it guides buy­ers and sellers to make de­cisions that help both ob­tain what they want.(9)
The mar­ket price of a product re­flects thou­sands, even mil­lions, of de­cisions made around the world by people who don’t know what the oth­ers are do­ing.
For each product or ser­vice, the mar­ket acts like a gi­ant com­puter net­work grind­ing out an in­dic­at­or
that gives all par­ti­cipants both the in­form­a­tion they need, and the in­cent­ive to act on it.
No in­di­vidu­al or cent­ral-plan­ning au­thor­ity could pos­sibly ob­tain or con­sider all the in­form­a­tion
needed for mil­lions of con­sumers and pro­du­cers of thou­sands of dif­fer­ent goods and ser­vices to co­ordin­ate their ac­tions the way mar­kets do.
Moreover, mar­ket prices con­tain this in­form­a­tion in a dis­tilled form.
They will dir­ect pro­du­cers and re­source sup­pli­ers to­ward pro­duc­tion of those things that con­sumers value most (re­l­at­ive to their costs).
No one will have to force a farm­er to raise apples or tell a con­struc­tion firm to build houses or con­vince a fur­niture man­u­fac­turer to pro­duce chairs.
When the prices of these and oth­er products in­dic­ate that con­sumers value them as much or more than their pro­duc­tion costs, pro­du­cers seek­ing per­son­al gain will sup­ply them.
Nor will it be ne­ces­sary for any­one to re­mind pro­du­cers to search for and util­ize low-cost meth­ods of pro­duc­tion.
Self-in­terest dir­ec­ted by the in­vis­ible hand of mar­ket prices will provide them with an in­cent­ive to seek out the best com­bin­a­tion of re­sources
and the most cost-effective pro­duc­tion meth­ods.
Be­cause lower costs will mean high­er profits, each pro­du­cer will strive to keep costs down and qual­ity up.
In fact, com­pet­i­tion will vir­tu­ally force them to do so.
In a mod­ern eco­nomy, the co­oper­a­tion that comes from self-in­terest dir­ec­ted by the in­vis­ible hand of mar­ket prices is truly amaz­ing.
The next time you sit down to a nice din­ner, think about all the people who helped make it pos­sible.
It is un­likely that any of them—from the farm­er to the truck driver to the gro­cer—was mo­tiv­ated by con­cern that you have an en­joy­able meal at the low­est pos­sible cost.
Mar­ket prices, however, brought their in­terests into har­mony with yours.
Farm­ers who raise the best beef or tur­keys re­ceive high­er prices,
truck drivers and gro­cers earn more money if their products are de­livered fresh and in good con­di­tion to the con­sumer,
and so on, al­ways us­ing the low-cost means to do so.
Lit­er­ally tens of thou­sands of people, most of whom we will nev­er meet, make con­tri­bu­tions that help each of us con­sume a bundle of goods that is far great­er than what we could pro­duce for ourselves.
Moreover, the in­vis­ible hand works so quietly and auto­mat­ic­ally that the or­der, co­oper­a­tion,
and avail­ab­il­ity of a vast ar­ray of goods and ser­vices are largely taken for gran­ted.
Even though un­der­ap­pre­ci­ated, the com­bin­a­tion of self-in­terest and the in­vis­ible hand is non­ethe­less a power­ful force for eco­nom­ic pro­gress.

Element 1.12: Unintended Consequences Create Problems

Too often long-term consequences, or the secondary effects, of an action are ignored.

In 1946, Henry Haz­litt, a fam­ous eco­nom­ic journ­al­ist, wrote a book titled Eco­nom­ics in One Les­son.
This eco­nom­ics primer, which builds on the 1850 es­say by the French­man Frédéric Basti­at (whose work was dis­cussed in Ele­ment 1.9), is per­haps the all-time best­selling treat­ise in eco­nom­ics.
Re­call Basti­at’s story of a young boy who breaks the win­dow of a shop­keep­er by throw­ing a ball through it.
As a res­ult, the shop­keep­er hires a glazi­er to fix the win­dow.
Some ob­serv­ers, not­ing the highly vis­ible em­ploy­ment of the glazer, ar­gue
that the broken win­dow is a good thing be­cause it cre­ated a job for the glazi­er.
However, as Haz­litt stresses, this is wrong be­cause it ig­nores the sec­ond­ary ef­fects.
If the shop­keep­er had not spent money fix­ing the win­dow, he would have spent it on oth­er things,
per­haps a pair of shoes, new clothes, or sim­il­ar items.
If the win­dow had not been broken, em­ploy­ment in these oth­er areas of pro­duc­tion would have been great­er and the com­munity would have had both the win­dow and the items pur­chased by the shop­keep­er.
Once the sec­ond­ary ef­fects are con­sidered, it is clear that de­struc­tion res­ult­ing from floods, hur­ricanes,
and badly de­signed pub­lic policy harm a so­ci­ety and fail to ex­pand net em­ploy­ment.
The view that re­pla­cing de­struc­tion cre­ates em­ploy­ment and is good for the eco­nomy is now known as the “broken win­dow fal­lacy.”
The re­sources used in such re­place­ment must re­duce a so­ci­ety’s abil­ity to pro­duce oth­er valu­able goods or ser­vices.
See Ele­ment 1.9 for sev­er­al ex­amples of this fal­la­cious view.
Haz­litt’s one les­son was that when ana­lyz­ing an eco­nom­ic pro­pos­al, a per­son:
…must trace not merely the im­me­di­ate res­ults but the res­ults in the long run, not merely the primary con­sequences but the sec­ond­ary con­sequences,
and not merely the ef­fects on some spe­cial group but the ef­fects on every­one.(10)
Haz­litt be­lieved that fail­ure to ap­ply this les­son was the most com­mon source of eco­nom­ic er­ror.
He had writ­ten ex­tens­ively on the eco­nomy dur­ing the Great De­pres­sion of the 1930s, and he knew that, es­pe­cially in polit­ics,
there is a tend­ency to stress the short-term be­ne­fits of a policy while ig­nor­ing the longer-term, of­ten un­in­ten­ded, con­sequences.
Let’s con­sider three ex­amples that il­lus­trate the po­ten­tial im­port­ance of sec­ond­ary ef­fects.
In an ef­fort to re­duce air pol­lu­tion from vehicle emis­sions by re­du­cing gas­ol­ine con­sump­tion, the Geor­gi­an gov­ern­ment
de­signed a new ex­cise tax tar­get­ing older auto­mo­biles with big­ger en­gines.
Since Geor­gia is a low-in­come coun­try, de­mand has al­ways been high for older used cars be­cause they are cheap­er
(91% of the cars for sale in used car lots were man­u­fac­tured be­fore 2006).
The new tax, which came into ef­fect in Janu­ary 2017, was a slid­ing scale.
For ex­ample, the cus­toms clear­ance plus ex­cise tax on a 2002 car with a 1.5 liter en­gine was GEL 3731,
but for a car of the same year with a 2.5 liter en­gine it was GEL 6219, and for a 3.5 liter en­gine, GEL 8706.
Al­though the changes in the tax policy clearly in­centiv­ized people to pur­chase cars with small en­gines,
one has to ask, was this reg­u­la­tion a sound policy? What was its full im­pact, in­clud­ing sec­ond­ary ef­fects?
Since the new Geor­gi­an ex­cise tax policy has been in ef­fect for only a short time,
we need to look at the ex­per­i­ence of oth­er coun­tries with sim­il­ar policies aimed at re­du­cing fuel con­sump­tion.
Data re­veals an in­crease in driv­ing since the great­er fuel ef­fi­ciency of light vehicles makes them cheap­er to op­er­ate.
This, in turn, in­creases con­ges­tion and res­ults in a smal­ler re­duc­tion in gas­ol­ine con­sump­tion than was in­ten­ded by the reg­u­la­tion.
Fur­ther­more, in the case of ac­ci­dents, the light­er cars, in­duced by the need to meet stand­ards,
do not of­fer as much pro­tec­tion for oc­cu­pants as the heav­ier, big­ger-en­gine cars they re­place,
so the res­ult may be an in­crease in high­way deaths and in­jur­ies.
Once the sec­ond­ary ef­fects are con­sidered, fuel ef­fi­ciency reg­u­la­tions may prove much less be­ne­fi­cial than they might first ap­pear.
Sim­il­ar un­in­ten­ded con­sequences were found after the in­tro­duc­tion of laws re­quir­ing the use of seat­belts.
The Brit­ish De­part­ment of Trans­port­a­tion found that in the 20 months after a law came into ef­fect
re­quir­ing drivers and front seat pas­sen­gers to wear seat belts, the num­ber of deaths among those trav­el­ing in the front seats was re­duced by 656.
The same time peri­od, however, saw an in­crease in deaths of ped­es­tri­ans (77), bi­cyc­lists (63), and back seat pas­sen­gers (69),(11)
ap­par­ently caused by drivers who felt safer when wear­ing seat belts and sub­sequently drove more dan­ger­ously.
Trade re­stric­tions between na­tions have im­port­ant sec­ond­ary ef­fects as well.
The pro­ponents of tar­iffs and im­port quotas on for­eign goods al­most al­ways ig­nore the sec­ond­ary ef­fects of their policies.
Tar­iffs and quotas may ini­tially pro­tect the coun­try’s work­ers
who make sim­il­ar products at a high­er cost, but there will be un­in­ten­ded sec­ond­ary con­sequences.
Con­sider the Com­mon Ag­ri­cul­ture Policy (CAP) of the European Uni­on,
which uses quotas and tar­iffs to re­strict sales of for­eign-pro­duced ag­ri­products,
and sub­sid­izes mem­ber coun­tries’ ag­ri­cul­ture dir­ectly from the E.U. budget.
“The CAP was cre­ated so that people could en­joy good food at af­ford­able prices and farm­ers earn a fair liv­ing,”
we read in the doc­u­ment ded­ic­ated to the 50-year an­niversary of the policy.(12)
Over­all, sub­sidies paid through the CAP ac­count for some­what over a third of the total E.U. budget.
Pro­ponents of this policy ar­gue that the E.U. farm and food sec­tors would be ap­prox­im­ately 8% smal­ler without CAP,(13) and that it is thereby “sav­ing” jobs and in­creas­ing em­ploy­ment.
No doubt, the sec­tor is big­ger than it oth­er­wise would be, but what about sec­ond­ary ef­fects?
Ex­pendit­ure on the CAP crowds out oth­er pos­sible uses with­in the E.U. budget and pre­vents al­loc­a­tion of E.U. funds to oth­er pub­lic goods activ­it­ies.
The sub­sidies cost each European Uni­on cit­izen more than €100 a year, ac­cord­ing to the European Com­mis­sion.
Moreover, tar­iffs and quotas main­tain loc­al prices at a high­er level than com­pet­it­ive world prices,(14) so E.U. con­sumers pay even more for ag­ri­products.
In­di­vidu­al fam­il­ies are es­sen­tially pay­ing twice for their food:
first, they pay high­er prices due to pro­tec­tion­ism of the ag­ri­cul­tur­al sec­tor, which raises prices in the stores;
second, they are taxed to pay for ag­ri­cul­tur­al sub­sidies.
Also, tar­iffs and quotas in­dir­ectly af­fect oth­er firms that pro­duce food by pro­cessing ag­ri­products.
For ex­ample, in France for 2007 the CAP re­duced the size of man­u­fac­tur­ing by 1.5%,
and the large ser­vices sec­tor con­trib­uted a mere 0.1% of its labor and cap­it­al to oth­er sec­tors that be­nefited from the CAP.
Re­leas­ing the CAP would de­crease the price of cap­it­al (land and equip­ment), which would be­ne­fit the farms that are not sup­por­ted by the CAP.
In ad­di­tion, the CAP re­duces the size of forestry, which com­petes dir­ectly along with oth­er rur­al activ­it­ies for ag­ri­cul­tur­al land.
(In France, the CAP re­duces the area de­voted to forestry by about 3.6%.)
Fur­ther­more, be­cause of tar­iffs and quotas, non-E.U. coun­tries sell less farm products in the E.U. mar­ket,
re­du­cing their abil­ity to pur­chase E.U. ex­ports, and re­du­cing em­ploy­ment in the sec­tors that lose these sales.
Once the sec­ond­ary ef­fects of trade re­stric­tions
like the CAP are taken into con­sid­er­a­tion, there is no reas­on to ex­pect E.U. em­ploy­ment and over­all pro­duc­tion to in­crease as a res­ult.
There may be more jobs in favored in­dus­tries, but there will be less em­ploy­ment in oth­ers.
Trade re­stric­tions re­shuffle em­ploy­ment rather than in­crease it.
But those who fail to con­sider the sec­ond­ary ef­fects will miss this point.
Sec­ond­ary ef­fects are not just a prob­lem for polit­ic­al de­cision-mak­ing.
They can also lead to unanti­cip­ated out­comes for in­di­vidu­als.
The re­cent ex­per­i­ence of a first-grade teach­er in West Vir­gin­ia il­lus­trates this point.
Her stu­dents were con­stantly los­ing their pen­cils, so she reasoned that if she paid them 10 cents for the stub,
they would re­spond to the in­cent­ive to hang on to the pen­cil un­til it was com­pletely used.
To her dis­may, the stu­dents soon formed long lines at the pen­cil sharpen­er, cre­at­ing stubs just as fast as she could pay for them.
It pays to be alert to un­in­ten­ded con­sequences!

Part 2: Seven Major Sources of Economic Progress

Elements:

  1. Leg­al sys­tem: The found­a­tion for eco­nom­ic pro­gress is a leg­al sys­tem that pro­tects privately owned prop­erty and en­forces con­tracts in an even­han­ded man­ner.
  2. Com­pet­it­ive mar­kets: Com­pet­i­tion pro­motes the ef­fi­cient use of re­sources and provides the in­cent­ive for in­nov­at­ive im­prove­ments.
  3. Lim­its on gov­ern­ment reg­u­la­tion: Reg­u­lat­ory policies that re­duce ex­change and re­strict com­pet­i­tion im­pede eco­nom­ic pro­gress.
  4. An ef­fi­cient cap­it­al mar­ket: To real­ize its po­ten­tial,
    a na­tion must have a mech­an­ism that chan­nels cap­it­al into wealth-cre­at­ing pro­jects.
  5. Prudent mon­et­ary policy: A stable mon­et­ary policy is es­sen­tial for the con­trol of in­fla­tion,
    ef­fi­cient al­loc­a­tion of in­vest­ment, and achieve­ment of eco­nom­ic sta­bil­ity.
  6. Low tax rates: People pro­duce more when they can keep more of what they earn.
    Con­trol of gov­ern­ment spend­ing and de­fi­cits (fisc­al policy) is cru­cial to eco­nom­ic sta­bil­ity and growth.
  7. Free trade: People achieve high­er in­comes when they are free to trade with people in oth­er coun­tries.

Introduction

Robert Lu­cas, the 1995 No­bel Laur­eate in eco­nom­ics, stated,
“Once you start think­ing about eco­nom­ic growth, it is hard to think about any­thing else.”(16)
Why do Lu­cas and many oth­er eco­nom­ists place so much em­phas­is on eco­nom­ic growth? Growth of real out­put is ne­ces­sary for the growth of real in­come.
Without growth, high­er in­come levels and liv­ing stand­ards can­not be achieved.
Dur­ing the past two hun­dred years, eco­nom­ic growth, par­tic­u­larly in the West, has el­ev­ated liv­ing stand­ards and im­proved both the length and qual­ity of life.
This peri­od, however, is ex­cep­tion­al. Throughout most of hu­man his­tory, eco­nom­ic growth has been ex­tremely rare.
Pri­or to 1800, most of the world’s pop­u­la­tion worked hard for fifty,
sixty, and sev­enty hours per week in or­der to ob­tain enough food and shel­ter for sub­sist­ence.
It was a con­stant struggle for sur­viv­al and many lost the battle.
Liv­ing stand­ards in 1800 were not much dif­fer­ent than a thou­sand years earli­er,
or even two thou­sand years earli­er, dur­ing the time of an­cient Rome.
The bleak eco­nom­ic story of hu­man his­tory began to change about two hun­dred years ago.
The late An­gus Mad­dis­on, an eco­nom­ist for the Or­gan­iz­a­tion for Eco­nom­ic Co-op­er­a­tion and De­vel­op­ment,
is widely re­cog­nized as the lead­ing au­thor­ity on his­tor­ic­al in­come and life ex­pect­ancy data.
Ex­hib­it 5 presents his es­tim­ated an­nu­al in­come levels per per­son for the past thou­sand years.
Meas­ured in 1990 dol­lars, the gross domestic product (GDP) per per­son of the world was $667 in 1820, com­pared to $450 in 1000.(17)
Thus, over 800 years, per-per­son in­come levels in­creased by only about 50 per­cent.
West­ern Europe and its off­shoots of the United States, Canada, Aus­tralia, and New Zea­l­and—com­monly re­ferred to as the West—did a little bet­ter,
as in­come in this re­gion ap­prox­im­ately tripled from $426 in 1000 to $1,202 in 1820.
But even in the West it took around five hun­dred years for in­come to double.
Now, take a good look at what has happened since 1820. Dur­ing the past two hun­dred years, there has been a vir­tu­al ex­plo­sion of eco­nom­ic growth.
By 2003, the world’s in­come per per­son had ris­en to $6,516, ten times the level of 1820.
In the West, by 2003 in­come per per­son had soared to $23,710, nearly twenty times the fig­ure for 1820.
Thus, after ex­per­i­en­cing cen­tur­ies of in­come levels at or near sub­sist­ence, real per cap­ita in­come has skyrock­eted dur­ing the past two hun­dred years.
Ex­hib­it 5: GDP per Cap­ita (1990 dol­lars)
A line chart show­ing GDP per cap­ita from the year 1000 to 2003, ex­pressed in 1990 US dol­lars. The chart shows little growth in in­come levels for the first 800 years, but ma­jor eco­nom­ic growth can be seen over the past 200 years. By 2003, world­wide in­come per cap­ita had ris­en to $6,516, a ten-fold in­crease, while in the West, this had ris­en to $23,710, a twenty-fold in­crease. The source is Con­tours of the World Eco­nomy, 1–2030 AD: Es­says in Mac­roe­co­nom­ic His­tory by An­gus Mad­dis­on, pub­lished by Ox­ford Uni­versity Press in 2007.
Source: An­gus Mad­dis­on, Con­tours of the World Eco­nomy, 1–2030 AD: Es­says in Macro-Eco­nom­ic His­tory (Ox­ford: Ox­ford Uni­versity Press, 2007).
The pat­tern of life ex­pect­ancy was sim­il­ar.
Life ex­pect­ancy at birth for the world rose from 24 years to 26 years between 1000 and 1820,
but it then in­creased to 31 years in 1900 be­fore soar­ing to 64 years in 2003.
In the West, life ex­pect­ancy rose from 24 years to 36 years between 1000 and 1820, but by 2003 it had reached 76 years.
As his­tory il­lus­trates, eco­nom­ic growth does not oc­cur auto­mat­ic­ally.
Why do some coun­tries grow and achieve high levels of in­come while oth­ers stag­nate?
What in­sti­tu­tions and policies will pro­mote growth and high­er liv­ing stand­ards?
This sec­tion ex­am­ines these vi­tally im­port­ant ques­tions.(18)
Be­fore we do, however, it is worth adding a cau­tion­ary note about the meas­ure­ment of GDP, es­pe­cially with re­spect to post-com­mun­ist coun­tries.
A defin­i­tion that seems simple such as “value of fi­nal out­put of goods and ser­vices” masks a host of dif­fi­cult ques­tions.
For something traded in a free mar­ket, es­tab­lish­ing value is easy. But what about something sub­ject to price con­trols?
Should it be val­ued at what people ac­tu­ally paid or what they would have paid in a free mar­ket?
Should the value of time spent queuing be in­cluded?
What about out­put that is not traded? If sol­diers are con­scrip­ted, how should their labor be eval­u­ated?
How well can stat­ist­ic­al au­thor­it­ies cap­ture the out­put in the un­der­ground (grey or black) mar­ket?
If I bake a pizza at home, the value of the cheese is in­cluded but not my time in the kit­chen.
On the oth­er hand, if I buy the pizza from a res­taur­ant the labor is in­cluded in the GDP.
Yet, as­sum­ing you are as good a cook as the chef, it is an identic­al pizza.
The dif­fi­culty in meas­ur­ing GDP and re­lated price changes cre­ates prob­lems in un­der­stand­ing the early years after the col­lapse of com­mun­ism.
The of­fi­cial stat­ist­ics show a huge drop in out­put—but this is in­con­sist­ent with the ac­tu­al ex­per­i­ence of cit­izens.(19)

Element 2.1: The Legal System

The foundation for economic progress is a legal system that protects privately owned property and enforces contracts in an evenhanded manner.

[A] private prop­erty re­gime makes people re­spons­ible for their own ac­tions in the realm of ma­ter­i­al goods.
Such a sys­tem there­fore en­sures that people ex­per­i­ence the con­sequences of their own acts.
Prop­erty sets up fences, but it also sur­rounds us with mir­rors, re­flect­ing back upon us the con­sequences of our own be­ha­vi­or.(20)
Tom Beth­ell, Eco­nom­ic Journ­al­ist
The leg­al sys­tem provides the found­a­tion for the pro­tec­tion of prop­erty rights and en­force­ment of con­tracts.
As we dis­cussed in Ele­ment 4 of Part 1, trade moves goods to­ward people
who value them more and makes lar­ger out­puts pos­sible as the res­ult of gains from spe­cial­iz­a­tion and large-scale pro­duc­tion meth­ods.
To re­duce the un­cer­tain­ties ac­com­pa­ny­ing trade, a leg­al sys­tem must provide even­han­ded en­force­ment of agree­ments and con­tracts.
This in­creases the volume of ex­change and the gains from trade, and thereby pro­motes eco­nom­ic pro­gress.
Well-defined and en­forced prop­erty rights are cru­cial for the real­iz­a­tion of gains from trade.
Prop­erty is a broad term that in­cludes own­er­ship of labor ser­vices, as well as phys­ic­al as­sets such as build­ings and land.
Private own­er­ship of prop­erty in­volves three things: (1) the right to ex­clus­ive use;
(2) leg­al pro­tec­tion against in­vaders—those who would seek to use or ab­use the prop­erty without the own­er’s per­mis­sion;
and (3) the right to trans­fer (sell or give) to oth­ers.
Private own­ers can de­cide how they will use their prop­erty, but they are held ac­count­able for their ac­tions.
People who use their prop­erty in a man­ner that in­vades or in­fringes on the prop­erty rights of an­oth­er will be sub­ject to the same leg­al forces that pro­tect their own prop­erty.
For ex­ample, private property rights pro­hib­it me from throw­ing my ham­mer through the wind­shield of your auto­mobile
be­cause if I did, I would be vi­ol­at­ing your prop­erty right to your car.
Your prop­erty right to your auto­mobile re­stricts me and every­one else from its use (or ab­use) without your per­mis­sion.
Sim­il­arly, my own­er­ship of my ham­mer and oth­er pos­ses­sions re­stricts you and every­one else from us­ing them without my per­mis­sion.
The im­port­ant thing about private own­er­ship is the in­cent­ives that flow from it.
There are four ma­jor reas­ons why the in­cent­ives ac­com­pa­ny­ing clearly defined and en­forced private own­er­ship rights pro­pel eco­nom­ic growth and pro­gress.
First, private own­er­ship provides people with a strong in­cent­ive to main­tain and care for items that they own.
If private own­ers fail to main­tain their prop­erty or if they al­low it to be ab­used or dam­aged,
they will bear the con­sequences in the form of a de­cline in their prop­erty’s value.
For ex­ample, if you own an auto­mobile, you have a strong in­cent­ive to change the oil,
have the car ser­viced reg­u­larly, and see that the in­teri­or of the car is well-main­tained.
Why is this so? If you are care­less in these areas, the car’s value to both you and po­ten­tial fu­ture own­ers will de­cline.
If the car is kept in good run­ning or­der, it will be of great­er value to you and to oth­ers who might want to buy it from you.
For the own­er, the mar­ket price will re­flect that stew­ard­ship.
Good stew­ard­ship is re­war­ded, but bad stew­ard­ship is pen­al­ized by a re­duc­tion in the value of the as­set.
In con­trast, when prop­erty is owned by oth­ers
(such as the gov­ern­ment, or a large group of people own­ing in com­mon—in so­cial­ist eco­nom­ies this was said to be “own­er­ship by the people”),
the in­cent­ive for each user to take good care of it is weakened.
For ex­ample, when the gov­ern­ment owns hous­ing, no in­di­vidu­al or small group of own­ers has a strong fin­an­cial in­cent­ive to main­tain the prop­erty,
be­cause no in­di­vidu­al or small group will pay the costs of a de­cline in the value of the prop­erty or be­ne­fit from its im­prove­ment.
That is why gov­ern­ment-owned hous­ing, com­pared to privately owned hous­ing, is more of­ten run down and poorly main­tained.
This is true in both cap­it­al­ist na­tions where mar­kets provide price sig­nals, and in so­cial­ist coun­tries where they do not.
Lax­ity in care, main­ten­ance, and re­pair re­flects the weak in­cent­ives that ac­com­pany gov­ern­ment own­er­ship of prop­erty,
even in the midst of work­ing mar­kets for oth­er privately owned as­sets.
A com­mon say­ing in So­viet times cap­tured this prob­lem: “When every­body is the own­er, nobody is the own­er.”
It is not just the lack of private own­er­ship it­self that causes prob­lems
so much as the dif­fer­ing in­terests between the users of prop­erty and the group or in­di­vidu­al who bears the cost of mis­use.
Much the same prob­lem oc­curs in the rent­al mar­ket where the private own­er dif­fers from the user.
This is why rent­al con­tracts of­ten con­tain long lists of how the prop­erty can and can­not be used.
In East­ern Europe be­fore the trans­ition, it was not un­com­mon to climb filthy stairs past broken el­ev­at­ors and burnt-out light bulbs, only to enter glor­i­ously main­tained apart­ments
be­cause people cared about where they lived privately but not for com­mon spaces.
Early in the trans­ition, how to as­sign own­er­ship rights to the hous­ing stock be­came a ma­jor is­sue.
It was clear that the units should be­come private prop­erty, but whose prop­erty?
For houses and apart­ments built in the re­cent past, the an­swer was easy—give them (or sell them for a low price) to the oc­cu­pants.
But what about older build­ings that had been seized from their own­ers when the com­mun­ists came to power?
Should own­er­ship be giv­en to those who lived in the unit or to those (or the des­cend­ants of those) whom had their prop­erty “stolen?”
The an­swer ad­op­ted by the Czechs was to give back (resti­tute) the prop­erty to its former own­ers but leave the sit­ting ten­ants in place covered by rent con­trols.
This ap­proach ran into ob­vi­ous prob­lems, as own­ers did not have suf­fi­cient in­come to main­tain the prop­erty and re­sen­ted not be­ing able to sell it for its mar­ket worth.
Insurance, while im­port­ant as will be dis­cussed later, also cre­ates such an in­cent­ive for “mis­use.”
This is known as a moral hazard,
where an in­di­vidu­al de­cid­ing how to use an as­set knows that someone else will pay the price for any bad out­come.
Drivers who know that the in­sur­ance com­pany will re­place their car if it is stolen
may be less care­ful about where they park or for­get to lock their cars.
Ski­ers without health in­sur­ance will be less likely to risk black dia­mond slopes.
Second, private own­er­ship en­cour­ages people to use and de­vel­op their prop­erty in ways oth­ers value highly.
If they em­ploy and de­vel­op their prop­erty in ways that oth­ers find at­tract­ive,
the mar­ket value of the prop­erty will in­crease.
In con­trast, changes that oth­ers dis­like—
par­tic­u­larly if the oth­ers are cus­tom­ers or po­ten­tial fu­ture buy­ers—will re­duce the value of one’s prop­erty.
Private own­er­ship also af­fects per­son­al de­vel­op­ment. When people are able to keep the fruits of their labor,
they have a power­ful in­cent­ive to im­prove their skills, work harder, and work smarter.
Such ac­tions will in­crease their in­come. Why are col­lege stu­dents will­ing to en­dure long hours of study and in­cur the cost of a col­lege edu­ca­tion?
Private own­er­ship of labor ser­vices provides the an­swer.
Be­cause they have an own­er­ship right to their labor ser­vices,
their fu­ture earn­ings will be high­er if they ac­quire know­ledge and de­vel­op skills that are highly val­ued by oth­ers.
Sim­il­arly, private own­er­ship provides the own­ers of land, build­ings,
and oth­er phys­ic­al as­sets with an in­cent­ive to use, pro­tect, and de­vel­op them in ways that are be­ne­fi­cial to oth­ers.
Fur­ther, those who fail to do so will bear the cost in terms of a lower value of their as­sets.
Con­sider the own­er of an apart­ment com­plex who per­son­ally cares noth­ing about hav­ing park­ing spaces,
con­veni­ent laun­dry fa­cil­it­ies, a nice workout room, or an at­tract­ive lawn and swim­ming pool with­in the com­plex.
If con­sumers value these things highly (re­l­at­ive to the costs of pro­du­cing them),
the apart­ment own­er has a strong in­cent­ive to provide them.
Why? Con­sumers will be will­ing to pay high­er rents for apart­ments with the highly val­ued amen­it­ies.
Thus, apart­ment own­ers who sup­ply such amen­it­ies will be able to im­prove the well-be­ing of their cus­tom­ers and in­crease their own net earn­ings
(and the mar­ket value of their apart­ment com­plex).
In con­trast, apart­ment own­ers who in­sist on provid­ing only what they like, rather than the things that con­sumers prefer,
will find that their earn­ings and the value of their cap­it­al (their apart­ments) will de­cline.
In­ter­est­ingly, private own­er­ship in­flu­ences pro­ductiv­ity even in so­cial­ist coun­tries.
Farm­ing in the former So­viet Uni­on il­lus­trates this point.
Un­der the Com­mun­ist re­gime, fam­il­ies were per­mit­ted to keep or sell the goods they pro­duced on small private plots, which ranged up to less than half a hec­tare in size.
These private plots made up only about 2 per­cent of the total land un­der cul­tiv­a­tion;
the oth­er 98 per­cent con­sisted of huge, col­lect­ively owned farms where the land and the out­put be­longed to the state.
As re­por­ted by the So­viet press, ap­prox­im­ately one-fourth of the total value of So­viet ag­ri­cul­tur­al out­put was raised on that tiny frac­tion of privately farmed land.
This in­dic­ates that the out­put per acre on the private plots was about six­teen times that of the state-owned farms.
Even a mod­est move away from state own­er­ship to­ward private own­er­ship can pro­duce im­press­ive res­ults.
In 1978 the Com­mun­ist gov­ern­ment of China began a de facto policy of let­ting farm­ers keep all rice grown on the col­lect­ive farms over and above a spe­cified grain quota that had to be giv­en to the state.
The res­ult was an im­me­di­ate in­crease in productivity be­cause farm­ers had an in­cent­ive to pro­duce ef­fi­ciently.
Once the quotas were met, the farm­ers were per­mit­ted to keep all of their ad­di­tion­al out­put.
When the word got out and the gov­ern­ment ig­nored the of­fi­cial policy against such “privat­iz­a­tion,” the prac­tice spread like wild­fire,
lead­ing to rap­id in­creases in ag­ri­cul­tur­al out­put and free­ing farm­ers to move into no­na­g­ri­cul­tur­al sec­tors of the eco­nomy.(21)
Third, private own­er­ship makes own­ers leg­ally re­spons­ible for dam­ages im­posed on oth­ers as the res­ult of how their prop­erty is used.
Courts of law re­cog­nize and en­force the au­thor­ity gran­ted by own­er­ship, but they also en­force the re­spons­ib­il­ity that goes with that au­thor­ity.
Private own­er­ship links con­trol with re­spons­ib­il­ity.
Own­ers are held re­spons­ible pre­cisely be­cause they are in a po­s­i­tion to ex­er­cise con­trol.
In turn, this ac­count­ab­il­ity provides own­ers with a strong in­cent­ive to use their prop­erty re­spons­ibly and take steps to re­duce the like­li­hood of harm to oth­ers.
Con­sider the fol­low­ing ex­amples. The own­er of a dy­ing tree has an in­cent­ive to cut it down be­fore it falls into a neigh­bor’s house.
Dog own­ers have an in­cent­ive to leash or re­strain their dogs if they are likely to bite oth­ers.
A car own­er has a right to drive his car, but will be held ac­count­able if the brakes aren’t main­tained and the car dam­ages someone else’s prop­erty.
Sim­il­arly, a chem­ic­al com­pany has con­trol over its products, but, ex­actly for that reas­on, it is leg­ally li­able for dam­ages if it mis­handles the chem­ic­als.
Fourth, private own­er­ship pro­motes the con­ser­va­tion of re­sources for the fu­ture, as well as wise de­vel­op­ment.
Us­ing a re­source may gen­er­ate rev­en­ue, which re­flects the de­sires of present con­sumers who want what the re­source can provide.
But fu­ture con­sumers also have a voice, thanks to prop­erty rights.
An own­er of a re­source, say a wood­lot or small forest whose trees could be har­ves­ted now or later, faces a de­cision.
Will the tim­ber be more valu­able later? In oth­er words, will the ex­pec­ted value of the trees when they are more ma­ture be great­er than if they are logged today?
And will that value ex­ceed their value if har­ves­ted now by more than the cost of hold­ing and pro­tect­ing them for fu­ture use?
If so, the own­er has an in­cent­ive to con­serve—that is, hold back on cur­rent use—
to make sure that the re­source will be avail­able when it is more valu­able.
Private own­ers will gain by con­ser­va­tion whenev­er the fu­ture value of a con­sum­able re­source is ex­pec­ted to ex­ceed its cur­rent value.
This is true even if the cur­rent own­er does not ex­pect to be around when the be­ne­fits ac­crue.
Sup­pose a sixty-five-year-old tree farm­er plants a crop of Douglas fir trees that typ­ic­ally take fifty years to grow to their op­tim­al har­vest­ing level.
Does the eld­erly tree farm­er have an in­cent­ive to con­serve the trees for fu­ture use?
With private own­er­ship rights, the an­swer is clearly “yes.”
As long as the growth of the trees is ex­pec­ted to en­hance fu­ture rev­en­ue as much as al­tern­at­ive in­vest­ments would, the farm­er will gain by con­serving the trees for the fu­ture.
With private own­er­ship, the mar­ket value of the farm­er’s land will in­crease as the trees grow and the ex­pec­ted day of har­vest moves closer.
So even though ac­tu­al log­ging may not take place un­til well after his death, the own­er will be able to sell the trees
(or the land in­clud­ing the trees) at any time, cap­tur­ing their in­creas­ing value.
For cen­tur­ies pess­im­ists have ar­gued that we are about to run out of trees, crit­ic­al min­er­als, or vari­ous sources of en­ergy.
Again and again, they have been wrong be­cause they failed to re­cog­nize the role of private prop­erty.
It is in­struct­ive to re­flect on these dooms­day fore­casts.
In six­teenth-cen­tury Eng­land fear arose that the sup­ply of wood—widely used as heat­ing fuel—would soon be ex­hausted.
High­er wood prices, however, en­cour­aged con­ser­va­tion of wood and led to in­vest­ment in the dis­cov­ery and bet­ter use of coal. The wood crisis soon dis­sip­ated.
Even when a spe­cif­ic re­source is not owned, the mar­ket for oth­er re­sources that are owned can of­ten solve prob­lems.
In the middle of the nine­teenth cen­tury, dire pre­dic­tions arose that the United States was about to run out of whale oil, the primary fuel for ar­ti­fi­cial light­ing at the time.
No one owned the whales, which were be­ing hunted to ex­cess on the high seas.
If a whale hunter failed to take a whale when the op­por­tun­ity arose, someone else would prob­ably do so in the near fu­ture.
As whale oil prices rose, the in­cent­ive for in­di­vidu­als to con­serve whales for the fu­ture was miss­ing be­cause private own­er­ship rights were ab­sent.
No one lim­ited whale hunt­ing even though the whale pop­u­la­tion was de­clin­ing.
However, the high­er whale oil prices strengthened the in­cent­ive to find and de­vel­op sub­sti­tute en­ergy sources.
If en­tre­pren­eurs could de­vel­op a cheap­er new en­ergy source, they could earn sub­stan­tial rev­en­ues.
With time, this led to the dis­cov­ery of com­mer­cially prof­it­able sources of pet­ro­leum, the de­vel­op­ment of re­l­at­ively cheap­er ker­osene,
a res­ult­ing drop in the price of whale oil, less whale hunt­ing, and thus the end of the whale oil crisis.
Later, as people switched to pet­ro­leum, pre­dic­tions emerged that this re­source, too, would be ex­hausted.
In 1914 the Bur­eau of Mines re­por­ted that the total U.S. sup­ply of oil was un­der six bil­lion bar­rels,
about what the United States now pro­duces every forty months.
In 1926 the Fed­er­al Oil Con­ser­va­tion Board es­tim­ated that the U.S. sup­ply of oil would last only for an­oth­er sev­en years.
More re­cently, a study sponsored by the highly in­flu­en­tial Club of Rome made sim­il­ar pre­dic­tions for the world dur­ing the 1970s.
Un­der­stand­ing the in­cent­ives that em­an­ate from private own­er­ship makes it easy to see
why such dooms­day fore­casts of re­source de­ple­tion have not ma­ter­i­al­ized.
When the scarcity of a privately owned re­source in­creases, the price of the re­source will rise.
The in­crease in price provides con­sumers, pro­du­cers, in­nov­at­ors,
and en­gin­eers with in­cent­ives to (1) con­serve on the dir­ect use of the re­source
(such as turn­ing off lights when the room is empty or wear­ing a sweat­er in­stead of turn­ing up the heat for con­sumers and tun­ing up cars and ma­chinery for both con­sumers and pro­du­cers);
(2) search more di­li­gently for substitutes
(such as buses in­stead of cars for con­sumers or wind, hy­dro, or nuc­le­ar power to re­place oil);
and (3) de­vel­op new meth­ods of dis­cov­er­ing and re­cov­er­ing lar­ger amounts of the re­source (such as ho­ri­zont­al drilling and frack­ing).
To date, these forces have pushed dooms­day ever fur­ther into the fu­ture,
and there is every reas­on to be­lieve that they will con­tin­ue to do so for re­sources that are privately owned.
If you want to see this dif­fer­ence in a stark man­ner, con­sider the dif­fer­ence between the cow and the Amer­ic­an buf­falo.
No two an­im­als could be more sim­il­ar in size and meat value, yet while the com­monly owned buf­falo was hunted al­most to the point of ex­tinc­tion,
no one could pos­sibly claim that there is a shortage of privately owned cows.(22)
A leg­al sys­tem that pro­tects prop­erty rights and en­forces con­tracts in an even­han­ded man­ner provides the found­a­tion for gains from trade,
capital formation, and re­source de­vel­op­ment, which com­prise the main­springs of eco­nom­ic growth.
In con­trast, in­sec­ure prop­erty rights, un­cer­tain en­force­ment of agree­ments, and leg­al favoritism un­der­mine both in­vest­ment and the pro­duct­ive use of re­sources.
Throughout his­tory people have tried oth­er forms of own­er­ship such as large-scale co­oper­at­ives, so­cial­ism, and com­mun­ism.
On any scale bey­ond the small vil­lage with a strong cul­tur­al har­mony,
these ex­per­i­ences have ranged from un­suc­cess­ful to dis­astrous.
To date, we do not know of any in­sti­tu­tion­al ar­range­ment that provides in­di­vidu­als with as much free­dom and in­cent­ive
to serve oth­ers by us­ing re­sources pro­duct­ively and ef­fi­ciently as does private own­er­ship with­in the frame­work of the rule of law.
The ref­er­ence to the “rule of law” is crit­ic­al. Prop­erty rights can nev­er be un­lim­ited.
So­ci­et­ies im­pose rules (“drive on the right side of the road” or “have a fire alarm in your home”)
to en­sure that the as­ser­tion of rights by one per­son does not cause harm to oth­ers.
The No­bel Prize-win­ning eco­nom­ist Ron­ald Coase has poin­ted out that in some cases mar­kets can achieve the same out­come,
but that when many people are af­fected pub­lic rules may be the only solu­tion.

Element 2.2: Competitive Markets

Competition promotes the efficient use of resources and provides the incentive for innovative improvements.

Com­pet­i­tion is con­du­cive to the con­tinu­ous im­prove­ments of in­dus­tri­al ef­fi­ciency.
It leads pro­du­cers to elim­in­ate wastes and cut costs so that they may un­der­sell oth­ers.
It weeds out those whose costs re­main high and thus op­er­ates to con­cen­trate pro­duc­tion in the hands of those whose costs are low.(23)
Clair Wil­cox, Former Pro­fess­or of Eco­nom­ics, Swarth­more Col­lege
Com­pet­i­tion is present when the mar­ket is open and al­tern­at­ive sellers are free to enter.
Com­pet­i­tion is the lifeblood of a mar­ket eco­nomy. The rival firms may op­er­ate in loc­al, re­gion­al, na­tion­al, or even glob­al mar­kets.
The com­pet­it­ive pro­cess places pres­sure on each to op­er­ate ef­fi­ciently and cater to the pref­er­ences of con­sumers.
Com­pet­i­tion weeds out in­ef­fi­cient pro­du­cers.
Firms that fail to provide con­sumers with qual­ity goods at at­tract­ive prices will ex­per­i­ence losses and even­tu­ally be driv­en out of busi­ness.
Suc­cess­ful com­pet­it­ors have to out­per­form rival firms.
They may do so through a vari­ety of meth­ods, in­clud­ing qual­ity of product, style, ser­vice, con­veni­ence of loc­a­tion, ad­vert­ising, and price,
but they must con­sist­ently of­fer con­sumers at least as much value re­l­at­ive to cost as is avail­able from rivals.
What keeps McDonald’s, Car­re­four, Amazon, Gen­er­al Mo­tors, or any oth­er busi­ness firm from rais­ing prices,
selling shoddy products, and provid­ing lousy ser­vice? Com­pet­i­tion provides the an­swer.
If McDonald’s fails to provide a tasty sand­wich at an at­tract­ive price de­livered with a smile,
people will turn to Bur­ger King, Wendy’s, Sub­way, Taco Bell, and oth­er rivals.
Even the largest firms will lose busi­ness to small up­starts
that find ways to provide con­sumers with bet­ter products at lower prices.
Firms as large as Fiat, Toyota, Gen­er­al Mo­tors, and Ford will lose cus­tom­ers to Honda, Hy­undai, Volk­swa­gen, and oth­er auto­mobile man­u­fac­tur­ers if they fall even a step be­hind in provid­ing the type of vehicle people want at com­pet­it­ive prices.
Com­pet­i­tion gives firms a strong in­cent­ive to de­vel­op bet­ter products and dis­cov­er lower-cost meth­ods of pro­duc­tion.
Be­cause tech­no­logy and prices change con­stantly, no one knows pre­cisely
what products con­sumers will want next or which pro­duc­tion tech­niques will min­im­ize costs per unit.
Com­pet­i­tion helps dis­cov­er the an­swer. Is marketing through so­cial me­dia the greatest re­tail idea since the shop­ping mall?
Or is it simply an­oth­er dream that will even­tu­ally turn to va­por?
Com­pet­i­tion will provide the an­swer, which will dif­fer across mar­kets and change over time.
In a mar­ket eco­nomy, en­tre­pren­eurs are free to in­nov­ate.
They need only the sup­port of in­vestors (of­ten in­clud­ing them­selves) will­ing to put up the ne­ces­sary funds.
The ap­prov­al of cent­ral plan­ners, a le­gis­lat­ive ma­jor­ity, or busi­ness rivals is not re­quired.
Non­ethe­less, com­pet­i­tion holds en­tre­pren­eurs and the in­vestors who sup­port them ac­count­able
be­cause their ideas must face a “real­ity check” im­posed by con­sumers.
If con­sumers value the in­nov­a­tion enough to cov­er its costs, the new busi­ness will profit and prosper.
But if con­sumers find that the new product is worth less than it costs, the busi­ness will suf­fer losses and fail.
Con­sumers are the ul­ti­mate judge and jury of busi­ness in­nov­a­tion and per­form­ance.
When new products are in­tro­duced, they typ­ic­ally fol­low a pre­dict­able price-qual­ity pat­tern.
Ini­tially, new products are gen­er­ally very ex­pens­ive and pur­chased by re­l­at­ively few con­sumers, mostly those with high in­comes.
These con­sumers will pay dearly for the earli­er avail­ab­il­ity be­cause dur­ing this ini­tial phase, the product qual­ity tends to be lower
than it will be later as pro­du­cers gain ex­per­i­ence,
while the price will be high due to lim­ited pro­duc­tion volume.
These ini­tial pur­chasers play a vi­tal role: They provide the rev­en­ue to cov­er the product’s start-up cost
and make it pos­sible for en­tre­pren­eurs to ac­quire the ex­per­i­ence that will help them im­prove qual­ity and re­duce per-unit cost in the fu­ture.
Moreover, mar­ket in­cent­ives will en­cour­age them to do so.
With time, en­tre­pren­eurs will fig­ure out how to make the product more af­ford­able and ex­pand its avail­ab­il­ity to more and more con­sumers.
Cel­lu­lar phones il­lus­trate this price/qual­ity pat­tern.
When cell phones were ini­tially in­tro­duced in the late 1980s, they sold for around $4,000,
were about the size of a brick, and could not do much of any­thing oth­er than make phone calls.
With time, their size was re­duced, their in­form­a­tion pro­cessing power and func­tions ex­pan­ded, and their price de­clined.
Today, they are avail­able at a frac­tion of the ini­tial price and they are viewed as a ne­ces­sity by many con­sumers in all in­come brack­ets.
Nu­mer­ous goods, in­clud­ing auto­mo­biles, tele­vi­sions, air con­di­tion­ers,
dish­wash­ers, mi­crowave ovens, and per­son­al com­puters have gone through this same pat­tern.
All were highly ex­pens­ive when they were ini­tially in­tro­duced, but en­tre­pren­eurs figured out
how to pro­duce them more eco­nom­ic­ally and im­prove their qual­ity, mak­ing them more af­ford­able to the over­whelm­ing bulk of con­sumers.
As we re­flect on the role of both en­tre­pren­eurs and the com­pet­it­ive pro­cess, it is im­port­ant to re­cog­nize this price-qual­ity pat­tern.
Pro­du­cers who wish to sur­vive in a com­pet­it­ive en­vir­on­ment can­not be com­pla­cent.
Today’s suc­cess­ful product may not pass to­mor­row’s com­pet­it­ive test.
In or­der to suc­ceed in a com­pet­it­ive mar­ket, en­tre­pren­eurs must be good at an­ti­cip­at­ing, identi­fy­ing, and quickly ad­opt­ing im­proved ideas.
Com­pet­i­tion also dis­cov­ers the busi­ness struc­ture and size of firm that can best keep the per-unit cost of a product or ser­vice low.
Un­like oth­er eco­nom­ic sys­tems, a mar­ket eco­nomy does not man­date the types of firms that are per­mit­ted to com­pete.
Any form of busi­ness or­gan­iz­a­tion is per­miss­ible.
An own­er-op­er­ated firm, part­ner­ship, corporation,
em­ploy­ee-owned firm, con­sumer co­oper­at­ive, com­mune, or any oth­er form of busi­ness is free to enter the mar­ket.
To suc­ceed it has to pass only one test: cost-ef­fect­ive­ness.
If a busi­ness en­tity, wheth­er a cor­por­a­tion or an em­ploy­ee-owned firm,
pro­duces qual­ity products at at­tract­ive prices, it will profit and suc­ceed.
But if its struc­ture res­ults in high­er costs than oth­er forms of busi­ness or­gan­iz­a­tion
pro­du­cing a product of sim­il­ar qual­ity, com­pet­i­tion will drive it from the mar­ket.
Of course, com­pet­i­tion also en­sures that products of dif­fer­ent qual­ity can co­ex­ist
so long as some con­sumers opt for the dif­fer­ing qual­ity/price trade-offs.
A Mer­cedes can sell (at a high price) along­side a lower-priced Volk­swa­gen.
On the oth­er hand, the East Ger­man car marque Wart­burg and the Rus­si­an car marque Zhiguli were un­able to sur­vive without some form of in­ter­fer­ence with mar­ket forces —
as was com­mon among com­mun­ist coun­tries that banned or im­posed high tar­iffs on im­ports from mar­ket eco­nom­ies.
The com­pet­it­ive pro­cess will also de­term­ine the size of firms in vari­ous sec­tors of the eco­nomy.
In some sec­tors—the man­u­fac­tur­ing of air­planes and auto­mo­biles, for ex­ample—
firms will need to be quite large to take full ad­vant­age of eco­nom­ies of scale.
Build­ing a single auto­mobile would be ex­tremely costly,
but when the fixed costs are spread over many thou­sands of units, the costs of pro­du­cing each car can plum­met.
Nat­ur­ally, con­sumers will tend to buy from the firms that can pro­duce goods eco­nom­ic­ally and sell them at lower prices.
In such in­dus­tries, small firms will be un­able to com­pete ef­fect­ively and only large firms will sur­vive.
In oth­er sec­tors, however, small firms, of­ten or­gan­ized as in­di­vidu­al pro­pri­et­or­ships or part­ner­ships, will be more cost-ef­fect­ive.
When con­sumers place a high value on per­son­al­ized ser­vice and in­di­vidu­al­ized products,
small firms will tend to dom­in­ate and large firms will have dif­fi­culty com­pet­ing.
This is gen­er­ally the case in the mar­kets for leg­al and med­ic­al ser­vices,
gour­met res­taur­ants, hair styl­ing, and spe­cial­ized print­ing. Thus, these mar­kets are usu­ally dom­in­ated by small firms.
Para­dox­ic­al as it may seem, self-in­terest dir­ec­ted by com­pet­i­tion is a power­ful force for eco­nom­ic pro­gress.
Dy­nam­ic com­pet­i­tion among products, tech­no­lo­gies,
or­gan­iz­a­tion­al meth­ods, and busi­ness firms will weed out the in­ef­fi­cient and con­sist­ently lead to the dis­cov­ery and in­tro­duc­tion of su­per­i­or products and tech­no­lo­gies.
When the new meth­ods im­prove qual­ity and/or re­duce costs, they will grow rap­idly and of­ten re­place the old ways of do­ing things.
His­tory abounds with ex­amples. The auto­mobile re­places the horse and buggy. The su­per­mar­ket re­places the mom-and-pop gro­cery store.
Fast-food chains like McDonald’s largely re­place the loc­al diner.
Car­re­four and Metro Cash & Carry grow rap­idly while oth­er re­tail­ers shrink or even go out of busi­ness.
MP3s and iPods re­place CD play­ers, which had pre­vi­ously dis­placed cas­sette decks and re­cord play­ers.
Per­son­al com­puters re­place type­writers, and smart phones sub­sti­tute for less mo­bile com­puter devices.
One could go on and on with sim­il­ar ex­amples.
The great eco­nom­ist Joseph Schum­peter re­ferred to this dy­nam­ic com­pet­i­tion as “creative destruction,”
and he ar­gued that it formed the very core of eco­nom­ic pro­gress.
Com­pet­i­tion har­nesses per­son­al self-in­terest and puts it to work, el­ev­at­ing our so­ci­ety’s stand­ard of liv­ing.
As Adam Smith noted in The Wealth of Na­tions:
It is not from the be­ne­vol­ence of the butcher, the brew­er, or the baker that we ex­pect our din­ner, but from their re­gard to their own self-in­terest.
We ad­dress ourselves not to their hu­man­ity but to their self-love, and nev­er talk to them of our own ne­ces­sit­ies, but of their ad­vant­ages.(24)
Taken to­geth­er, private own­er­ship and com­pet­it­ive mar­kets provide the found­a­tion for co­oper­at­ive be­ha­vi­or and ef­fi­cient use of re­sources.
When private prop­erty rights are clearly defined and en­forced, pro­du­cers face the op­por­tun­ity cost of their re­source use.
At the same time, prices in open and com­pet­it­ive mar­kets provide pro­du­cers with a strong in­cent­ive to keep costs low,
cater to the de­sires of con­sumers, and dis­cov­er su­per­i­or products and bet­ter ways of do­ing things.
It is im­port­ant to note that com­pet­i­tion is not “pro-busi­ness.”
In fact, busi­nesses do not like to face com­pet­i­tion and they com­monly lobby for policies to pro­tect them­selves from it.
They will of­ten seek to erect bar­ri­ers lim­it­ing the mar­ket entry of po­ten­tial rivals.
As we move on to the ana­lys­is of reg­u­la­tion and the polit­ic­al pro­cess,
ex­amples of busi­ness be­ha­vi­or seek­ing to re­duce the com­pet­it­ive­ness of mar­kets will arise again and again.
In­deed, the prob­lem of ol­ig­archs man­aging to dom­in­ate mar­kets for cer­tain goods and ser­vices is par­tic­u­larly com­mon in post-com­mun­ist eco­nom­ies.

Element 2.3: Sensible and Limited Regulation

Regulatory policies that reduce exchange and restrict competition impede economic progress.

As we pre­vi­ously noted, gains from trade dir­ec­ted by com­pet­it­ive mar­kets pro­mote both eco­nom­ic pro­gress and so­cial co­oper­a­tion.
Gov­ern­ment reg­u­la­tions, of­ten pro­moted by es­tab­lished busi­nesses,
are a ma­jor source of trade bar­ri­ers and mar­ket entry re­straints.
There are three ma­jor ways that reg­u­la­tions lim­it ex­change and re­duce the com­pet­it­ive­ness of mar­kets.
First, reg­u­la­tions of­ten re­strict entry into mar­kets.
Many coun­tries im­pose reg­u­la­tions that make it dif­fi­cult to enter and com­pete in vari­ous busi­nesses and oc­cu­pa­tions.
In those coun­tries, if you want to start a busi­ness or provide a ser­vice, you have to ac­quire a li­cense, fill out forms, get per­mis­sion from dif­fer­ent bur­eaus, show
that you are qual­i­fied, in­dic­ate that you have suf­fi­cient fin­an­cing, and meet vari­ous oth­er reg­u­lat­ory tests.
Some of­fi­cials may re­fuse your ap­plic­a­tion un­less you are will­ing to pay a bribe or con­trib­ute to their polit­ic­al cof­fers.
Of­ten, well-es­tab­lished and polit­ic­ally in­flu­en­tial busi­nesses that you would be com­pet­ing against can suc­cess­fully op­pose your ap­plic­a­tion.
In his re­veal­ing book The Mys­tery of Cap­it­al, Hernando de Soto re­ports that in the late 1990s in Lima, Peru, it took 289 days
for a team of people work­ing six hours a day to meet the reg­u­la­tions re­quired to leg­ally open a small busi­ness pro­du­cing gar­ments.
(In an earli­er book, The Oth­er Path, he re­vealed
that along the way, ten bribes were so­li­cited and it was ne­ces­sary to pay two of the re­ques­ted bribes in or­der to get per­mis­sion to op­er­ate leg­ally.)
In an ex­ample of the power of simple un­der­stand­ing of eco­nom­ic com­mon sense, at­ten­tion to these delays, per­haps mo­tiv­ated by the wide at­ten­tion giv­en to Pro­fess­or de Soto’s work, has res­ul­ted in a massive eas­ing of the bur­eau­cracy re­quired to open a busi­ness in re­cent years.
The World Bank re­ports that the glob­al av­er­age time to open a busi­ness has fallen from 51 days in 2005 to 20 days in 2018.
Time re­quired im­proved dra­mat­ic­ally among coun­tries at every in­come level and in every re­gion of the world
ex­cept North Amer­ica, where it re­mained con­stant at an already low 3.5 days.
Last place in the league table is held, not sur­pris­ingly, by Venezuela, where leg­ally open­ing a busi­ness would take 230 days.
Top ranked were New Zea­l­and and Geor­gia, where the pro­cess could be com­pleted in half a day.(25)
Among post-com­mun­ist coun­tries the longest time to open a busi­ness was in Bos­nia and Herzegov­ina, where 80 days were re­quired.
Post-com­mun­ist coun­tries have ac­tu­ally made great strides in ease of open­ing busi­nesses,
which takes 14 days on av­er­age across the re­gion as com­pared to 23 days in East Asia and 28 days in Lat­in Amer­ica.
Second, reg­u­la­tions that sub­sti­tute polit­ic­al au­thor­ity for the rule of law and free­dom of con­tract will tend to un­der­mine gains from trade.
Sev­er­al coun­tries make a habit of ad­opt­ing laws that grant polit­ic­al ad­min­is­trat­ors sub­stan­tial dis­cre­tion­ary au­thor­ity.
For ex­ample, in the mid-1980s cus­toms of­fi­cials in Guatem­ala were per­mit­ted to waive tar­iffs if they thought that do­ing so was in the “na­tion­al in­terest.”
Such le­gis­la­tion is an open in­vit­a­tion for gov­ern­ment of­fi­cials to so­li­cit bribes.
It cre­ates reg­u­lat­ory un­cer­tainty and makes busi­ness activ­ity cost­li­er and less at­tract­ive, par­tic­u­larly for hon­est people.
Pop­u­lar sup­port for reg­u­la­tion of­ten stems from the de­sire to pro­mote a clean­er en­vir­on­ment or provide con­sumers with pro­tec­tion against un­scru­pu­lous busi­ness op­er­at­ors.
Reg­u­la­tions can play a pos­it­ive role in these areas.
Even here, however, the law needs to be pre­cise, un­am­bigu­ous, and nondis­crim­in­at­ory.
If it is not, it will be a road­b­lock to gains from trade.
Reg­u­la­tions of­ten help some busi­nesses by re­strict­ing com­pet­it­ors.
Be­cause such reg­u­la­tions are luc­rat­ive to the few who be­ne­fit, they im­pose an ad­di­tion­al cost:
Busi­nesses, labor or­gan­iz­a­tions, and oth­er spe­cial in­terest groups will seek ad­vant­age for their con­stitu­ents by try­ing to in­flu­ence the polit­ic­al pro­cess.
Some will lobby politi­cians and reg­u­lat­ors to es­tab­lish or in­crease these road­b­locks,
while oth­ers (those most severely harmed) will lobby to di­min­ish their ef­fects.
Lob­by­ing for all sides of any is­sue con­sumes the time and ef­fort of highly skilled in­di­vidu­als
who could be pro­du­cing wealth in­stead of seek­ing polit­ic­al ad­vant­ages from policies that re­duce the pro­ductiv­ity of oth­ers.
Ef­forts that waste valu­able re­sources in ways that may be pro­duct­ive for an in­di­vidu­al or firm but not for so­ci­ety as a whole
are re­ferred to as rent-seeking be­ha­vi­or and are fre­quently the res­ult of reg­u­la­tions.
Third, the im­pos­i­tion of price con­trols will also stifle trade. Gov­ern­ments some­times set prices above the mar­ket level.
For ex­ample, some gov­ern­ments re­quire that the pro­du­cers of vari­ous ag­ri­cul­tur­al products be paid a spe­cified min­im­um price for their com­mod­it­ies.
At the high­er set price, buy­ers will pur­chase few­er units than they oth­er­wise would.
Some gov­ern­ments also set prices lower than the mar­ket level,
as in cases of apart­ment rent con­trols and reg­u­lated elec­tric power rates.
In terms of units pro­duced and sold, it makes little dif­fer­ence wheth­er price con­trols push prices up or force them down.
Both will re­duce the volume of trade and the gains from pro­duc­tion and ex­change.
Minimum wage rates are per­haps the most com­monly im­posed price con­trol throughout the world.
A min­im­um wage rate es­tab­lishes a price floor that pushes the hourly wage of some work­ers (and jobs) above mar­ket level.
It is cur­rently a hot top­ic in North Mace­do­nia, as in many oth­er European coun­tries.
Among European Uni­on mem­bers, an­nu­al min­im­um wages in 2017 (ad­jus­ted for dif­fer­ences in price levels)
ranged from $7,900 in Latvia to $22,600 in the Neth­er­lands.
The ba­sic pos­tu­late of eco­nom­ics in­dic­ates that a high­er min­im­um wage will re­duce the em­ploy­ment of low-skill work­ers.
There is some con­tro­versy about the size of the em­ploy­ment re­duc­tion,
but the weight of the em­pir­ic­al evid­ence in­dic­ates that each 10 per­cent in­crease in the min­im­um wage will re­duce em­ploy­ment by between 1 and 2 per­cent.
Be­cause the wage in­creases are sub­stan­tially lar­ger than the re­duc­tions in em­ploy­ment,
a high­er min­im­um wage will nearly al­ways in­crease the total earn­ings of low-skill work­ers.
The pro­ponents of high­er min­im­um wages be­lieve
that the high­er total earn­ings are well worth the cost of the re­l­at­ively small re­duc­tions in em­ploy­ment.
Many sup­port­ers of a high­er min­im­um wage also be­lieve
that it will re­duce the poverty rate.
At first glance, this ap­pears to be true, but ex­am­in­a­tion of the data in­dic­ates it is highly ques­tion­able.
There are sev­er­al ma­jor reas­ons why this is the case. Take the fig­ures for the United States, for ex­ample.
The bulk of min­im­um wage em­ploy­ees—about 80 per­cent—are mem­bers of households with in­comes above the poverty level;
one-third live in house­holds with above av­er­age in­comes.
Half of the min­im­um wage work­ers are between the ages of 16 and 24 years and most of them work part-time.
Only 1 out of every 7 min­im­um wage work­ers (about 15 per­cent) is the primary earner for a fam­ily with one or more chil­dren.
Thus, the typ­ic­al min­im­um wage work­er is a single, youth­ful, part-time sec­ond­ary work­er in a house­hold with an in­come above the poverty level.
Second, there will be un­in­ten­ded ef­fects of the high­er min­im­um.
Em­ploy­ers will take steps to con­trol (or com­pensate for) their high­er wage costs.
These will in­clude a re­duc­tion in hours worked, few­er train­ing op­por­tun­it­ies,
a less con­veni­ent work sched­ule, and few­er fringe be­ne­fits.
Fur­ther, many of the min­im­um wage work­ers are also con­sumers of products im­pacted by the high­er min­im­um wage.
These work­ers will have to pay high­er prices for goods such as fast food as will oth­er low-in­come con­sumers such as re­tir­ees.
Thus, the ac­tu­al com­pens­a­tion of the min­im­um wage work­ers will in­crease by less than the ex­pan­sion in the min­im­um.(26)
Fi­nally, more than half of the poor fam­il­ies in the United States do not have any­one in the labor force,
and there­fore a high­er min­im­um wage will not help them.
The evid­ence re­gard­ing min­im­um wages in less de­veloped coun­tries is mixed
but tends to show that min­im­um wages that are high enough to have an im­pact may raise wages in the form­al eco­nomy
at the cost of driv­ing a large num­ber of work­ers out of the form­al eco­nomy into the in­form­al sec­tor, where earn­ings are lower and much more highly vari­able.
When think­ing about the ef­fects of the min­im­um wage on youth­ful low-skill work­ers,
it is im­port­ant to con­sider the im­pact in both the short and long run.
Work ex­per­i­ence provides youth­ful work­ers with an op­por­tun­ity to de­vel­op self-con­fid­ence, good work habits,
skills, and at­ti­tudes that will make them more valu­able to fu­ture em­ploy­ers.
This op­por­tun­ity is par­tic­u­larly im­port­ant for high school dro­pouts and oth­ers with weak edu­ca­tion­al back­grounds.
Un­less these young people are able to prove their value to em­ploy­ers and de­vel­op on-the-job skills, it is un­likely
that they will be able to move up the job lad­der and real­ize high­er earn­ings in the fu­ture.
The value of work ex­per­i­ence and skill de­vel­op­ment is widely re­cog­nized in the case of those with high­er levels of edu­ca­tion.
For ex­ample, col­lege stu­dents of­ten take un­paid in­tern­ships—that is, they work for a zero wage—
with gov­ern­ment agen­cies and non­profit or­gan­iz­a­tions in or­der to gain ex­per­i­ence that will en­hance their fu­ture earn­ing op­por­tun­it­ies.
In­deed, mem­bers of the United States Con­gress ad­vert­ise un­paid in­tern­ships to col­lege stu­dents by point­ing out the be­ne­fits of work ex­per­i­ence in be­gin­ning-level jobs.
Yet many of these same politi­cians sup­port min­im­um wage levels
that re­duce the op­por­tun­ity of dis­ad­vant­aged youth to ac­quire the work ex­per­i­ence and on-the-job train­ing
that will en­hance their fu­ture em­ploy­ment pro­spects.
This ad­verse im­pact on low-skill youth is al­most al­ways ig­nored, ex­cept by eco­nom­ists.
Non­ethe­less, it is an im­port­ant un­in­ten­ded sec­ond­ary ef­fect of min­im­um wages that ad­versely im­pacts the long-term em­ploy­ment of young people,
par­tic­u­larly those with the least amount of edu­ca­tion.
Reg­u­la­tions are par­tic­u­larly im­port­ant in labor markets.
Many coun­tries have im­posed reg­u­la­tions
that in­ter­fere with and un­der­mine the use of con­tracts or vol­un­tary agree­ments to deal with vari­ous is­sues.
Dis­missal reg­u­la­tions provide an ex­ample.
A num­ber of European coun­tries re­quire em­ploy­ers who want to re­duce the size of their work­force
to (1) ob­tain per­mis­sion from polit­ic­al au­thor­it­ies;
(2) no­ti­fy the dis­missed em­ploy­ees months in ad­vance; and (3) con­tin­ue pay­ing the dis­missed em­ploy­ees for sev­er­al more months.
Such reg­u­la­tions may ap­pear to be in the in­terests of work­ers, but the sec­ond­ary ef­fects must be con­sidered.
Reg­u­la­tions that make it costly to dis­miss work­ers also make it costly to hire them.
Em­ploy­ers will be re­luct­ant to take on ad­di­tion­al work­ers be­cause of the high dis­missal costs.
As a res­ult, it will be dif­fi­cult for new labor force entrants to find jobs, and the growth of em­ploy­ment will be slowed.
This has been the case in European coun­tries, where re­strict­ive labor mar­ket reg­u­la­tions are more pro­nounced than in the United States.
Such reg­u­la­tions are a ma­jor reas­on why the un­em­ploy­ment rates of West­ern European coun­tries such as Italy,
Spain, and France have been at least 4 or 5 per­cent­age points high­er than the United States dur­ing the past couple of dec­ades.(27)
Re­search by Steve Hanke at Johns Hop­kins Uni­versity has found that between 2010 and 2015 un­em­ploy­ment rates in E.U. coun­tries with man­dated min­im­um wages were up to 50 per­cent high­er than in those E.U. coun­tries without man­dated min­im­um wages.
Post-com­mun­ist Rus­sia provides an in­ter­est­ing labor­at­ory to study the ef­fects of min­im­um wages.
In 2007, the coun­try more than doubled the fed­er­al min­im­um wage (and in­creased it even more in some re­gions).
Res­ults sug­gest that this caused a de­crease in em­ploy­ment of young people and an in­crease in the size of the in­form­al eco­nomy.(28)
While hir­ing and dis­missal reg­u­la­tions are gen­er­ally less re­strict­ive in the United States than in Europe,
occupational licensing is a ma­jor labor mar­ket re­stric­tion in both the United States and the European Uni­on.
Most of the oc­cu­pa­tion­al li­cens­ing in the United States oc­curs at the state level.
In or­der to ob­tain a li­cense, one has to pay fees ran­ging from mod­est to ex­or­bit­ant,
take train­ing courses for 6 to 12 months, and pass ex­am­in­a­tions.
As re­cently as 1970, few­er than 15 per­cent of Amer­ic­ans worked in jobs that re­quired a li­cense.
Today, the fig­ure is nearly 30 per­cent, and it is con­tinu­ing to grow.
In the mid-1980s, 800 oc­cu­pa­tions were li­censed in at least one state.
Now, ac­cord­ing to the Coun­cil on Li­cen­sure, En­force­ment and Reg­u­la­tion, more than 1,100 oc­cu­pa­tions are li­censed.
Re­cent stud­ies find that ap­prox­im­ately 22 per­cent of work­ers in the European Uni­on are sub­ject to oc­cu­pa­tion­al li­cens­ing re­quire­ments,
al­though the num­ber and im­pact of such re­quire­ments var­ies greatly across mem­ber coun­tries, with Ger­many lead­ing the pack at 33 per­cent.
It has been es­tim­ated that li­cens­ing re­duced em­ploy­ment in re­lated in­dus­tries in the E.U. by ap­prox­im­ately 700,000 jobs in 2015.
The same study also found that the above-mar­ket wages as­so­ci­ated with re­strict­ive li­cens­ing con­trib­utes to in­come in­equal­ity with­in the E.U.(29)
The sup­port­ers of li­cens­ing ar­gue that it is ne­ces­sary to pro­tect con­sumers from shoddy and po­ten­tially un­safe products.
But, li­censes are re­quired in nu­mer­ous oc­cu­pa­tions that have little to do with pub­lic safety or pro­tec­tion of the con­sumer.(30)
For ex­ample, one or more states in the United States re­quire a per­son to be li­censed in or­der to work in the fol­low­ing oc­cu­pa­tions:
in­teri­or de­sign­er, makeup artist, flor­ist, hair braid­er, sham­poo spe­cial­ist, di­eti­cian, private de­tect­ive,
ath­let­ic train­er, tour guide, hear­ing-aid fit­ter, fu­ner­al at­tend­ant, cas­ket seller, and even fer­ret breed­er and palm read­er.
The pres­sure for li­cens­ing sel­dom ori­gin­ates from con­sumer groups. In­stead, it nearly al­ways arises from those already in the oc­cu­pa­tion.
This is not sur­pris­ing to eco­nom­ists be­cause the cur­rent sup­pli­ers are the primary be­ne­fi­ciar­ies of li­cens­ing.
In­di­vidu­als can of­ten ac­quire the skills ne­ces­sary for high-level per­form­ance in many li­censed oc­cu­pa­tions
through on-the-job ex­per­i­ence and work­ing with oth­ers skilled in the trade.
The li­cens­ing re­quire­ments pro­hib­it per­sons de­vel­op­ing their skills via these meth­ods from pur­su­ing their de­sired ca­reer.
Li­cens­ing, par­tic­u­larly when it man­dates lengthy form­al train­ing and levies ex­pens­ive fees,
re­duces sup­ply and drives up the price of the goods and ser­vices provided by the li­censed prac­ti­tion­ers.
Those cur­rently in the oc­cu­pa­tion gain at the ex­pense of con­sumers and un­li­censed po­ten­tial pro­du­cers.
The em­ploy­ment op­por­tun­it­ies of the un­li­censed pro­du­cers are di­min­ished and po­ten­tial gains from trade lost.
Certification provides an at­tract­ive al­tern­at­ive to li­cens­ing.
With cer­ti­fic­a­tion, the gov­ern­ment could re­quire sup­pli­ers to provide in­form­a­tion about their edu­ca­tion,
train­ing, and oth­er qual­i­fic­a­tions to con­sumers, without pro­hib­it­ing any­one from work­ing in his or her chosen field.
In es­sence, cer­ti­fic­a­tion makes in­form­a­tion about the sup­pli­ers’ qual­i­fic­a­tions read­ily avail­able to con­sumers, without re­strict­ing their choices.
Fur­ther, it would make it pos­sible for prac­ti­tion­ers to de­vel­op and demon­strate their com­pet­ence,
while still provid­ing con­sumers with the in­form­a­tion needed to make in­formed choices.
Reg­u­la­tions of­ten ap­pear to be an easy way to solve prob­lems. Want high­er wages? In­crease the min­im­um wage.
Want a lower un­em­ploy­ment rate? Pass laws mak­ing dis­missal of work­ers more dif­fi­cult.
Want high­er earn­ings in an oc­cu­pa­tion? Re­strict the entry of price-cut­ters.
But there is a prob­lem here: These simplist­ic policies do not en­hance pro­duc­tion and they ig­nore the sec­ond­ary ef­fects.
Our liv­ing stand­ard is dir­ectly linked to the pro­duc­tion of goods and ser­vices that people value.
Mu­tu­ally ad­vant­age­ous trade and com­pet­it­ive mar­kets en­cour­age ef­fi­cient use of re­sources and dis­cov­ery of bet­ter ways of do­ing things.
They help us get more value from our re­sources.
Thus, reg­u­lat­ory policies that im­pose road­b­locks against trade and entry into mar­kets will al­most al­ways be coun­ter­pro­duct­ive.
If a coun­try is go­ing to grow and prosper, it should min­im­ize reg­u­la­tions that re­strict trade and the com­pet­it­ive­ness of mar­kets.

Element 2.4: Efficient Capital Markets

To realize its potential, a nation must have a mechanism that channels capital into wealth-creating projects.

While con­sump­tion is the goal of all pro­duc­tion, it will of­ten be ne­ces­sary first to use re­sources to build ma­chines,
heavy equip­ment, and build­ings, which can then be used to pro­duce the de­sired con­sumer goods.
In oth­er words, in­vest­ment in­creases fu­ture con­sump­tion, but it re­quires for­go­ing some present con­sump­tion.
the con­struc­tion and de­vel­op­ment of long-last­ing re­sources de­signed to help pro­duce more con­sumer goods and ser­vices in the fu­ture—
is an im­port­ant po­ten­tial source of eco­nom­ic growth.
For ex­ample, the pur­chase of an in­vest­ment good such as an oven by a loc­al pizzer­ia will help en­large its fu­ture out­put.
Re­sources (such as labor, land, and en­tre­pren­eur­ship) used to pro­duce these investment goods
will be un­avail­able for the pro­duc­tion of con­sumer goods.
If we con­sume all that we pro­duce, no re­sources will be avail­able for in­vest­ment.
There­fore, in­vest­ment re­quires saving
a re­duc­tion in cur­rent con­sump­tion in or­der to make the funds avail­able for oth­er uses.
Someone, either the in­vestor or someone will­ing to sup­ply funds to the in­vestor, must save in or­der to fin­ance in­vest­ment.
Sav­ing is an in­teg­ral part of the in­vest­ment pro­cess.
Not all in­vest­ment pro­jects, however, are pro­duct­ive.
An in­vest­ment pro­ject will en­hance the wealth of a na­tion only if the value of the ad­di­tion­al out­put from the in­vest­ment ex­ceeds the cost.
When it does not, the pro­ject is coun­ter­pro­duct­ive and re­duces wealth.
In­vest­ments can nev­er be made with per­fect foresight,
so even the most prom­ising in­vest­ment pro­jects will some­times fail to en­hance wealth.
To make the most of its po­ten­tial for eco­nom­ic pro­gress,
a na­tion must have a mech­an­ism that will at­tract sav­ings and chan­nel them into the in­vest­ments that are most likely to cre­ate wealth.
In a mar­ket eco­nomy, the capital market per­forms this func­tion.
Broadly defined, it in­cludes the mar­kets for stocks, bonds, and real es­tate.
such as stock exchanges, banks, in­sur­ance com­pan­ies, mu­tu­al funds, and in­vest­ment firms play im­port­ant roles in the op­er­a­tion of the cap­it­al mar­ket.
Private in­vestors, such as small busi­ness own­ers, cor­por­ate stockholders and venture capitalists place their own funds at risk in the cap­it­al mar­ket.
In­vestors some­times make mis­takes, however. Some­times they un­der­take pro­jects that prove to be un­prof­it­able.
If in­vestors were un­will­ing to take such chances, many new ideas would go un­tested and many worth­while
but risky pro­jects would not be un­der­taken.
Con­sider the role of en­tre­pren­eur­ship, risk-tak­ing, and the cap­it­al mar­ket in the de­vel­op­ment of In­ter­net ser­vices.
In the mid-1990s, Sergey Brin (an im­mig­rant from Rus­sia) and Larry Page were gradu­ate stu­dents at Stan­ford Uni­versity in Cali­for­nia,
work­ing on a re­search pro­ject de­signed to make it easi­er to find things on the In­ter­net.
They might have seemed un­likely can­did­ates for en­tre­pren­eur­i­al suc­cess.
But in 1998, Brin and Page foun­ded Google Inc.,
a busi­ness provid­ing free In­ter­net ser­vices that gen­er­ates rev­en­ues through ad­vert­ising.
The power­ful In­ter­net search en­gine that they de­veloped in­creases the pro­ductiv­ity of mil­lions of in­di­vidu­als and busi­nesses each day.
They have earned a for­tune and Google is a house­hold name with more than 85,000 em­ploy­ees (in­clud­ing its par­ent com­pany Al­pha­bet) in 2018.
Oth­er In­ter­net-based com­pan­ies, such as eBay and Amazon, have also earned profits and achieved sub­stan­tial growth dur­ing the past dec­ade.
But the ex­per­i­ence of nu­mer­ous oth­er In­ter­net start-ups was quite dif­fer­ent.
Many “dot-coms,” like Broad­band Sports and eVineyard, went bust be­cause their rev­en­ues were in­suf­fi­cient to cov­er their costs.
The high hopes of these firms did not ma­ter­i­al­ize.
In a world of un­cer­tainty, mis­taken in­vest­ments are a ne­ces­sary price that must be paid
for fruit­ful in­nov­a­tions in new tech­no­lo­gies and products.
Such coun­ter­pro­duct­ive pro­jects, however, must be re­cog­nized and brought to a halt.
In a mar­ket eco­nomy, the cap­it­al mar­ket per­forms this func­tion.
If a firm con­tin­ues to ex­per­i­ence losses, even­tu­ally in­vestors will ter­min­ate the pro­ject and stop wast­ing their money.
Giv­en the pace of change and the di­versity of en­tre­pren­eur­i­al tal­ent,
the know­ledge re­quired for sound de­cision-mak­ing about the al­loc­a­tion of cap­it­al is far bey­ond the scope of any single lead­er,
in­dus­tri­al plan­ning com­mit­tee, or gov­ern­ment agency.
Without a private cap­it­al mar­ket, there is no mech­an­ism
that can be coun­ted on to con­sist­ently chan­nel in­vest­ment funds into wealth-cre­at­ing pro­jects.
Why? When in­vest­ment funds are al­loc­ated by the gov­ern­ment, rather than by the mar­ket, an en­tirely dif­fer­ent set of factors comes into play.
Polit­ic­al in­flu­ence rather than mar­ket re­turns will de­term­ine which pro­jects will be un­der­taken.
In­vest­ment pro­jects that re­duce rather than cre­ate wealth will be­come far more likely.
Polit­ic­al de­cision mak­ing is also biased to­wards new pro­jects rather then main­ten­ance. Rib­bon cut­ting on a new high­way is much more vis­ible than pothole re­pair.
The ex­per­i­ences of the cent­rally planned so­cial­ist eco­nom­ies dur­ing the So­viet era il­lus­trate this point.
For four dec­ades (1950–1990), the in­vest­ment rates in these coun­tries were among the highest in the world.
Cent­ral plan­ners al­loc­ated ap­prox­im­ately one-third of the na­tion­al out­put into cap­it­al in­vest­ment.
Even these high rates of in­vest­ment, however, did little to im­prove liv­ing stand­ards
be­cause polit­ic­al rather than eco­nom­ic con­sid­er­a­tions de­term­ined which pro­jects would be fun­ded.
Re­sources were of­ten wasted on eco­nom­ic­ally im­prac­tic­al pro­jects and im­port­ant polit­ic­al lead­ers favored in­vest­ments with high polit­ic­al vis­ib­il­ity (“prestige”).
Two ex­amples il­lus­trate this mis­al­loc­a­tion.
Stal­in in­sisted on build­ing the White Sea Canal, but to meet his un­reas­on­able sched­ule the canal was too shal­low to be use­ful.
Khrushchev’s cam­paign to make Kaza­kh­stan pro­duce wheat at the level of Amer­ic­an and Ca­na­dian prair­ies
res­ul­ted in vast ir­rig­a­tion schemes, which even­tu­ally des­troyed the Aral Sea(31).
Mis­dir­ec­tion of in­vest­ment and fail­ure to keep up with dy­nam­ic change even­tu­ally led to the de­mise of so­cial­ism in most of these coun­tries.
Re­cent U.S. ex­per­i­ence with gov­ern­ment al­loc­a­tion of cred­it for hous­ing fin­ance also provides in­sight into how polit­ic­al al­loc­a­tion of cap­it­al works.
The Fed­er­al Na­tion­al Mort­gage As­so­ci­ation and Fed­er­al Home Loan Mort­gage Cor­por­a­tion, com­monly known as Fan­nie Mae and Fred­die Mac,
were chartered by Con­gress as gov­ern­ment-sponsored cor­por­a­tions in 1968 and 1970, re­spect­ively.
It was thought that they would im­prove the op­er­a­tion of the cap­it­al mar­ket and make home fin­an­cing more af­ford­able.
Even though Fan­nie Mae and Fred­die Mac were privately owned busi­nesses, in­vestors per­ceived
that the bonds they is­sued to raise their funds were less risky be­cause they were backed by the gov­ern­ment.
As a res­ult, Fan­nie Mae and Fred­die Mac were able to bor­row funds at ap­prox­im­ately half of a per­cent­age point cheap­er than private firms.
This gave them a huge ad­vant­age over their rivals and they were highly prof­it­able for many years.
But the gov­ern­ment spon­sor­ship also made Fan­nie Mae and Fred­die Mac highly polit­ic­al.
The pres­id­ent ap­poin­ted sev­er­al mem­bers to their boards of dir­ect­ors.
Top man­age­ment of Fan­nie Mae and Fred­die Mac provided key con­gres­sion­al lead­ers with large polit­ic­al con­tri­bu­tions.
They also of­ten hired away con­gres­sion­al staffers into high pay­ing jobs,
who then lob­bied their former gov­ern­ment bosses.
Their lob­by­ing activ­it­ies were le­gendary.
Between 1998 and 2008, Fan­nie Mae spent $79.5 mil­lion and Fred­die Mac spent $94.9 mil­lion lob­by­ing Con­gress for spe­cial fa­vors and con­tinu­ation of their priv­ileged status.(32)
Fan­nie Mae and Fred­die Mac did not ori­gin­ate mortgages;
that is, they did not dir­ectly lend money to people buy­ing houses.
In­stead, they pur­chased the mort­gages in the sec­ond­ary mar­ket, a mar­ket
where mort­gages ori­gin­ated by banks and oth­er lenders are pur­chased.
Be­cause they had cheap­er ac­cess to funds, they could pur­chase lots of mort­gages
and by the mid-1990s, these two gov­ern­ment-sponsored en­ter­prises held ap­prox­im­ately 40 per­cent of all home mort­gages.
Their dom­in­ance of the sec­ond­ary mar­ket was even great­er.
Dur­ing the dec­ade pri­or to their insolvency in 2008,
Fan­nie Mae and Fred­die Mac pur­chased more than 80 per­cent of the mort­gages sold by banks and oth­er mort­gage ori­gin­at­ors.
While Fan­nie Mae and Fred­die Mac lob­bied for and re­ceived fa­vors from Con­gress,
mem­bers of Con­gress used them to achieve polit­ic­al ob­ject­ives,
in­clud­ing mak­ing mort­gage funds for hous­ing pur­chases more read­ily avail­able to low and middle-in­come bor­row­ers.
Re­spond­ing to earli­er con­gres­sion­al dir­ect­ives, the De­part­ment of Hous­ing and Urb­an De­vel­op­ment man­dated
that, by 1996, 40 per­cent of the mort­gages fin­anced by Fan­nie Mae and Fred­die Mac must go to house­holds with in­comes be­low the me­di­an.
This fig­ure was in­creased to 50 per­cent by 2000 and to 56 per­cent by 2008.
In or­der to meet these man­dates, Fan­nie Mae and Fred­die Mac began ac­cept­ing more mort­gages with little or no down payment.
They also sub­stan­tially in­creased the share of mort­gages gran­ted to bor­row­ers with a poor cred­it his­tory, known as subprime bor­row­ers.
Be­cause of their dom­in­ance of the sec­ond­ary mar­ket, their lend­ing prac­tices ex­er­ted a huge im­pact on the lend­ing stand­ards ac­cep­ted by mort­gage ori­gin­at­ors.
Re­cog­niz­ing that ris­ki­er loans could be passed on to Fan­nie Mae and Fred­die Mac,
the ori­gin­at­ors had less in­cent­ive to scru­tin­ize the cred­it wor­thi­ness of bor­row­ers or worry much about their abil­ity to re­pay the funds.
After all, sale of the mort­gage to Fan­nie Mae and Fred­die Mac would trans­fer the risk to them as well.
As Ex­hib­it 6 shows, subprime mort­gages (in­clud­ing those ex­ten­ded with in­com­plete doc­u­ment­a­tion) soared from 4.5 per­cent of the new mort­gages in 1994 to 13.2 per­cent in 2000 and to 33.6 per­cent of the total share of mort­gage ori­gin­a­tions by 2006.
Dur­ing the same time frame, con­ven­tion­al loans, for which bor­row­ers are re­quired to make at least a 20 per­cent down pay­ment, fell from two-thirds of the total to only one-third.
The de­fault and foreclosure rates for subprime loans range from sev­en to ten times the par­al­lel rates for con­ven­tion­al loans to prime bor­row­ers.
Pre­dict­ably, the grow­ing share of loans to those with weak­er cred­it even­tu­ally led to high­er de­fault and fore­clos­ure rates.
Both Con­gress and the pres­id­en­tial ad­min­is­tra­tions of Bill Clin­ton and George W. Bush were highly sup­port­ive of these reg­u­lat­ory policies 
and took cred­it for the ini­tial in­crease in home own­er­ship they helped to gen­er­ate.
As the policies eroded mort­gage-lend­ing stand­ards,
mak­ing cred­it more read­ily avail­able for risky loans, the ini­tial ef­fects seemed pos­it­ive.
The de­mand for hous­ing in­creased, hous­ing prices soared dur­ing 2001–2005, and there was a boom in the con­struc­tion in­dustry.
Ex­hib­it 6: Subprime Mort­gages as a Share of the Total, 1994–2007
A bar chart show­ing sub-prime mort­gages as a per­cent­age share of total U.S. mort­gage lend­ing between 1994 and 2007. This rose from 4.5% in 1994 to 33.6% in 2006.
Source: The 1994–2000 data are from Ed­ward M. Gram­lich, Fin­an­cial Ser­vices Roundtable An­nu­al Hous­ing Policy Meet­ing, Chica­go, Illinois, 21 May 2004.
The 2002–2007 data are from the Joint Cen­ter for Hous­ing Stud­ies of Har­vard Uni­versity, The State of the Na­tions Hous­ing 2008, https://www.jchs.harvard.edu/research-areas/reports/state-nations-housing-2008.
Loans with in­com­plete doc­u­ment­a­tion and veri­fic­a­tion, known as Alt-A loans, are in­cluded in the subprime cat­egory.
Stud­ies in­dic­ate that most of the Alt-A loans were to subprime bor­row­ers.
But the ar­ti­fi­cially cre­ated hous­ing boom was not sus­tain­able.
By 2004–2005, ap­prox­im­ately half of all mort­gages were either subprime
(in­clud­ing those with in­com­plete doc­u­ment­a­tion) or loans against the equity people had in their homes.
As soon as prices leveled off and then began their de­cline dur­ing the second half of 2006, the house of cards came crash­ing down.
The fore­clos­ure and mortgage default rates im­me­di­ately began to rise.
All of this oc­curred well be­fore the recession, which did not start un­til Decem­ber 2007.
Of course, the col­lapse of the hous­ing in­dustry even­tu­ally spread to the rest of the eco­nomy,
and the bad mort­gages gen­er­ated huge fin­an­cial prob­lems in bank­ing and fin­ance both in the United States and abroad.
By sum­mer 2008, Fan­nie Mae and Fred­die Mac were in­solv­ent.
Their op­er­a­tions were taken over by the gov­ern­ment and the Amer­ic­an tax­pay­er was left with ap­prox­im­ately $400 bil­lion of bad debt.
The in­terest rate policies of the Fed­er­al Re­serve Sys­tem also con­trib­uted to the Great Re­ces­sion of 2008–2009,
as we will ex­plain in the fol­low­ing ele­ment.
But one thing is clear: The polit­ic­al al­loc­a­tion of cred­it and ac­com­pa­ny­ing reg­u­lat­ory erosion of lend­ing stand­ards channeled a lot of fin­an­cial cap­it­al into pro­jects
that should nev­er have been un­der­taken.
Many home­buy­ers were in­centiv­ized to pur­chase more hous­ing than they could af­ford,
and that was a ma­jor con­trib­ut­ing factor in the hous­ing boom and sub­sequent bust, and the re­ces­sion it helped gen­er­ate.
Al­though the spe­cif­ics were dif­fer­ent, the United States was not the only coun­try
where mis­guided gov­ern­ment policies cre­ated a crisis in the hous­ing mar­ket in the years just be­fore 2010.
Between 2007 and 2010 av­er­age house prices fell by ap­prox­im­ately 35 per­cent in Ire­land and by half or more in Dub­lin.
Fol­low­ing the crash of the “Ir­ish hous­ing bubble,” eval­u­ation by out­side ex­perts,
in­clud­ing seni­or fin­ance min­istry of­fi­cials from Canada and Fin­land,
at­trib­uted the over­heated mar­ket to a com­bin­a­tion of ex­cess­ively low in­terest rates set by the European Cent­ral Bank (ECB),
massive in­creases in Ir­ish gov­ern­ment spend­ing en­cour­aged by high­er
than ex­pec­ted prop­erty tax rev­en­ue, and, es­pe­cially, a gov­ern­ment policy
that at­temp­ted to en­cour­age home own­er­ship by al­low­ing mort­gages for 100 per­cent of a home’s pur­chase price, just like in the United States.
Cor­rup­tion also played a role.(33)
Sim­il­ar policies in Spain cre­ated pre­cisely the same res­ult dur­ing the same time frame.
When gov­ern­ments are heav­ily in­volved, al­loc­a­tion of in­vest­ment is in­ev­it­ably char­ac­ter­ized
by fa­vor­it­ism, con­flict of in­terest, in­ap­pro­pri­ate fin­an­cial re­la­tions, and vari­ous forms of cor­rup­tion.
When ac­tions of this type oc­cur in oth­er coun­tries, they are of­ten re­ferred to as crony capitalism.
His­tor­ic­ally, the gov­ern­ment has played a lar­ger role in the al­loc­a­tion of in­vest­ment in oth­er coun­tries than in the United States,
but the Amer­ic­an ex­per­i­ence with gov­ern­ment al­loc­a­tion of in­vest­ment funds for hous­ing il­lus­trates
that crony cap­it­al­ism oc­curs in the United States as well. Re­gard­less of the la­bel, polit­ic­al al­loc­a­tion of cap­it­al im­poses a heavy cost on cit­izens.

Element 2.5: Monetary Stability

A stable monetary policy is essential for the control of inflation, efficient allocation of investment, and achievement of economic stability.

Money is vi­tally im­port­ant for the op­er­a­tion of an eco­nomy. Most im­port­antly, money is a means of ex­change.
It re­duces trans­ac­tion costs be­cause it provides a com­mon de­nom­in­at­or into which the value of all goods and ser­vices can be con­ver­ted.
Eco­nom­ists refer to this prop­erty of money as be­ing a “me­di­um of ex­change.”
We have dis­cussed else­where the be­ne­fits of division of labor.
Ima­gine, however, a world where people spe­cial­ized but ex­changed goods dir­ectly for oth­er goods through what is known as the barter system.
How many apples would equal one cow? How would you make change if someone had enough apples to buy only one-third of a cow?
Money makes it pos­sible for people to gain from com­plex ex­changes that take place over time, such as the sale or pur­chase of a home or car,
which in­volve the re­ceipt of in­come or pay­ment of a pur­chase price across lengthy time peri­ods.
Money also provides a means to store pur­chas­ing power for fu­ture use.
This en­ables the ac­cu­mu­la­tion of funds for in­vest­ments that drive pro­ductiv­ity and eco­nom­ic growth.
Eco­nom­ists call this func­tion of money a “store of value.”
Money is also a “unit of ac­count” that en­hances people’s abil­ity to keep track of be­ne­fits and costs, in­clud­ing those in­curred across time peri­ods.
Without money it’s al­most im­possible to com­pare be­ne­fits and costs which oc­cur over time,
and it’s this com­par­is­on which al­lows people to make bet­ter de­cisions
re­gard­ing when to spend and when to save, and what to buy and what not to buy.
The pro­duct­ive con­tri­bu­tion of money, however, is dir­ectly re­lated to the sta­bil­ity of its value.
In this re­spect, money is to an eco­nomy what lan­guage is to com­mu­nic­a­tion.
Without words that have a clearly defined mean­ing to both speak­er and listen­er, com­mu­nic­a­tion would be dif­fi­cult. So it is with money.
If money does not have a stable and pre­dict­able value, it will be dif­fi­cult for bor­row­ers and lenders to find mu­tu­ally agree­able terms for a loan,
sav­ing and in­vest­ing will in­volve ad­di­tion­al risks, and trans­ac­tions that take place over time
(such as pay­ment for a house or auto­mobile) will be fraught with ad­di­tion­al un­cer­tainty.
When the value of money is un­stable, many po­ten­tially be­ne­fi­cial ex­changes are not made and the gains from spe­cial­iz­a­tion, large-scale pro­duc­tion, and so­cial co­oper­a­tion are re­duced.
There is no mys­tery about the cause of mon­et­ary in­stabil­ity. Like oth­er com­mod­it­ies, the value of money is de­term­ined by sup­ply and de­mand.
When the sup­ply of money is con­stant or in­creases at a slow, steady rate, the pur­chas­ing power of money will be re­l­at­ively stable.
In con­trast, when the sup­ply of money ex­pands rap­idly com­pared to the sup­ply of goods and ser­vices, the value of money de­clines and prices rise.
This is inflation.
It oc­curs when gov­ern­ments print money or bor­row from a cent­ral bank in or­der to pay their bills.
Per­sist­ent in­fla­tion has a single source: rap­id growth in the sup­ply of money.
The money supply is the total of the na­tion’s cur­rency,
checking deposits, and sim­il­ar sources of pay­ment(34) held by in­di­vidu­als and busi­nesses.
When that sup­ply in­creases faster than the growth of the eco­nomy, the prices of goods and ser­vices will rise.
Ex­hib­it 7: Mon­et­ary Growth and In­fla­tion, 1990–2014
Av­er­age An­nu­al Growth Rate of Money Sup­ply (%)Av­er­age An­nu­al Rate of In­fla­tion (%)
Slow Growth of the Money Sup­ply
Sweden32.3
United States32.1
Switzer­land3.41.1
Singa­pore3.51.4
United King­dom5.52.7
Cent­ral Afric­an Re­pub­lic6.43.6
Canada7.52.1
Rap­id Growth of the Money Sup­ply
Ni­ger­ia22.623.2
Ur­uguay2323.4
Malawi26.723.4
Ghana2924.5
Venezuela, RB37.634
Rus­si­an Fed­er­a­tion41.439.3
Ro­mania46.153.1
Tur­key48.441.7
Hy­per­growth Growth of the Money Sup­ply
Ukraine140.4276.8
Zi­m­b­ab­we164.8165.3
Source: The World Bank (WB), World De­vel­op­ment In­dic­at­ors (WDI), 2015 and In­ter­na­tion­al Mon­et­ary Fund, In­ter­na­tion­al Fin­an­cial Stat­ist­ics (an­nu­al).
Note: The data for Ghana and Venezuela are for 1990–2013. The data for Rus­sia are for 1994–2014. The data for Ukraine are for 1993–2014.
In the case of miss­ing data, they were up­dated from coun­try sources:
Canada fig­ures for 1990–2008 come from the World Bank and fig­ures for 2009–2014 come from the Canada Cent­ral Bank.
The data for Zi­m­b­ab­we are for 1990–2007 and come from the World Bank, World De­vel­op­ment In­dic­at­ors 2009 re­port.
Ex­hib­it 7 il­lus­trates the link­age between growth of the money sup­ply and in­fla­tion.
Note how coun­tries that in­creased their money sup­ply at a slow an­nu­al rate (7.5 per­cent or less) ex­per­i­enced low rates of in­fla­tion dur­ing 1990–2014.
This was true for large high-in­come coun­tries like the United States and Canada, as well as for smal­ler ones like Sweden,
Singa­pore, and the Cent­ral Afric­an Re­pub­lic.
When the growth rate of the money sup­ply in a coun­try ex­pan­ded more rap­idly, however, the in­fla­tion rate ac­cel­er­ated.
Dur­ing 1990–2014, the money sup­ply grew at an an­nu­al rate between 20 per­cent and 50 per­cent in Ni­ger­ia,
Ur­uguay, Malawi, Ghana, Venezuela, Rus­si­an Fed­er­a­tion, Ro­mania, and Tur­key.
Note how these coun­tries ex­per­i­enced an­nu­al in­fla­tion rates sim­il­ar to their rates of mon­et­ary growth.
Ex­tremely high rates of mon­et­ary growth (100 per­cent and above) lead to hyperinflation, as in Ukraine and Zi­m­b­ab­we.
As the growth rate of the money sup­ply in these coun­tries soared, so too did their rate of in­fla­tion.
As Ex­hib­it 7 il­lus­trates, there is a close re­la­tion­ship between rap­id mon­et­ary ex­pan­sion and high rates of in­fla­tion when meas­ured over lengthy time peri­ods.
His­tor­ic­ally, this link­age has been one of the most con­sist­ent re­la­tion­ships in all of eco­nom­ics.(35)
Coun­tries with high rates of in­fla­tion fre­quently also have wide fluc­tu­ations in the in­fla­tion rate.
Vari­able rates of in­fla­tion make it even harder than con­sist­ent high rates to plan for the fu­ture, un­der­min­ing prosper­ity.
When prices in­crease 20 per­cent one year, 50 per­cent the next year, 15 per­cent the year after that, and so on,
in­di­vidu­als and busi­nesses are un­able to de­vel­op sens­ible long-term plans.
This un­cer­tainty makes the plan­ning and im­ple­ment­a­tion of cap­it­al in­vest­ment pro­jects risky and less at­tract­ive.
Un­ex­pec­ted changes in the in­fla­tion rate can quickly turn an oth­er­wise prof­it­able pro­ject into an eco­nom­ic dis­aster.
Rather than deal­ing with these un­cer­tain­ties, many de­cision-makers will simply forgo cap­it­al in­vest­ments
and oth­er trans­ac­tions in­volving long-term com­mit­ments.
Some will even move their busi­ness and in­vest­ment activ­it­ies to coun­tries with a more stable en­vir­on­ment.
As a res­ult, po­ten­tial gains from trade, busi­ness activ­it­ies, and cap­it­al form­a­tion will be lost.
Moreover, when gov­ern­ments pur­sue in­fla­tion­ary policies,
people will spend less time pro­du­cing and more time try­ing to pro­tect their wealth.
Be­cause fail­ure to ac­cur­ately an­ti­cip­ate the rate of in­fla­tion can dev­ast­ate one’s wealth,
in­di­vidu­als will shift scarce re­sources away from the pro­duc­tion of goods and ser­vices and to­ward ac­tions de­signed to hedge against in­fla­tion.
The abil­ity of busi­ness de­cision-makers to fore­cast changes in prices be­comes more valu­able
than their abil­ity to man­age and or­gan­ize pro­duc­tion.
When the in­fla­tion rate is un­cer­tain, busi­nesses will shy away from en­ter­ing into long-term con­tracts,
place many in­vest­ment pro­jects on hold, and di­vert re­sources and time into less pro­duct­ive activ­it­ies.
Funds will flow into the pur­chase of gold, sil­ver, and art ob­jects, in the hope that their prices will rise with in­fla­tion,
rather than into more pro­duct­ive in­vest­ments such as build­ings, ma­chines, and tech­no­lo­gic­al re­search.
As re­sources move from more pro­duct­ive to less pro­duct­ive activ­it­ies, eco­nom­ic pro­gress slows.
Eco­nom­ic pro­gress will also be un­der­mined when mon­et­ary poli­cy­makers are con­stantly shift­ing between mon­et­ary ex­pan­sion and con­trac­tion.
When the mon­et­ary au­thor­it­ies ex­pand the money sup­ply rap­idly, ini­tially the more ex­pan­sion­ary monetary policy
will gen­er­ally push in­terest rates down­ward, stim­u­lat­ing cur­rent in­vest­ment and cre­at­ing an ar­ti­fi­cial eco­nom­ic boom.
However, the boom will not be sus­tain­able.
If the ex­pan­sion­ary mon­et­ary policy con­tin­ues, it will gen­er­ate in­fla­tion,
which will cause mon­et­ary poli­cy­makers to shift to­ward a more re­strict­ive policy.
As they do so, in­terest rates will rise,
which will im­pede private investment and throw the eco­nomy into a re­ces­sion.
Thus, mon­et­ary shifts between ex­pan­sion and re­stric­tion will gen­er­ate eco­nom­ic in­stabil­ity,
jerking the eco­nomy back and forth between booms and busts.
This pat­tern of mon­et­ary policy will also cre­ate un­cer­tainty, slow private in­vest­ment, and re­duce the rate of eco­nom­ic growth.
Why might those in con­trol of the sup­ply of money (the mon­et­ary au­thor­it­ies) shift between ex­pan­sion­ary and con­trac­tion­ary re­gimes?
Note that there is likely to be an un­sus­tain­able boom fol­low­ing a rap­id ex­pan­sion of the money sup­ply.
If the mon­et­ary au­thor­it­ies are sub­ject to con­trol by or in­flu­ence from polit­ic­al lead­ers,
the in­terests of these lead­ers may be to cre­ate just such a boom pri­or to elec­tions in the hope that they will be re-elec­ted be­fore the in­ev­it­able re­ces­sion ar­rives.
While these political business cycles can be seen in much of the world,
there has been a dif­fer­ent re­la­tion­ship in trans­ition eco­nom­ies.
As al­ways, policy sta­bil­ity is im­port­ant to cre­ate busi­ness con­fid­ence and, there­fore, in­vest­ment and ex­pan­sion.
Post-com­mun­ist coun­tries had to de­cide between dif­fer­ent paths of reform to a mar­ket eco­nomy.
Some coun­tries were con­sist­ent and early re­formers (such as Es­to­nia),
while the lead­er­ship in oth­ers was dom­in­ated by ex-com­mun­ists (Uzbek­istan).
Coun­tries, there­fore, fol­lowed dif­fer­ent speeds and types of re­forms, some bet­ter than oth­ers.
In all of them, however, eco­nom­ic act­ors could rely on con­sist­ent policies and plan for the fu­ture un­der these policies.
By con­trast, in coun­tries that fol­lowed in­con­sist­ent and chan­ging paths, switch­ing back and forth between re­form and delay (such as Bul­garia and Ukraine)
in­creased un­cer­tainty pri­or to elec­tions when it was not clear who would form the new gov­ern­ment.
The polit­ic­al busi­ness cycle was re­versed, with slow growth lead­ing up to elec­tions be­cause of policy un­cer­tainty lead­ing to low in­vest­ment.(36)
Poor mon­et­ary policy is what is at least par­tially re­spons­ible for eco­nom­ic suc­cess or fail­ure as coun­tries transitioned from com­mun­ism in the 1990s.
All of the eco­nom­ies suffered from an ap­par­ent huge drop in re­por­ted pro­duc­tion and struggled to form mar­ket eco­nom­ies.
In Ukraine, between 1990 and 1994, the re­por­ted GDP fell by more than 48 per­cent.(37)
The gov­ern­ment of Ukraine re­spon­ded to this shock by is­su­ing massive ruble cred­its,
thereby fin­an­cing sub­sidies in in­dustry and ag­ri­cul­ture.
Huge budget deficits were mon­et­ized, mean­ing they were paid for
by hav­ing the Na­tion­al Bank of Ukraine (NBU) simply cre­ate money to pay the gov­ern­ment’s bills.
In Feb­ru­ary and March 1992, the mon­et­ary base was in­creased monthly by 50 per­cent.
Hyper­in­fla­tion reached 2,730 per­cent in 1992, and 10,155 per­cent in 1993.
In total, ten of the four­teen coun­tries cre­ated by the break­up of the former So­viet Uni­on re­cor­ded hyper­in­fla­tion at some point
(due to sim­il­ar ex­cess­ive money sup­ply policies), as did Po­land, Yugoslavia, and Bul­garia.
Only war-rid­den Ar­menia had high­er in­fla­tion than Ukraine ac­cord­ing to the EBRD.(38)
Ukraine’s NBU, which was lit­er­ar­ily sub­or­din­ated by the Par­lia­ment, real­ized its mis­take and hal­ted the is­su­ing of cred­its.
Monthly in­fla­tion fell to 2.1 per­cent in July 1994. Par­lia­ment was un­happy with the NBU’s de­cision
and in Au­gust 1994 the NBU was forced to again is­sue large cred­its (i.e. im­ple­men­ted ex­pan­sion­ary mon­et­ary policy), and these cred­its boos­ted in­fla­tion to 23 per­cent in Oc­to­ber 1994.
Re­ces­sions caused by the pro­cess of col­lapse of the So­viet eco­nomy were fur­ther deepened by the mon­et­ary policy of that era.
Ex­hib­it 8: Money Sup­ply Growth and In­fla­tion, 1992–94
A line chart dis­play­ing money sup­ply growth and in­fla­tion in Ukraine between 1992 and 1994, demon­strat­ing the im­pact of ex­pan­sion­ary mon­et­ary policy on the rate of in­fla­tion. Where the Na­tion­al Bank of Ukraine was al­lowed to halt the is­su­ing of ruble cred­its, in­fla­tion fell, but the gov­ern­ment’s de­cisions to over­ride the NBU and in­crease mon­et­ary sup­ply led to hyper­in­fla­tion.
Source: The graph is from His­tory of Mon­et­ary De­vel­op­ment in Ukraine (2006), Petryk, Oleksandr, Na­tion­al Bank of Ukraine, p.7.
Data source: State Stat­ist­ics Com­mit­tee of Ukraine, own cal­cu­la­tions.
Mon­et­ary sta­bil­ity is an es­sen­tial in­gredi­ent of the en­vir­on­ment for eco­nom­ic pro­gress.
Without mon­et­ary sta­bil­ity, po­ten­tial gains from cap­it­al in­vest­ment and oth­er ex­changes in­volving time com­mit­ments will be eroded and the people of the coun­try will fail to real­ize their full po­ten­tial.

Element 2.6: Prudent Fiscal Policy

People produce more when they can keep more of what they earn.

Taxes are paid in the sweat of every man who labors.
If those taxes are ex­cess­ive, they are re­flec­ted in idle factor­ies, in tax-sold farms,
and in hordes of hungry people tramp­ing streets and seek­ing jobs in vain.
Frank­lin D. Roosevelt, Pitt­s­burgh, Oc­to­ber 19, 1932
Car­toon of two middle-aged men seated across a desk from each oth­er. One is an ac­count­ant hold­ing a sheet of pa­per. The oth­er, a bald man in shirt and tie, asks: “Can I write off last year’s taxes as a bad in­vest­ment?”
When high tax rates take a large share of in­come, the in­cent­ive to work and use re­sources pro­duct­ively de­clines.
The marginal tax rate is par­tic­u­larly im­port­ant.
This is the share of ad­di­tion­al in­come that is taxed away at any giv­en in­come level.
The mar­gin­al tax rates vary across coun­tries.
For ex­ample, in the United States in 2015, if a tax­pay­er with $60,000 in tax­able in­come earned an ex­tra $100, 
he or she had to pay $25 of that $100 in fed­er­al in­come tax.
There­fore, the tax­pay­er faced a mar­gin­al tax rate of 25 per­cent.
The mar­gin­al tax rate in Ro­mania is 16%; in Po­land it is 32% if a tax­pay­er earns more than €20,000;
and in France it is up to 45% for in­comes over €152,260.
As mar­gin­al tax rates in­crease, the share of ad­di­tion­al earn­ings that people get to keep de­clines.
For ex­ample, at the 25 per­cent mar­gin­al tax rate, in­di­vidu­als are per­mit­ted to keep €75 if they earn an ad­di­tion­al €100.
But, if the mar­gin­al tax rate rose to 40 per­cent, then the tax­pay­er would get to keep only €60 out of a €100 in­crease in earn­ings.
There are three reas­ons why high mar­gin­al tax rates will re­duce out­put and in­come.
First, high mar­gin­al tax rates dis­cour­age work ef­fort and re­duce the pro­ductiv­ity of labor.
When mar­gin­al tax rates soar to 55 or 60 per­cent, in­di­vidu­als get to keep less than half of their ad­di­tion­al earn­ings.
When people are not al­lowed to keep much of what they earn, they tend not to earn very much.
Some, per­haps people with work­ing spouses, will drop out of the labor force.
Oth­ers will simply work few­er hours, re­tire earli­er, or take jobs with longer va­ca­tions or a more pre­ferred loc­a­tion.
Still oth­ers will be more par­tic­u­lar about ac­cept­ing jobs when un­em­ployed, re­fuse to move to take a job or to gain a pay raise,
or for­get about pur­su­ing that prom­ising but risky busi­ness ven­ture.
High tax rates can even drive a na­tion’s most pro­duct­ive cit­izens to coun­tries where taxes are lower.
Such move­ments will re­duce the size and pro­ductiv­ity of the avail­able labor sup­ply, caus­ing out­put to de­cline.
Of course, most people will not im­me­di­ately quit work, or even work less di­li­gently, in re­sponse to an in­crease in the mar­gin­al tax rate.
A per­son who has spent years train­ing for a par­tic­u­lar oc­cu­pa­tion will prob­ably con­tin­ue work­ing—
and work­ing hard—es­pe­cially if that per­son is in the peak earn­ing years of life.
But many young­er people who have not already made costly in­vest­ments in spe­cial­ized train­ing will be dis­cour­aged from do­ing so by high mar­gin­al tax rates.
Thus, some of the neg­at­ive ef­fects of high tax rates on work ef­fort will be felt in the form of re­duced pro­ductiv­ity for many years in the fu­ture.
High tax rates will also cause some people to shift to activ­it­ies
in which they are less pro­duct­ive be­cause they do not have to pay taxes on them.
For ex­ample, high taxes will drive up the costs of skilled paint­ers,
per­haps lead­ing you to paint your own house, even though you lack the skill to do it ef­fi­ciently.
Without high tax rates, the pro­fes­sion­al paint­er would do the job at a cost you could af­ford,
and you could spend your time do­ing work for which you are bet­ter suited.
Waste and eco­nom­ic in­ef­fi­ciency res­ult from these tax-dis­tor­ted in­cent­ives.
Second, high mar­gin­al tax rates will re­duce both the level and ef­fi­ciency of cap­it­al form­a­tion.
High tax rates re­pel foreign investment
and cause do­mest­ic in­vestors to search for in­vest­ment pro­jects abroad where both taxes and pro­duc­tion costs are lower than at home.
This re­duces in­vest­ment and the avail­ab­il­ity of pro­duct­ive equip­ment, which provides the fuel for eco­nom­ic growth.
Do­mest­ic in­vestors will also turn to pro­jects that shel­ter cur­rent in­come from tax­a­tion,
and away from pro­jects with a high­er rate of return but few­er tax-avoid­ance be­ne­fits.
These tax shel­ters en­able people to gain per­son­ally from pro­jects that do not en­hance the value of re­sources.
Again, scarce cap­it­al is wasted, and re­sources are channeled away from their most pro­duct­ive uses.
Third, high mar­gin­al tax rates en­cour­age in­di­vidu­als to con­sume tax-deductible goods in place of non­de­duct­ible goods, even though the non­de­duct­ible goods may be more de­sir­able.
When pur­chases are tax-de­duct­ible, in­di­vidu­als who pur­chase them do not bear their full cost,
be­cause the ex­pendit­ure re­duces the taxes they would oth­er­wise pay.
When mar­gin­al tax rates are high, tax-de­duct­ible ex­pendit­ures be­come re­l­at­ively cheap.
The sales of the Brit­ish-made lux­ury car Rolls-Royce in the 1970s provide a vivid il­lus­tra­tion of this point.
Dur­ing this era, the mar­gin­al in­come tax rates in the United King­dom were as high as 98 per­cent on large in­comes.
A busi­ness own­er pay­ing that tax rate could buy a car as a tax-de­duct­ible busi­ness ex­pense, so why not buy an exot­ic, more ex­pens­ive car?
The pur­chase would re­duce the own­er’s profit by the car’s price—say £100,000—
but the own­er would have re­ceived only £2,000 of his or her profit any­way,
be­cause the 98 per­cent mar­gin­al tax rate would have re­duced the £100,000 to £2,000.
In ef­fect, the gov­ern­ment was pay­ing 98 per­cent of the car’s costs (through lost tax rev­en­ue).
When the United King­dom cut the top mar­gin­al tax rate to 70 per­cent, the sales of Rolls-Royces plummeted.
After the rate re­duc­tion, the £100,000 car now cost the busi­ness own­er not £2,000 but £30,000.
The lower mar­gin­al rates made it much more ex­pens­ive for wealthy Brits to pur­chase Rolls-Royces, and they re­spon­ded by re­du­cing their pur­chases.
High mar­gin­al rates ar­ti­fi­cially re­duce the per­son­al cost, but not the cost to so­ci­ety,
of items that are tax-de­duct­ible or that can be taken as a busi­ness ex­pense.
Pre­dict­ably, tax­pay­ers con­front­ing high mar­gin­al tax rates will spend more money on such tax-de­duct­ible items
as plush of­fices, Hawaii­an busi­ness con­fer­ences, busi­ness en­ter­tain­ment, and a com­pany-provided auto­mobile.
Be­cause such tax-de­duct­ible ex­pendit­ures re­duce their taxes,
people will of­ten buy goods they would not buy if they were pay­ing the full cost.
Waste and in­ef­fi­ciency are byproducts of high mar­gin­al tax rates and the per­verse in­cent­ives they gen­er­ate.
Re­duc­tions in tax rates, par­tic­u­larly high rates, can usu­ally in­crease the in­cent­ive to earn and im­prove the ef­fi­ciency of re­source use.
The gov­ern­ment of Geor­gia made rad­ic­al changes to tax le­gis­la­tion from 2005 to 2008.
The 21 dif­fer­ent tax rates that were ap­plied in 2004 were re­duced to 6 in 2005.
From 2009, ag­greg­ated taxes (in­come tax and so­cial tax to­geth­er) were re­duced by ab­ol­ish­ing so­cial tax and im­ple­ment­ing a single personal income tax rate.
The mar­gin­al in­come tax was re­duced from 32 per­cent to 20 per­cent.
The dis­in­cent­ive ef­fects dis­cussed above have caused many eco­nom­ists to ad­voc­ate for what is called a “flat tax,”
un­der which the mar­gin­al tax rate is the same for all in­come levels above a cer­tain min­im­um.
The un­taxed min­im­um, if high enough, can still mean that ac­tu­al taxes paid as a per­cent­age of in­come in­crease as fam­il­ies get wealth­i­er.
Many post-com­mun­ist gov­ern­ments have been lead­ers in mov­ing to flat taxes, in­clud­ing Rus­sia, Geor­gia, Slov­akia, and Ser­bia.
As pre­dicted, there is re­search show­ing that such policy causes a de­crease in the share of eco­nom­ic activ­ity that hap­pens “off the books” in what is called the shad­ow or un­der­ground eco­nomy.
In con­trast, large tax in­creases can ex­ert a dis­astrous im­pact on the eco­nomy.
United States tax policy dur­ing the Great De­pres­sion il­lus­trates this point.
Seek­ing to re­duce the fed­er­al budget de­fi­cit in 1932, the Re­pub­lic­an Hoover ad­min­is­tra­tion and the Demo­crat­ic Con­gress
passed the largest peace­time tax rate in­crease in the his­tory of the United States.
The low­est mar­gin­al tax rate on per­son­al in­come was raised from 1.5 per­cent to 4 per­cent.
At the top of the in­come scale, the highest mar­gin­al tax rate was raised from 25 per­cent to 63 per­cent.
Es­sen­tially, per­son­al in­come tax rates were more than doubled in one year!
This huge tax in­crease re­duced the after-tax in­come of house­holds and the in­cent­ive to earn, con­sume, save, and in­vest.
The res­ults were cata­stroph­ic. In 1932, real out­put fell by 13 per­cent, the largest single-year de­cline dur­ing the Great De­pres­sion era.
Un­em­ploy­ment rose from 15.9 per­cent in 1931 to 23.6 per­cent in 1932.
Just four years later, the Roosevelt ad­min­is­tra­tion in­creased taxes again, push­ing the top mar­gin­al rate to 79 per­cent in 1936.
Thus, dur­ing the lat­ter half of the 1930s, high earners were per­mit­ted to keep only 21 cents of each ad­di­tion­al dol­lar they earned.
(Note: It is in­ter­est­ing to con­trast the words of can­did­ate Roosevelt presen­ted at the top of this ele­ment with the tax policy fol­lowed dur­ing his pres­id­ency.)
Sev­er­al oth­er factors, in­clud­ing a huge con­trac­tion in the money sup­ply and a large in­crease in tar­iff rates, con­trib­uted to both the sever­ity and length of the Great De­pres­sion.
But it is also clear that the tax in­creases of both the Hoover and Roosevelt ad­min­is­tra­tions played a ma­jor role in this tra­gic chapter of Amer­ic­an his­tory.
The dis­in­cent­ive ef­fects of high mar­gin­al tax rates are not just an is­sue for those with high earn­ings.
Many people with re­l­at­ively low in­comes also con­front high im­pli­cit mar­gin­al tax rates,
the com­bin­a­tion of ad­di­tion­al taxes plus the loss of be­ne­fits from in­come-tested trans­fer pro­grams.
For ex­ample, sup­pose that an in­di­vidu­al’s in­come in­creases from €20,000 to €30,000
and, as a res­ult, in­come and payroll taxes take 30 per­cent of the ad­di­tion­al earn­ings.
Fur­ther, be­cause of this in­crease in in­come, the in­di­vidu­al loses €5,000 in be­ne­fits from ex­ist­ing so­cial pro­grams.
He or she would con­front an im­pli­cit mar­gin­al tax rate of 80 per­cent!
Thirty per­cent would come in the form of a high­er tax bill and an ad­di­tion­al 50 per­cent in the form of lost trans­fer be­ne­fits.
People in this po­s­i­tion who earn an ad­di­tion­al €10,000 get to keep only 20 per­cent of it.
Ob­vi­ously, this will sub­stan­tially re­duce their in­cent­ive to earn and make it more dif­fi­cult to move up the in­come lad­der.
We will re­turn to this is­sue in Part 3, Ele­ment 8, when ex­amin­ing the im­pact of trans­fer pro­grams on the poverty rate.
In sum­mary, eco­nom­ic ana­lys­is in­dic­ates that high tax rates, in­clud­ing im­pli­cit rates re­flect­ing the loss of trans­fer be­ne­fits,
will re­duce pro­duct­ive activ­ity, im­pede both em­ploy­ment and in­vest­ment, and pro­mote waste­ful use of re­sources.
They are an obstacle to prosper­ity and the growth of in­come.
Moreover, large tax rate in­creases dur­ing a peri­od of eco­nom­ic weak­ness can ex­ert a dis­astrous im­pact on the eco­nomy.
Of course, low tax rates do not mean no taxes.
As will be dis­cussed in Part 3 be­low, there are le­git­im­ate reas­ons for gov­ern­ments to provide some goods and ser­vices
that it is hard for the mar­ket to de­liv­er.
So­ci­et­ies are also free to de­cide, after con­sid­er­ing the ef­fects of in­cent­ives and un­in­ten­ded con­sequences, that they want to use tax and spend­ing policy to al­ter the dis­tri­bu­tion of in­come.
Fi­nally, as will also be dis­cussed in Part 3, many eco­nom­ists be­lieve that there is a role for taxes and gov­ern­ment spend­ing
(so-called fisc­al policy) to re­duce the in­her­ent vari­ations in eco­nom­ic activ­ity.
Of course, the bur­dens of taxes ex­tend far bey­ond the ef­fect of the funds raised
(es­pe­cially where those funds are used for pro­ductiv­ity-in­creas­ing pub­lic in­vest­ments).
To the ex­tent that a high tax bur­den en­cour­ages firms to pro­duce in the un­der­ground eco­nomy,
they are likely to re­main in­ef­fi­ciently small in or­der to re­duce the chance of be­ing dis­covered by the tax au­thor­it­ies.
In ad­di­tion, the more ex­tens­ive and com­plex the tax sys­tem, the more time and money that firms will have to spend in tax com­pli­ance.
While cre­at­ing in­dices of com­plex mat­ters is al­ways hard and the res­ults are sub­ject to chal­lenge,
the rank­ings of the bur­den of taxes com­piled by the World Bank as a part of its “Do­ing Busi­ness” in­dex (which in­cludes both tax rates and com­plex­ity) seem in­tu­it­ively cor­rect.(39)
For 2019, the most tax-friendly coun­tries in­clude some we would ex­pect to find, such as Hong Kong,(40) Singa­pore, New Zea­l­and, Ire­land, and Fin­land
(plus some small Per­sian Gulf states where oil rev­en­ues mean al­most no taxes on firms).
The worst per­formers also seem about right and in­clude Venezuela, Somalia, Bolivia, Chad, and the Cent­ral Afric­an Re­pub­lic.
Among post-com­mun­ist coun­tries, the least-bur­den­some tax sys­tems are found in Es­to­nia (ranked 12th), Geor­gia (14th), Latvia (16th), and Lithuania (18th).
The av­er­age trans­ition eco­nomy ranked 67th, about the same as Greece, surely not a mod­el to be emu­lated.
If post-com­mun­ist coun­tries could re­duce their tax bur­dens to the level of the lead­ers in the Balt­ics and Geor­gia, growth rates would clearly in­crease.

Element 2.7: Free Trade

People achieve higher incomes when they are free to trade with people in other countries.

Free trade con­sists simply in let­ting people buy and sell as they want to buy and sell.
Protective tariffs are as much ap­plic­a­tions of force as are block­ad­ing squad­rons, and their ob­ject­ive is the same—to pre­vent trade.
The dif­fer­ence between the two is that block­ad­ing squad­rons are a means whereby na­tions seek to pre­vent their en­emies from trad­ing; pro­tect­ive tar­iffs are a means whereby na­tions at­tempt to pre­vent their own people from trad­ing.(41)
Henry George, nine­teenth-cen­tury polit­ic­al eco­nom­ist
The prin­ciples in­volved in international trade are ba­sic­ally the same as those un­der­ly­ing any vol­un­tary ex­change.
As is the case with do­mest­ic trade, in­ter­na­tion­al trade al­lows each of the trad­ing part­ners to pro­duce
and con­sume more goods and ser­vices than would oth­er­wise be pos­sible. There are three reas­ons why this is so.
First, the people of each na­tion be­ne­fit if they can ac­quire a product or ser­vice through trade more cheaply than they can pro­duce it do­mest­ic­ally.
Re­source en­dow­ments dif­fer sub­stan­tially across coun­tries.
Goods that are costly to pro­duce in one coun­try may be eco­nom­ic­al to pro­duce in an­oth­er.
For ex­ample, coun­tries with warm, moist cli­mates such as Brazil and Colom­bia find it ad­vant­age­ous to spe­cial­ize in the pro­duc­tion of cof­fee.
In tem­per­ate con­tin­ent­al cli­mates such as Mol­dova and Geor­gia,
we see spe­cial­iz­a­tion in wine-mak­ing and fruit orch­ards while Siber­ia ex­ports swamp cran­ber­ries.
People in Canada and Aus­tralia, where land is abund­ant and pop­u­la­tion sparse,
tend to spe­cial­ize in land-in­tens­ive products, such as wheat, feed grains, and beef.
The cit­izens of Ja­pan, where land is scarce and the labor force highly skilled,
spe­cial­ize in man­u­fac­tur­ing such items as cam­er­as, auto­mo­biles, and elec­tron­ic products.
Trade will per­mit each of the trad­ing part­ners to use more of their re­sources to pro­duce and sell things they do well rather
than hav­ing them tied up pro­du­cing things at a high cost.
As a res­ult of this spe­cial­iz­a­tion and trade, total out­put in­creases
and people in each coun­try are able to achieve a high­er stand­ard of liv­ing than would oth­er­wise be at­tain­able.
Second, in­ter­na­tion­al trade al­lows do­mest­ic pro­du­cers and con­sumers to be­ne­fit from the eco­nom­ies of scale typ­ic­al of many large op­er­a­tions.
This point is par­tic­u­larly im­port­ant for small coun­tries.
With in­ter­na­tion­al trade, do­mest­ic pro­du­cers can op­er­ate on a lar­ger scale and there­fore achieve lower per-unit costs
than would be pos­sible if they were solely de­pend­ent on their do­mest­ic mar­ket.
For ex­ample, trade makes it pos­sible for tex­tile man­u­fac­tur­ers in coun­tries like Costa Rica,
Guatem­ala, Thai­l­and, and Vi­et­nam to en­joy the be­ne­fits of large-scale pro­duc­tion.
If they were un­able to sell abroad, their costs per unit would be much high­er be­cause their do­mest­ic tex­tile mar­kets are too small to sup­port large, low-cost firms in this in­dustry.
With in­ter­na­tion­al trade, however, tex­tile firms in these coun­tries can pro­duce
and sell large quant­it­ies and com­pete ef­fect­ively in the world mar­ket.
In­ter­na­tion­al trade also al­lows do­mest­ic con­sumers to be­ne­fit by pur­chas­ing from large-scale pro­du­cers abroad.
Giv­en the huge design and en­gin­eer­ing costs of air­planes today, for ex­ample,
no coun­try has a do­mest­ic mar­ket large enough to per­mit even a single air­plane man­u­fac­turer to real­ize fully the eco­nom­ies of large-scale pro­duc­tion.
With in­ter­na­tion­al trade, however, Boe­ing and Air­bus can sell many more planes, each at a lower cost.
As a res­ult, con­sumers in every na­tion can fly in planes pur­chased eco­nom­ic­ally from such large-scale pro­du­cers.
Third, in­ter­na­tion­al trade pro­motes com­pet­i­tion in do­mest­ic mar­kets and al­lows con­sumers to pur­chase a wider vari­ety of goods at lower prices.
Com­pet­i­tion from abroad keeps do­mest­ic pro­du­cers on their toes.
It forces them to im­prove the qual­ity of their products and keep costs down.
At the same time, the vari­ety of goods avail­able from abroad provides con­sumers with a much great­er ar­ray of choices
than would be avail­able without in­ter­na­tion­al trade.
Gov­ern­ments of­ten im­pose reg­u­la­tions that re­strain in­ter­na­tion­al trade.
These can be tar­iffs (taxes on im­por­ted goods), quotas (lim­its on the amount im­por­ted),
exchange rate con­trols (ar­ti­fi­cially hold­ing down the value of the do­mest­ic cur­rency to dis­cour­age im­ports and en­cour­age ex­ports),
or bur­eau­crat­ic reg­u­la­tions on im­port­ers or ex­port­ers.
All such trade re­stric­tions in­crease trans­ac­tion costs and re­duce the gains from ex­change.
As Henry George noted in the quo­ta­tion at the be­gin­ning of this ele­ment,
trade re­straints are like a mil­it­ary block­ade that a na­tion im­poses on its own people.
Just as a block­ade im­posed by an en­emy will harm a na­tion, im­pos­ing a block­ade in the form of trade re­stric­tions also harms the na­tion.
Should any giv­en coun­try be con­sidered a sup­port­er of free trade?
If there are all kinds of products in the loc­al shop­ping malls and su­per­mar­kets, it may seem reas­on­able to as­sume the coun­try sup­ports free trade—but that would not ne­ces­sar­ily be true.
For ex­ample, the av­er­age tar­iff in Ukraine for all in­dus­tri­al products ex­ceeds 10 per­cent, and is up to 20 per­cent for ag­ri­cul­tur­al products.
Im­ports of oth­er products are dis­cour­aged even more, with sug­ar be­ing taxed at 50 per­cent and sun­flower seed oil at 30 per­cent.
In Bul­garia, tar­iff rates for im­ports from coun­tries out­side the E.U. range from 5 per­cent to 45 per­cent.
The United States im­poses quotas on dairy products, sug­ar, eth­an­ol, cot­ton, beef, canned tuna, and to­bacco.
Im­ports above the quotas are sub­ject to pro­hib­it­ively high tar­iffs.
In ad­di­tion to tar­iffs, coun­tries may im­pose quotas (nu­mer­ic­al lim­its on amounts im­por­ted)
or even total bans on products from oth­er coun­tries, or from some coun­tries in par­tic­u­lar.
Tar­iffs, quotas, and bans can be used for pur­poses oth­er than trade policies.
Rus­sia, for ex­ample, banned al­most all ag­ri­cul­tur­al im­ports from the European Uni­on, the United States, Canada, Aus­tralia, and Nor­way in re­sponse to polit­ic­al dis­putes after the start of con­flicts with Ukraine.
In 2018 and 2019, Pres­id­ent Trump of the United States used tar­iff policy in dis­putes with China.
Non-eco­nom­ists of­ten ar­gue that im­port re­stric­tions can cre­ate jobs.
As we dis­cussed in Part 1, Ele­ment 9, it is pro­duc­tion of value that really mat­ters, not jobs.
If jobs were the key to high in­comes, we could eas­ily cre­ate as many as we wanted.
All of us could work one day dig­ging holes and the next day filling them up.
We would all be em­ployed, but we would also be ex­ceed­ingly poor be­cause such jobs would not gen­er­ate goods and ser­vices that people value.
Im­port re­stric­tions may ap­pear to ex­pand em­ploy­ment
be­cause the in­dus­tries shiel­ded by re­straints may in­crease in size or at least re­main steady.
This does not mean, however, that the re­stric­tions ex­pand total em­ploy­ment.
Re­mem­ber the sec­ond­ary ef­fects dis­cussed in Part 1, Ele­ment 12.
When a coun­try erects tar­iffs, quotas, and oth­er bar­ri­ers lim­it­ing the abil­ity of for­eign­ers to sell in that coun­try,
it is sim­ul­tan­eously re­du­cing for­eign­ers’ abil­ity to buy from it­self.
Imports into a coun­try sim­ul­tan­eously provide people in oth­er coun­tries with the pur­chas­ing power they need to buy exports from, or in­vest in, the im­port­ing coun­try.
Thus, im­port re­stric­tions will in­dir­ectly re­duce ex­ports.
Out­put and em­ploy­ment in ex­port in­dus­tries will de­cline, off­set­ting any jobs “saved” in the pro­tec­ted in­dus­tries.(42)
Trade re­stric­tions neither cre­ate nor des­troy jobs; they re­shuffle them.(43)
The re­stric­tions ar­ti­fi­cially dir­ect work­ers and oth­er re­sources to­ward the pro­duc­tion of things
that are pro­duced at a high­er cost than in oth­er coun­tries.
Out­put and em­ploy­ment shrink in areas where a coun­try’s re­sources are more pro­duct­ive—areas where its firms could com­pete suc­cess­fully in the world mar­ket if it were not for the im­pact of the re­stric­tions.
Thus, labor and oth­er re­sources are shif­ted away from areas where their pro­ductiv­ity is high and moved into areas where it is low.
Such policies re­duce both the out­put and in­come levels of coun­tries ad­opt­ing them.
Many people be­lieve that work­ers from high-in­come coun­tries can­not com­pete with for­eign­ers
who some­times make as little as $2 or $3 per day.
This view is wrong and stems from a mis­un­der­stand­ing of both the source of high wages and the law of com­par­at­ive ad­vant­age.
Work­ers in high-in­come coun­tries are well-edu­cated, pos­sess a high skill level, and work with large amounts of cap­it­al equip­ment.
These factors con­trib­ute to their high pro­ductiv­ity, which is the source of their high wages.
In low-wage coun­tries like Bur­undi and Ethiopia, wages are low pre­cisely be­cause pro­ductiv­ity is low.
The fact that Ukrain­i­ans have av­er­age in­comes over twenty-five times those of Bur­undi­ans should not pre­vent Ukrain­i­ans from en­joy­ing a cup of Bur­undi­an cof­fee.
Each coun­try will al­ways have some things that it does re­l­at­ively bet­ter than oth­ers.
Both high- and low-wage coun­tries will be­ne­fit when they can fo­cus on us­ing more of their re­sources pur­su­ing pro­duct­ive activ­it­ies that they do com­par­at­ively well.
If a high-wage coun­try can im­port a product from for­eign pro­du­cers at a lower cost than it can be pro­duced do­mest­ic­ally, im­port­ing it makes sense.
Few­er re­sources will be tied up pro­du­cing items that could be sup­plied do­mest­ic­ally only at a high cost,
and more will be dir­ec­ted to­ward pro­duc­tion of goods and ser­vices that do­mest­ic pro­du­cers can sup­ply at a low cost.(44)
Trade will make it pos­sible for work­ers in both high- and low-wage coun­tries to pro­duce a lar­ger out­put than would oth­er­wise be pos­sible.
In turn, the high­er level of pro­ductiv­ity will lead to high­er wages for both.
What if for­eign pro­du­cers were able to provide con­sumers with a good so cheap(45) that do­mest­ic pro­du­cers were un­able to com­pete?
The sens­ible thing to do would be to ac­cept the eco­nom­ic­al goods and use do­mest­ic re­sources to pro­duce oth­er things.
Re­mem­ber, it is avail­ab­il­ity of goods and ser­vices, not jobs, that de­term­ines our liv­ing stand­ards.
The French eco­nom­ist Frédéric Basti­at dra­mat­ic­ally high­lighted this point in his 1845 satire, “A Pe­ti­tion on Be­half of the Can­dle­stick Makers.”
The pe­ti­tion was sup­posedly writ­ten to the French Cham­ber of Depu­ties by French pro­du­cers of candles, lan­terns, and oth­er products provid­ing in­door light­ing.
The pe­ti­tion com­plained that do­mest­ic sup­pli­ers of light­ing were
“suf­fer­ing from the ru­in­ous com­pet­i­tion of a for­eign rival who ap­par­ently works un­der con­di­tions so su­per­i­or to our own
for pro­duc­tion of light that he is flood­ing the do­mest­ic mar­ket with it at an in­cred­ibly low price;
for the mo­ment he ap­pears, our sales cease, all the con­sumers turn to him, and a branch of the French in­dustry whose rami­fic­a­tions are in­nu­mer­able is all at once re­duced to com­plete stag­na­tion.”
Of course, this rival is the sun, and the pe­ti­tion­ers were re­quest­ing that the Depu­ties pass a law
re­quir­ing the clos­ing of win­dows, blinds, and oth­er open­ings so that sun­light could not enter build­ings.
The pe­ti­tion goes on to list the oc­cu­pa­tions in the light­ing in­dustry
in which there would be a large in­crease in em­ploy­ment if the use of the sun for in­door light­ing was out­lawed.
Basti­at’s point in this satire is clear: As silly as the pro­posed le­gis­la­tion in the pe­ti­tion is,
it is no sil­li­er than le­gis­la­tion that re­duces the avail­ab­il­ity of low-cost goods and ser­vices in or­der to “save” do­mest­ic pro­du­cers and pro­mote em­ploy­ment.
Dur­ing the past sev­er­al dec­ades, trans­port­a­tion costs have fallen and trade bar­ri­ers have de­clined.
The re­duc­tion in trade bar­ri­ers has been most pro­nounced in low-in­come coun­tries.
In 1980, it was com­mon­place for poor, less-developed countries to im­pose tar­iffs of 20 per­cent or more.
Many also im­posed ex­change rate con­trols, which made it dif­fi­cult for their cit­izens to get their hands on the for­eign cur­rency needed to pur­chase im­ports.
Today, the situ­ation is dra­mat­ic­ally dif­fer­ent.
Be­gin­ning in the 1980s, nu­mer­ous less-de­veloped coun­tries, in­clud­ing China and In­dia,
lowered their tar­iffs, re­laxed ex­change rate con­trols, and re­moved oth­er trade bar­ri­ers.
As a res­ult, in­ter­na­tion­al trade has grown rap­idly.
The growth of in­ter­na­tion­al trade has made it pos­sible for the world to pro­duce a lar­ger out­put and achieve a high­er level of con­sump­tion than oth­er­wise would have been the case.
Per cap­ita in­come has in­creased rap­idly in many less-de­veloped coun­tries, par­tic­u­larly the pop­u­lous na­tions of Asia.
The poor in par­tic­u­lar have be­nefited from the freer trade.
World­wide the num­ber of people in ex­treme poverty fell by over 1.1 bil­lion between 1980 and 2015, fall­ing from 40% of the world’s pop­u­la­tion to less than 10%.
Today ap­prox­im­ately two-thirds of products ex­por­ted from de­vel­op­ing coun­tries to the rest of the world face zero tar­iffs.
Fur­ther, the growth of in­ter­na­tion­al trade has nar­rowed the in­come gap between rich and poor na­tions.
In re­cent dec­ades, less-de­veloped coun­tries have grown more rap­idly than high-in­come de­veloped na­tions.
Moreover, the growth of in­come has been par­tic­u­larly rap­id in China and In­dia, home to nearly one-third of the world’s pop­u­la­tion.
As a res­ult, the dis­tri­bu­tion of in­come world­wide is be­com­ing more and more equal, es­pe­cially since the year 2000.(46)
However, the im­pact of the ex­pan­sion in trade on the dis­tri­bu­tion of in­come is of­ten dif­fer­ent in high-in­come coun­tries such as the United States, Canada, Ja­pan, and those of West­ern Europe.
Pre­dict­ably, high-in­come coun­tries will tend to ex­port goods re­quir­ing lots of high-skill, well-edu­cated labor
while dis­pro­por­tion­ately im­port­ing goods pro­duced by low-skill labor.
Thus, trade may in­crease the de­mand for high-skill labor re­l­at­ive to low-skill labor.
To the ex­tent that this is the case, the earn­ings of high-skill work­ers will rise re­l­at­ive to low-skill work­ers,
in­creas­ing do­mest­ic in­come in­equal­ity.
In­come in­equal­ity has in­creased in al­most all high-in­come coun­tries in re­cent dec­ades,
and the growth of in­ter­na­tion­al trade may well be a con­trib­ut­ing factor.
Cur­rently, there ap­pears to be a surge in hos­til­ity to­ward in­ter­na­tion­al trade in sev­er­al high-in­come coun­tries.
Lead­ing polit­ic­al fig­ures have called for vari­ous types of trade bar­ri­ers,
par­tic­u­larly re­stric­tions dir­ec­ted to­ward im­ports from poor coun­tries.
The in­creased in­come in­equal­ity and slow growth in the earn­ings of low-skill, poorly edu­cated work­ers con­trib­ute to this hos­til­ity.
But there is an­oth­er cru­cially im­port­ant factor here: the polit­ic­al power of well-or­gan­ized in­terests.
Trade re­stric­tions be­ne­fit spe­cif­ic pro­du­cers and their re­source sup­pli­ers,
in­clud­ing some work­ers, at the ex­pense of con­sumers and sup­pli­ers in oth­er in­dus­tries.
Typ­ic­ally, in­dus­tries lob­by­ing the gov­ern­ment for pro­tec­tion against for­eign rivals are well-or­gan­ized
and their gains are con­cen­trated and highly vis­ible, while con­sumers, oth­er work­ers,
and oth­er re­source sup­pli­ers are gen­er­ally poorly or­gan­ized and their gains from in­ter­na­tion­al trade widely dis­persed.
Pre­dict­ably, the or­gan­ized in­terests will have more polit­ic­al clout (in the form of con­tri­bu­tions and oth­er forms of polit­ic­al sup­port),
provid­ing politi­cians with a strong in­cent­ive to cater to their views.
Fur­ther­more, it is easy to see the harm to the work­ers who lose their jobs when steel, for ex­ample, is pro­duced more cheaply abroad and freely im­por­ted.
In con­trast, the gains of those helped by the freer trade are much less vis­ible.
In the case of trade re­stric­tions, sound eco­nom­ic think­ing of­ten con­flicts with a win­ning polit­ic­al strategy.
His­tory in­dic­ates that the grow­ing hos­til­ity to trade is po­ten­tially dan­ger­ous.
As the eco­nom­ies slowed in the late 1920s, a sim­il­ar hos­til­ity to­ward trade de­veloped.
This led to the pas­sage in the United States of the Smoot-Hawley tariff bill at mid-year 1930.
This le­gis­la­tion in­creased tar­iffs by more than 50 per­cent on ap­prox­im­ately 3,200 im­por­ted products.
Pres­id­ent Her­bert Hoover, Sen­at­or Reed Smoot, Con­gress­man Wil­lis Haw­ley,
and oth­er pro­ponents of the bill thought high­er tar­iffs would stim­u­late the eco­nomy and save jobs.
As Haw­ley put it, “I want to see Amer­ic­an work­ers em­ployed pro­du­cing Amer­ic­an goods for Amer­ic­an con­sump­tion.”(47)
While the rhet­or­ic soun­ded great, the res­ults were dra­mat­ic­ally dif­fer­ent.
The tar­iff in­crease angered for­eign­ers, and sixty coun­tries re­spon­ded with high­er tar­iffs on Amer­ic­an products.
In­ter­na­tion­al trade plunged and so did out­put in the United States.
By 1932 the volume of United States trade had fallen to less than half the level pri­or to the bill.
Gains from trade were lost, the tar­iff rev­en­ues of the fed­er­al gov­ern­ment ac­tu­ally fell, out­put and em­ploy­ment plunged, and the un­em­ploy­ment rate soared.
Un­em­ploy­ment stood at 7.8 per­cent when the Smoot-Haw­ley bill was passed, but it bal­looned to 23.6 per­cent just two years later.
The stock market, which had re­gained al­most all of the Oc­to­ber 1929 losses pri­or to pas­sage of Smoot-Haw­ley, plunged dur­ing the months fol­low­ing ad­op­tion.
More than a thou­sand eco­nom­ists signed an open let­ter to Pres­id­ent Hoover warn­ing of the harm­ful ef­fects of Smoot-Haw­ley and plead­ing with him not to sign the le­gis­la­tion.
He re­jec­ted their pleas, but his­tory con­firmed the valid­ity of their warn­ings.
Oth­er factors, such as the sharp con­trac­tion in the money sup­ply and the huge tax in­creases of both 1932 and 1936, con­trib­uted to the Great De­pres­sion.
But the Smoot-Haw­ley trade bill was also a ma­jor cause of the tra­gic events of that era.
Will his­tory re­peat it­self? Hope­fully not, but the ex­per­i­ence of the 1930s in­dic­ates
that un­in­formed polit­ic­al rhet­or­ic and hos­til­ity to­ward trade can lead to cata­stroph­ic res­ults.
Look­ing at in­ter­na­tion­al trade im­pacts in post­war peri­ods, it is clear
that the open­ness level of West­ern Europe af­fected the re­cov­ery speed and volume of the eco­nom­ies after both World Wars.
The con­trast between the dec­ade of eco­nom­ic in­stabil­ity in West­ern Europe after World War I
and the eco­nom­ic re­cov­ery es­tab­lished in the dec­ade fol­low­ing World War II is strik­ing and closely re­lated to dif­fer­ences in trade policies.(48)
Eco­nom­ic re­struc­tur­ing fol­low­ing World War I lacked any in­sti­tu­tion­al mech­an­ism to fa­cil­it­ate the re­duc­tion of trade bar­ri­ers that had aris­en dur­ing the war and had be­come en­trenched af­ter­wards.
Yet, just two years after Ger­many’s sur­render in 1945, twenty-three coun­tries
es­tab­lished a Gen­er­al Agree­ment on Tar­iffs and Trade (GATT) that set bind­ing agree­ments to re­duce tar­iffs.
Just five years after the end of the war, all ma­jor West­ern European coun­tries had par­ti­cip­ated in three sep­ar­ate ne­go­ti­at­ing rounds
that had ex­pan­ded GATT mem­ber­ship and fur­ther re­duced im­port tar­iffs.
The ma­jor achieve­ment of the GATT was the ex­tens­ive tar­iff re­duc­tions in the first ne­go­ti­at­ing round in Geneva in 1947. The rap­id de­crease in tar­iffs is rep­res­en­ted in Ex­hib­it 9.(49)
Ex­hib­it 9: Av­er­age Tar­iff Levels in Se­lect Coun­tries
19131925192719311952
Bel­gi­um971117N/A
France149233819
Ger­many1215244016
Italy1716274824
Neth­er­lands24N/AN/AN/A
United King­domN/A4N/A1717
United States3226N/AN/A16
Note: Not all years are com­par­able.
Sources: Cal­cu­la­tions for 1913 and 1925 are from the League of Na­tions as re­por­ted in GATT (1953), p. 62, and also the source for the 1952 GATT cal­cu­la­tion.
For 1927 and 1931 tar­iff data, see Liep­mann (1938), p. 415, and Kit­son and So­lomou (1990), p. 65–6, for the United King­dom in 1932.
Ex­hib­its 10 and 11(50) show the path of ex­port volume and real in­come for five ma­jor West European coun­tries—France, Ger­many, Italy, the Neth­er­lands, and the United King­dom—after the two wars.
Ex­hib­it 10: Ex­port Volume After World Wars I and II (in Five West European Eco­nom­ies)
A line chart show­ing ex­port volumes in five West European eco­nom­ies after the First and Second World Wars. The y axis gives an in­dex from 100 to 900, where 100 is equal to ex­port volumes in 1918 and 1946, down from 380 in 1913 and 450 in 1938. Volumes in­crease after both wars, rising to just un­der 400 by 1929, and rising steeply after the Second World War to over 850 by 1957.
Ex­hib­it 11: Real Out­put After World Wars I and II (in Five West European Eco­nom­ies)
A line chart show­ing real out­put in five West European eco­nom­ies after the First and Second World Wars. The y axis gives an in­dex start­ing at 100 for 1918 and 1946, down from 112 in 1913 and 122 in 1938. After the First World War, out­put de­creases un­til 1921, then rises stead­ily to above 125 by 1929. Out­put in­creases im­me­di­ately after the Second World War to al­most 200 by 1957.
Free­ing Europe’s re­gion­al and in­ter­na­tion­al trade from gov­ern­ment re­stric­tions
per­mit­ted eco­nom­ies to take ad­vant­age of spe­cial­iz­a­tion ac­cord­ing to their com­par­at­ive ad­vant­age, and thereby ex­pand more rap­idly.

Part 2 Final Thoughts

The Importance of Institutions and Policies

In re­cent years there has been a vir­tu­al ex­plo­sion of schol­arly re­search provid­ing sup­port for the view
that economic institutions and policies are the primary de­term­in­ants of eco­nom­ic growth and de­vel­op­ment.
By eco­nom­ic in­sti­tu­tions, we mean the leg­al re­quire­ments, reg­u­la­tions, tra­di­tions, and cus­toms that cre­ate the frame­work in which an eco­nomy op­er­ates.
They in­clude con­sti­tu­tion­al man­dates, leg­al pro­cesses, rules that gov­ern ex­change, and the struc­ture of mon­et­ary ar­range­ments. 
Eco­nom­ic policies are defined as more spe­cif­ic polit­ic­al ac­tions that can be altered much more quickly than in­sti­tu­tions.
The area of study that ana­lyzes the im­pact of in­sti­tu­tions and policies
on eco­nom­ic growth, de­vel­op­ment, and per­form­ance is known as the New In­sti­tu­tion­al Eco­nom­ics.
In­sti­tu­tions and policies that en­cour­age pro­duct­ive ac­tions and dis­cour­age pred­at­ory be­ha­vi­or
are re­garded as provid­ing the key to eco­nom­ic growth and prosper­ity.
Nu­mer­ous eco­no­met­ric stud­ies have ex­amined the im­prove­ment in in­sti­tu­tion qual­ity gen­er­ated by the trans­ition from com­mun­ism
and have found that coun­tries that moved faster to de­vel­op good in­sti­tu­tions gen­er­ally per­formed much bet­ter eco­nom­ic­ally.(51)
While there is some de­bate about the pre­cise in­sti­tu­tions that are most ap­pro­pri­ate for the achieve­ment of rap­id growth,
there is con­sid­er­able agree­ment that se­cure prop­erty rights, open mar­kets,
mon­et­ary sta­bil­ity, and min­im­al trade re­stric­tions are cent­ral to the es­tab­lish­ment of a sound in­sti­tu­tion­al en­vir­on­ment.
The points out­lined in this sec­tion re­flect the New In­sti­tu­tion­al Eco­nom­ics.
How much do in­sti­tu­tions and policies mat­ter?
To an­swer this ques­tion, we need a way of com­par­ing the in­sti­tu­tions and policies of dif­fer­ent coun­tries.
Since the mid-1980s, the Fraser In­sti­tute of Van­couver, Canada,
along with a num­ber of part­ners, has re­por­ted a cross-coun­try in­dex of eco­nom­ic free­dom called the “Eco­nom­ic Free­dom of the World (EFW)” in­dex.
Now pub­lished by a world­wide net­work of in­sti­tutes, this in­dex meas­ures the ex­tent
to which a coun­try’s in­sti­tu­tions and policies are con­sist­ent with eco­nom­ic free­dom.
It cap­tures size of gov­ern­ment, the leg­al sys­tem and prop­erty rights, sound money, free­dom to trade, and the reg­u­lat­ory en­vir­on­ment.
The in­dex in­cor­por­ates 42 sep­ar­ate com­pon­ents and provides rat­ings for ap­prox­im­ately 160 coun­tries, some go­ing as far back as 1980 and oth­ers ad­ded as data be­comes avail­able.
In many ways, the EFW in­dex re­flects the ele­ments out­lined in pre­vi­ous sec­tions of this book.
To achieve a high EFW rat­ing, a coun­try must provide se­cure pro­tec­tion of privately owned prop­erty,
even­han­ded en­force­ment of con­tracts, and a stable mon­et­ary en­vir­on­ment.
It also must keep taxes low, re­frain from cre­at­ing bar­ri­ers to both do­mest­ic and in­ter­na­tion­al trade,
and rely more fully on mar­kets rather than gov­ern­ment ex­pendit­ures and reg­u­la­tions to al­loc­ate goods and re­sources.
If these in­sti­tu­tion­al and policy factors really do af­fect eco­nom­ic per­form­ance,
coun­tries with per­sist­ently high EFW rat­ings should do much bet­ter than those with per­sist­ently low rat­ings.
Ex­hib­it 12 presents data on 2017 per cap­ita in­come and its re­cent growth for the ten coun­tries with the highest and low­est EFW rat­ings in 2016.
The coun­tries with the highest rat­ings are not sur­pris­ing, ex­cept for Geor­gia and Maur­i­ti­us,
where the ef­fect of re­cent eco­nom­ic re­forms is clearly evid­ent.
At the bot­tom of the rank­ings is Venezuela.
Un­der the Chavez/Ma­duro gov­ern­ment, what was once the most pros­per­ous coun­try in South Amer­ica
has be­come a clear ex­ample of the dis­astrous fail­ure of com­mun­ist/so­cial­ist eco­nom­ic plan­ning.
Coun­tries ex­hib­it­ing the most eco­nom­ic free­dom have an av­er­age 2017 per cap­ita in­come of $56,749,
al­most sev­en times the av­er­age for the least-free coun­tries.
As can also be seen in Ex­hib­it 12, eco­nom­ic­ally free coun­tries have con­sist­ently pos­it­ive growth rates.
The least-free coun­tries ex­hib­it a wide vari­ety of growth ex­per­i­ences.
Some, dur­ing peri­ods of sta­bil­ity and start­ing from a low growth rate, grow strongly,
but oth­ers with es­pe­cially bad policies, even shrink over time.
The av­er­age an­nu­al growth rate of the top group was 3.7 per­cent, com­pared to -0.4 per­cent for the bot­tom group.
Ex­hib­it 12: Eco­nom­ic Free­dom, In­come and Eco­nom­ic Growth
Eco­nom­ic Free­domCoun­try2017 GDP Per Cap­ita2013–2017 An­nu­al Growth
Top 10 Rank 2016
1Hong Kong$61,5402.8%
2Singa­pore$93,9053.5%
3New Zea­l­and$40,9173.3%
4Switzer­land$65,0061.8%
5Ire­land$76,3059.4%
6United States$59,5322.2%
7Geor­gia$10,6893.7%
8Maur­i­ti­us$22,2793.7%
9United King­dom$43,8872.2%
10Aus­tralia$47,0472.4%
10Canada$46,3782.2%
AV­ER­AGE$56,7493.7%
Bot­tom 10 Rank 2016
153Su­dan$4,9042.8%
154Guinea-Bis­sau$1,7004.5%
155An­gola$6,3891.1%
156Cent­ral Afric­an Re­pub­lic$726-4.4%
157Syr­ia$2,900N/A
157Re­pub­lic of the Congo$8876.1%
159Al­ger­ia$15,2753%
160Ar­gen­tina$20,7870.7%
161Libya$19,631-9.2%
162VenezuelaN/A-7.8%
AV­ER­AGE$8,133-0.4%
Source: Data from the World Bank.
Note: GDP per cap­ita, PPP.
When low-in­come coun­tries ad­opt good in­sti­tu­tions and policies,
they are able to achieve ex­ceed­ingly high growth rates and nar­row the in­come gap re­l­at­ive to high-in­come in­dus­tri­al na­tions.
In 1980, the two most pop­u­lous coun­tries, China and In­dia, were also among the world’s least free eco­nom­ies.
Dur­ing the 1980s and 1990s, they ad­op­ted policies more con­sist­ent with eco­nom­ic free­dom and are now achiev­ing im­press­ive rates of eco­nom­ic growth of 6% a year or more.
Al­though the great­er eco­nom­ic suc­cess of freer coun­tries can be in­ferred from the ex­amples above,
there are al­ways coun­tries that don’t quite fit the pat­tern.
The link is clear­er if we com­bine coun­tries in groups.
Ex­hib­it 13 breaks the coun­tries into four groups (called quart­iles), where each group con­tains 25% of the coun­tries ar­rayed from low to high by their EFW rat­ing,
and shows their av­er­age in­come level over a longer peri­od.
Since cur­rent in­come re­flects the ef­fect of growth over dec­ades or more, the dif­fer­ences stand out.
Mak­ing the as­sump­tion (which is sup­por­ted by deep­er ana­lys­is)
that cur­rently free coun­tries have spent more time in re­cent years also be­ing free, it is clear that the freer eco­nom­ies
(as meas­ured by av­er­age scores for the two dec­ades from 1995 to 2016) have achieved much high­er in­come levels.
The most-free coun­tries had an av­er­age 2016 per cap­ita in­come of $40,376, over sev­en times the av­er­age for the least-free coun­tries.
Ex­hib­it 13: Eco­nom­ic Free­dom and In­come per Cap­ita
A bar chart show­ing the re­la­tion­ship between eco­nom­ic free­dom and in­come per cap­ita for each quart­ile of the Eco­nom­ic Free­dom Quart­ile. GDP is shown in US dol­lars at 2016 pur­chas­ing power par­ity. Coun­tries in the low­est quart­ile had an av­er­age GDP per cap­ita of $5,649 while coun­tries in the top quart­ile had an av­er­age GDP per cap­ita of $40,376.
Coun­tries with great­er eco­nom­ic free­dom have sub­stan­tially high­er per-cap­ita in­comes.
Note: In­come = GDP per cap­ita, (PPP con­stant US$), 2016.
Sources: Av­er­age Eco­nom­ic Free­dom Pan­el Score, 1995–2016; World Bank, 2017, World De­vel­op­ment In­dic­at­ors.
The graphs in this sec­tion are taken from James Gwart­ney et al. Eco­nom­ic Free­dom of the World: 2018 An­nu­al Re­port at: https://www.fraserinstitute.org/studies/economic-freedom.
Not only were freer coun­tries more pros­per­ous over­all, the be­ne­fits of a freer eco­nomy ex­ten­ded to poorer house­holds.
Ex­hib­it 14 shows the av­er­age per cap­ita in­come of the poorest tenth in each coun­try sor­ted by their level of eco­nom­ic free­dom.
Even without con­sid­er­ing the be­ne­fits of free­dom it­self,
giv­en a choice, poor house­holds would ob­vi­ously choose to live in the free so­ci­et­ies.
This marked dif­fer­ence says a great deal about the mi­gra­tion pres­sures
that have come to dom­in­ate pub­lic policy dis­cus­sions in many coun­tries in re­cent years.
Ex­hib­it 14: Eco­nom­ic Free­dom and the In­come Earned by the Poorest 10%
A bar chart show­ing the re­la­tion­ship between eco­nom­ic free­dom and in­come earned by the poorest 10% of house­holds by Eco­nom­ic Free­dom Quart­ile. GDP is shown in US dol­lars at 2016 pur­chas­ing power par­ity. An­nu­al in­come per cap­ita of the poorest 10% in the low­est quart­ile was $1,345 while for the poorest 10% in the top quart­ile, an­nu­al in­come reached $10,660.
The amount of in­come, as op­posed to the share, earned by the poorest 10% of the pop­u­la­tion is much high­er in coun­tries with high­er eco­nom­ic free­dom.
Note: An­nu­al in­come per cap­ita of poorest 10% (PPP con­stant US$), 2016.
Sources: Av­er­age Eco­nom­ic Free­dom Pan­el Score, 1995–2016; World Bank, 2017, World De­vel­op­ment In­dic­at­ors.
Of course, us­ing the in­comes of the low­est 10% to meas­ure poverty can be mis­lead­ing.
The poorest 10% may be liv­ing rather well in a rich coun­try, but truly suf­fer­ing in a poor coun­try.
Let us ex­am­ine Ex­hib­it 15, which shows the frac­tion of the pop­u­la­tion
liv­ing in “ex­treme” or “mod­er­ate” poverty as defined by the World Bank.
Ex­treme poverty means liv­ing on $1.90 per per­son per day while mod­er­ate poverty means less than $3.20 a day
(U.S. dol­lars ad­jus­ted for price dif­fer­ences).(52)
It is easy to see the ad­vant­age of liv­ing in a coun­try that has high levels of eco­nom­ic free­dom—cit­izens of such coun­tries are very un­likely to be poor.
Glob­ally, the world has made great pro­gress in elim­in­at­ing poverty.
Ac­cord­ing to the World Bank, 42% of people lived in ex­treme poverty in 1981. By 2016, this frac­tion had fallen to less than 10%.
While there is still a way to go, the fo­cus on mar­ket eco­nom­ics by United States Pres­id­ent Ron­ald Re­agan (1981–1989)
and United King­dom Prime Min­is­ter Mar­garet Thatch­er (1979–1990) was surely a ma­jor factor in this pro­gress.
Ex­hib­it 15: Eco­nom­ic Free­dom and Ex­treme and Mod­er­ate Poverty Rates
A bar chart dis­play­ing ex­treme and mod­er­ate poverty rates, show­ing that these are lower in coun­tries which en­joy great­er eco­nom­ic free­dom. Ex­treme and mod­er­ate poverty rates for those in the least free quart­ile stood at 31.71% and 51.74% of the pop­u­la­tion. Ex­treme and mod­er­ate poverty rates for those in the most free quart­ile stood at 1.48% and 4.31% of the pop­u­la­tion.
Ex­treme and mod­er­ate poverty are lower in coun­tries with more eco­nom­ic free­dom.
Note: The ex­treme poverty rate is the per­cent­age of a coun­try’s pop­u­la­tion that lives on $1.90 per day;
the mod­er­ate poverty rate is the per­cent­age that lives on $3.20 per day, in 2011 con­stant PPP-ad­jus­ted dol­lars.
Sources: Av­er­age Eco­nom­ic Free­dom Pan­el Score, 1995–2016; World Bank, 2017, World De­vel­op­ment In­dic­at­ors; for de­tails, see Con­nors, 2011.
Of course, money is not the only way to meas­ure in­creas­ing well-be­ing in the world.
Eco­nom­ic­ally free coun­tries are also the place to live if you care about oth­er out­comes.
In­fant mor­tal­ity (shown in Ex­hib­it 16) serves as a good in­dic­at­or of the qual­ity of med­ic­al care.
Ex­hib­it 16: Eco­nom­ic Free­dom and In­fant Mor­tal­ity Rate
A bar chart show­ing the re­la­tion­ship between eco­nom­ic free­dom and in­fant mor­tal­ity, where the mor­tal­ity rate is giv­en per 1,000 live births in 2016. The data show that in­fant mor­tal­ity rates are al­most sev­en times high­er in coun­tries in the low­est quart­ile of eco­nom­ic free­dom at 42.45 per thou­sand in con­trast with 6.28 per thou­sand in the top quart­ile.
The in­fant mor­tal­ity rate is al­most sev­en times high­er in na­tions in the low­est quart­ile of eco­nom­ic free­dom com­pared to na­tions in the highest quart­ile.
Sources: Av­er­age Eco­nom­ic Free­dom Pan­el Score, 1995–2016; World Bank, 2017, World De­vel­op­ment In­dic­at­ors.
Fi­nally, there is hap­pi­ness it­self. Eco­nom­ists are un­com­fort­able with simply ask­ing people: “How happy are you?”,
but Ex­hib­it 17 re­veals that there is clearly a link between their an­swers to such a ques­tion and the de­gree of eco­nom­ic free­dom they have.
Ex­hib­it 17: Eco­nom­ic Free­dom and the UN World Hap­pi­ness In­dex
A bar chart show­ing the re­la­tion­ship between eco­nom­ic free­dom and hu­man hap­pi­ness. The UN World Hap­pi­ness In­dex shows that people liv­ing in the top quart­ile of eco­nom­ic­ally free coun­tries tend to be hap­pi­er than those in the lower three quart­iles. The most eco­nom­ic­ally free coun­tries score an in­dex of 6.54, com­pared to 4.48 for the least eco­nom­ic­ally free coun­tries.
People in coun­tries with great­er eco­nom­ic free­dom tend to be hap­pi­er about their lives.
Note: “The rank­ings are based on an­swers to the main life eval­u­ation ques­tion ... This is called the Cantril lad­der:
it asks re­spond­ents to think of a lad­der, with the best pos­sible life for them be­ing a 10, and the worst pos­sible life be­ing a 0.
They are then asked to rate their own cur­rent lives on that 0 to 10 scale.” Data are for 2015.
Sources: Av­er­age Eco­nom­ic Free­dom Pan­el Score, 1995–2016; United Na­tions, 2016, World Hap­pi­ness Re­port 2016 Up­date.
Re­cently, the Fraser In­sti­tute and its part­ners have sup­ple­men­ted the Eco­nom­ic Free­dom In­dex with a second meas­ure de­signed to cap­ture “Per­son­al Free­dom.”
This meas­ure fo­cuses on the rule of law, se­cur­ity and safety, and free­dom of move­ment, re­li­gion, as­sembly, ex­pres­sion and iden­tity.
As can be seen in Ex­hib­it 18, there is a close cor­res­pond­ence between per­son­al free­dom and eco­nom­ic free­dom.
Free so­ci­et­ies are not only rich­er, they usu­ally show great­er re­spect for hu­man rights.
Ex­hib­it 18: Re­la­tion­ship Between Per­son­al and Eco­nom­ic Free­dom, 2016
A scat­ter plot show­ing the re­la­tion­ship between per­son­al and eco­nom­ic free­dom. The y axis shows eco­nom­ic free­dom and the x axis shows per­son­al free­dom, on a scale of 2–10. Syr­ia and Ye­men both have low levels of per­son­al free­dom and me­di­um levels of eco­nom­ic free­dom. Venezuela scores low­est on eco­nom­ic free­dom but nears 6 on the per­son­al free­dom scale. Coun­tries such as Hong Kong, New Zea­l­and, and the United States are above 8 on both scales.
Source: Ian Vasquez and Tanja Por­c­nik, The Hu­man Free­dom In­dex 2018: A Glob­al Meas­ure­ment of Per­son­al, Civil, and Eco­nom­ic Free­dom.
Pub­lish­ers: The Cato In­sti­tute, the Fraser In­sti­tute, and the Friedrich Nau­mann Found­a­tion for Free­dom.
Both eco­nom­ic the­ory and the em­pir­ic­al evid­ence in­dic­ate that coun­tries grow more rap­idly, achieve high­er in­come levels,
and make more pro­gress against poverty when they ad­opt and main­tain policies along the lines out­lined in this sec­tion.
The key to eco­nom­ic pro­gress is to cre­ate sound in­sti­tu­tions and ad­opt con­sist­ent policies to en­hance both eco­nom­ic and per­son­al freedoms.
The soon­er cit­izens and polit­ic­al lead­ers around the world be­come aware of this need and be­gin mov­ing their coun­tries to­ward great­er eco­nom­ic free­dom, the more pros­per­ous the world will be.

Part 3: Ten Key Elements of Economic Thinking About Government

Elements:

  1. Gov­ern­ment pro­motes eco­nom­ic pro­gress by pro­tect­ing the rights of in­di­vidu­als and sup­ply­ing cer­tain goods and ser­vices
    that are dif­fi­cult to provide through mar­kets.
  2. When mono­poly is present and bar­ri­ers to entry are high, mar­kets will fail to achieve ideal ef­fi­ciency.
  3. Pub­lic goods and ex­tern­al­it­ies res­ult in in­cent­ives that may en­cour­age self-in­ter­ested in­di­vidu­als to un­der­take activ­it­ies
    that are in­con­sist­ent with ideal eco­nom­ic ef­fi­ciency.
  4. Al­loc­a­tion through polit­ic­al vot­ing is fun­da­ment­ally dif­fer­ent than mar­ket al­loc­a­tion.
  5. Un­less re­strained by con­sti­tu­tion­al or oth­er strict rules,
    spe­cial in­terest groups will use the demo­crat­ic polit­ic­al pro­cess to ob­tain gov­ern­ment fa­vors at the ex­pense of oth­ers.
  6. Un­less re­strained by con­sti­tu­tion­al or oth­er strict rules, le­gis­lat­ors will run budget de­fi­cits and spend ex­cess­ively.
  7. When gov­ern­ments be­come heav­ily in­volved in provid­ing fa­vors to some in­di­vidu­als or firms at the ex­pense of oth­ers,
    in­ef­fi­ciency res­ults and im­prop­er, un­eth­ic­al re­la­tion­ships de­vel­op between gov­ern­ment of­fi­cials and busi­nesses.
  8. The net gain of trans­fer re­cip­i­ents is less, and of­ten sub­stan­tially less, than the amount of the trans­fer.
  9. The eco­nomy is far too com­plex to be cent­rally planned and ef­forts to do so will res­ult in in­ef­fi­ciency and cronyism.
  10. Com­pet­i­tion is just as im­port­ant in gov­ern­ment as in mar­kets.

Introduction

Eco­nom­ists use the stand­ard of eco­nom­ic ef­fi­ciency to as­sess the op­er­a­tion of an eco­nomy.
When re­sources are used ef­fi­ciently, only ac­tions that yield more be­ne­fits than costs are un­der­taken.
No ac­tion will be un­der­taken that costs more than it is worth.
Put simply, economic efficiency means get­ting the most value from the avail­able re­sources.
Courses in eco­nom­ics gen­er­ally ex­plain why mar­kets will fail to achieve ideal ef­fi­ciency for cer­tain cat­egor­ies of activ­ity and high­light what the gov­ern­ment might do to im­prove the situ­ation.
We fol­low this con­ven­tion—we con­sider the po­ten­tial of ideal­ized polit­ic­al ac­tion, but we also ap­ply the tools of eco­nom­ics to the op­er­a­tion of the polit­ic­al pro­cess.
Gov­ern­ment ex­pendit­ures now con­sti­tute 40 per­cent or more of na­tion­al in­come in the United States and sev­er­al oth­er coun­tries.
Giv­en its size and scope, un­der­stand­ing how polit­ic­al al­loc­a­tion works is vi­tally im­port­ant.
Dur­ing the past half cen­tury, this top­ic has be­come an in­teg­ral part of eco­nom­ics.
Eco­nom­ists use the term public choice when re­fer­ring to this area of study.(53) Part 3 will in­cor­por­ate this ana­lys­is.
Gov­ern­ments of­ten use taxes and bor­row­ing to provide some in­di­vidu­als and busi­nesses with trans­fers, sub­sidies, and oth­er forms of fa­vor­it­ism.
We will ana­lyze this pro­cess and ex­plain why the im­pact of these pro­grams is dif­fer­ent, and of­ten sub­stan­tially dif­fer­ent, than most be­lieve.
Part 3 will also out­line a set of con­sti­tu­tion­al rules that might im­prove the op­er­a­tion of gov­ern­ment and its po­ten­tial to en­hance the qual­ity of our lives.
We hope you find our ap­proach stim­u­lat­ing and that it will chal­lenge you to think more ser­i­ously about both the po­ten­tial and lim­it­a­tions of the polit­ic­al pro­cess.

Element 3.1: Protect Rights and Produce Limited Goods and Services

Government promotes economic progress by protecting the rights of individuals and supplying a few goods and services that are difficult to provide through markets.

A wise and frugal Gov­ern­ment, which shall re­strain men from in­jur­ing one an­oth­er,
which shall leave them oth­er­wise free to reg­u­late their own pur­suits of in­dustry and im­prove­ment, and shall not take from the mouth of labor the bread it has earned.
This is the sum of good gov­ern­ment, and this is ne­ces­sary to close the circle of our fe­li­cit­ies.
Thomas Jef­fer­son, First In­aug­ur­al Ad­dress, March 4, 1801
Gov­ern­ments play a vi­tally im­port­ant eco­nom­ic role.
Gov­ern­ments can pro­mote so­cial co­oper­a­tion and en­hance the wel­fare of the cit­izenry through the per­form­ance of two ma­jor func­tions:
(1) the pro­tect­ive func­tion that provides people with pro­tec­tion for their lives, liber­ties, and prop­er­ties;
and (2) the pro­duct­ive func­tion that sup­plies a few se­lect goods that have un­usu­al char­ac­ter­ist­ics
that make them dif­fi­cult to provide through mar­kets.
The protective function en­com­passes the gov­ern­ment’s main­ten­ance of a frame­work of se­cur­ity and or­der,
in­clud­ing the en­force­ment of rules against theft, fraud, and vi­ol­ence.
Gov­ern­ments are gran­ted a mono­poly on the le­git­im­ate use of force in or­der to pro­tect cit­izens from each oth­er and from out­siders.
Thus the “pro­tect­ive state” seeks to pre­vent in­di­vidu­als from harm­ing one an­oth­er
and main­tains an in­fra­struc­ture of rules that al­low people to in­ter­act with one an­oth­er co­oper­at­ively and har­mo­ni­ously.
A leg­al sys­tem that pro­tects in­di­vidu­als and their prop­erty from ag­gressors, en­forces con­tracts in an un­biased man­ner, and provides equal treat­ment un­der the law (see Part 2, Ele­ment 1) forms the core of the pro­tect­ive func­tion of gov­ern­ment.
The pro­tect­ive func­tion is cru­cially im­port­ant for the smooth op­er­a­tion of mar­kets.
When the gov­ern­ment clearly defines and en­forces prop­erty rights, mar­ket prices will re­flect the op­por­tun­ity cost of re­sources,
and pro­du­cers will be dir­ec­ted to­ward pro­duc­tion of the goods and ser­vices that are most highly val­ued by con­sumers com­pared to their cost.
Moreover, if con­tracts are en­forced in a way that is ef­fi­cient and without fa­vor­it­ism,
trans­ac­tion costs will be low and the volume of trade en­larged.
In turn, the incentive structure will en­cour­age people to de­vel­op re­sources,
en­gage in mu­tu­ally ad­vant­age­ous trade, and un­der­take wealth-cre­at­ing pro­jects.
It is dif­fi­cult to over­state the im­port­ance of the gov­ern­ment’s pro­tect­ive func­tion. When this func­tion is per­formed well,
cit­izens can have con­fid­ence that they will not be cheated and that the wealth they cre­ate will not be taken from them—by either selfish in­truders or by the gov­ern­ment it­self.
This pro­tec­tion provides cit­izens with as­sur­ance that if they sow, they will be per­mit­ted to reap.
When this is true, people will sow and reap abund­antly, and eco­nom­ic pro­gress will res­ult.
In con­trast, when the pro­tect­ive func­tion is per­formed poorly, prob­lems will abound.
Op­por­tun­it­ies to get ahead through de­cep­tion, fraud, theft, and polit­ic­al fa­vor­it­ism rather than through pro­duc­tion and trade will emerge.
Earn­ings and wealth will be in­sec­ure, and mar­ket prices will fail to re­gister the true cost of sup­ply­ing goods and ser­vices.
In­cent­ives to de­vel­op re­sources will be weak, and eco­nom­ic growth will stag­nate.
Un­for­tu­nately, this is pre­cisely the situ­ation in many poor, less-de­veloped coun­tries.
The second primary func­tion of gov­ern­ment, the productive function, in­volves the pro­vi­sion of activ­it­ies that are dif­fi­cult to provide through mar­kets.
There is both an in­dir­ect and dir­ect com­pon­ent of this pro­duct­ive func­tion.
The in­dir­ect com­pon­ent in­volves the cre­ation of an en­vir­on­ment for the ef­fi­cient op­er­a­tion of mar­kets.
As noted, a leg­al struc­ture that pro­tects prop­erty rights and en­forces con­tracts en­hances gains from trade and mar­ket ef­fi­ciency.
Sim­il­arly, mon­et­ary ar­range­ments that provide res­id­ents with ac­cess to money with stable pur­chas­ing power across time
re­duces un­cer­tainty and fa­cil­it­ates gains from ex­change.
The pro­vi­sion of a stable mon­et­ary and price en­vir­on­ment is one of the most im­port­ant pro­duct­ive func­tions of gov­ern­ment.
As dis­cussed in Part 2, Ele­ment 5, when gov­ern­ments per­form this func­tion well,
people will in­vest more, co­oper­ate more fully through trade, and achieve high­er in­come levels.
Some­times the pro­duct­ive func­tion of gov­ern­ment is more dir­ect.
There are some goods for which it is dif­fi­cult to es­tab­lish a one-to-one re­la­tion­ship between pay­ment for and re­ceipt of the good.
For ex­ample, na­tion­al de­fense is jointly con­sumed by the cit­izenry.
It would be vir­tu­ally im­possible to provide some cit­izens with pro­tec­tion against for­eign ag­gressors without sim­ul­tan­eously provid­ing it to all.
Mar­kets will tend to pro­duce too little of goods with such char­ac­ter­ist­ics.
As a res­ult, gov­ern­ment pro­vi­sion may im­prove eco­nom­ic con­di­tions.
This is­sue is con­sidered in more de­tail in Ele­ment 3 be­low.
In oth­er cases, it may be very costly to mon­it­or us­age and col­lect pay­ments dir­ectly from users.
When this is the case, it may be in­ef­fi­cient to provide such goods through mar­kets. Roads, par­tic­u­larly those in cit­ies and towns, provide an ex­ample.
The cost of col­lect­ing fees and thereby char­ging users dir­ectly for their use would be ex­ceed­ingly high.
Thus, it is typ­ic­ally more ef­fi­cient to make most roads avail­able to all and fin­ance them through tax­a­tion.
As we have stressed throughout, get­ting the most value from our re­sources re­quires that ac­tions be un­der­taken only when the be­ne­fits ex­ceed the costs.
This prin­ciple ap­plies to gov­ern­ment as well as mar­ket activ­ity.
Un­for­tu­nately, when gov­ern­ment ac­tion in­volves pro­jects fin­anced with taxes or through bor­row­ing, both be­ne­fits and costs are dif­fi­cult to meas­ure.
In the mar­ket­place, the choices of buy­ers and sellers re­veal in­form­a­tion about be­ne­fits and costs.
Con­sumers will not pur­chase goods un­less they value them more than their price.
Sim­il­arly, pro­du­cers will not con­tin­ue to sup­ply goods un­less they can cov­er their costs.
But the in­form­a­tion provided by the choices of con­sumers and pro­du­cers is lost when the gov­ern­ment un­der­takes an activ­ity and fin­ances it with taxes.
There are no buy­ers spend­ing their own money and thereby re­veal­ing in­form­a­tion about their be­ne­fits.
Moreover, the rev­en­ues paid to the sup­pli­ers were ex­trac­ted through com­puls­ory tax­a­tion and there­fore they provide no as­sur­ance that the pro­ject is val­ued more than its cost.
Gov­ern­ment plan­ners may try to es­tim­ate the be­ne­fits and costs,
but their es­tim­ates, to a large de­gree, will be guesses be­cause they lack sol­id in­form­a­tion based on the choices of buy­ers and sellers.
Fur­ther, in the real world, such be­ne­fit-cost cal­cu­la­tions will of­ten be in­flu­enced by polit­ic­al con­sid­er­a­tions.
As the quo­ta­tion from Thomas Jef­fer­son in­tro­du­cing this ele­ment in­dic­ates,
it is vi­tally im­port­ant for gov­ern­ment to re­strain people from im­pos­ing harm on oth­ers (the gov­ern­ment’s pro­tect­ive func­tion).
Eco­nom­ics also in­dic­ates that there is a case for gov­ern­ment pro­vi­sion of goods
that are dif­fi­cult to sup­ply through mar­kets (the gov­ern­ment’s pro­duct­ive func­tion).
However, as the gov­ern­ment moves bey­ond these activ­it­ies, the case for still more gov­ern­ment weak­ens.
In or­der to bet­ter eval­u­ate the eco­nom­ic role of gov­ern­ment,
de­vel­op­ing a deep­er un­der­stand­ing of the short­com­ings of mar­kets and ap­ply­ing the tools of eco­nom­ics to the op­er­a­tion of the polit­ic­al pro­cess are im­port­ant.

Element 3.2: Regulate Monopolies

When a monopoly is present and barriers to entry are high, markets will fail to achieve ideal efficiency.

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, An In­quiry into the Nature and Causes of the Wealth of Na­tions
If a so­ci­ety is go­ing to get the most out of its re­sources, the re­sources must be used ef­fi­ciently.
Com­pet­i­tion is cent­ral to this ef­fi­cient use.
As pre­vi­ously dis­cussed, busi­nesses op­er­at­ing in a com­pet­it­ive en­vir­on­ment have in­cent­ives to cater to the views of con­sumers
and pro­duce goods and ser­vices eco­nom­ic­ally.
If busi­nesses do not provide con­sumers with value for the price they pay, they will spend their money else­where.
A mono­poly ex­ists when there is a firm that is the only pro­du­cer of a good or ser­vice for which there are no good sub­sti­tutes.
When this is the case, the firm will have an in­cent­ive to re­strict out­put and raise price.
By pro­du­cing a smal­ler quant­ity and char­ging a high­er price, the firm may be able to earn more profit
than it would if re­sources were be­ing used more pro­duct­ively—pro­du­cing a lar­ger quant­ity at a lower price.
In­ef­fi­ciency will res­ult be­cause the firm is fail­ing to pro­duce some units of the good or ser­vice
that cus­tom­ers value more than their cost of pro­duc­tion.
There are two ma­jor sources of mono­poly: eco­nom­ies of scale and grants of priv­ilege.
Eco­nom­ies of scale oc­cur when large firms have lower per-unit costs than their smal­ler rivals.
If eco­nom­ies of scale per­sist as a firm ob­tains a lar­ger and lar­ger share of the mar­ket,
a single firm will dom­in­ate and be­come a mono­poly.
The pro­duc­tion of elec­tri­city provides an ex­ample.
As power plants for the gen­er­a­tion of elec­tri­city be­come lar­ger, the per-unit cost of gen­er­at­ing elec­tri­city gen­er­ally de­clines.
As a res­ult, there is a tend­ency for a single, large firm to dom­in­ate this mar­ket.
This is why the gov­ern­ment usu­ally reg­u­lates the prices charged by elec­tric power com­pan­ies and, in some cases, owns and op­er­ates the power plants.
Even where mono­pol­ies do not de­vel­op, some in­dus­tries may have only a few dom­in­ant firms, usu­ally be­cause the mar­ket is costly to enter.
This is re­ferred to as an “oli­go­poly” mean­ing “sales by a few.” Note the sim­il­ar­ity to “ol­ig­archy,” or “rule by the few.”
A firm may have to pro­duce a large share of the in­dustry out­put—for ex­ample 20 or 25 per­cent—in or­der to achieve a low per-unit cost and com­pete ef­fect­ively.
When this is the case, there may be room for only four or five low per-unit cost firms.
Such mar­kets tend to be dom­in­ated by a small num­ber of firms, which have an in­cent­ive to col­lude,
raise the price of their product, and act as a mono­pol­ist would.
Man­u­fac­tur­ing in­dus­tries such as auto­mo­biles, tele­vi­sion sets, and com­puter op­er­at­ing sys­tems
are ex­amples of mar­kets dom­in­ated by a re­l­at­ively small num­ber of firms.
The privat­iz­a­tion of large state en­ter­prises in post-com­mun­ist coun­tries of­ten res­ul­ted in such mar­ket con­cen­tra­tion by ol­ig­archs who be­nefited from in­sider deals in re­turn for sup­port to those in power.
But the gov­ern­ment it­self is some­times the source of mono­poly.
Li­cens­ing, taxes that fa­vor one group over an­oth­er, tar­iffs, quotas, and oth­er grants of priv­ilege re­duce the com­pet­it­ive­ness of mar­kets.
While some of these policies may be well-in­ten­tioned,
they pro­tect ex­ist­ing firms and make it more dif­fi­cult for po­ten­tial rivals to enter the mar­ket,
thereby en­cour­aging mono­pol­ies and dom­in­ant firms.
What can the gov­ern­ment do to en­sure that mar­kets are com­pet­it­ive? The first guideline might be bor­rowed from the med­ic­al pro­fes­sion: Do no harm.
The gov­ern­ment should re­frain from mak­ing things worse through li­cens­ing re­quire­ments and dis­crim­in­at­ory taxes.
In the vast ma­jor­ity of mar­kets, sellers will find it dif­fi­cult or im­possible to lim­it the entry of rival firms (in­clud­ing rival pro­du­cers from oth­er coun­tries).
This means that sup­pli­ers will be un­able to lim­it com­pet­i­tion un­less gov­ern­ment im­poses entry re­stric­tions or cre­ates rules and reg­u­la­tions that fa­vor some firms re­l­at­ive to rivals.
To pro­mote com­pet­i­tion, gov­ern­ments may also pro­hib­it an­ti­com­pet­it­ive ac­tions
such as collusion, the mer­ger of dom­in­ant firms in an in­dustry, and in­ter­lock­ing own­er­ship of firms.
In this re­gard, the European Uni­on com­pet­i­tion law pro­motes com­pet­i­tion with­in the European single mar­ket
by mak­ing it il­leg­al for firms to col­lude or at­tempt to mono­pol­ize a mar­ket.
The re­cord of gov­ern­ment in this area has been mixed, however.
On the one hand, gov­ern­ment policies have re­duced the in­cid­ence of col­lu­sion and vari­ous prac­tices that lim­it com­pet­i­tion.
But some laws have al­most the op­pos­ite ef­fect;
they re­strict entry into mar­kets, pro­tect ex­ist­ing pro­du­cers from rivals, and lim­it price com­pet­i­tion.
Thus, while high entry bar­ri­ers and the ab­sence of com­pet­i­tion provide the po­ten­tial for gov­ern­ment to im­prove mar­ket per­form­ance,
some policies have ac­tu­ally gran­ted mono­poly powers. As we pro­ceed, the un­der­ly­ing reas­ons for this be­come more vis­ible.

Element 3.3: Mitigate Market Failures

Public goods and externalities result in incentives that may encourage self-interested individuals to undertake activities that are inconsistent with ideal economic efficiency.

As we have stressed, if mar­kets are go­ing to al­loc­ate re­sources ef­fi­ciently,
prop­erty rights must be well es­tab­lished and pro­du­cers must be able to cap­ture the be­ne­fits of their pro­duct­ive ac­tions.
But the nature of some goods makes this dif­fi­cult.
In this ele­ment, two cat­egor­ies of eco­nom­ic activ­ity that pose ser­i­ous chal­lenges to the ef­fi­cient al­loc­a­tion of re­sources through mar­kets are con­sidered.
They are pub­lic goods and ex­tern­al­it­ies.

Public Goods

The nature of some goods makes it dif­fi­cult for pro­du­cers to be­ne­fit from their pro­duc­tion.
This is the case with a cat­egory of goods that eco­nom­ists call pub­lic goods.
Public goods have the fol­low­ing two char­ac­ter­ist­ics:
(1) joint­ness in con­sump­tion—pro­vi­sion of the good to one party sim­ul­tan­eously makes it avail­able to oth­ers;
and (2) non-ex­clud­ab­il­ity—it is dif­fi­cult or vir­tu­ally im­possible to ex­clude non­pay­ing cus­tom­ers.
For ex­ample, flood con­trol meets the first cri­terion be­cause once it is provided every­one in the re­gion be­ne­fits,
and it meets the second cri­terion be­cause the sup­pli­er will have trouble char­ging people for the ser­vice.
Thus, be­cause po­ten­tial sup­pli­ers are un­able to es­tab­lish a one-to-one re­la­tion­ship between pay­ment for and re­ceipt of the good,
it will be dif­fi­cult to provide pub­lic goods through mar­kets.
Con­sumers will have an in­cent­ive to be­come “free riders”—to con­sume the good even though they do not help to pay for it.
And when a large num­ber of people be­come free riders, the good may not be pro­duced
(or too little of it may be pro­duced) even when the value de­rived from its con­sump­tion ex­ceeds the cost.
In such cases, mar­kets will of­ten fail to pro­duce a quant­ity of pub­lic goods con­sist­ent with eco­nom­ic ef­fi­ciency.
In ad­di­tion to flood con­trol, na­tion­al de­fense, mu­ni­cip­al po­lice pro­tec­tion, and mos­quito abate­ment are ex­amples of pub­lic goods.
Be­cause these goods are dif­fi­cult to sup­ply through mar­kets, they are of­ten provided by gov­ern­ments.
It is im­port­ant to note that it is the char­ac­ter­ist­ic of a good, not the sec­tor in which it is pro­duced, that de­term­ines wheth­er it qual­i­fies as a pub­lic good.
There is a tend­ency to think that if a good is provided by the gov­ern­ment, then it is a pub­lic good. This is not the case.
Many of the goods provided by gov­ern­ments clearly do not have the char­ac­ter­ist­ics of pub­lic goods.
Med­ic­al ser­vices, edu­ca­tion, mail de­liv­ery, trash col­lec­tion, and elec­tri­city come to mind.
Al­though these goods are of­ten sup­plied by gov­ern­ments,
non­pay­ing cus­tom­ers could be eas­ily ex­cluded and provid­ing them to one party does not make them avail­able to oth­ers.
Even a park is not a pub­lic good since non-pay­ers can be ex­cluded if de­sired—think EuroDisney.
Thus, even though they are of­ten provided by gov­ern­ments, they are not pub­lic goods.
There are very few true pub­lic goods and ser­vices.
In most cases it is easy to es­tab­lish a link between pay­ment and re­ceipt of a good or ser­vice.
If you do not pay for an ice cream, an auto­mobile, tele­vi­sion set, smart phone, a pair of jeans, and lit­er­ally thou­sands of oth­er items,
sup­pli­ers will not provide them to you and you can­not freely be­ne­fit from those items pur­chased by oth­ers.
In the case of private goods, it is un­likely that con­sumers will be­ne­fit from gov­ern­ment pro­vi­sion.

Externalities

Some­times the ac­tions of an in­di­vidu­al or group will “spill over” and ex­ert an im­pact on oth­ers, af­fect­ing their well-be­ing without their con­sent.
Such spillover ef­fects are called externalities.
For ex­ample, if you are try­ing to study and oth­ers in your apart­ment com­plex or dorm­it­ory are dis­tract­ing you with loud mu­sic, they are im­pos­ing an ex­tern­al­ity on you.
You are an ex­tern­al party—not dir­ectly in­volved in the trans­ac­tion,
activ­ity, or ex­change—but you have been af­fected by it, det­ri­ment­ally in this case.
The spillover ef­fects may either im­pose a cost or cre­ate a be­ne­fit for ex­tern­al parties.
When the spillover ef­fects are harm­ful, they are called ex­tern­al costs.
Be­cause costs are im­posed on non­con­sent­ing parties,
re­sources may be used to pro­duce goods that are val­ued less than their full pro­duc­tion costs, and in­ef­fi­ciency res­ults.
Con­sider the pro­duc­tion of pa­per. The firms in the mar­ket pur­chase trees, labor, and oth­er re­sources to first pro­duce pulp, and then pa­per.
The man­u­fac­tur­ing pro­cess may emit pol­lut­ants into the at­mo­sphere
that im­pose costs on res­id­ents liv­ing around the mills—the smell caused by sul­fur,
the or­gan­ic com­pounds that con­trib­ute to smog, and even pol­lut­ants that can cause paint on build­ings to de­teri­or­ate.
Such pol­lut­ants may make it dif­fi­cult for some people to breathe nor­mally and per­haps cause oth­er health haz­ards.
If the res­id­ents liv­ing near a pulp mill can prove they have been harmed, they could take the mill to court
and force the pa­per pro­du­cer to cov­er the cost of their dam­ages.
But it will of­ten be dif­fi­cult to prove the harm and that the pulp mill is re­spons­ible.
When this is the case, the costs they ex­per­i­ence will not be re­flec­ted through mar­kets
and, there­fore, the cost of pro­du­cing pa­per will be un­der­stated.
In­ef­fi­ciency oc­curs be­cause units of pa­per will be pro­duced that are val­ued less than the costs of their pro­duc­tion, in­clud­ing the ex­tern­al costs.
To a large de­gree, ex­tern­al costs re­flect a lack of fully defined and en­forced prop­erty rights.
Be­cause the prop­erty right to a re­source—clean air for ex­ample—is poorly en­forced,
the firm does not pay the full cost of us­ing the re­source.
Thus, the cost of pro­du­cing goods and ser­vices us­ing such re­sources is un­der­stated.
Some­times the spillover ef­fects will gen­er­ate be­ne­fits for oth­ers.
When the spillover ef­fects en­hance oth­ers’ wel­fare, they are called ex­tern­al be­ne­fits.
But ex­tern­al be­ne­fits can pose prob­lems for mar­kets, too.
When the per­sons or firms that gen­er­ate the ex­tern­al be­ne­fits are un­com­pensated, they may fail to pro­duce some units even when they are val­ued more than their pro­duc­tion costs.
For ex­ample, sup­pose a phar­ma­ceut­ic­al com­pany de­vel­ops a vac­cine provid­ing pro­tec­tion against a deadly vir­us.
The vac­cine can eas­ily be mar­keted to con­sumers who will be­ne­fit dir­ectly from it.
However, be­cause of the com­mun­al nature of vir­uses, as more and more people take the vac­cine, those who haven’t bought the vac­cine will also be less likely to catch the vir­us.
Yet it will be very dif­fi­cult for the phar­ma­ceut­ic­al com­pan­ies to cap­ture the be­ne­fits de­rived by the no­nusers.
As a res­ult, they may pro­duce too little of the vac­cine.
Thus, when ex­tern­al be­ne­fits are present, mar­ket forces may sup­ply less
than the amount con­sist­ent with eco­nom­ic ef­fi­ciency.
Per­haps the gov­ern­ment should take ac­tion. In the case of ex­tern­al costs, a tax im­posed on the activ­it­ies that gen­er­ate the ex­tern­al costs
might lead the per­son or firm to re­duce its activ­it­ies and achieve an out­put level more con­sist­ent with eco­nom­ic ef­fi­ciency.
Sim­il­arly, in the case of ex­tern­al be­ne­fits, gov­ern­ment sub­sidies might spur pro­duc­tion, res­ult­ing in a more ef­fi­cient out­put level.
The po­ten­tial ad­verse con­sequences of ex­tern­al­it­ies can some­times be con­trolled without gov­ern­ment, however.
In the case of ex­tern­al be­ne­fits, en­tre­pren­eurs have an in­cent­ive to fig­ure out ways to cap­ture more fully the gains their ac­tions gen­er­ate for oth­ers.
The de­vel­op­ment of golf courses il­lus­trates this point. Be­cause of the beauty and open­ness of golf courses, many people find it at­tract­ive to live nearby.
Thus, con­struct­ing a golf course typ­ic­ally gen­er­ates an ex­tern­al be­ne­fit—an in­crease in the value of the nearby prop­erty.
In re­cent years, golf course de­velopers have figured out how to cap­ture this be­ne­fit.
Now, they typ­ic­ally pur­chase a large tract of land around the planned course be­fore it is built.
This lets them re­sell the land at a high­er price after the golf course has been com­pleted and the sur­round­ing land has in­creased in value.
By ex­tend­ing the scope of their activ­it­ies to in­clude real es­tate as well as golf course de­vel­op­ment,
they are able to ob­tain rev­en­ues from what would oth­er­wise be ex­tern­al be­ne­fits.
As for ex­tern­al costs, simple rules can help con­trol them. For ex­ample, with re­spect to noise from nearby res­id­ents,
apart­ment own­ers of­ten have rules about play­ing loud mu­sic late at night and they en­force the rules by ex­pelling vi­ol­at­ors.
Man­ners and so­cial con­ven­tions can also play a role.
If your room­mates are aware that hav­ing the tele­vi­sion on in­ter­feres with your study­ing, they may have the good man­ners to turn it off.
More broadly, over time it has be­come “so­cially un­ac­cept­able” for com­pan­ies to emit pol­lu­tion that harms people and their en­vir­on­ment.
There is in­creas­ing pres­sure for com­pan­ies to be good cit­izens—
and private watch­dogs such as en­vir­on­ment­al groups will pub­li­cize their ac­tions if they be­have ir­re­spons­ibly.
Our ana­lys­is in­dic­ates that pub­lic goods and ex­tern­al­it­ies may un­der­mine the ef­fi­cient op­er­a­tion of mar­kets.
Eco­nom­ists use the term market failure to de­scribe the situ­ation where the ex­ist­ing struc­ture of in­cent­ives cre­ates a con­flict between per­son­al self-in­terest and get­ting the most out of the avail­able re­sources.
Mar­ket fail­ure en­cour­ages self-in­ter­ested de­cision-makers to en­gage in coun­ter­pro­duct­ive rather than pro­duct­ive activ­it­ies.
Mar­ket fail­ure cre­ates the po­ten­tial for gov­ern­ment ac­tion to im­prove eco­nom­ic ef­fi­ciency.
But the polit­ic­al pro­cess is merely an al­tern­at­ive form of eco­nom­ic or­gan­iz­a­tion.
We need to know more about how that form of or­gan­iz­a­tion works so that it can be com­pared real­ist­ic­ally with mar­kets.(54) We now turn to that top­ic.

Element 3.4: Understand Political Pressures

Allocation through political voting is fundamentally different than market allocation.

The first les­son of eco­nom­ics is scarcity: there is nev­er enough of any­thing to fully sat­is­fy all those who want it.
The first les­son of polit­ics is to dis­reg­ard the first les­son of eco­nom­ics.(55)
Thomas Sow­ell, Pro­fess­or of Eco­nom­ics, Stan­ford Uni­versity
The polit­ic­al pro­cess is an al­tern­at­ive form of eco­nom­ic or­gan­iz­a­tion.
It is not a cor­rect­ive device that can be coun­ted on to provide a sound rem­edy when prob­lems arise.
Even when it is con­trolled by elec­ted polit­ic­al of­fi­cials (as op­posed to,
say, an auto­crat­ic re­gime), there is no as­sur­ance that gov­ern­ment ac­tions will be pro­duct­ive.
This is par­tic­u­larly true when gov­ern­ments be­come heav­ily in­volved in al­loc­at­ing scarce re­sources to­ward favored sec­tors, busi­nesses, and in­terest groups.
As men­tioned in the in­tro­duc­tion to Part 3, the pub­lic choice ana­lys­is de­veloped dur­ing the past half cen­tury provides con­sid­er­able in­sight into the op­er­a­tion of demo­crat­ic polit­ic­al de­cision-mak­ing.
Clearly, policies favored by a ma­jor­ity do not al­ways make a so­ci­ety bet­ter off.
Here’s a thought ex­per­i­ment: Con­sider a simple eco­nomy with five voters.
Sup­pose three of the voters fa­vor a pro­ject that gives each a net be­ne­fit of €2,
but im­poses a net cost of €5 on each of the oth­er two voters.
In ag­greg­ate, the pro­ject gen­er­ates net costs of €10 against net be­ne­fits of only €6.
It is coun­ter­pro­duct­ive and will make the five-per­son so­ci­ety worse off.
Non­ethe­less, if de­cided by ma­jor­ity vote, it would pass three to two.
In­creas­ing the num­ber of voters from five to 5 mil­lion or 200 mil­lion will not al­ter the gen­er­al out­come.
As this simple ex­ample il­lus­trates, ma­jor­ity vot­ing can clearly lead to ad­op­tion of coun­ter­pro­duct­ive pro­jects.
It is use­ful to com­pare mar­kets with demo­crat­ic polit­ic­al al­loc­a­tion, the ma­jor al­tern­at­ive form of eco­nom­ic or­gan­iz­a­tion.
It is par­tic­u­larly im­port­ant to keep the fol­low­ing four points in mind.
First, in a demo­cracy, the basis for gov­ern­ment ac­tion is ma­jor­ity rule.
In con­trast, mar­ket activ­ity is based on mu­tu­al agree­ment and vol­un­tary ex­change.
In a demo­crat­ic set­ting, when a ma­jor­ity—either dir­ectly or through their elec­ted rep­res­ent­at­ives—
ad­opts a policy, the minor­ity is forced to pay for its sup­port even if they strongly dis­agree.
For ex­ample, if the ma­jor­ity votes for a new foot­ball sta­di­um,
hous­ing subsidy pro­gram,
or bail­out of an auto­mobile com­pany, minor­ity voters are forced to yield and pay taxes for sup­port of such pro­jects.
Wheth­er they be­ne­fit or not, they pay high­er taxes, suf­fer loss of in­come, or are harmed in oth­er ways.
The power to tax and reg­u­late makes it pos­sible for the ma­jor­ity to co­erce the minor­ity.
There is no such co­er­cive power when re­sources are al­loc­ated by com­pet­it­ive mar­kets.
Mar­ket ex­changes do not oc­cur un­less all parties agree.
Private firms can charge a high price, but they can­not force any­one to buy their product.
In­deed, private firms must provide be­ne­fits that ex­ceed the price charged in or­der to at­tract cus­tom­ers.
Second, there is little in­cent­ive for voters to be well-in­formed about either can­did­ates or is­sues.
An in­di­vidu­al voter will vir­tu­ally nev­er de­cide the out­come of an elec­tion.
It is more likely that a voter will be struck by light­ning on the way to the polling place
than it is that their vote will be de­cis­ive in a city, re­gion­al, or na­tion­al elec­tion!
Re­cog­niz­ing this point, most voters spend little, if any, time and en­ergy study­ing is­sues and can­did­ates in or­der to cast a well-in­formed vote.
Most simply de­cide on the basis of in­form­a­tion ac­quired as the res­ult of their oth­er activ­it­ies
(watch­ing tele­vi­sion, in­ter­ac­tion with friends on so­cial me­dia, or dis­cus­sions at the work­place).
Giv­en these in­cent­ives, most voters have little or no idea where can­did­ates stand
or what im­pact gov­ern­ment ac­tions (such as ag­ri­cul­tur­al sub­sidies and trade re­stric­tions) have on the eco­nomy.
Eco­nom­ists refer to this as the rational ignorance effect.
That is, voters are poorly in­formed, but their lack of in­form­a­tion is ra­tion­al be­cause an in­di­vidu­al’s vote is so rarely de­cis­ive.
The weak in­cent­ive of voters to make in­formed choices is in sharp con­trast to that of con­sumers in the mar­ket­place.
Mar­ket con­sumers in­di­vidu­ally de­cide how to spend their money, and if they make bad choices, they per­son­ally bear the con­sequences.
That fact gives them the mo­tiv­a­tion to spend their money wisely.
When con­sumers con­sider the pur­chase of an auto­mobile, per­son­al com­puter, gym mem­ber­ship, or thou­sands of sim­il­ar items,
they have a strong in­cent­ive to ac­quire in­form­a­tion and make in­formed choices.
Third, the polit­ic­al pro­cess gen­er­ally im­poses the same out­come on every­one, while mar­kets al­low for di­verse rep­res­ent­a­tion.
Put an­oth­er way, gov­ern­ment al­loc­a­tion res­ults in a “one size fits all” out­come,
while mar­kets al­low dif­fer­ent in­di­vidu­als and groups to “vote” for and re­ceive de­sired op­tions.
This can be il­lus­trated with school­ing.
When school­ing is al­loc­ated through the mar­ket (through private schools and homeschool­ing), rather than sup­plied by the gov­ern­ment,
some par­ents choose schools that stress re­li­gious val­ues,
while oth­ers opt for edu­ca­tion that em­phas­izes ba­sic skills, cul­tur­al di­versity, or vo­ca­tion­al pre­par­a­tion.
In­di­vidu­al buy­ers (or mem­bers of a group) will­ing to pay the cost are able to choose a de­sired edu­ca­tion­al op­tion and re­ceive it.
Mar­kets provide for a sys­tem of pro­por­tion­al rep­res­ent­a­tion and this makes it pos­sible
for more people to ob­tain goods and ser­vices more con­sist­ent with their pref­er­ences.
Moreover, mar­kets also avoid the con­flicts that in­ev­it­ably arise when the ma­jor­ity im­poses its will on vari­ous minor­it­ies.
Fourth, mar­ket and polit­ic­al de­cision-makers face dif­fer­ent in­cent­ives.
As pre­vi­ously dis­cussed, the profit-and-loss mech­an­ism of a mar­ket eco­nomy tends to dir­ect re­sources to­ward pro­duct­ive pro­jects and away from coun­ter­pro­duct­ive ones.
But, the polit­ic­al pro­cess does not have a sim­il­ar mech­an­ism that can be coun­ted on to dir­ect re­sources to­ward pro­duct­ive activ­it­ies.
This is true even when con­trolled through vot­ing.
In­stead, when un­con­strained by con­sti­tu­tion­al lim­its, elec­ted of­fi­cials
will tend to gain votes by provid­ing fa­vors to some at the ex­pense of oth­ers.
As the say­ing goes, if you take from Peter and give to Paul, you can usu­ally count on the sup­port of Paul.
To a large de­gree, the mod­ern polit­ic­al pro­cess can be viewed as a series of “ex­changes” between co­ali­tions and politi­cians.
Con­cen­trated in­terest groups provide votes, fin­an­cial con­tri­bu­tions, high-pay­ing jobs in the fu­ture,
and oth­er forms of sup­port in ex­change for sub­sidies, spend­ing pro­grams, and reg­u­lat­ory fa­vors of­ten fin­anced by tax­pay­ers.
The ra­tion­al ig­nor­ance ef­fect—the fact that voters choose not to spend the time re­quired to be well-in­formed—
fa­cil­it­ates this pro­cess be­cause a lot can hap­pen in the halls of le­gis­latures of which voters are un­aware.
As a res­ult, re­sources are moved to­ward lob­by­ing and oth­er fa­vor-seek­ing activ­it­ies and away from pro­duc­tion and de­vel­op­ment of bet­ter products.
As ex­plained in the two pre­vi­ous ele­ments, eco­nom­ic ana­lys­is in­dic­ates there are cases where mar­kets will fail to al­loc­ate re­sources ef­fi­ciently.
But this is also true of the polit­ic­al pro­cess. Put an­oth­er way, there is gov­ern­ment fail­ure as well as mar­ket fail­ure.
when the in­cent­ives con­fron­ted by polit­ic­al par­ti­cipants en­cour­age coun­ter­pro­duct­ive rather than pro­duct­ive use of re­sources.
Like mar­ket fail­ure, gov­ern­ment fail­ure re­flects the situ­ation where there is a con­flict between what is best for in­di­vidu­al de­cision-makers and get­ting the most value out of re­sources.
After sig­ni­fic­antly lib­er­al­iz­ing eco­nom­ic policy in Geor­gia, the framers of the Rose Re­volu­tion were aware
that even a demo­crat­ic and lib­er­al-ori­ented gov­ern­ment might un­der­take coun­ter­pro­duct­ive ac­tions.
Thus, in 2010, the Constitution in­cor­por­ated re­straints on the eco­nom­ic role of gov­ern­ment.
Art­icle 94 spe­cified what taxes were per­miss­ible (the num­ber of taxes, and their rates)
and al­loc­ated the power to change tax rates or in­tro­duce new taxes to the people, via ref­er­en­dum.
Fur­ther­more, by the or­gan­ic law called “Liberty Act,”
the gov­ern­ment budget de­fi­cit was re­stric­ted to less than 3 per­cent of GDP, and debt to no more than 60 per­cent of GDP.
However, as time passed and gov­ern­ments changed, the ma­jor­ity party in Par­lia­ment ini­ti­ated changes
aim­ing to re­lease the re­stric­tion and re­store the power to ini­ti­ate new taxes and/or change ex­ist­ing rates.
As we pro­ceed, we will ana­lyze in more de­tail the op­er­a­tion of the demo­crat­ic polit­ic­al pro­cess and con­sider modi­fic­a­tions
that might bring gov­ern­ment into great­er har­mony with eco­nom­ic growth and prosper­ity.

Element 3.5: Adopt Rules to Limit the Influence of Special Interests

Unless restrained by constitutional or other strict rules, special-interest groups will use the democratic political process to achieve gains at the expense of taxpayers and consumers.

Car­toon of a be­draggled over­weight man stand­ing in a door­way. Bank­notes are stuffed into his shirt, his belt, and his trouser turn-ups and his briefcase and folder are over­flow­ing with cash. He looks at his be­wildered wife and says: “Honey, you’ll nev­er guess what just happened! On my way home from work, I was cor­rup­ted by sev­er­al ob­scure but power­ful spe­cial in­terest groups!”
Demo­crat­ic­ally elec­ted of­fi­cials can of­ten be­ne­fit by sup­port­ing policies that fa­vor spe­cial-in­terest groups at the ex­pense of the gen­er­al pub­lic.
Con­sider a policy that gen­er­ates sub­stan­tial per­son­al gain for the mem­bers of a well-or­gan­ized group
(for ex­ample, an as­so­ci­ation rep­res­ent­ing busi­ness in­terests, mem­bers of a labor uni­on, or a farm group)
at the ex­pense of the broad­er in­terests of tax­pay­ers or con­sumers.
While the or­gan­ized in­terest group has few­er mem­bers than the total num­ber of tax­pay­ers or con­sumers,
each mem­ber’s per­son­al gain from the le­gis­la­tion is likely to be large.
In con­trast, while many tax­pay­ers and con­sumers are harmed,
the cost im­posed on each is small, and the source of the cost is of­ten dif­fi­cult to identi­fy.
Since the per­son­al stake of the in­terest group mem­bers is sub­stan­tial,
they have a power­ful in­cent­ive to form al­li­ances and let can­did­ates and le­gis­lat­ors know how strongly they feel about the is­sue.
Many in­terest group mem­bers will de­cide whom to vote
for and whom to sup­port fin­an­cially al­most ex­clus­ively on the basis of a politi­cian’s stand on a few is­sues of spe­cial im­port­ance to them.
In con­trast, as the ra­tion­al ig­nor­ance ef­fect il­lus­trates, the bulk of voters will be gen­er­ally un­in­formed and they will not care much
about the special-interest issue be­cause each one ex­erts little im­pact on their per­son­al wel­fare.
If you were a vote-seek­ing politi­cian, what would you do?
Clearly you would not get much cam­paign sup­port by fa­vor­ing the in­terests of the largely un­in­formed and un­or­gan­ized ma­jor­ity.
But you can get vo­cal sup­port­ers, cam­paign work­ers, and, most im­port­ant,
cam­paign con­tri­bu­tions by fa­vor­ing the po­s­i­tion of the spe­cial in­terest.
In the age of me­dia polit­ics, politi­cians are un­der strong pres­sure
to sup­port spe­cial in­terests, tap them for cam­paign funds, and use the con­tri­bu­tions to pro­ject a pos­it­ive can­did­ate im­age on tele­vi­sion and the In­ter­net.
Politi­cians un­will­ing to play this game—
those un­will­ing to use the gov­ern­ment treas­ury to provide well-or­gan­ized in­terest groups with fa­vors in ex­change for polit­ic­al sup­port—are ser­i­ously dis­ad­vant­aged.
Giv­en these in­cent­ives, politi­cians are led as if by an in­vis­ible hand to re­flect the views of spe­cial-in­terest groups, even though this of­ten leads to policies
that, summed across all voters, waste re­sources and re­duce our liv­ing stand­ards.
Eco­nom­ists refer to this bias of the polit­ic­al pro­cess as the special-interest effect.
The power of spe­cial in­terests is fur­ther strengthened by logrolling and pork-bar­rel le­gis­la­tion.
Logrolling is the prac­tice of trad­ing votes between politi­cians to get the ne­ces­sary sup­port to pass de­sired le­gis­la­tion.
Pork-barrel legislation is the bund­ling of un­re­lated pro­jects be­ne­fit­ing many in­terests into a single bill.
Both logrolling and pork-bar­rel le­gis­la­tion of­ten make it pos­sible for coun­ter­pro­duct­ive pro­jects be­ne­fit­ing con­cen­trated in­terests to gain le­gis­lat­ive ap­prov­al.
Ex­hib­it 19 il­lus­trates how pork-bar­rel polit­ics and vote trad­ing re­in­force the spe­cial-in­terest ef­fect and lead to the ad­op­tion of coun­ter­pro­duct­ive pro­jects.
In this simple ex­ample, a five-mem­ber le­gis­lature is con­sid­er­ing three pro­jects:
(1) a sports sta­di­um in Dis­trict A;
(2) con­struc­tion of an in­door rain forest in Dis­trict B;
and (3) sub­sidies for eth­an­ol that gen­er­ate be­ne­fits for the corn farm­ers of Dis­trict C.
For the res­id­ents of each dis­trict, the net be­ne­fit or cost is shown—that is, the be­ne­fit to the res­id­ents of the dis­trict minus the tax cost im­posed on them.
Note: The sum of the net be­ne­fits gen­er­ated by each of the pro­jects is neg­at­ive.
Be­cause the total costs across all voters ex­ceeds the be­ne­fits by €20, each pro­ject is coun­ter­pro­duct­ive.
If these coun­ter­pro­duct­ive pro­jects were voted on sep­ar­ately, each would lose by a 4-to-1 vote be­cause only one dis­trict would gain, and the oth­er four would lose.
However, when the pro­jects are bundled to­geth­er through either logrolling (rep­res­ent­at­ives A, B, and C could agree to trade votes)
or pork-bar­rel le­gis­la­tion (all three pro­grams in­cor­por­ated into a single bill), they can all pass, des­pite the fact that all are in­ef­fi­cient.
This can be seen by not­ing that the total com­bined net be­ne­fit is pos­it­ive for rep­res­ent­at­ives A, B, and C.
Giv­en the weak in­cent­ive for voters to ac­quire in­form­a­tion, those harmed by pork-barrelling and oth­er spe­cial in­terest policies are un­likely to even be aware of them.
Thus, the in­cent­ive to sup­port spe­cial-in­terest pro­jects, in­clud­ing those that are coun­ter­pro­duct­ive,
is even stronger than is im­plied by the simple nu­mer­ic ex­ample of Ex­hib­it 19.
Ex­hib­it 19: Trad­ing Votes and Passing Coun­ter­pro­duct­ive Le­gis­la­tion
Net Be­ne­fits (+) or Costs (-) to Voters in Equal Size Dis­tricts
Votes of Dis­trictsSports Sta­di­umIn­door Rain­forest Pro­jectEth­an­ol Sub­sidyTotal
A€100-€30-€30-€40
B-€30€100-€30-€40
C-€30-€30€100-€40
D-€30-€30-€30-€90
E-€30-€30-€30-€90
Total-€20-€20-€20-€60
Mar­ket ex­change is a win-win, pos­it­ive-sum activ­ity: Both trad­ing part­ners ex­pect to gain or the ex­change will not oc­cur.
In con­trast, “polit­ic­al ex­change” can be a win-lose, neg­at­ive-sum activ­ity, where the vot­ing ma­jor­ity gains but the minor­ity loses more.
Here, there is no as­sur­ance that the gains of the win­ners will ex­ceed the losses im­posed on oth­ers.
The tend­ency of the un­res­trained polit­ic­al pro­cess to fa­vor well-or­gan­ized groups helps ex­plain the pres­ence of many pro­grams that re­duce the size of the eco­nom­ic pie.
For ex­ample, con­sider the case of the roughly 20,000 Amer­ic­an sug­ar grow­ers.
For many years, the price of sug­ar paid by Amer­ic­an con­sumers has been 50 per­cent to 100 per­cent high­er than the world sug­ar price
be­cause of the fed­er­al gov­ern­ment’s price sup­port pro­gram and highly re­strict­ive quotas lim­it­ing the im­port of sug­ar.
As a res­ult of these pro­grams, sug­ar grow­ers gain about $1.7 bil­lion, or ap­prox­im­ately $85,000 per grow­er.
Most of these be­ne­fits are reaped by large grow­ers whose own­ers have in­comes far above the na­tion­al av­er­age.
On the oth­er hand, sug­ar con­sumers pay between $2.9 bil­lion and $3.5 bil­lion, or ap­prox­im­ately $25 per house­hold, in the form of high­er sug­ar prices.(56)
As a res­ult, Amer­ic­ans are worse off be­cause their re­sources are wasted in pro­du­cing a good
Amer­ic­ans are ill-suited to pro­duce and one that could be ob­tained at a sub­stan­tially lower cost through trade.
Non­ethe­less, Con­gress con­tin­ues to sup­port the sug­ar pro­gram, and it is easy to see why.
Giv­en the siz­able im­pact on their per­son­al wealth, it is per­fectly sens­ible for sug­ar grow­ers, par­tic­u­larly the large ones, to use their wealth
and polit­ic­al clout to help politi­cians who sup­port their in­terests.
This is pre­cisely what they do. Dur­ing the most re­cent four-year elec­tion cycle, the sug­ar lobby con­trib­uted more than $16 mil­lion to can­did­ates and polit­ic­al-ac­tion com­mit­tees.
A single firm, the Amer­ic­an Crys­tal Sug­ar Com­pany, gave $1.3
mil­lion to 221 mem­bers of Con­gress dur­ing this elec­tion cycle and spent an­oth­er $1.4 mil­lion lob­by­ing Con­gress.
In con­trast, it would be ir­ra­tion­al for the av­er­age voter to in­vest­ig­ate this is­sue or give it any sig­ni­fic­ant weight when de­cid­ing for whom to vote.
In fact, most voters are un­aware that this pro­gram costs them money.
Thus, politi­cians gain by con­tinu­ing to sub­sid­ize the sug­ar in­dustry even though the policy wastes re­sources and re­duces the wealth of the na­tion.
One could say that the primary busi­ness of mod­ern polit­ics is to ex­tract re­sources from the gen­er­al pub­lic in or­der to provide fa­vors to well-or­gan­ized vot­ing blocs in a man­ner that will cre­ate a vot­ing ma­jor­ity.
Ex­amples abound.
Tax­pay­ers and con­sumers from all over the world spend their earn­ings to sup­port spe­cif­ic sec­tors and thus spe­cif­ic in­terest groups in their coun­tries.
Com­ic­ally, the sub­sidy pro­gram, of­ten pro­moted in the name of the equity, al­most nev­er achieves its goal and of­ten has the op­pos­ite ef­fect.
In 2014, less than 20 per­cent of Egyp­tian food sub­sidies be­nefited poor people.
Gas­ol­ine sub­sidies in most coun­tries be­ne­fit the middle class, while the poor walk or take pub­lic trans­port­a­tion.
In In­dia, less than 0.1 per­cent of rur­al sub­sidies for Li­que­fied Pet­ro­leum Gas go to the poorest quin­tile, while 52.6 per­cent go to the wealth­i­est.
World­wide, far less than 20 per­cent of fossil-fuel sub­sidies be­ne­fit the poorest 20 per­cent of the pop­u­la­tion.(57)
While each of these pro­grams im­poses only a small drag on our eco­nom­ies,
to­geth­er they ex­pand the gov­ern­ment budget de­fi­cit, waste re­sources, and sig­ni­fic­antly lower our stand­ard of liv­ing.
The polit­ic­al power of spe­cial in­terests ex­plains the pres­ence of dir­ect sub­sidies, tar­iffs, or quotas on cer­tain products,
and all these kinds of policies are polit­ic­ally mo­tiv­ated to spe­cial-in­terest ef­fect rather than the net be­ne­fits of the over­all pop­u­la­tion.
The spe­cial-in­terest ef­fect also tends to stifle in­nov­a­tion and the com­pet­it­ive pro­cess.
Older, more es­tab­lished busi­nesses have built a stronger re­cord of polit­ic­al con­tri­bu­tions,
have bet­ter know­ledge of lob­by­ing tech­niques, and have de­veloped a closer re­la­tion­ship with power­ful polit­ic­al fig­ures.
Pre­dict­ably, the more ma­ture firms will gen­er­ally have more polit­ic­al clout
than new­er up­starts, and they will use it to de­ter in­nov­at­ive rivals.
Con­sider the ex­per­i­ence of Uber, which uses tech­no­logy to bring will­ing drivers to­geth­er with po­ten­tial ground-trans­port­a­tion pas­sen­gers.
Con­sumers search­ing for ground trans­port­a­tion re­quest cars via their smart­phones and the Uber app im­me­di­ately gives them a wait time.
Uber also provides feed­back in­form­a­tion about drivers to po­ten­tial pas­sen­gers and vice versa.
The tech­no­logy re­duces trans­ac­tion costs and the pro­cess is of­ten faster and cheap­er than tra­di­tion­al taxi ser­vice.
As Uber has sought to enter mar­kets in large cit­ies throughout the world,
the tra­di­tion­al taxi in­dustry has fought for and of­ten achieved le­gis­la­tion pro­hib­it­ing the use of the tech­no­logy em­ployed by Uber and sim­il­ar firms seek­ing to enter this mar­ket.(58)
As a res­ult, the gains from the in­nov­at­ive tech­no­logy and ex­pan­sion in the volume of ex­change have been slowed.
The ex­per­i­ence of Tesla, an elec­tric car man­u­fac­turer, provides an­oth­er ex­ample of ex­ist­ing pro­du­cers us­ing the polit­ic­al pro­cess to de­ter the entry of a new­comer.
Tesla’s busi­ness mod­el was based on the sale of its autos dir­ectly to con­sumers.
But a well-or­gan­ized in­terest group, the es­tab­lished auto deal­ers, lob­bied state le­gis­latures de­mand­ing that they ad­opt laws
pro­hib­it­ing man­u­fac­tur­ers from selling their cars dir­ectly to con­sumers.
Ap­prox­im­ately half of the states ad­op­ted pro­hib­i­tions on such dir­ect sales.
These laws made it much more dif­fi­cult for Tesla to enter the auto man­u­fac­tur­ing mar­ket.
In­ter­est­ingly, the de­vel­op­ment of Tesla it­self was based on gov­ern­ment fa­vor­it­ism.
Tesla re­ceived hun­dreds of mil­lions of dol­lars in sub­sidies (grants, gov­ern­ment guar­an­teed loans, and tax cred­its)
from the fed­er­al gov­ern­ment to de­vel­op and pro­duce its Mod­el S lux­ury elec­tric car, which sells for more than $100,000.
In 2014, the state of Nevada provided Tesla with a pack­age of sub­sidies es­tim­ated to be worth $1.3 bil­lion to build a bat­tery-man­u­fac­tur­ing fa­cil­ity near Reno.
Tesla will not have to pay any payroll or prop­erty taxes for ten years and no sales taxes for twenty years,
and will re­ceive $195 mil­lion in “trans­fer­able tax cred­its” that can be sold to oth­er com­pan­ies to sat­is­fy their Nevada tax bills.(59)
Per­haps there is a les­son here: Crony busi­nesses that live by gov­ern­ment fa­vor­it­ism will some­times get gored by oth­er crony busi­nesses with even more polit­ic­al clout.
The framers of the Con­sti­tu­tion of the United States were well aware of the prob­lems arising from the power of spe­cial-in­terest groups.
They called the in­terest groups “fac­tions.”
The Con­sti­tu­tion sought to lim­it pres­sure from the fac­tions in Art­icle I, Sec­tion 8,
which spe­cifies that Con­gress is to levy only uni­form taxes for pro­grams that pro­mote the com­mon de­fense and gen­er­al wel­fare.
This clause was de­signed to pre­clude the use of gen­er­al tax rev­en­ue to provide be­ne­fits to sub­groups of the pop­u­la­tion.
However, through the years court de­cisions and le­gis­lat­ive acts have altered its mean­ing.
Thus, as it is cur­rently in­ter­preted, the Con­sti­tu­tion now fails to con­strain the polit­ic­al power of well-or­gan­ized spe­cial-in­terest groups.

Element 3.6: Avoid Excessive Spending and Deficits

Unless restrained by constitutional or other strict rules, legislators will run budget deficits and spend excessively.

The at­tract­ive­ness of fin­an­cing spend­ing by debt is­sue to the elec­ted politi­cians should be ob­vi­ous.
Bor­row­ing al­lows spend­ing to be made that will yield im­me­di­ate polit­ic­al pay­offs without the in­cur­ring of any im­me­di­ate polit­ic­al cost.(60)
James Buchanan, 1986 No­bel Laur­eate
When a gov­ern­ment’s spend­ing ex­ceeds its rev­en­ues, a budget de­fi­cit res­ults.
Gov­ern­ments gen­er­ally is­sue in­terest-earn­ing bonds to fin­ance their budget de­fi­cits.
These bonds com­prise the national debt.
An an­nu­al budget de­fi­cit in­creases the size of the na­tion­al debt by the amount of the de­fi­cit.
In con­trast, when gov­ern­ment rev­en­ues ex­ceed spend­ing,
a budget surplus is present.
This al­lows the gov­ern­ment to pay off bond­hold­ers and thereby re­duce the size of its out­stand­ing debt.
Ba­sic­ally, the na­tion­al debt rep­res­ents the cu­mu­lat­ive ef­fect of all the pri­or budget de­fi­cits and sur­pluses.
Pri­or to 1960 the con­sensus among eco­nom­ists was that, while debts typ­ic­ally in­creased dur­ing wars, it was the re­spons­ib­il­ity of gov­ern­ments to run budget sur­pluses to pay down these debts as quickly as pos­sible.
There were ma­jor debt re­duc­tions in the United King­dom in the cen­tury fol­low­ing the Na­po­leon­ic Wars,
in France fol­low­ing the Franco-Prus­si­an War, and in the United States fol­low­ing the Amer­ic­an Civil War.
The Keyne­sian re­volu­tion changed all of this. The Eng­lish eco­nom­ist John Maynard Keynes de­veloped a the­ory
that provided both an ex­plan­a­tion for the length and sever­ity of the Great De­pres­sion and a rem­edy for pre­ven­tion of such events in the fu­ture.
Dur­ing the 1940s and 1950s, the Keyne­sian view swept the eco­nom­ics pro­fes­sion and it soon dom­in­ated the think­ing of in­tel­lec­tu­al and polit­ic­al lead­ers.
Ac­cord­ing to Keyne­sian ana­lys­is, gov­ern­ment spend­ing and budget de­fi­cits could be used to pro­mote a more stable eco­nomy.
Keyne­sians ar­gued that rather than bal­an­cing the budget, the gov­ern­ment should run budget de­fi­cits dur­ing peri­ods of re­ces­sion and shift to­ward a budget sur­plus when there was con­cern about in­fla­tion.
While the ef­fect­ive­ness of Keyne­sian fisc­al policy is a point of con­tro­versy, its im­pact on the budget of most coun­tries is clear.
Freed from the balanced budget con­straint,
politi­cians con­sist­ently spent more than they were will­ing to tax.
Over 22 years, from 1995, the Greek gov­ern­ment ran twenty de­fi­cits and two sur­pluses.
Ex­hib­it 20 shows the path of the Greek gov­ern­ment de­fi­cit meas­ured as a share of GDP dur­ing this era.
The de­fi­cits were lar­ger dur­ing re­ces­sions, es­pe­cially dur­ing the fin­an­cial crisis in the years 2008–2009.
The gov­ern­ment de­fi­cit av­er­aged about 6.5 per­cent of GDP be­fore the fin­an­cial crisis,
and the era of de­fi­cit con­trol was ex­ceed­ingly short. Greece only man­aged to switch to sur­plus in 2016 and 2017.
De­fi­cits push the na­tion­al debt up­ward. Meas­ured as a share of GDP, out­stand­ing gen­er­al gov­ern­ment debt in Greece rose from 97 per­cent in 1995 to 134 per­cent in 2009, and 183 per­cent in 2015.
Greece’s pub­lic debt is the highest share of GDP in the E.U.
Be­sides Greece there are four oth­er European na­tions where debts ex­ceed 100% of an­nu­al eco­nom­ic out­put (Bel­gi­um, Cyprus, Por­tugal, and Italy).(61)
The polit­ic­al at­tract­ive­ness of spend­ing fin­anced by bor­row­ing rather than tax­a­tion is not sur­pris­ing.
It re­flects what eco­nom­ists call the shortsightedness effect:
the tend­ency of elec­ted polit­ic­al of­fi­cials to fa­vor pro­jects
that gen­er­ate im­me­di­ate, highly vis­ible be­ne­fits at the ex­pense of costs that can be cast into the fu­ture and are dif­fi­cult to identi­fy.
Le­gis­lat­ors have an in­cent­ive to spend money on pro­grams
that be­ne­fit the voters of their dis­trict and spe­cial-in­terest groups that will help them win re-elec­tion.
They do not like to tax be­cause taxes im­pose a vis­ible cost on voters.
Debt is an al­tern­at­ive to cur­rent taxes; it pushes the vis­ible cost of gov­ern­ment into the fu­ture.
Budget de­fi­cits and bor­row­ing al­low politi­cians to sup­ply voters with im­me­di­ate be­ne­fits without im­pos­ing high­er taxes.
Thus, de­fi­cits are a nat­ur­al out­growth of demo­crat­ic polit­ics un­res­trained by com­mit­ment to a bal­anced budget.
Ex­hib­it 20: Greek Gen­er­al Gov­ern­ment De­fi­cit or Sur­plus as a Share of GDP, 1995–2017
A line graph show­ing the Greek gov­ern­ment’s de­fi­cit and sur­plus as a share of na­tion­al GDP between 1995 and 2017. The gov­ern­ment ran a sur­plus in only 2 of these 22 years, spe­cific­ally in 2016 and 2017. The de­fi­cit in­creased in times of re­ces­sion, in par­tic­u­lar dur­ing the 2008/09 fin­an­cial crisis. The highest de­fi­cit was re­cor­ded in 2009, when it reached around 15% of GDP.
The un­con­strained polit­ic­al pro­cess plays into the hands of well-or­gan­ized in­terest groups
and en­cour­ages politi­cians to in­crease spend­ing to gain be­ne­fits for a few at the ex­pense of many.
For ex­ample, each mem­ber of a le­gis­lature has a strong in­cent­ive to fight hard for ex­pendit­ures be­ne­fi­cial to his or her con­stitu­ents.
In con­trast, there is little in­cent­ive for a le­gis­lat­or to be a spend­ing “watch­dog,” for two reas­ons.
First, such a watch­dog would in­cur the wrath of col­leagues be­cause the spend­ing re­straint would make it more dif­fi­cult for them to de­liv­er spe­cial pro­grams for their dis­tricts.
They would re­tali­ate by provid­ing little sup­port for spend­ing in the watch­dog’s dis­trict.
Second, and more im­port­antly, the be­ne­fits of spend­ing cuts and de­fi­cit re­duc­tions that the watch­dog is try­ing to at­tain (for ex­ample, lower taxes)
will ac­crue equally to voters in the oth­er dis­tricts.
Thus, even if the watch­dog is suc­cess­ful, the con­stitu­ents in his or her dis­trict will reap only a small frac­tion of the be­ne­fits.
Per­haps the fol­low­ing il­lus­tra­tion will help ex­plain why it is so dif­fi­cult for the par­lia­ments of all coun­tries to bring gov­ern­ment spend­ing and the budget de­fi­cit un­der con­trol.
The Verkhovna Rada of Ukraine (par­lia­ment of Ukraine) has 450 depu­ties.
Sup­pose these 450 in­di­vidu­als go out to din­ner know­ing that after the meal each will re­ceive a bill for 1/450th of the cost.
No one feels com­pelled to or­der less be­cause his or her re­straint will ex­ert little im­pact on the total bill.
Why not or­der shrimp for an ap­pet­izer, en­trées of steak and lob­ster, and a large piece of cheese­cake for dessert?
After all, the ex­tra spend­ing will add only a few pen­nies to each per­son’s share of the total bill.
For ex­ample, if one mem­ber of the din­ner party or­ders ex­pens­ive items that push up the total bill by €45,
his share of the cost will be less than 10 cents (1/450th of €45).
What a bar­gain! Of course, he will have to pay ex­tra for the ex­tra­vag­ant or­ders of the oth­er 449 diners, too.
But that’s true no mat­ter what he or­ders.
The res­ult is that every­one ends up or­der­ing ex­tra­vag­antly and pay­ing more for ex­tras that provide little value re­l­at­ive to cost.(62)
The in­cent­ive struc­ture out­lined here ex­plains why de­fi­cit fin­ance is so at­tract­ive to politi­cians.
Dur­ing the sev­en-year peri­od 2008–2015, E.U. mem­bers’ de­fi­cits pushed up the E.U. debt by more than 30 per­cent­age points as a share of GDP.
Moreover, the be­ne­fits prom­ised to seni­or cit­izens un­der the so­cial pro­tec­tion pro­grams are far great­er than the payroll tax rev­en­ues that provide their fin­an­cing.
These un­fun­ded li­ab­il­it­ies are an­oth­er form of debt.
So­cial pro­tec­tion rep­res­en­ted the largest area of gen­er­al gov­ern­ment ex­pendit­ure in 2016 in all E.U. mem­ber states (the largest was in Fin­land—25.6 per­cent of GDP).(63)
As the pro­por­tion of the work­ing pop­u­la­tion shrinks and the num­ber of those re­tired ex­pands,(64) spend­ing on so­cial pro­tec­tion will out­strip the rev­en­ues for fin­an­cing it, fur­ther com­plic­at­ing the debt li­ab­il­ity of the fed­er­al gov­ern­ment.
What will hap­pen if the E.U. mem­ber gov­ern­ments do not bring their fin­ances un­der con­trol?
As a na­tion’s debt gets lar­ger and lar­ger re­l­at­ive to the size of its eco­nomy, there will be re­per­cus­sions in cred­it mar­kets.
Ex­tend­ing loans to the gov­ern­ment of a coun­try with a large ra­tio of debt to GDP is risky.
As a res­ult, the highly in­debted gov­ern­ment will have to pay high­er in­terest rates.
In turn, the high­er in­terest costs will make it even more dif­fi­cult for the gov­ern­ment to keep with­in its budget and keep taxes at reas­on­able levels.
If the debt con­tin­ues to rise re­l­at­ive to in­come,
in­vestors will be­come more and more re­luct­ant to buy the bonds is­sued by the coun­try’s treas­ury.
Even­tu­ally a fin­an­cial crisis will res­ult—either out­right de­fault by the gov­ern­ment or fin­an­cing the debt by money cre­ation and in­fla­tion.
In either case, there will be a de­struct­ive im­pact on the eco­nomy.
This has oc­curred in oth­er coun­tries such as Greece that have failed to con­trol gov­ern­ment fin­ances.
No coun­try is im­mune to the laws of eco­nom­ics.
It is vi­tally im­port­ant for all gov­ern­ments to con­trol their spend­ing and bor­row­ing in the years ahead.
This is un­likely to hap­pen without a change in the polit­ic­al rules to make it more dif­fi­cult for politi­cians to spend more than they are will­ing to tax.
There are sev­er­al ways this might be done.
The con­sti­tu­tion could be amended to re­quire a gov­ern­ment to bal­ance its budget, as Geor­gia’s gov­ern­ment is re­quired to do.
Or the cur­rent year’s spend­ing might be lim­ited to last year’s level of rev­en­ues.
Pro­posed con­sti­tu­tion­al rule changes of this kind would make it more dif­fi­cult for le­gis­lat­ors to spend un­less they were will­ing to tax or to charge users for the gov­ern­ment ser­vices.

Element 3.7: Avoid Subsidies Not Based on Economic Logic

When governments become heavily involved in providing favors to some at the expense of others,

inefficiency results and improper, unethical relationships develop between government officials and businesses.

The tool of polit­ics (which fre­quently be­comes its ob­ject­ive) is to ex­tract re­sources from the gen­er­al tax­pay­er with min­im­um of­fense
and to dis­trib­ute the pro­ceeds among in­nu­mer­able claimants in such a way to max­im­ize the sup­port at the polls.
Polit­ics, so far as mo­bil­iz­ing sup­port is con­cerned, rep­res­ents the art of cal­cu­lated cheat­ing or, more pre­cisely, how to cheat without be­ing caught.(65)
James R. Schle­sing­er, Former United States Sec­ret­ary of De­fense
There are two ways in­di­vidu­als can ac­quire wealth: pro­duc­tion and plunder.
People can get ahead by pro­du­cing goods or ser­vices of value and ex­chan­ging them for in­come.
This pos­it­ive-sum meth­od of ac­quir­ing in­come helps both trad­ing part­ners and en­hances the wealth of so­ci­ety.
But some­times people will try to get ahead through plun­der, the tak­ing from oth­ers without their con­sent.
Of course, the vic­tims of plun­der will lose what the plun­der­er gains.
But, in ad­di­tion, where plun­der is feared, po­ten­tial vic­tims will em­ploy re­sources to de­fend them­selves against it.
In a so­ci­ety in which burg­lary is com­mon, for ex­ample, people will buy more locks, use more se­cur­ity ser­vices,
de­mand more po­lice, and even design their homes in ways to dis­cour­age theft.
The costs im­posed on the cit­izenry will be great­er than the gains ob­tained by those en­ga­ging in plun­der.
In con­trast with pos­it­ive-sum ex­change activ­it­ies, plun­der is a neg­at­ive-sum activ­ity.
It not only fails to gen­er­ate ad­di­tion­al in­come but also con­sumes re­sources, re­du­cing the wealth of the so­ci­ety.
(You can see the clas­sic en­tirety at: https://www.dailymotion.com/video/x2hwqki)
Gov­ern­ments pro­mote economic prosperity when they en­cour­age pro­duc­tion
and ex­change, and dis­cour­age plun­der.
When ef­fect­ive law and its en­force­ment make it dif­fi­cult to take from oth­ers, either via crime or use of polit­ic­al ac­tion,
few re­sources will flow into plun­der. Moreover, the re­sources em­ployed de­fend­ing against plun­der will also be small.
In the mod­ern world, however, gov­ern­ment it­self has be­come a ma­jor source of plun­der.
Gov­ern­ments of­ten take re­sources from some in or­der to provide sub­sidies and fa­vors to oth­ers.
While it is not tech­nic­ally theft be­cause it is done through laws,
it is still a neg­at­ive-sum activ­ity that harms the cit­izenry and slows eco­nom­ic growth.
In France, trans­fers and sub­sidies now ac­count for ap­prox­im­ately half of the over­all budget.(66) So­cial Pro­tec­tion sub­sidies com­prise the bulk of the trans­fers (43 per­cent of the total budget),(67)
but the gov­ern­ment now sup­ports nu­mer­ous oth­er activ­it­ies, in­clud­ing cul­ture, air­ports,
spe­cif­ic man­u­fac­tur­ing firms, sol­ar power, fossil fuels, and ag­ri­cul­tur­al goods ran­ging from chick­ens to wine.
There are 250 dif­fer­ent grants and sub­sidies for small busi­ness start-ups in rur­al areas of France.
Sub­sidies and gov­ern­ment fa­vor­it­ism are a danger to both polit­ic­al demo­cracy and eco­nom­ic ef­fi­ciency. There are sev­er­al reas­ons why this is the case.
First, the sub­sidies dis­tort prices and en­cour­age busi­nesses to spend more time search­ing for fa­vor­it­ism in cent­ral gov­ern­ments
and less time de­vel­op­ing bet­ter and more eco­nom­ic­al products.
Pre­dict­ably, an in­crease in the avail­ab­il­ity of gov­ern­ment fa­vor­it­ism will strengthen the power of spe­cial in­terests and en­cour­age de­cep­tion.
In or­der to ob­tain more gov­ern­ment funds and gain ad­vant­ages re­l­at­ive to rivals,
busi­nesses and oth­er fa­vor-seekers will tie their in­terests to pop­u­lar ob­ject­ives such as in­creas­ing em­ploy­ment,
re­du­cing poverty, im­prov­ing en­vir­on­ment­al qual­ity, and lessen­ing de­pend­ence on for­eign­ers.
Even when their ac­tions are mo­tiv­ated by fin­an­cial gain and polit­ic­al power, in­terest groups will have a strong in­cent­ive to claim
they are seek­ing to achieve broad­er, more pop­u­lar ob­ject­ives than is ac­tu­ally the case.
Second, sub­sidies to some firms and sec­tors place oth­ers at a dis­ad­vant­age.
Some of the un­sub­sid­ized firms will be driv­en out of busi­ness or fail to enter the mar­ket be­cause they can’t com­pete with sub­sid­ized rivals.
The res­ult is a di­ver­sion of re­sources from busi­nesses de­pend­ent on mar­ket con­sumers to those favored by politi­cians.
Third, and per­haps most im­port­ant, the sub­sidies and fa­vor­it­ism will cre­ate an im­prop­er,
un­eth­ic­al re­la­tion­ship between busi­ness and polit­ic­al of­fi­cials.
“Cor­por­ate wel­fare” and “crony cap­it­al­ism” are thereby en­cour­aged, and the in­terests of the tax­pay­er com­prom­ised.
The great­er the de­gree of cor­por­ate wel­fare (i.e., the more nu­mer­ous the gov­ern­ment sub­sidy pro­grams dir­ec­ted to­ward busi­ness),
the great­er the flow of re­sources into fa­vor-seek­ing activ­it­ies.
(Note: Eco­nom­ists of­ten use the term rent-seek­ing to de­scribe the fa­vor-seek­ing of busi­nesses and oth­er groups.)
As polit­ics re­places mar­kets, the eco­nomy will be in­creas­ingly char­ac­ter­ized by cronyism and coun­ter­pro­duct­ive activ­it­ies,
and eco­nom­ic growth will fall be­low its po­ten­tial.
In­creas­ingly, the gov­ern­ments of high-in­come demo­crat­ic coun­tries use taxes and bor­row­ing to provide sub­sidies
and oth­er fa­vors to spe­cified vot­ing blocs in ex­change for polit­ic­al con­tri­bu­tions and sup­port.
In a state­ment widely at­trib­uted to Scots­man Al­ex­an­der Tytler, the fol­low­ing ar­gu­ment is made:
A demo­cracy can­not ex­ist as a per­man­ent form of gov­ern­ment.
It can only ex­ist un­til the voters dis­cov­er that they can vote them­selves lar­gesse from the pub­lic treas­ury.
From that mo­ment on, the ma­jor­ity al­ways votes for the can­did­ates prom­ising the most be­ne­fits from the pub­lic treas­ury with the res­ult that a demo­cracy al­ways col­lapses over loose fisc­al policy...(68)
Once busi­nesses and oth­er in­terest groups be­come heav­ily in­volved in provid­ing politi­cians with sup­port in ex­change for sub­sidies and fa­vor­it­ism, these forces will be very dif­fi­cult to re­strain.
As gov­ern­ment fa­vor­it­ism grows and both the re­cip­i­ents and politi­cians be­come more de­pend­ent on it,
trans­fer spend­ing will grow and re­sources will move away from pro­duct­ive activ­it­ies.
Moreover, de­ceit­ful be­ha­vi­or, un­eth­ic­al re­la­tions, and even cor­rup­tion will be­come com­mon­place.
There will be up­ward pres­sure on taxes, budget de­fi­cits will ex­pand even fur­ther, and the polit­ic­ally ma­nip­u­lated eco­nomy will stag­nate.
Un­less the con­sti­tu­tion­al pro­tec­tion of prop­erty rights and lim­it­a­tions on the spend­ing,
sub­sid­iz­ing, and bor­row­ing activ­it­ies of gov­ern­ment are re­stored, demo­crat­ic­ally elec­ted politi­cians will con­tin­ue to en­act pro­grams
that waste re­sources and im­pair the gen­er­al stand­ard of liv­ing.
As il­lus­trated by the case of Greece—whose gov­ern­ment over­spent it­self into a debt crisis in 2015—
this path will even­tu­ally lead to ex­cess­ive debt and eco­nom­ic col­lapse.

Element 3.8: Watch out for Inefficiencies Even From Useful Subsidies

The net gain of transfer recipients is less, and often substantially less, than the amount of the transfer.

Car­toon of two scruffy men drink­ing in an empty bar. One says to the oth­er: “You can col­lect for dis­ab­il­ity. I don’t know about in­ab­il­ity.”
To non-eco­nom­ists, income transfers look like an ef­fect­ive way to help tar­geted be­ne­fi­ciar­ies.
However, eco­nom­ic ana­lys­is in­dic­ates that it is ac­tu­ally quite dif­fi­cult to trans­fer in­come to a group of re­cip­i­ents in a way that will im­prove their long-term well-be­ing.
As is of­ten the case in eco­nom­ics, the un­in­ten­ded sec­ond­ary ef­fects ex­plain why this pro­pos­i­tion is true.(69)
Three ma­jor factors un­der­mine the ef­fect­ive­ness of in­come trans­fers.
While the pro­cess may be easi­est to see in the case of dir­ect in­come trans­fers like wel­fare as­sist­ance, the same types of forces oc­cur when the be­ne­fits are ag­ri­cul­tur­al sub­sidies or grants to in­di­vidu­als or cor­por­a­tions.
First, an in­crease in gov­ern­ment trans­fers will gen­er­ally re­duce the in­cent­ive of both the tax­pay­er-donor and the trans­fer re­cip­i­ent to earn in­come and cre­ate value.
Many trans­fer pro­grams provide for an in­verse re­la­tion­ship between the size of the trans­fer and the in­come level of the re­cip­i­ent.
As the re­cip­i­ent’s in­come rises, the amount of the trans­fer is re­duced.
When this is the case, neither tax­pay­ers nor trans­fer re­cip­i­ents will pro­duce and earn as much as they would in the ab­sence of the trans­fer pro­gram.
As taxes go up to fin­ance great­er trans­fers, tax­pay­ers have less in­cent­ive to make the sac­ri­fices needed to pro­duce and earn,
and more in­cent­ive to in­vest in tax shel­ters to try to keep the money they earned.
Sim­il­arly, re­cip­i­ents will have less in­cent­ive to earn be­cause ad­di­tion­al earn­ings will in­crease their net in­come by only a frac­tion—
and in many cases only a small frac­tion—of their ad­di­tion­al earn­ings. As a res­ult, eco­nom­ic growth will be slowed.
To see the neg­at­ive ef­fect of al­most any trans­fer policy on pro­duct­ive ef­fort, con­sider the re­ac­tion of stu­dents
if a pro­fess­or an­nounces at the be­gin­ning of the term that the grad­ing policy for the class will re­dis­trib­ute the points earned on the ex­ams so that no one will re­ceive less than a C.
Un­der this plan, stu­dents who earned A grades by scor­ing an av­er­age of 90 per­cent or high­er on the ex­ams would have to give up enough of their points to bring up the av­er­age of those who would oth­er­wise get Ds and Fs.
And, of course, the B stu­dents would also have to con­trib­ute some of their points as well, al­though not as many,
in or­der to achieve a more equal grade dis­tri­bu­tion.
Does any­one doubt that at least some of the stu­dents who would have made As and Bs will study less when their ex­tra ef­fort is “taxed” to provide be­ne­fits to oth­ers?
And so would the stu­dents who would have made Cs and Ds, since the pen­alty for ex­ert­ing less ef­fort would be cush­ioned by point trans­fers they would not be giv­en if they earned more points on their own.
The same lo­gic ap­plies even to those who would have made Fs, al­though they prob­ably wer­en’t do­ing very much study­ing any­way.
Pre­dict­ably, the out­come will be less study­ing by every­one in the class, and over­all achieve­ment will de­cline.
The im­pact of tax and trans­fer schemes is sim­il­ar: less work ef­fort and lower over­all in­come levels.
In­come is not like “manna from heav­en.” In­stead, it is something that people pro­duce and earn.
In­di­vidu­als earn in­come as they provide goods and ser­vices for oth­ers will­ing to pay for them.
We can think of national income as an eco­nom­ic pie whose
size is de­term­ined by the ac­tions of mil­lions of people, each us­ing pro­duc­tion and trade to earn an in­di­vidu­al slice.
It is im­possible to re­dis­trib­ute por­tions of the slices they might earn without sim­ul­tan­eously re­du­cing the work ef­fort and in­nov­at­ive ac­tions that gen­er­ate the pie in the first place.
Second, com­pet­i­tion for trans­fers can erode most of the long-term gain of the in­ten­ded be­ne­fi­ciar­ies.
Gov­ern­ments must es­tab­lish a cri­terion for the re­ceipt of in­come trans­fers and oth­er polit­ic­al fa­vors.
If they did not do so, the trans­fers would bust the budget im­me­di­ately.
Gen­er­ally, the gov­ern­ment will re­quire a trans­fer re­cip­i­ent to own something, do something, or be something.
For ex­ample, the re­cip­i­ent of un­em­ploy­ment pay must be out of a job, and a com­pany must not have more than a cer­tain num­ber of em­ploy­ees to qual­i­fy for a small-busi­ness grant or loan.
Once the cri­terion is es­tab­lished, people will modi­fy their be­ha­vi­or to qual­i­fy
for the “free” money or oth­er gov­ern­ment fa­vors. As they do so, their net gain from the trans­fers de­clines.
Think about the fol­low­ing: sup­pose that the Pol­ish gov­ern­ment de­cided to give away 300 zloty in cash between 9:00 a.m. and 5:00 p.m. each week­day
to all per­sons will­ing to wait in line at the tell­er win­dows of the Min­istry of Fin­ance.
Long lines would emerge. How long? How much time would people be will­ing to take from their leis­ure and their pro­duct­ive activ­it­ies?
A per­son whose time was worth 30 zloty per hour would be will­ing to spend al­most as much as ten hours wait­ing in line for the 300 zloty cash.
But it might take longer than ten hours if there were enough oth­ers whose time was worth less, say 20 zloty or 10 zloty per hour.
Every­one would find that the time spent wait­ing con­sumed much of the value of the 300 zloty trans­fer.
If the pro­ponents thought the pro­gram would make the re­cip­i­ents 300 zloty bet­ter off, they would have been wrong.
This ex­ample il­lus­trates why the in­ten­ded be­ne­fi­ciar­ies of trans­fer pro­grams are not helped as much as is gen­er­ally per­ceived.
When be­ne­fi­ciar­ies have to do something in or­der to qual­i­fy for a trans­fer (for ex­ample, wait in line, fill out forms,
lobby gov­ern­ment of­fi­cials, take an exam, en­dure delays, or con­trib­ute to se­lec­ted polit­ic­al cam­paigns),
much of their po­ten­tial gain can of­ten be lost as they seek to meet the qual­i­fy­ing cri­ter­ia.
Sim­il­arly, when be­ne­fi­ciar­ies have to own something in or­der to get a sub­sidy
(for ex­ample, land with a his­tory of past pro­duc­tion of a par­tic­u­lar crop or a li­cense to op­er­ate a tax­icab or sell a product to for­eign­ers),
people will bid up the price of the as­set needed to ac­quire the sub­sidy.
The high­er price of the as­set, such as tax­icab li­censes, will cap­ture the value of the sub­sidy.
In each case the po­ten­tial be­ne­fi­ciar­ies will com­pete to meet the cri­ter­ia un­til they dis­sip­ate much of the value of the trans­fer.
As a res­ult, the re­cip­i­ent’s net gain will gen­er­ally be sub­stan­tially less than the amount of the trans­fer pay­ment.
In­deed, the net gain of the mar­gin­al re­cip­i­ent
(the per­son who barely finds it worth­while to qual­i­fy for the trans­fer) will be very close, if not equal, to zero.
Con­sider the im­pact of sub­sidies (grants and low-cost loans) to col­lege stu­dents in the United States.
These pro­grams were de­signed to make col­lege more af­ford­able.
But the sub­sidies also in­crease the de­mand for col­lege, which pushes tu­ition prices up­ward.
A re­cent study by the Fed­er­al Re­serve Bank of New York es­tim­ates
that about 65 per­cent of the in­creases in trans­fers to stu­dents was passed through in the form of high­er tu­ition prices.
Fur­ther­more, the sub­sidy pro­grams have con­trib­uted to a glut of col­lege stu­dents en­ter­ing the job mar­ket,
which has re­duced their em­ploy­ment pro­spects as well as the value of their de­grees.
In post-com­mun­ist trans­ition coun­tries, rap­id ex­pan­sion,
com­bined with low qual­ity and ir­rel­ev­ance (in many fields) of uni­versity edu­ca­tion, has res­ul­ted in a ser­i­ous prob­lem of “overedu­ca­tion”
where gradu­ates end up tak­ing jobs in which they do not need a uni­versity edu­ca­tion.
Many such gradu­ates re­main trapped in low-skilled jobs years after com­plet­ing school­ing.(70)
There is a third reas­on for the in­ef­fect­ive­ness of trans­fers.
Trans­fer pro­grams re­duce the ad­verse con­sequences suffered by those who make im­prudent de­cisions,
thereby re­du­cing their mo­tiv­a­tion to take steps to avoid the ad­versity.
For ex­ample, gov­ern­ment sub­sidies of in­sur­ance premi­ums in areas prone to hur­ricanes
re­duce the per­son­al cost of in­di­vidu­als pro­tect­ing them­selves against eco­nom­ic losses res­ult­ing from hur­ricanes.
But there is still a cost to so­ci­ety.
Be­cause the sub­sidy makes the pur­chase of hur­ricane in­sur­ance cheap­er, more people will build in hur­ricane-prone areas,
which res­ults in hur­ricanes do­ing more dam­age than they would oth­er­wise.
Un­em­ploy­ment com­pens­a­tion provides an­oth­er ex­ample.
The be­ne­fits make it less costly for un­em­ployed work­ers to re­fuse ex­ist­ing of­fers and keep look­ing for bet­ter jobs.
There­fore, work­ers spend a longer time search­ing for jobs, which makes the un­em­ploy­ment rate high­er than it would be oth­er­wise.(71)
In un­der­stand­ing poverty and the im­pact of gov­ern­ment pro­grams, it is im­port­ant to dis­tin­guish
between “be­ing in poverty,” which is an of­fi­cial gov­ern­ment stat­ist­ic, and “be­ing de­prived,” which is an in­tu­it­ive un­der­stand­ing about the qual­ity of life.
The United States de­clared a “War on Poverty” un­der Pres­id­ent Lyn­don John­son in the mid-1960s.
Pres­id­ent John­son and oth­er pro­ponents of the pro­gram ar­gued
that poverty could be elim­in­ated if only Amer­ic­ans were will­ing to trans­fer a little more in­come to the less for­tu­nate mem­bers of so­ci­ety.
They were will­ing, and in­come-trans­fer pro­grams ex­pan­ded sub­stan­tially.
As can be seen in the chart be­low (Ex­hib­it 21), trans­fers dir­ec­ted to­ward the poor or near poor have ris­en sharply (nine-fold) in real dol­lars (2017 val­ues) since the 1960s in the United States.
The rate of poverty, however, has re­mained al­most con­stant.(72)
As Pres­id­ent Ron­ald Re­agan once quipped: “In the six­ties we waged a war on poverty, and poverty won.”
Ex­hib­it 21: Poverty Level and Wel­fare Spend­ing per Per­son in Poverty
A bar chart dis­play­ing poverty levels and wel­fare spend­ing per per­son in poverty in the United States from 1967 to 2017. Val­ues are in 2017 dol­lars. Des­pite a nine-fold in­crease in wel­fare pay­ments over that time, poverty levels have re­mained more or less con­stant at an av­er­age 15% of the pop­u­la­tion.
Why haven’t the anti-poverty trans­fer pro­grams been more ef­fect­ive?
The trans­fers gen­er­ate three un­in­ten­ded sec­ond­ary ef­fects that slow pro­gress against poverty.
First, the in­come-linked trans­fers re­duce the in­cent­ive of low-in­come in­di­vidu­als to earn, move up the in­come lad­der, and es­cape poverty.
The be­ne­fits from most of these pro­grams are scaled down and even­tu­ally elim­in­ated as the re­cip­i­ents’ earn­ings rise.
As a res­ult, many low-in­come re­cip­i­ents get caught in a poverty trap.
If they earn more, the com­bin­a­tion of the ad­di­tion­al taxes owed and trans­fers lost means
that they get to keep only a frac­tion of the ad­di­tion­al earn­ings.
In 2018, the OECD re­por­ted that lost be­ne­fits as a res­ult of in­creased earn­ings
equaled 93 per­cent of the min­im­um wage for work­ers in the Czech Re­pub­lic and 92 per­cent of this wage in Croa­tia.(73)
In some cases, the ad­di­tion­al earn­ings may even re­duce the re­cip­i­ent’s net in­come.
Thus, the poverty trap sub­stan­tially re­duces the in­cent­ive for many low-in­come re­cip­i­ents to work,
earn more, ac­quire ex­per­i­ence, and move up the job lad­der.
To a large de­gree, the trans­fers merely re­place in­come that would have oth­er­wise been earned,
and as a res­ult, the net gains of the poor are small—far less than the trans­fer spend­ing sug­gests.
This is not a new in­sight. Ob­serving the Eng­lish Poor Laws in 1835, Alex­is de Toc­queville wrote in Mem­oirs on Pau­per­ism:
Man, like all so­cially-or­gan­ized be­ings, has a nat­ur­al pas­sion for idle­ness.
There are, however, two in­cent­ives to work: the need to live and the de­sire to im­prove con­di­tions of life…
Any meas­ure which es­tab­lishes leg­al char­ity on a per­man­ent basis and gives it an ad­min­is­trat­ive form thereby cre­ates an idle and lazy class, liv­ing at the ex­pense of the in­dus­tri­al and work­ing class.(74)
Second, trans­fer pro­grams that sig­ni­fic­antly re­duce the hard­ship of poverty also re­duce the op­por­tun­ity cost of risky choices (such as drug use, drop­ping out of school or the work­force,
child­bear­ing by teen­agers and un­mar­ried wo­men, di­vorce, or aban­don­ment of chil­dren by fath­ers), which of­ten lead to poverty.
As more people choose these high-risk op­tions, it is very dif­fi­cult to re­duce the poverty rate.
The poverty rate of single-par­ent house­holds is sub­stan­tially great­er than that of two-par­ent house­holds.
In the Czech Re­pub­lic, for ex­ample, 9.7 per­cent of the gen­er­al pop­u­la­tion lived be­low the poverty line in 2017,
while 37 per­cent of people in house­holds with single moth­ers or fath­ers fell be­low this line.
In Be­larus in 2013 the poverty rate among single-par­ent house­holds was 17 per­cent as com­pared to 11 per­cent for the gen­er­al pop­u­la­tion.
A 2009 study by Isa­bel Sawhill and Ron Haskins of the Brook­ings In­sti­tu­tion
found that in the United States a per­son can re­duce his or her chances of liv­ing in poverty from 12 per­cent to 2 per­cent by do­ing just three ba­sic things:
com­plet­ing high school (at a min­im­um), work­ing full time, and get­ting mar­ried be­fore hav­ing a child.(75)
The ef­fect of per­son­al choices on poverty is a vi­tally im­port­ant point
that edu­cat­ors, par­ents, guard­i­ans, and oth­ers need to dis­cuss with young people, many of whom are mak­ing these life-chan­ging de­cisions.
They should be con­sidered by voters and mem­bers of so­ci­ety in gen­er­al when ad­opt­ing pro­grams that al­ter in­cent­ives for be­ha­vi­or
that can in­crease or re­duce the prob­ab­il­ity of harm­ful de­cisions.
Third, gov­ern­ment an­ti­poverty trans­fers crowd out private char­it­able ef­forts.
When people per­ceive that the gov­ern­ment is provid­ing for the poor, ac­tion by fam­il­ies, churches, and civic or­gan­iz­a­tions be­comes less ur­gent.
The Judeo-Chris­ti­an concept of tith­ing and the Is­lam­ic ob­lig­a­tion of za­kat both em­phas­ize in­di­vidu­als’ ob­lig­a­tions to as­sist the less for­tu­nate.
When taxes are levied and the gov­ern­ment does more, pre­dict­ably, private in­di­vidu­als and groups will do less.
Fur­ther, private givers are more likely to see the real nature of the prob­lem,
be more sens­it­ive to the life­styles of re­cip­i­ents, and fo­cus their giv­ing on those mak­ing a good ef­fort to help them­selves.
As a res­ult, private char­it­able ef­forts will tend to be more ef­fect­ive
than those of the gov­ern­ment, and there­fore the prob­lem wor­sens as the private ef­forts are crowded out.
Com­pound­ing these ef­fects, stud­ies have found that private char­it­ies de­liv­er a sub­stan­tially lar­ger share of their in­come to the even­tu­al be­ne­fi­ciar­ies
than gov­ern­ment pro­grams, which have much lar­ger over­head and ad­min­is­trat­ive costs.(76)
From an eco­nom­ic view­point, the poor re­cord of trans­fer pro­grams ran­ging from farm price sup­ports to an­ti­poverty pro­grams is not sur­pris­ing.
Ideally, such pro­grams should en­able those caught in poverty to sus­tain them­selves as they work to no longer need such trans­fers.
In real­ity, the evid­ence sug­gests that trans­fer pro­grams can achieve the first part of this mis­sion but may well do so at the cost of in­hib­it­ing the second.
As a res­ult, as­sist­ance pro­grams in both the de­vel­op­ing and de­veloped world are in­creas­ingly be­ing de­signed as
“con­di­tion­al cash trans­fers,” where sup­port is provided only if the re­cip­i­ent en­gages in cer­tain be­ha­vi­ors.
It is worth mak­ing some clos­ing ob­ser­va­tions on the dif­fi­cult polit­ic­al de­cisions re­gard­ing poverty.
When read­ing dis­cus­sions in the press or listen­ing to can­did­ates for of­fice, it is im­port­ant to un­der­stand pre­cisely what they are talk­ing about.
  1. Even the defin­i­tion of “poverty” is of­ten con­fus­ing. When some people talk about poverty, they are think­ing “ab­so­lute poverty,” which means
    that an in­di­vidu­al or fam­ily does not have suf­fi­cient re­sources to pur­chase a pre-de­term­ined “min­im­um bas­ket of goods and ser­vices.”
  2. Oth­ers refer to “re­l­at­ive poverty,” where an in­di­vidu­al or fam­ily is defined as poor
    if their in­come falls be­low a pre-de­cided po­s­i­tion in the in­come dis­tri­bu­tion (say is lower than half of the so­ci­ety’s me­di­an in­come).
  3. Re­l­at­ive poverty relates to, but is not the same as, in­equal­ity.
    Sup­pose you had two so­ci­et­ies with four fam­il­ies in each.
    In­comes in the first so­ci­ety are $1,000,000, $50,000, $50,000, and $4,000 while in­comes in the second were $51,000, $50,000, $50,000, and $24,999.
    Both so­ci­et­ies would have the same re­l­at­ive poverty rate (25%) but very dif­fer­ent levels of in­equal­ity.
  4. Poverty meas­ures are some­times presen­ted without tak­ing ac­count of taxes (which re­duce in­come) and trans­fers (which in­crease in­come).
    Which is be­ing used? The first defin­i­tion of­ten finds twice as many people in poverty as the lat­ter.
  5. Stand­ards of what con­sti­tutes a min­im­um con­sump­tion level vary widely across coun­tries and over time.
    In middle and up­per in­come coun­tries today, so­ci­et­al ex­pect­a­tions for reas­on­able stand­ards of liv­ing
    in­clude goods and ser­vices un­ima­gin­able for pre­vi­ous gen­er­a­tions. (Think cell­phones or tele­vi­sion sets.)
  6. Fi­nally, it is im­port­ant to dis­tin­guish between poverty at a giv­en time com­pared to over a life­time.
    Hav­ing a low in­come as a stu­dent is very dif­fer­ent from be­ing poor year after year.

Element 3.9: Central Planning Has Never Worked

The economy is far too complex to be centrally planned and efforts to do so will result in inefficiency.

The man of sys­tem is apt to be very wise in his own con­ceit.
He seems to ima­gine that he can ar­range the dif­fer­ent mem­bers of a great so­ci­ety with as much ease as the hand ar­ranges the dif­fer­ent pieces upon a chess-board;
he does not con­sider that the pieces upon the chess-board have no oth­er prin­ciple of mo­tion be­sides that which the hand im­presses upon them;
but that, in the great chess-board of hu­man so­ci­ety, every single piece has a prin­ciple of mo­tion of its own,
al­though dif­fer­ent from that which the le­gis­lature might choose to im­press upon it.
If those two prin­ciples co­in­cide and act in the same dir­ec­tion,
the game of hu­man so­ci­ety will go on eas­ily and har­mo­ni­ously, and is very likely to be happy and suc­cess­ful.
If they are op­pos­ite or dif­fer­ent, the game will go on miser­ably, and the so­ci­ety must be at all times in the highest de­gree of dis­order.(77)
Adam Smith (1759), The The­ory of Mor­al Sen­ti­ments
As pre­vi­ously dis­cussed, gov­ern­ments can of­ten co­ordin­ate the pro­vi­sion of pub­lic goods—
a small class of goods for which it is dif­fi­cult to lim­it con­sump­tion to pay­ing cus­tom­ers—bet­ter than mar­kets.
Many people also be­lieved that gov­ern­ment of­fi­cials can man­age all, or most, of the eco­nomy bet­ter than mar­kets.
Since the Bolshev­ik re­volu­tion in 1917, nu­mer­ous pro­ponents of cent­ral plan­ning claimed
that the gen­er­al popu­lace would be bet­ter off if gov­ern­ment of­fi­cials used taxes, sub­sidies,
man­dates, dir­ect­ives, and reg­u­la­tions to cent­rally plan and man­age the key sec­tors of the eco­nomy.
Un­der cent­ral plan­ning, the mar­ket forces we dis­cussed earli­er are re­placed by gov­ern­ment diktat
in­volving dir­ect com­mand and con­trol, as un­der the old So­viet sys­tem.
To a less­er ex­tent, such gov­ern­ment con­trol can oc­cur in any so­ci­ety where elec­ted polit­ic­al of­fi­cials sub­sti­tute their ver­dicts for those of con­sumers, in­vestors, and en­tre­pren­eurs dir­ec­ted by mar­ket forces.
It is easy to see why cent­ral plan­ning has a cer­tain ap­peal to the novice. Surely it makes sense to plan.
Aren’t elec­ted of­fi­cials and gov­ern­ment ex­perts more likely to rep­res­ent the “gen­er­al wel­fare” of the people than busi­ness en­tre­pren­eurs?
Won’t gov­ern­ment of­fi­cials be “less greedy” than private busi­nesses?
People who do not un­der­stand pub­lic choice eco­nom­ics and the op­er­a­tion of the polit­ic­al pro­cess of­ten find the ar­gu­ment for cent­ral plan­ning per­suas­ive.
Eco­nom­ics, however, in­dic­ates that cent­ral plan­ning will be in­ef­fi­cient. There are five ma­jor reas­ons why this will be the case.
First, cent­ral plan­ning merely sub­sti­tutes polit­ics for mar­ket de­cisions.
Real-world cent­ral plan­ners (and the le­gis­lat­ors who dir­ect them) are not a group of om­ni­scient self­less saints.
In­ev­it­ably, the sub­sidies and in­vest­ment funds al­loc­ated by plan­ners will be in­flu­enced by polit­ic­al con­sid­er­a­tions.
Think how this pro­cess works even when de­cisions are made demo­crat­ic­ally.
Ex­pendit­ures will have to be ap­proved by the le­gis­lature.
Vari­ous busi­ness and uni­on­ized labor in­terests will lobby for in­vest­ment funds and sub­sidies.
Le­gis­lat­ors will be par­tic­u­larly sens­it­ive to those in a po­s­i­tion to provide cam­paign con­tri­bu­tions or to de­liv­er key vot­ing blocs.
Pre­dict­ably, the polit­ic­al pro­cess will fa­vor older firms with more lob­by­ing ex­per­i­ence and polit­ic­al clout,
even if they are eco­nom­ic­ally weak, over new­er growth-ori­ented firms.
In ad­di­tion, the chair­men of key le­gis­lat­ive com­mit­tees will of­ten block vari­ous pro­grams
un­less oth­er le­gis­lat­ors agree to sup­port pro­jects be­ne­fi­cial to their con­stitu­ents and favored in­terest groups (“pork-bar­rel” pro­jects).
Giv­en this in­cent­ive struc­ture, only a naïve ideal­ist would ex­pect this politi­cized pro­cess to res­ult in less waste,
more wealth cre­ation, and a bet­ter al­loc­a­tion of in­vest­ment funds than mar­kets.
It is not just man­agers who lack in­cent­ives to achieve the greatest ef­fi­ciency.
Work­ers who are guar­an­teed jobs and are paid the same re­gard­less of how hard they work have an in­cent­ive to min­im­ize their ef­fort.
The So­viet real­ity was cap­tured in the old phrase: “They pre­tend to pay us and we pre­tend to work.”
(An­oth­er well un­der­stood So­viet ex­pres­sion was: “Any­one who does not steal from the state steals from his fam­ily.”)
Second, the in­cent­ive of government enterprises and agen­cies to keep costs low,
be in­nov­at­ive, and ef­fi­ciently sup­ply goods is weak.
Un­like private own­ers, the dir­ect­ors and man­agers of pub­lic-sec­tor en­ter­prises have little to gain from im­proved ef­fi­ciency and lower costs.
Rather than serving cus­tom­ers to build their agen­cies, they rely on a gov­ern­ment budget.
Pre­dict­ably, they will be mo­tiv­ated to pur­sue a lar­ger budget.
A lar­ger budget will provide fund­ing for ex­pan­sion, salary in­creases,
ad­di­tion­al spend­ing on cli­ents, and oth­er factors that will make life more com­fort­able for the man­agers.
Man­agers of gov­ern­ment en­ter­prises and agen­cies, al­most without ex­cep­tion, will try to con­vince the plan­ners
that their activ­it­ies are pro­du­cing goods or ser­vices that are enorm­ously valu­able to the gen­er­al pub­lic
and, if they were just giv­en more funds, they would do even more mar­velous things for so­ci­ety.
Moreover, they will ar­gue, if the fund­ing is not forth­com­ing, people will suf­fer and the con­sequences will likely be dis­astrous.
It will of­ten be dif­fi­cult for le­gis­lat­ors and oth­er gov­ern­ment plan­ners to eval­u­ate such claims,
not only be­cause there will be thou­sands of such claims, but also be­cause there is noth­ing
com­par­able to private-sec­tor profit that the plan­ners can use to meas­ure per­form­ance of the en­ter­prise man­agers.
In the private sec­tor, bankruptcy even­tu­ally weeds out in­ef­fi­cient pro­du­cers,
but in the pub­lic sec­tor, there is no par­al­lel mech­an­ism for the ter­min­a­tion of un­suc­cess­ful pro­grams.
In fact, poor per­form­ance and fail­ure to achieve ob­ject­ives is of­ten used as an ar­gu­ment for in­creased gov­ern­ment fund­ing.
For ex­ample, the po­lice de­part­ment will use a rising crime rate to ar­gue for ad­di­tion­al law-en­force­ment fund­ing.
Sim­il­arly, if the achieve­ment scores of stu­dents are de­clin­ing,
pub­lic school ad­min­is­trat­ors will use this fail­ure to ar­gue for still more funds.
Giv­en the strong in­cent­ive of gov­ern­ment en­ter­prise man­agers to ex­pand their budgets, and the weak in­cent­ive to op­er­ate ef­fi­ciently,
gov­ern­ment en­ter­prises can be ex­pec­ted to have high­er per-unit costs than com­par­able private firms.
Third, there is every reas­on to be­lieve that in­vestors risk­ing their own money will make bet­ter in­vest­ment choices
than cent­ral plan­ners spend­ing the money of tax­pay­ers.
Re­mem­ber, an in­vestor who is go­ing to profit must dis­cov­er and in­vest in a pro­ject that in­creases the value of re­sources.
The in­vestor who makes a mis­take—that is, whose pro­ject res­ults in losses—will bear the con­sequences dir­ectly.
In con­trast, the suc­cess or fail­ure of gov­ern­ment pro­jects sel­dom ex­erts much im­pact on the per­son­al wealth of gov­ern­ment plan­ners.
Even if a pro­ject is pro­duct­ive, the plan­ner’s per­son­al gain is likely to be mod­est.
Sim­il­arly, if the pro­ject is waste­ful—if it re­duces the value of re­sources—
this fail­ure will ex­ert little neg­at­ive im­pact on the in­come of plan­ners.
They may even be able to reap per­son­al gain from waste­ful pro­jects that chan­nel sub­sidies and oth­er be­ne­fits to­ward polit­ic­ally power­ful groups
who will then give their agency or en­ter­prise ad­ded polit­ic­al sup­port.
Giv­en this in­cent­ive struc­ture, there is no reas­on to be­lieve
that gov­ern­ment plan­ners will be more likely than private in­vestors to dis­cov­er and act on pro­jects that in­crease so­ci­ety’s wealth.
Fourth, the ef­fi­ciency of gov­ern­ment spend­ing will also be un­der­mined be­cause the budget of an un­con­strained gov­ern­ment is something like a com­mon pool re­source.
As we saw in Part 2, Ele­ment 1, private own­er­ship provides a strong mo­tiv­a­tion to take the fu­ture ef­fects of cur­rent de­cisions into con­sid­er­a­tion.
But when money and re­sources are owned in com­mon there is little mo­tiv­a­tion to con­sider the fu­ture.
For ex­ample, fish in the ocean are owned in com­mon un­til someone catches them
and, as a res­ult, many spe­cies are on the verge of de­ple­tion be­cause of over­fish­ing.
All fish­er­men would be bet­ter off if the fish were har­ves­ted less rap­idly so there would be more op­por­tun­ity for their pop­u­la­tions to re­pro­duce.
But, be­cause of the com­mon own­er­ship, each fish­er­man knows that fish he does not catch today will be caught by someone else to­mor­row.
Thus, there is little in­cent­ive for any­one to re­duce his or her catch today so more fish will be avail­able in the fu­ture.
Sim­il­arly, when in­terest groups are “fish­ing” for gov­ern­ment spend­ing (that is, lob­by­ing polit­ic­al plan­ners),
they have little in­cent­ive to con­sider the ad­verse con­sequences of high­er taxes and ad­di­tion­al bor­row­ing on fu­ture out­put.
The pro­ponents of each spend­ing pro­ject may re­cog­nize
that fu­ture out­put would be great­er if taxes were lower and private in­vest­ment high­er.
But they will also re­cog­nize that if they do not grab more of the gov­ern­ment budget, some oth­er in­terest group will.
Giv­en these in­cent­ives, in­ef­fi­cient spend­ing pro­jects and per­petu­al budget de­fi­cits are an ex­pec­ted res­ult.
See the dis­cus­sion in Part 3, Ele­ment 6, on the prob­lem of chron­ic gov­ern­ment budget de­fi­cits.
Fifth, there is no way that cent­ral plan­ners can ac­quire enough in­form­a­tion
to cre­ate, main­tain, and con­stantly up­date a plan that makes sense.
We live in a world of dy­nam­ic change.
Tech­no­lo­gic­al ad­vances, new products, polit­ic­al un­rest,
chan­ging de­mand, and shift­ing weath­er con­di­tions are con­stantly al­ter­ing the re­l­at­ive scarcity of both goods and re­sources.
No cent­ral au­thor­ity will be able to keep up with these changes,
polit­ic­ally as­sess them, and provide en­ter­prise man­agers with sens­ible in­struc­tions.
Mar­kets are dif­fer­ent. Mar­ket prices re­gister and tab­u­late widely frag­men­ted in­form­a­tion.
Price in­form­a­tion is con­stantly ad­just­ing to re­flect the per­sist­ent changes tak­ing place in the eco­nomy.
Prices re­flect this widely dis­persed in­form­a­tion and send sig­nals to busi­ness firms and re­source sup­pli­ers.
These price sig­nals provide busi­nesses and re­source own­ers with the in­form­a­tion—and the in­cent­ives—
re­quired to co­ordin­ate their ac­tions and bring them into har­mony with the new con­di­tions.
Fail­ure to prop­erly in­ter­pret these mar­ket price sig­nals and re­spond prop­erly will bring losses to the busi­ness or in­di­vidu­als.
It is the in­form­a­tion com­mu­nic­ated through mar­ket prices that in­forms in­vestors,
firms, and work­ers where their dol­lars and ef­forts cre­ate the most value for oth­ers.
Without mar­ket prices for their out­put, gov­ern­ment agen­cies make de­cisions
without any such par­al­lel meas­ure of wheth­er they are cre­at­ing pos­it­ive net val­ues or wast­ing re­sources.
No­bel Laur­eate Friedrich Hayek sum­mar­ized the im­plic­a­tions of the in­form­a­tion prob­lem con­fron­ted by cent­ral plan­ners in the fol­low­ing man­ner:
If man is not to do more harm than good in his ef­forts to im­prove the so­cial or­der, he will have to learn that in this,
as in all oth­er fields where es­sen­tial com­plex­ity of an or­gan­ized kind pre­vails, he can­not ac­quire the full know­ledge which would make mas­tery of the events pos­sible.
He will there­fore have to use what know­ledge he can achieve, not to shape the res­ults as the crafts­man shapes his handi­work, but rather to cul­tiv­ate growth by provid­ing the ap­pro­pri­ate en­vir­on­ment, in the man­ner in which the garden­er does this for his plants.(78)
In oth­er words, the eco­nomy is far too com­plex to be mi­cro­man­aged.
In­stead, as stressed in Part 2, the best strategy for the achieve­ment of growth and prosper­ity is the es­tab­lish­ment of in­sti­tu­tions and long-range policies
that will cre­ate an en­vir­on­ment in which in­di­vidu­als pur­su­ing their own in­terest will un­der­take pro­duct­ive, wealth-cre­at­ing activ­it­ies.
Some years ago it was widely be­lieved that gov­ern­ment plan­ning and industrial policy provided the keys to eco­nom­ic growth.
Eco­nom­ists Paul Samuel­son and Lester Thurow were among the lead­ing pro­ponents of this view,
which dom­in­ated the pop­u­lar me­dia and in­tel­lec­tu­al circles dur­ing the 1970s and 1980s.
They ar­gued that mar­ket eco­nom­ies faced a di­lemma:
They would either have to move to­ward more gov­ern­ment plan­ning or suf­fer the con­sequences of slower growth and eco­nom­ic de­cline.
The col­lapse of the So­viet sys­tem and the poor per­form­ance of the Ja­pan­ese eco­nomy have largely eroded the pop­ular­ity of this view.
Non­ethe­less, many still be­lieve that the gov­ern­ment can dir­ect vari­ous sec­tors of the eco­nomy, such as health care and edu­ca­tion.
However, giv­en the in­cent­ives and in­form­a­tion prob­lems ac­com­pa­ny­ing cent­ral plan­ning, this is un­likely to be the case.
More than two and a half cen­tur­ies ago Adam Smith ar­tic­u­lated the source of cent­ral-plan­ning fail­ures,
in­clud­ing those that arise from ef­forts to plan spe­cif­ic sec­tors (see the quo­ta­tion at the be­gin­ning of this ele­ment).
Un­for­tu­nately for gov­ern­ment plan­ners, in­di­vidu­als have minds of their own, what Smith calls “a prin­ciple of mo­tion.”
When in­di­vidu­als face per­son­al in­cent­ives that en­cour­age them to act in ways that con­flict with the cent­ral plan, prob­lems arise.
When gov­ern­ments move bey­ond the pro­tect­ive func­tion and be­gin to sub­sid­ize vari­ous activ­it­ies,
op­er­ate en­ter­prises, dir­ect vari­ous sec­tors, and, in the ex­treme case, cent­rally plan the en­tire eco­nomy,
in­vari­ably in­tern­al con­flicts will arise and liv­ing stand­ards will fall well be­low their po­ten­tial.
The re­cord of gov­ern­ment plan­ning in dif­fer­ent coun­tries il­lus­trates this point.
It is fraught with con­flicts and in­tern­al in­con­sist­en­cies:
In gen­er­al, con­flict­ing policies res­ult from a fun­da­ment­al ten­sion between on the one hand a sys­tem of mar­ket reg­u­la­tion that aims to put cit­izens and pro­ductiv­ity in charge of the eco­nomy
and on the oth­er a sys­tem of gov­ern­ment­al rig­ging of the eco­nomy to be­ne­fit polit­ic­ally favored sec­tors and firms.
Eco­nom­ic ana­lys­is in­dic­ates that ex­tens­ive use of gov­ern­ment plan­ning will lead to both eco­nom­ic in­ef­fi­ciency and cronyism.
When gov­ern­ment of­fi­cials de­cide what is bought and sold, or the prices of those items, the first thing that will be bought and sold will be the votes of elec­ted of­fi­cials.
When en­ter­prises get more funds from gov­ern­ments and less from con­sumers,
they will spend more time try­ing to in­flu­ence politi­cians and less time try­ing to re­duce costs and please cus­tom­ers.
Pre­dict­ably, the sub­sti­tu­tion of polit­ics for mar­kets will lead to eco­nom­ic re­gres­sion
and, in the words of Ukrain­i­an born eco­nom­ist Lud­wig Von Mises,
“The worst evils which man­kind has ever had to en­dure were in­flic­ted by bad gov­ern­ments.”(81)

Element 3.10: Competition and External Anchors Are Key

Competition is just as important in government as in markets.

Pho­to­graph of Kim Jong Un post­ing a card into a bal­lot box. The cap­tion reads: Kim Jong Un wins North Korea elec­tions with 100% of the vote.
Com­pet­i­tion is a dis­cip­lin­ary force. In the mar­ket­place, busi­nesses must com­pete for the loy­alty of cus­tom­ers.
When firms serve their cus­tom­ers poorly, they gen­er­ally lose busi­ness to rivals of­fer­ing a bet­ter deal.
Com­pet­i­tion provides con­sumers with pro­tec­tion against high prices, poor qual­ity mer­chand­ise, poor ser­vice, and/or rude be­ha­vi­or.
Al­most every­one re­cog­nizes this point with re­gard to the private sec­tor.
Un­for­tu­nately, the im­port­ance of com­pet­i­tion in the pub­lic sec­tor is of­ten over­looked.
As dis­cussed in the pri­or ele­ment, the struc­ture of in­cent­ives con­fron­ted by gov­ern­ment agen­cies and en­ter­prises is not very con­du­cive to ef­fi­cient op­er­a­tion.
There is noth­ing com­par­able to profits and losses to help cit­izens eval­u­ate the per­form­ance of pub­lic sec­tor agen­cies and en­ter­prises.
As a res­ult, man­agers of gov­ern­ment firms can of­ten gloss over eco­nom­ic in­ef­fi­ciency. There is little in­cent­ive to con­trol spend­ing.
If an agency fails to spend this year’s budget al­loc­a­tion, its case for a lar­ger budget next year is weakened.
Agen­cies typ­ic­ally go on a spend­ing spree at the end of the budget peri­od if ap­pro­pri­ations have not yet been spent.
Giv­en the struc­ture of in­cent­ives with­in the pub­lic sec­tor, it is vi­tally im­port­ant that gov­ern­ment faces com­pet­i­tion wherever feas­ible.
If we are go­ing to get the most from the avail­able re­sources,
private firms must be per­mit­ted to com­pete on a level play­ing field with gov­ern­ment agen­cies and en­ter­prises.
For ex­ample, when gov­ern­ments op­er­ate vehicle main­ten­ance de­part­ments, print­ing shops, food ser­vices, garbage col­lec­tion ser­vices, street main­ten­ance de­part­ments, schools, and sim­il­ar agen­cies,
private firms can eas­ily be giv­en an equal op­por­tun­ity to com­pete with pub­lic en­ter­prises, es­pe­cially if care is ex­er­cised to avoid polit­ic­al fa­vor­it­ism or even bribery.
Com­pet­i­tion can im­prove per­form­ance, re­duce costs,
and stim­u­late in­nov­at­ive be­ha­vi­or in gov­ern­ment, as well as in the private sec­tor.
Com­pet­i­tion among de­cent­ral­ized gov­ern­ment units—states in the United States or Ger­many,
re­gions or ob­lasts in oth­er coun­tries and loc­al (mu­ni­cip­al) gov­ern­ments—can also help pro­tect cit­izens from gov­ern­ment ex­ploit­a­tion.
A gov­ern­ment can­not be op­press­ive when cit­izens can eas­ily choose the “exit op­tion,” mov­ing to an­oth­er loc­a­tion that provides a level of gov­ern­ment ser­vices and taxes more to their lik­ing.
Of course, it is not as easy to walk away from your gov­ern­ment as from your gro­cer!
But the more gov­ern­ment func­tions are de­cent­ral­ized, the easi­er it is for cit­izens to vote with their feet.
Moreover, people can be­ne­fit from more com­pet­i­tion between sub-na­tion­al gov­ern­ments without mov­ing them­selves.
The fact that some do move from less ef­fi­cient to more ef­fi­cient gov­ern­ments and that oth­ers could do the same mo­tiv­ates all gov­ern­ments to be­come more sens­it­ive to the con­cerns of their cit­izens.
Decentralization can also en­hance the abil­ity of people to ob­tain gov­ern­ment ser­vices more to their lik­ing.
Just as people dif­fer re­gard­ing how much they want to spend on hous­ing or auto­mo­biles, they will also have dif­fer­ent views con­cern­ing ex­pendit­ures on pub­lic ser­vices.
Some will prefer high­er levels of ser­vices and be will­ing to pay high­er taxes for them.
Oth­ers will prefer lower taxes and few­er gov­ern­ment ser­vices.
Some will want to fund gov­ern­ment ser­vices with taxes, while oth­ers will prefer great­er re­li­ance on user charges.
With­in the frame­work of a de­cent­ral­ized polit­ic­al sys­tem, in­di­vidu­als will be able to group to­geth­er with oth­ers de­sir­ing sim­il­ar com­bin­a­tions of gov­ern­ment ser­vices and taxes, and this group­ing will make it pos­sible for more people to ob­tain ser­vices more con­sist­ent with their pref­er­ences.
Moreover, the move­ment of people among the de­cent­ral­ized gov­ern­ment­al units will also help im­prove ef­fi­ciency.
If a gov­ern­ment levies high taxes (without provid­ing a par­al­lel qual­ity of ser­vice)
and reg­u­lates ex­cess­ively, some in­di­vidu­als and busi­nesses that make up their tax base will choose the exit op­tion.
Between 2003 and 2013, the pop­u­la­tion of the nine U.S. states without a per­son­al in­come tax grew by an av­er­age of 3.7 per­cent a year as the res­ult of im­mig­ra­tion from oth­er states.
Dur­ing the same peri­od, the nine states with the highest in­come taxes lost an av­er­age of 2 per­cent in pop­u­la­tion. Em­ploy­ment growth in the nine states without an in­come tax was more than double that of the high-tax states.
Sim­il­arly, with­in the European Uni­on, coun­tries where after-tax in­comes are a great­er pro­por­tion of pretax in­comes at­tract sig­ni­fic­antly lar­ger num­bers of for­eign high-skilled work­ers.(82)
These movers are send­ing a mes­sage to high tax­ing, poorly run gov­ern­ments. Like busi­nesses that real­ize losses when they fail to serve their cus­tom­ers, gov­ern­ments lose cit­izens when they serve them poorly,
un­less they use the power of the state to re­strict move­ments, as China does by not al­low­ing those who do not have an urb­an res­id­ence per­mit (hukou) for a spe­cif­ic city to re­ceive med­ic­al care or send their chil­dren to school.
To sum­mar­ize, de­cent­ral­iz­a­tion al­lows people to move to­ward gov­ern­ment­al units that provide de­sired pub­lic ser­vices at a low cost.
In turn, the move­ments of voters will dis­cip­line gov­ern­ments and help keep them in line with the pref­er­ences of cit­izens.
If com­pet­i­tion among de­cent­ral­ized gov­ern­ments is go­ing to serve the in­terests of cit­izens,
however, it must not be stifled by the policies of high­er levels of gov­ern­ment.
When the na­tion­al gov­ern­ment (or the European Uni­on) sub­sid­izes, man­dates,
and reg­u­lates the bundle of ser­vices provided by lower levels of gov­ern­ment, it un­der­mines the com­pet­it­ive pro­cess among them.
The best thing the cent­ral gov­ern­ment can do is per­form its lim­ited func­tions well and re­main neut­ral with re­gard to the op­er­a­tion and level of ser­vices of lower levels of gov­ern­ment.
Like private en­ter­prises, units of gov­ern­ment prefer pro­tec­tion from rivals. There will be a tend­ency for gov­ern­ments to seek a mono­poly po­s­i­tion.
There­fore, com­pet­i­tion among gov­ern­ments will not evolve auto­mat­ic­ally. It will have to be in­cor­por­ated into the polit­ic­al struc­ture.

Thinking About Constitutional Rules for Prosperity

There is enorm­ous in­er­tia—a tyranny of the status quo—in private and es­pe­cially gov­ern­ment ar­range­ments.
Only a crisis—ac­tu­al or per­ceived—pro­duces real change. When that crisis oc­curs, the ac­tions that are taken de­pend on the ideas that are ly­ing around.
That, I be­lieve, is our ba­sic func­tion: to de­vel­op al­tern­at­ives to ex­ist­ing policies,
to keep them alive and avail­able un­til the polit­ic­ally im­possible be­comes polit­ic­ally in­ev­it­able.(83)
Milton Fried­man, 1976 No­bel Laur­eate
What are the ma­jor mes­sages of Part 3? First, eco­nom­ic ana­lys­is es­tab­lishes that mono­poly, pub­lic goods, and ex­tern­al­it­ies are all prob­lems of the mar­ket
that en­cour­age self-in­ter­ested in­di­vidu­als to en­gage in coun­ter­pro­duct­ive ac­tions.
These mar­ket fail­ures cre­ate an op­por­tun­ity for gov­ern­ment in­ter­ven­tion to en­hance ef­fi­ciency.
But there is no as­sur­ance this will be the case.
Polit­ic­al al­loc­a­tion, even when dir­ec­ted demo­crat­ic­ally,
is an al­tern­at­ive form of eco­nom­ic or­gan­iz­a­tion—and, like mar­kets, it has both be­ne­fits and short­com­ings.
There is gov­ern­ment fail­ure as well as mar­ket fail­ure. Gov­ern­ment fail­ures in­clude the fol­low­ing, as dis­cussed above:
If gov­ern­ment is go­ing to be a pos­it­ive force for eco­nom­ic prosper­ity,
the rules of the polit­ic­al game must bring the self-in­terest of voters, politi­cians, and bur­eau­crats into har­mony with eco­nom­ic pro­gress.
What would this look like and how might it be achieved?
Clearly, equal treat­ment un­der the law and re­straints on the powers of gov­ern­ments are cent­ral to the design of a polit­ic­al struc­ture sup­port­ive of eco­nom­ic pro­gress.
Al­though in­sti­tu­tion­al ar­range­ments vary around the world, there are les­sons to be learned from the suc­cess­ful (and the fail­ing) op­tions found in vari­ous coun­tries.
To a large de­gree, the framers of the United States Con­sti­tu­tion got the gen­er­al struc­ture right.
They built checks and bal­ances into the sys­tem. Polit­ic­al power was di­vided among the le­gis­lat­ive, ex­ec­ut­ive, and ju­di­cial branches.
Le­gis­la­tion had to pass through two le­gis­lat­ive bod­ies that, at the time,
rep­res­en­ted di­verse and of­ten-con­flict­ing in­terests, and the ap­prov­al of the pres­id­ent was re­quired for pas­sage into law.
The lim­it­a­tions on the powers of the cent­ral gov­ern­ment provided for a de­cent­ral­ized fed­er­al sys­tem and still more dis­pers­al of gov­ern­ment­al powers.
The per­miss­ible fisc­al powers of the cent­ral gov­ern­ment were enu­mer­ated (Art­icle I, Sec­tion 8)
and all oth­er powers were al­loc­ated to the states and the people (Tenth Amend­ment).
Con­gress was to levy uni­form taxes in or­der “to provide for the com­mon de­fense and gen­er­al wel­fare.”
The clear in­tent was to pre­vent the use of the fed­er­al treas­ury as a tool to fa­vor some groups and re­gions re­l­at­ive to oth­ers.
The Amer­ic­an Con­sti­tu­tion also pro­tec­ted the prop­erty rights of in­di­vidu­als and their free­dom to en­gage in vol­un­tary ex­change.
The Fifth Amend­ment spe­cified that private prop­erty shall not be “taken for pub­lic use without just com­pens­a­tion.”
States were pro­hib­ited from ad­opt­ing le­gis­la­tion “im­pair­ing the ob­lig­a­tion of con­tracts” (Art­icle I, Sec­tion 10).
Per­haps most im­port­antly, states were pro­hib­ited from im­ple­ment­ing trade bar­ri­ers, and as a res­ult, the United States of Amer­ica be­came the world’s largest free-trade zone.
The United States Con­sti­tu­tion sought to lim­it the abil­ity of gov­ern­ment, par­tic­u­larly the fed­er­al gov­ern­ment,
to politi­cize the eco­nomy and re­strict the rights of cit­izens.
Put an­oth­er way, the Con­sti­tu­tion was de­signed to pro­mote gov­ern­ment ac­tion based on agree­ment rather than co­er­cion.
Why is this im­port­ant? People will agree to an ac­tion only when each party gains.
Thus, ac­tions based on agree­ment, wheth­er un­der­taken through mar­kets or gov­ern­ment,
will be mu­tu­ally ad­vant­age­ous and will there­fore pro­mote the gen­er­al wel­fare rather than the in­terests of some parties at the ex­pense of oth­ers.
With the pas­sage of time gov­ern­ments of­ten seek to be­come in­volved in lar­ger and lar­ger por­tions of cit­izens’ eco­nom­ic and per­son­al lives,
so that by now, in most coun­tries, gov­ern­ment is in­volved in al­most everything
and the res­ults are highly vis­ible: polit­ic­al fa­vor­it­ism, spe­cial-in­terest spend­ing, large budget de­fi­cits,
ex­cess­ive reg­u­la­tion, polit­ic­al cor­rup­tion, and in­creased in­flu­ence over many as­pects of our lives.
The chal­lenge be­fore all coun­tries, both those with long-es­tab­lished gov­ern­ment­al struc­tures and those newly de­vis­ing the rules un­der which they will op­er­ate, is to design a set of con­sti­tu­tion­al rules
that will pro­mote gov­ern­ment ac­tion based on broad con­sensus and bring the polit­ic­al pro­cess into har­mony with eco­nom­ic pro­gress.
How can this be ac­com­plished?
What pro­vi­sions would a con­sti­tu­tion de­signed to pro­mote eco­nom­ic prosper­ity and sta­bil­ity con­tain?
Sev­er­al pro­pos­als flow dir­ectly from the ana­lyses dis­cussed above. Al­though oth­ers may have dif­fer­ent ideas worth dis­cuss­ing, we be­lieve that both eco­nom­ic lo­gic and em­pir­ic­al re­search sup­port the fol­low­ing gen­er­al prin­ciples that would con­trib­ute to a well-func­tion­ing gov­ern­ment and pro­mote eco­nom­ic pro­gress.

Constitutional Principles for Prosperity

  1. De­cent­ral­iz­a­tion such that eco­nom­ic policy de­cisions are, to the max­im­um ex­tent pos­sible, made at the level of gov­ern­ment closest to those af­fected
    Some­times re­ferred to as subsidiarity, this prin­ciple is found in the Tenth Amend­ment to the United States Con­sti­tu­tion, which states,
    “The powers not del­eg­ated to the United States by the Con­sti­tu­tion, nor pro­hib­ited by it to the States, are re­served to the States re­spect­ively, or to the people.”
    Sub­si­di­ar­ity is also “a gen­er­al prin­ciple of European Uni­on law” un­der the 1992 Treaty of Maastricht.
    As mod­i­fied by the Lis­bon Treaty of 2009 “un­der the prin­ciple of sub­si­di­ar­ity, in areas which do not fall with­in its ex­clus­ive com­pet­ence,
    the Uni­on shall act only if and in so far as the ob­ject­ives of the pro­posed ac­tion can­not be suf­fi­ciently achieved by Mem­ber States, either at the cent­ral level or at the re­gion­al or loc­al level…”
    The lo­gic of sub­si­di­ar­ity stems from sev­er­al sources.
    The more dir­ect con­tact between gov­ern­ment and cit­izens
    at the loc­al rather than na­tion­al (or supra­na­tion­al) level al­lows bet­ter dis­cov­ery of needs and de­sires.
    As dis­cussed earli­er, com­pet­i­tion among gov­ern­ments res­ults in in­cent­ives to bet­ter serve cit­izens.
    As a res­ult of dif­fer­ent loc­al groups of cit­izens be­ing in­centiv­ized to ad­dress com­mon prob­lems, the di­versity of ap­proaches to prob­lems util­ized by dif­fer­ent loc­al­it­ies
    will in­crease the odds that ef­fect­ive policies will be dis­covered and ad­op­ted by oth­er gov­ern­ment­al units.
    While the spe­cif­ic term “sub­si­di­ar­ity” arose from Pope Pius XI’s en­cyc­lic­al Quad­rages­imo anno in the early twen­ti­eth cen­tury, the idea was un­der­stood well be­fore the term came into wide use.
    Ob­serving early nine­teenth-cen­tury Amer­ica, Alex­is de Toc­queville con­cluded:
    De­cent­ral­iz­a­tion has, not only an ad­min­is­trat­ive value, but also a civic di­men­sion,
    since it in­creases the op­por­tun­it­ies for cit­izens to take in­terest in pub­lic af­fairs; it makes them get ac­cus­tomed to us­ing free­dom.
    And from the ac­cu­mu­la­tion of these loc­al, act­ive, per­snick­ety freedoms, is born the most ef­fi­cient coun­ter­weight against the claims of the cent­ral gov­ern­ment,
    even if it were sup­por­ted by an im­per­son­al, col­lect­ive will.(84)
  2. Checks and bal­ances that keep gov­ern­ment­al power clearly di­vided across in­de­pend­ent units
    Gov­ern­ments typ­ic­ally have three areas of activ­ity:
    1. A le­gis­lat­ive branch that makes the laws.
    2. An ex­ec­ut­ive branch that ad­min­is­ters the laws.
    3. A ju­di­cial (court) branch that in­ter­prets the laws.
    There are, however, a very large num­ber of in­sti­tu­tion­al ar­range­ments of these three ba­sic func­tions.
    Ig­nor­ing mon­arch­ies, dic­tat­or­ships, and mil­it­ary jun­tas (which may have the trap­pings of more demo­crat­ic re­gimes
    but are, in fact, dom­in­ated by a single in­di­vidu­al or small clique), the ba­sic types of sys­tems can be clas­si­fied as:
    1. Par­lia­ment­ary, in which ex­ec­ut­ive power is held by a lead­er (typ­ic­ally called a “Prime Min­is­ter”) se­lec­ted by the par­lia­ment, and par­lia­ment through the Prime Min­is­ter se­lects the cab­in­et of min­is­ters.
      In such sys­tems the Prime Min­is­ter serves at the will of the par­lia­ment and can be re­moved at any time.
      Such coun­tries may have a fig­ur­at­ive head of state (a mon­arch such as the Queen of Eng­land) or a Pres­id­ent with lim­ited powers (as in Ger­many).
    2. Pres­id­en­tial, in which the ex­ec­ut­ive is se­lec­ted dir­ectly by the voters and ap­points his or her cab­in­et, typ­ic­ally sub­ject only to ap­prov­al by the le­gis­lat­ive body. The United States is a good ex­ample of such a sys­tem.
    3. Semi-Pres­id­en­tial or Mixed, in which the voters se­lect the Pres­id­ent,
      who has lim­ited but mean­ing­ful powers, but the Cab­in­et (min­is­ters) is ac­count­able to the par­lia­ment.
      Such a sys­tem can be found in France.
    In ex­amin­ing par­lia­ment­ary sys­tems, spe­cif­ic in­sti­tu­tion­al factors are im­port­ant.
    Are elec­tions run in small dis­tricts that elect a single mem­ber or in lar­ger dis­tricts that elect mul­tiple mem­bers?
    In the lat­ter case, are seats al­loc­ated on the basis of share of the votes and what is the min­im­um share ne­ces­sary to enter the le­gis­lature?
    The ma­jor­ity of post-com­mun­ist trans­ition coun­tries (about 60 per­cent) have ad­op­ted a mixed sys­tem. Thirty per­cent have a par­lia­ment­ary sys­tem and the re­mainder a Pres­id­en­tial sys­tem.
    Over time, some coun­tries—in­clud­ing Geor­gia in 2004, the Czech Re­pub­lic in 2012, and Ar­menia in 2015—have switched from par­lia­ment­ary to mixed sys­tems.
    The powers of the Pres­id­ent in these mixed sys­tems vary a great deal across coun­tries.
    Ukraine has been es­pe­cially un­stable, with re­vi­sions in the re­l­at­ive power of the Pres­id­ent and Par­lia­ment in 1994, 1996, 2004, 2010, and 2014.
    Such in­stabil­ity of ba­sic in­sti­tu­tions clearly makes plan­ning on the part of in­vestors ex­tremely dif­fi­cult.
    While there are ad­vant­ages and dis­ad­vant­ages to all of the above types,
    re­search sug­gests that Pres­id­en­tial sys­tems tend to have smal­ler gov­ern­ments.
    This may be due to the fact that par­lia­ment­ary sys­tems are more likely to be co­ali­tion gov­ern­ments
    where mul­tiple parties make de­mands for their con­stitu­ents and pri­or­it­ies in or­der to sup­port the gov­ern­ment.
    On the oth­er hand, par­lia­ment­ary sys­tems across the world seem to grow faster than Pres­id­en­tial ones.
    In post-com­mun­ist sys­tems, however, Pres­id­en­tial sys­tems seem to have an ad­di­tion­al dis­ad­vant­age and be of lar­ger size due to a tend­ency to cent­ral­ize power,
    even to the ex­tent of be­com­ing auto­crat­ic states with only a façade of demo­cracy.
    An ex­cel­lent sum­mary of the ad­vant­ages and dis­ad­vant­ages of vari­ous forms of gov­ern­ment struc­ture in the con­text of a post-com­mun­ist coun­try has been provided by eco­nom­ists Ro­ger My­er­son, Ger­ard Ro­land, and Ty­mofiy Mylovan­ov.(85)
    Ro­ger My­er­son, who won the No­bel Prize in Eco­nom­ics in 2007,
    has else­where sug­ges­ted a prac­tic­al struc­ture that re­spects the concept of checks and bal­ances.
    Giv­en the ex­tens­ive prob­lems with cor­rup­tion in trans­ition eco­nom­ies,
    one lo­gic­al solu­tion is to di­vorce re­spons­ib­il­ity for op­er­at­ing the gov­ern­ment from re­spons­ib­il­ity for in­vest­ig­at­ing and pro­sec­ut­ing crim­in­al activ­ity.
    The former could be ves­ted in the Prime Min­is­ter and the lat­ter in the Pres­id­ent’s of­fice.
    The ba­sic prin­ciple is that even in a long-es­tab­lished leg­al sys­tem, but es­pe­cially in newly demo­crat­iz­ing coun­tries, hav­ing an in­de­pend­ent power source in charge of in­vest­ig­at­ing cor­rupt acts sig­ni­fic­antly re­duces the abil­ity of such act­ors to sub­vert justice.
    Car­toon of bird­man stand­ing at a po­di­um on a tree branch de­clar­ing: “Our gov­ern­ment is run on a sys­tem of checks and bal­ances.” Two bird­men are sit­ting in front of him. One com­ments: “Ex­actly. You write the checks and we pay the bal­ances.”
    Shoe by Gary Brook­ins and Susie MacNelly (April 5, 2010)
  3. An in­de­pend­ent ju­di­ciary
    While con­trol of ju­di­cial ap­point­ments is im­port­ant, it is not the only factor that con­trib­utes to the leg­al sys­tem func­tion­ing as a check and bal­ance.
    Eco­nom­ic re­search has shown, over and over, that the in­de­pend­ence of the ju­di­ciary is an im­port­ant de­term­in­ant of eco­nom­ic prosper­ity.
    It must be clear that by “in­de­pend­ence” we mean real in­de­pend­ence (de facto—or in­de­pend­ence in fact),
    and not merely what is form­ally writ­ten in the law but which can be avoided (de jure—or in­de­pend­ence in law).(86)
    Prin­ciples that con­trib­ute to such a ju­di­ciary in­clude the fol­low­ing:
    1. Sep­ar­a­tion of powers. The ju­di­ciary must not have any con­tact with polit­ic­al parties—es­pe­cially the party in power—
      and must lim­it con­tact with the ex­ec­ut­ive branch to se­cur­ity, fin­an­cial, and ad­min­is­trat­ive mat­ters.
    2. Se­cur­ity of re­mu­ner­a­tion. The salary of judges should be fixed and se­cure.
    3. Guar­an­teed ten­ure un­til re­tire­ment or ex­piry of of­fice.
      Judges should be re­moved or sus­pen­ded only for reas­ons of “in­ca­pa­city” or “be­ha­vi­or that renders them un­fit to dis­charge their du­ties.” Such be­ha­vi­or would en­com­pass things such as ac­cept­ing bribes.
    4. An open court. Mem­bers of the pub­lic should have the right to enter the court at any time a tri­al is in pro­gress and have ac­cess to de­cisions.
      Guidelines and prin­ciples should be ap­plied to the me­dia with max­im­um free­dom about what they can re­port in or­der to en­sure fair tri­als.
    5. A re­quire­ment to com­mu­nic­ate the law to the pub­lic.
      Even a con­cerned and in­volved cit­izen­ship can­not hold polit­ic­al lead­ers and gov­ern­ment or­gans re­spons­ible for their ac­tions (or lack of ac­tions)
      if they do not know what be­ha­vi­or is ac­tu­ally re­quired of their lead­ers in both loc­al and in­ter­na­tion­al law.
    6. A ju­di­cial se­lec­tion pro­cess that is fair.
      The se­lec­tion of judges should be made from people with “in­teg­rity” and “abil­ity,” with “ap­pro­pri­ate train­ing and qual­i­fic­a­tions” and without dis­crim­in­a­tion.
    This last prin­ciple should ap­ply wheth­er the se­lec­tion pro­cess is made by ap­point­ment or elec­tion.
    In­deed, giv­en the com­plex re­quire­ments in­volved in qual­ity ad­ju­dic­a­tion and the fact that judges should not at­tempt to make policy from the bench, se­lec­tion of judges by largely un­in­formed voters is likely to be es­pe­cially prob­lem­at­ic.
  4. An in­de­pend­ent cent­ral bank
    One dis­ad­vant­age of a demo­crat­ic sys­tem (al­though cer­tainly one that does not off­set its many ad­vant­ages) is
    that politi­cians fa­cing a con­tested elec­tion may make de­cisions
    that cre­ate be­ne­fits now but im­pose much lar­ger costs in the fu­ture when they will no longer be in of­fice.
    This short time ho­ri­zon can lead to high pub­lic spend­ing without in­creased taxes to pay for such spend­ing.
    Faced with this di­lemma, politi­cians are of­ten temp­ted to “pay for” their spend­ing by or­der­ing the cent­ral bank to cre­ate money.
    As we saw in Part 2, Ele­ment 5, ex­cess­ive cre­ation of money will lead to a high level of in­fla­tion, per­haps even hyper­in­fla­tion.
    Both eco­nom­ic the­ory and past evid­ence say that by chan­ging in­cent­ives and in­tro­du­cing un­cer­tainty that makes plan­ning for the fu­ture dif­fi­cult, such in­fla­tion will lower eco­nom­ic growth and cit­izens’ well-be­ing in years to come.
    When Cent­ral Banks have the in­de­pend­ence to res­ist pres­sure from politi­cians,
    the res­ults have been lower and more stable prices and high­er growth rates.
  5. Pro­tec­tion of prop­erty rights
    The philo­soph­er John Locke, writ­ing in the late sev­en­teenth cen­tury, claimed that the right to own and use private prop­erty was a “nat­ur­al right”
    and that the “pre­ser­va­tion of prop­erty” was the “great and chief end” for which hu­man be­ings cre­ated gov­ern­ments.
    Al­most every con­sti­tu­tion makes men­tion of the pro­tec­tion of prop­erty. Ex­amples in­clude:
    1. The European Charter of Fun­da­ment­al Rights, which says:
      “Every­one has the right to own, use, dis­pose of and be­queath his or her law­fully ac­quired pos­ses­sions.
      No one may be de­prived of his or her pos­ses­sions,
      ex­cept in the pub­lic in­terest and in the cases and un­der the con­di­tions provided for by law, sub­ject to fair com­pens­a­tion be­ing paid in good time for their loss.”
    2. The United States Con­sti­tu­tion, which con­tains the widely quoted phrase:
      “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.”
    3. The Con­sti­tu­tion of the Rus­si­an Fed­er­a­tion, which is even more spe­cif­ic: “The right of private prop­erty shall be pro­tec­ted by law.
      Every­one shall have the right to have prop­erty and to pos­sess, use and dis­pose of it both in­di­vidu­ally and jointly with oth­er per­sons.
      Nobody may be de­prived of prop­erty ex­cept un­der a court or­der.
      Forced ali­en­a­tion of prop­erty for State re­quire­ments may take place only sub­ject to pri­or and fair com­pens­a­tion.”
    Un­for­tu­nately, many of these words are, as the say­ing goes, “not worth the pa­per they are prin­ted on.”
    Gov­ern­ments fre­quently erode the pro­tec­tions of prop­erty.
    Phrases like “pub­lic in­terest,” “just com­pens­a­tion,” or “fair com­pens­a­tion” are sub­ject to in­ter­pret­a­tion.
    Gov­ern­ments fre­quently use reg­u­la­tions to take or con­trol private prop­erty without com­pens­a­tion,
    even though the prop­erty own­er had vi­ol­ated the rights of no one.
    Courts have gen­er­ally al­lowed such tak­ings of private prop­erty as long as a le­gis­lat­ive body deemed that the ac­tion was
    “in the pub­lic in­terest,” or that the tak­ing did not deny the own­er all uses of his or her prop­erty.
    This is­sue of ef­fect­ive tak­ing (deny­ing many uses of the prop­erty while tech­nic­ally not chan­ging own­er­ship) is es­pe­cially prob­lem­at­ic.
    What does it mean, for ex­ample, for an in­di­vidu­al to “own” a piece of beach­front prop­erty if there is a reg­u­la­tion that it can­not be built on?
    In sum, simply writ­ing prop­erty rights into law or even con­sti­tu­tions is not suf­fi­cient to pro­mote eco­nom­ic growth.
    Such rights must be cred­ible and be­lieved by po­ten­tial in­vestors.
    Eco­nom­ic re­search has shown that the ef­fect of prop­erty rights on growth is much stronger when com­bined with ju­di­cial in­de­pend­ence and a great­er level of checks and bal­ances in gov­ern­ment struc­ture.
  6. Guar­an­tees of free­dom of speech and the press
    While, as dis­cussed above, checks and bal­ances with­in the struc­ture of gov­ern­ment are im­port­ant, they need to be sup­ple­men­ted with ex­tern­al mon­it­or­ing.
    This is es­pe­cially the case for what is known as “col­lus­ive cor­rup­tion” in which both the pay­er of a bribe and the re­cip­i­ent are leg­ally pun­ish­able,
    mean­ing that it is hard to gath­er evid­ence since no one in­volved has an in­cent­ive to be­tray the oth­er.
    While there are more soph­ist­ic­ated stat­ist­ic­al tests, the link between a free press and the over­all ef­fect­ive­ness of gov­ern­ment
    (and re­lated great­er eco­nom­ic suc­cess) is clear from a simple graph such as the one be­low.
    It is no won­der that in an au­thor­it­ari­an gov­ern­ment, journ­al­ists are threatened with cen­sor­ship, ar­rest, and even murder.
    Ex­hib­it 22: Press Free­dom Re­duces Cor­rup­tion
    A scat­ter graph show­ing that coun­tries which are per­ceived to have lower levels of cor­rup­tion ex­per­i­ence great­er free­dom of the press.
    Source: Aymo Bru­netti, Be­atrice Weder, “A free press is bad news for cor­rup­tion,”
    Journ­al of Pub­lic Eco­nom­ics, (2003), 87(7): 1801–1824, 10.1016/S0047-2727(01)00186-4.
    Tech­no­lo­gic­al ad­vances over the past 20 years have massively in­creased cit­izens’ abil­ity to mon­it­or gov­ern­ments and hold them ac­count­able.
    Again, a simple graph makes the con­nec­tion between In­ter­net pen­et­ra­tion and low cor­rup­tion ob­vi­ous (here Face­book is used simply as a stand-in for all so­cial me­dia):
    Ex­hib­it 23: So­cial Me­dia Means Less Cor­rup­tion
    A scat­ter graph show­ing that coun­tries with high­er levels of cor­rup­tion have lower levels of Face­book pen­et­ra­tion.
    Source: C.K. Jha, & S. Sarangi “Does so­cial me­dia re­duce cor­rup­tion?”, In­form­a­tion Eco­nom­ics and Policy, Volume 39 (June, 2017): 60–71.
    The im­port­ance of the “Great Fire­wall of China” in con­trolling Chinese so­ci­ety is ob­vi­ous, as is the role of so­cial me­dia in en­abling cit­izen protests to hold gov­ern­ments ac­count­able in many trans­ition eco­nom­ies.
    Some re­cent ex­amples in­clude the #RejectSerzh protests in Ar­menia in the spring of 2018 and Eur­omaidan in Ukraine in 2013-2014.(87)
    Press free­dom means more than simply not sup­press­ing out­lets or threat­en­ing journ­al­ists.
    Gov­ern­ments con­trolling and us­ing tele­vi­sion for pro­pa­ganda is a prob­lem in many coun­tries.
    An ad­di­tion­al dis­turb­ing tend­ency is for rich politi­cians to pur­chase their own news­pa­pers, and tele­vi­sion sta­tions and ra­dio sta­tions.
    While in­ter­fer­ing with private own­ers is al­ways ques­tion­able, this is one area where sound pub­lic policy may well re­quire lim­it­a­tions.
  7. Free­dom of move­ment, in­vest­ment, and trade
    The free­dom of in­di­vidu­als to com­pete in busi­ness and en­gage in vol­un­tary ex­change activ­it­ies is a corner­stone of both eco­nom­ic free­dom and pro­gress.
    Price con­trols, busi­ness and oc­cu­pa­tion­al entry re­straints,
    laws re­strict­ing the ex­change of goods and ser­vices across na­tion­al bound­ar­ies, and oth­er gov­ern­ment reg­u­la­tions that re­strain trade are not sound eco­nom­ics.
    Oc­cu­pa­tion­al li­cens­ing (which re­quires gov­ern­ment ap­prov­al to en­gage in an oc­cu­pa­tion such as, to take an ex­treme but real ex­ample, hair braid­ing)
    is a ma­jor an­ti­com­pet­it­ive device that re­stricts work op­por­tun­it­ies, in­clud­ing those of many of the least well-off mem­bers of so­ci­ety.
    When there is con­cern about pro­tect­ing the pub­lic, cer­ti­fic­a­tion (which provides in­form­a­tion about an in­di­vidu­al’s train­ing but leaves con­sumers free to eval­u­ate the rel­ev­ance of that train­ing) provides a su­per­i­or op­tion.
    With cer­ti­fic­a­tion, buy­ers are provided with the in­form­a­tion to make sound choices without clos­ing off the op­por­tun­ity for oth­ers to prove that they are cap­able pro­viders.
    Pre­dict­ably, li­cens­ing will be used to re­strain trade and provide ex­ist­ing sup­pli­ers with mono­poly power.
    The free­dom to trade is a ba­sic hu­man right, just like free­dom of speech and free­dom of re­li­gion.
    There is no reas­on why cit­izens should not be per­mit­ted to buy from, and sell to, who­ever will give them the best deal, even if the trad­ing part­ner lives in an­oth­er coun­try.
    Some­what sur­pris­ingly, while re­cip­roc­al free trade (where both part­ners are open to buy­ing and selling from each oth­er) is clearly ad­vant­age­ous, the con­sensus among eco­nom­ists is that re­cipro­city is not es­sen­tial.
    In al­most all cases a coun­try will im­prove the lives of its cit­izens if it drops bar­ri­ers to free im­port of goods, no mat­ter what the policy of its trad­ing part­ners.
    The lo­gic of such “uni­lat­er­al free trade” can be seen in a quo­ta­tion from Joan Robin­son (1903–83), one of the most ori­gin­al and pro­lif­ic eco­nom­ists of the twen­ti­eth cen­tury:
    Even if your trad­ing part­ner dumps rocks into his har­bour to ob­struct ar­riv­ing cargo ships, you do not make your­self bet­ter off by dump­ing rocks into your own har­bour.
    Pub­lic dis­cus­sion of­ten tries to ana­lyze free­dom of trade, free­dom of move­ment, and free­dom of in­vest­ment as sep­ar­ate top­ics.
    They are not. If work­ers are paid less in one coun­try than an­oth­er, all three chan­nels will come into play.
    Work­ers will try to move to the high­er wage area, in­vestors will come to the lower wage coun­try to take ad­vant­age of cheap labor,
    and goods pro­duced us­ing this labor will be less ex­pens­ive in glob­al mar­kets.
    Block­ing any one of these chan­nels will only in­crease the pres­sure on the oth­ers.
  8. Use of ex­tern­al an­chors
    Voters, like all eco­nom­ic­ally ra­tion­al people, make de­cisions by com­par­ing costs and be­ne­fits.
    Politi­cians, as we have already dis­cussed, of­ten have very short time ho­ri­zons, end­ing at the next elec­tion.
    This dis­con­nect cre­ates dif­fi­culty in ad­opt­ing policies that may im­pose cur­rent costs in re­turn for much lar­ger long-term be­ne­fits.
    This time in­con­sist­ency makes it hard for politi­cians to make be­liev­able policy com­mit­ments.
    Lead­ers may also be sub­ject to pres­sure from power­ful ves­ted in­terests to ad­opt policies that fa­vor in­siders at the ex­pense of the pub­lic at large.
    One pos­sible solu­tion is for far-sighted lead­ers to lim­it their abil­ity to re­spond to pres­sure by join­ing an in­ter­na­tion­al or­gan­iz­a­tion that re­quires good policies as a con­di­tion of join­ing or con­tinu­ing mem­ber­ship.
    There are many such or­gan­iz­a­tions. The European Uni­on (E.U.) im­poses re­quire­ments of a low budget de­fi­cit and a lim­it to total level of gov­ern­ment bor­row­ing.
    It also re­quires mem­bers to ad­opt a set of com­mon leg­al rules (called the ac­quis com­mun­autaire).
    While some E.U. policies (farm sub­sidies un­der the Com­mon Ag­ri­cul­tur­al Policy are an ob­vi­ous ex­ample)
    may not be be­ne­fi­cial (or are even con­trary to sound eco­nom­ics), they are typ­ic­ally far bet­ter than those
    that might have been ad­op­ted by many post-com­mun­ist coun­tries without the in­cent­ive of pro­spect­ive E.U. mem­ber­ship.
    Coun­tries with a reas­on­able ex­pect­a­tion of join­ing the E.U. made many pain­ful re­forms that ul­ti­mately be­nefited their cit­izens.(88)
    Oth­er or­gan­iz­a­tions that could have a sim­il­ar pos­it­ive in­flu­ence in­clude NATO,
    the WTO, the European Court of Hu­man Rights, the OECD, and the In­ter­na­tion­al Centre for Set­tle­ment of In­vest­ment Dis­putes (IC­SID).
    The In­ter­na­tion­al Mon­et­ary Fund (IMF) is par­tic­u­larly im­port­ant in in­du­cing gov­ern­ments to ad­opt growth-en­han­cing gov­ern­ment­al policies.
    Coun­tries tend to turn to the IMF for as­sist­ance
    when ex­cess­ive gov­ern­ment spend­ing has cre­ated cur­rency crises where in­ter­na­tion­al cred­it mar­kets are no longer ac­cess­ible to fin­ance even more gov­ern­ment debt.
    An ex­ample would be the Greek crisis of 2010–2018.
    Only pres­sure from the IMF and the European Cent­ral Bank per­suaded the Greek gov­ern­ment to ad­opt ne­ces­sary re­forms.
    Even ex­tern­al rank­ings that do not re­quire mem­ber­ship can have a pos­it­ive in­flu­ence on gov­ern­ment per­form­ance.
    Geor­gia, for ex­ample, takes great pride in be­ing ranked among the top 10 coun­tries in the World Bank’s
    “Ease of Do­ing Busi­ness” in­dex and gov­ern­ment min­is­ters are held ac­count­able for re­forms that im­prove this rank­ing.

Part 3 Final Thoughts

The pro­vi­sions out­lined above would en­hance the pro­tec­tion of private own­er­ship rights, pro­mote com­pet­i­tion,
strengthen fed­er­al­ism, and help bring gov­ern­ment spend­ing and bor­row­ing un­der con­trol,
while lim­it­ing the in­clin­a­tion of politi­cians to serve spe­cial-in­terest groups.
They would be a pos­it­ive step to­ward the es­tab­lish­ment of gov­ern­ment based on mu­tu­al agree­ment rather than the power to plun­der.
There is, however, one im­port­ant ad­di­tion­al is­sue. All of the above sug­ges­tions will work only if cit­izens in­sist that the spir­it of the law rather than the let­ter of the law is fol­lowed.
An ex­ample of what can go wrong comes from an at­tempt in the con­sti­tu­tion of Guatem­ala to re­duce cor­rup­tion in the ju­di­ciary and lessen the in­flu­ence of politi­cians and their friends over judges.
Deans of law schools were giv­en a ma­jor role in the se­lec­tion of judges.
As cyn­ics could have pre­dicted, this “re­form” res­ul­ted in cor­rup­tion in the se­lec­tion of Deans.
Those seek­ing in­flu­ence over the ju­di­ciary bank­rolled cam­paigns of pro­fess­ors seek­ing to be­come dean by throw­ing elab­or­ate parties for stu­dents who get a vote in the Dean’s se­lec­tion.
There was also an ex­plo­sion in the num­ber of law schools, many of which ex­is­ted in name only.(89)
We con­clude with a sen­ti­ment at­trib­uted to many au­thors but per­haps best ex­pressed by Al­dous Hux­ley, in­tro­du­cing the 1956 ra­dio ver­sion of A Brave New World:
The price of liberty, and even of com­mon hu­man­ity, is etern­al vi­gil­ance.
Parts 2 and 3 have fo­cused on na­tion­al prosper­ity. The fi­nal sec­tion of this book will fo­cus on per­son­al prosper­ity
by con­sid­er­ing some prac­tic­al choices you can make that will help you achieve a more pros­per­ous life.

Part 4: Twelve Key Elements of Practical Personal Finance

Elements:

  1. Dis­cov­er your com­par­at­ive ad­vant­age.
  2. Cul­tiv­ate skills, at­ti­tudes, and en­tre­pren­eur­ship that in­crease pro­ductiv­ity and make your ser­vices more valu­able to oth­ers.
  3. Use budget­ing to help you spend your money ef­fect­ively and save reg­u­larly.
  4. Don’t fin­ance any­thing for longer than its use­ful life.
  5. Two ways to get more out of your money: Avoid cred­it card debt and con­sider pur­chas­ing used items.
  6. Be­gin pay­ing into an emer­gency or “rainy day” savings account every month.
  7. Put the power of com­pound in­terest to work for you.
  8. Di­ver­si­fy—don’t put all your eggs in one bas­ket.
  9. Indexed equity mutual funds or in­dexed ex­change traded funds (ETFs) can help you beat the ex­perts without tak­ing ex­cess­ive risk.
  10. In­vest in stocks for long-run ob­ject­ives, but as the need for money ap­proaches, in­crease the pro­por­tion of bonds or cash.
  11. Take steps that will re­duce risk when mak­ing hous­ing, edu­ca­tion, and oth­er in­vest­ment de­cisions.
  12. Use in­sur­ance to help man­age risk.

Introduction

Com­pared to post-com­mun­ist coun­tries, the coun­tries of the European Uni­on have much high­er in­come levels.
Still, many people in West­ern European coun­tries (and even more in poorer coun­tries) are un­der fin­an­cial stress.
How can this be? The an­swer is that fin­an­cial in­sec­ur­ity is mainly the res­ult of the choices we make, not the in­comes we earn.
If you do not take charge of your fin­ances, they will take charge of you. As Yogi Berra, the great Amer­ic­an philo­soph­er (and base­ball star)
said, “You’ve got to be very care­ful if you don’t know where you are go­ing, be­cause you might not get there.(90)
In oth­er words, each of us needs a plan.
If we don’t have one, we may end up where we do not want to be. The twelve ele­ments in Part 4 form the core of a prac­tic­al plan.
They fo­cus on prac­tic­al sug­ges­tions—things that you can do im­me­di­ately—
that will help you make bet­ter fin­an­cial de­cisions whatever your cur­rent age, in­come level, or back­ground.
Of­ten, per­son­al fin­ance and in­vest­ment de­cisions seem totally di­vorced from the world of eco­nom­ics. But they are not.
As il­lus­trated in Ele­ment 1, the prin­ciple of com­par­at­ive ad­vant­age, which ex­plains why coun­tries be­ne­fit from spe­cial­iz­ing in the activ­it­ies they do best,
also ex­plains why you as an in­di­vidu­al can be­ne­fit from spe­cial­iz­a­tion in things you do well that are val­ued highly by oth­ers.
Sim­il­arly, when it comes to build­ing wealth over time, en­tre­pren­eur­ship, fin­an­cial ac­count­ab­il­ity,
ca­reer plan­ning, and in­vest­ment in cap­it­al (es­pe­cially hu­man cap­it­al) are as valu­able for in­di­vidu­als as they are for coun­tries.
The prin­ciples, guidelines, and tools presen­ted here could be di­vided into four cat­egor­ies:
Ele­ments 1 and 2 fo­cus on how you can earn more; Ele­ments 3 through 6 on how to get more value from your in­come;
Ele­ments 7 through 10 on earn­ing more from your in­vest­ments; and Ele­ments 11 and 12 on man­age­ment of risk.
The ad­vice out­lined here is ba­sic, prac­tic­al, and un­der­stand­able.
It will not make you a fin­an­cial wiz­ard or an in­stant mil­lion­aire, but it will help you avoid ma­jor fin­an­cial er­rors.
More soph­ist­ic­ated plans are avail­able. However, the search for per­fec­tion is of­ten the en­emy of pos­it­ive ac­tion.
In­di­vidu­als who think they don’t have the time or the ex­pert­ise to de­vel­op a sound fin­an­cial plan
may fail even to ap­ply simple guidelines that will help them avoid ma­jor fin­an­cial troubles. This sec­tion will provide such guidelines.
Life is about choices. Our goal is to en­hance your abil­ity to choose op­tions that will lead to a more suc­cess­ful life.
John Mor­ton, one of the United States’ lead­ing eco­nom­ic edu­cat­ors, states:
I al­ways told my stu­dents that life is not a lot­tery and life is not a zero-sum game.
Your suc­cess will not take away from any­one else’s suc­cess. Your suc­cess de­pends on your choices, and choices have con­sequences.
Be­fore ex­amin­ing how you can make bet­ter fin­an­cial choices and get more from the re­sources avail­able to you,
we want to share a couple of thoughts about the im­port­ance of money and wealth.
There is more to a good life than mak­ing money.
When it comes to hap­pi­ness, non-financial assets
such as a good mar­riage, fam­ily, friends, ful­filling work, re­li­gious con­vic­tions, and en­joy­able hob­bies are far more im­port­ant than money.(91)
Thus the single-minded pur­suit of money and wealth makes no sense.
At the same time, however, there is noth­ing un­seemly about the de­sire for more wealth.
This de­sire is not lim­ited to those who are only in­ter­ested in their per­son­al wel­fare, nar­rowly defined.
For ex­ample, Moth­er Teresa would have liked more wealth so that she could have done more to help the poor.
Many people would like more wealth so they can donate more
to re­li­gious, cul­tur­al, and char­it­able or­gan­iz­a­tions, or do more to help eld­erly par­ents.
No mat­ter what our ob­ject­ives in life, they are easi­er to achieve if we have less debt and more wealth.
Thus, all of us have an in­cent­ive to im­prove our fin­an­cial de­cision-mak­ing.

Element 4.1: Discover Your Comparative Advantage

Car­toon of two cave­men ne­go­ti­at­ing a trans­ac­tion. One cave­man has a wheel. The oth­er of­fers him an apple in ex­change, then a full sack. Only when he of­fers a flint tool as well does the wheel own­er agree to trade.
The prin­ciple of com­par­at­ive ad­vant­age is used most of­ten to ex­plain
why in­ter­na­tion­al trade makes it pos­sible for people in dif­fer­ent coun­tries to achieve high­er liv­ing stand­ards.
As il­lus­trated in Ele­ment 4 of Part 1, spe­cial­iz­a­tion ac­cord­ing to the law of com­par­at­ive ad­vant­age makes it pos­sible for trad­ing part­ners to pro­duce more and achieve a high­er in­come level.
The prin­ciple of com­par­at­ive ad­vant­age is just as im­port­ant when in­di­vidu­als are con­sid­er­ing oc­cu­pa­tion­al and busi­ness op­por­tun­it­ies.
Like na­tions, in­di­vidu­als will be able to achieve high­er in­come levels when they spe­cial­ize—
that is, con­cen­trate their ef­forts on those things where they have a com­par­at­ive ad­vant­age.
Think about the re­la­tion­ship between your skills and op­por­tun­ity costs.
To pick one ex­treme, sup­pose that you are bet­ter than every­one else in every pro­duct­ive activ­ity.
Would that mean that you should try to spend some time on each activ­ity? Or to go to an­oth­er ex­treme, someone could be worse than every­one else.
Would that in­di­vidu­al be un­able to gain from spe­cial­iz­a­tion be­cause he or she would be un­able to com­pete suc­cess­fully in any­thing? The an­swer to both ques­tions is no.
No mat­ter how tal­en­ted you are, you will be re­l­at­ively more pro­duct­ive in some areas than oth­ers when op­por­tun­ity costs are taken into ac­count.
Sim­il­arly, no mat­ter how poor your abil­ity to pro­duce, you will be able to pro­duce some things at a lower cost than oth­ers.
You will be able to com­pete suc­cess­fully in some areas and can gain by spe­cial­iz­ing where you have a com­par­at­ive ad­vant­age.
Your com­par­at­ive ad­vant­age is de­term­ined by your re­l­at­ive abil­it­ies, not your ab­so­lute abil­it­ies.
For ex­ample, Mark Zuck­er­berg, cofounder of Face­book, has the skills not only to be a highly suc­cess­ful in­nov­at­or and busi­ness en­tre­pren­eur,
but he also has what it takes to be an out­stand­ing com­puter pro­gram­mer.
It took a lot of pro­gram­ming skills and cre­ativ­ity to jump-start the pop­ular­ity of a so­cial me­dia net­work in his dorm room at Har­vard.
While Zuck­er­berg was a highly skilled pro­gram­mer,
his com­par­at­ive ad­vant­age was non­ethe­less in the de­vel­op­ment of the in­nov­at­ive, so­cial me­dia fea­tures of Face­book.
Sim­il­arly, even though the com­puter pro­gram­mers work­ing at Face­book are prob­ably less skilled than Zuck­er­berg,
their com­par­at­ive ad­vant­ages still lie in pro­gram­ming rather than in man­age­ment (or deal­ing with in­vestors).
In­di­vidu­als will al­ways be bet­ter off if they are really good at something that is highly val­ued by oth­ers.
This ex­plains why people like Zuck­er­berg can make in­cred­ible amounts of money.
In 2007, at the age of just 23, he be­came the world’s young­est self-made bil­lion­aire.(92)
Some people may feel that they are at a dis­ad­vant­age when they trade with oth­ers who earn far more money. But re­mem­ber that trade be­ne­fits both parties.
Gen­er­ally, the more ac­com­plished and wealthy the people with whom you trade (work­ing for someone in­volves trade),
the bet­ter off you are be­cause your ser­vice is typ­ic­ally worth more to them than to those who are less ac­com­plished and wealthy.
For ex­ample, if the au­thors were en­ter­tain­ment agents, we would rather work for Björk, the Rolling Stones, or U2
than for oth­er mu­si­cians be­cause we would al­most surely make more money that way.
The worst thing you can do is con­vince your­self, or be con­vinced by oth­ers,
that you are some­how a vic­tim and there­fore un­able to achieve suc­cess through your own ef­fort and ini­ti­at­ive.
Some people start out with few­er ad­vant­ages than oth­ers,
but even those who are less ad­vant­aged can do ex­tremely well if they make the ef­fort and ap­ply them­selves in­tel­li­gently.
You need to take charge of your ca­reer de­vel­op­ment and plan
how you can best de­vel­op your tal­ents and use mar­ket co­oper­a­tion to achieve your goals.
No one else cares more about your per­son­al suc­cess than you do. Neither does any­one else know more about your in­terests, skills, and goals.
We usu­ally per­ceive of costs as something that should be kept as low as pos­sible.
But re­mem­ber, costs re­flect the highest val­ued op­por­tun­ity giv­en up when we choose an op­tion.
Thus, when you have at­tract­ive al­tern­at­ives, your choices will be costly.
Should you take that job at Star­bucks to have more money while you’re a stu­dent? Or should you take an ex­tra course so that you can com­plete your col­lege de­gree more quickly?
Both op­tions are at­tract­ive.
Fur­ther­more, as you im­prove your skills and your op­por­tun­it­ies be­come even more at­tract­ive, the choice among op­tions will be more costly.
In con­trast, your costs will be low when you have very few good choices.
For ex­ample, a very ef­fect­ive way of re­du­cing the cost of read­ing this book is to get thrown in jail with it
so that read­ing it is the only op­por­tun­ity you have oth­er than star­ing at the walls.
This is ob­vi­ously a bad idea.
It would re­duce the cost of do­ing one thing (a very de­sir­able thing in our opin­ion)
by elim­in­at­ing your op­por­tun­ity to do many oth­er at­tract­ive things.
You make your­self bet­ter off by in­creas­ing your op­por­tun­it­ies, not by re­du­cing them.
Young people are en­cour­aged to get a good edu­ca­tion so they will have more at­tract­ive op­por­tun­it­ies later in life.
A good edu­ca­tion will gen­er­ally in­crease your pro­ductiv­ity, and the amount em­ploy­ers are will­ing to pay you.
This will en­hance your earn­ings, but it also means you will have to turn down some at­tract­ive of­fers that may come your way while you are hop­ing to qual­i­fy for even bet­ter ones later.
Sound ca­reer de­cision-mak­ing in­volves more than fig­ur­ing out those things that you do best.
It is also vi­tally im­port­ant to dis­cov­er where your pas­sions lie—those pro­duct­ive activ­it­ies that provide you with the most ful­fill­ment.
If you en­joy what you do and be­lieve it is im­port­ant, you will be happy to do more of it and work to do it bet­ter.
Thus, com­pet­ency and pas­sion for an activ­ity tend to go to­geth­er. Moreover, real wealth is meas­ured in terms of per­son­al ful­fill­ment.
For ex­ample, the au­thors of this book (all eco­nom­ists)
have found it sat­is­fy­ing to find an­swers to eco­nom­ic ques­tions and to ex­press what we know in ways
that can help oth­ers bet­ter un­der­stand the corners of the world that we have ex­amined pro­fes­sion­ally.
Even though the hours are some­times long, we find most of those hours en­joy­able. What we do is not for every­one.
But for us, with our in­terests, the joys of what we do more than make up for the rough patches.

Element 4.2: Increase Your Value to Others

Cultivate skills and attitudes (including entrepreneurship) that increase productivity and make your services more valuable to others.

In a mar­ket eco­nomy, fin­an­cial suc­cess re­flects the abil­ity to provide oth­ers with value. This is true for both em­ploy­ees and busi­nesses.
If you want to achieve high earn­ings, you had bet­ter fig­ure out how to provide oth­ers with ser­vices they value highly.
As pre­vi­ously stressed, im­proved know­ledge,
high­er skill level, and ex­per­i­ence gen­er­ally in­crease pro­ductiv­ity and en­hance one’s abil­ity to provide valu­able ser­vices to oth­ers.
As a res­ult, in­vest­ments in hu­man cap­it­al—edu­ca­tion,
train­ing, and oth­er forms of skill ac­quis­i­tion—can im­prove both pro­ductiv­ity and earn­ings.
But oth­er per­son­al at­trib­utes also in­flu­ence pro­ductiv­ity.
Two of the most im­port­ant are per­son­al at­ti­tudes and think­ing en­tre­pren­eur­i­ally.
The im­port­ance of these two at­trib­utes as a source of pro­ductiv­ity is closely re­lated to what psy­cho­lo­gists call emo­tion­al in­tel­li­gence (EQ).
Many psy­cho­lo­gists now be­lieve that EQ is more im­port­ant than IQ as a de­term­in­ant of per­son­al suc­cess.(93)
Eco­nom­ists have of­ten not fo­cused on these vi­tally im­port­ant sources of per­son­al pro­ductiv­ity.(94)
How does one’s per­son­al at­ti­tude im­pact pro­ductiv­ity and suc­cess? Con­sider the fol­low­ing simple thought ex­per­i­ment.
Sup­pose an em­ploy­er is eval­u­at­ing two po­ten­tial em­ploy­ees.
The first has the fol­low­ing set of at­trib­utes: hon­esty, de­pend­ab­il­ity, per­sist­ence,
re­li­ab­il­ity, trust­wor­thi­ness, re­spect for oth­ers, de­sire to learn and im­prove, and abil­ity to work with oth­ers.
The second has a dif­fer­ent set: dis­respect for oth­ers, un­re­li­able, quar­rel­some, con­tempt for edu­ca­tion,
vul­gar­ity of speech, blam­ing oth­ers for prob­lems, dis­hon­esty, and re­li­ance on al­co­hol and drugs.
If you were the em­ploy­er, which would you hire?
Pre­dict­ably, most would hire the first can­did­ate be­cause those at­ti­tudes are suc­cess-ori­ented.
Oth­er things be­ing equal, em­ploy­ees with these pos­it­ive at­ti­tudes are more pro­duct­ive.
In con­trast, the second set of at­trib­utes are fail­ure-ori­ented. They will un­der­mine pro­ductiv­ity and the abil­ity of the em­ploy­ee to work with oth­ers.
If you want to be suc­cess­ful, you need to cul­tiv­ate, de­vel­op, and strengthen the first set of at­trib­utes.
They need to be­come habits—the core val­ues of your life. Equally im­port­ant, you need to cast the second set out of your life.
Do not let any­one, in­clud­ing friends, con­vince you that any of the fail­ure at­trib­utes are “cool.” They are the path to trouble, and you do not want to go down that route.
There is some good news here: You can choose the suc­cess at­ti­tudes rather than the fail­ure ones.
Moreover, you can do so re­gard­less of your fam­ily back­ground, cur­rent in­come, edu­ca­tion­al level, or choice of ca­reer.
Your at­ti­tudes will ex­ert a huge im­pact on your fu­ture fin­an­cial suc­cess.
Pos­it­ive at­ti­tudes will help you over­come oth­er dis­ad­vant­ages,
such as a poor edu­ca­tion or a fin­an­cially re­stric­ted child­hood.
Of course, if you choose the fail­ure at­ti­tudes, you can blame oth­ers:
your fam­ily, your neigh­bor­hood, the schools you at­ten­ded, or so­ci­ety in gen­er­al.
These factors may in­flu­ence your choices, but they do not de­term­ine them. Your at­ti­tude char­ac­ter­ist­ics are un­der your con­trol.
If you grew up in a trouble­some en­vir­on­ment, it may be more dif­fi­cult to at­tain and main­tain these at­ti­tudes.
But a per­son who over­comes a neg­at­ive en­vir­on­ment is ad­mired and re­spec­ted by al­most all.
Some of you may be think­ing,
“My at­ti­tudes are my own busi­ness. No one is go­ing to tell me what to do or change my be­ha­vi­or.”
Sup­pose a busi­ness own­er we’ll call Misha has this per­spect­ive.
Misha ig­nores the wishes of con­sumers and in­stead provides what he or she thinks con­sumers should value. Misha is free to make this choice.
By do­ing so, however, Misha will pay a price in the form of lower sales, pos­sibly even lead­ing to losses and busi­ness fail­ure.
Sim­il­arly, po­ten­tial em­ploy­ees are free to “do their own thing.”
They can ig­nore how their at­ti­tudes and be­ha­vi­or af­fect pro­ductiv­ity and em­ploy­ab­il­ity.
But, like the busi­ness that ig­nores the de­sires of con­sumers, people who ig­nore
how their at­ti­tudes and be­ha­vi­or in­flu­ence their pro­ductiv­ity will pay a price in the form of poor op­por­tun­it­ies and low earn­ings.
None of us is an is­land unto ourselves.
If we want oth­ers to provide us with in­come, we need to co­oper­ate and make our ser­vices valu­able to them.
The bot­tom line is straight­for­ward: Suc­cess-ori­ented at­ti­tudes are a highly im­port­ant de­term­in­ant of fin­an­cial suc­cess.
You can­not buy these at­ti­tudes. Neither can someone else provide them to you. You must choose them and in­teg­rate them into your life.
Fur­ther, if you do so, it is a near cer­tainty that you will have a sub­stan­tial de­gree of eco­nom­ic suc­cess.
But the op­pos­ite is also true: If your life is largely a re­flec­tion of the fail­ure set of at­trib­utes,
it is a vir­tu­al cer­tainty that your fu­ture will be char­ac­ter­ized by fin­an­cial troubles and per­son­al bit­ter­ness.
En­tre­pren­eur­i­al think­ing is also a per­son­al at­trib­ute that can en­hance your pro­ductiv­ity.
En­tre­pren­eur­ship is of­ten as­so­ci­ated with de­cision-mak­ing in busi­ness, but in a very real sense all of us are en­tre­pren­eurs.
We are con­stantly mak­ing de­cisions about the de­vel­op­ment and use of know­ledge, skills, and oth­er re­sources un­der our con­trol.
Our fin­an­cial suc­cess will re­flect the out­come of these choices.
If you want to be fin­an­cially suc­cess­ful, think en­tre­pren­eur­i­ally.
Put an­oth­er way, fo­cus on how to de­vel­op and use your tal­ents and mo­bil­ize avail­able re­sources to provide oth­ers with things that they value highly.
Provid­ing oth­ers with goods and ser­vices that are highly val­ued com­pared to their cost is the key to fin­an­cial suc­cess.
Con­sider the hy­po­thet­ic­al case of Robert Jones, a land de­veloper.
Jones pur­chases large land tracts, sub­divides them, and adds vari­ous amen­it­ies such as roads, sewage dis­pos­al, golf courses, and parks.
Jones will profit if he is able to sell the plots for more than the cost of the land,
the vari­ous amen­it­ies he has con­struc­ted, and his labor ser­vices, in­clud­ing the earn­ings for­gone in his best al­tern­at­ive pur­suit.
If his ac­tions are prof­it­able, they will in­crease the value of the re­sources and help oth­ers
by provid­ing them with bet­ter home sites than are avail­able else­where.
Jones’s fin­an­cial suc­cess or fail­ure is de­pend­ent on his abil­ity to en­hance the value of re­sources.
Once you be­gin to think en­tre­pren­eur­i­ally and think about how you can in­crease the value of your ser­vices to oth­ers, do not un­der­es­tim­ate your abil­ity to achieve suc­cess.
En­tre­pren­eur­i­al tal­ent is of­ten found in un­ex­pec­ted places.
Who would have thought that a former So­viet state would be­come one of the world’s most ad­vanced di­git­al na­tions?
Wel­come to Es­to­nia, the birth­place of Skype and TransferWise, a coun­try
that runs com­pletely on­line, a place where In­ter­net ac­cess is de­clared a ba­sic hu­man right.(95)
Who would have thought that a middle-aged, milk­shake-ma­chine sales­man, Ray Kroc, would re­vo­lu­tion­ize the fran­chising busi­ness
and ex­pand a single McDonald’s res­taur­ant in San Bern­ardino, Cali­for­nia, into the world’s largest fast-food chain?
That the ath­let­ic shoe brand star­ted by Adi Dassler in his moth­er’s kit­chen in 1924 would grow to $20 bil­lion in sales?(96)
Did any­one in the 1950s ex­pect In­gvar Kamprad, founder of IKEA,
to take his first small show­room in the small town of Älm­hult, in Sweden and make it the largest fur­niture re­tail­er in the world?(97)
These are high-pro­file cases, but the same pat­tern oc­curs over and over.
Suc­cess­ful busi­ness and pro­fes­sion­al lead­ers of­ten come from di­verse back­grounds that ap­pear to be largely un­re­lated to the areas of their achieve­ment.
But they have something in com­mon. They are good at dis­cov­er­ing bet­ter ways of do­ing things
and stra­tegic­ally act­ing on op­por­tun­it­ies to in­crease the value of re­sources that have been over­looked by oth­ers.
Self-employed en­tre­pren­eurs are dis­pro­por­tion­ately rep­res­en­ted among the wealthy.
While the self-em­ployed con­sti­tute a big part of the labor force, they ac­count for a much lar­ger share of mil­lion­aires.
For ex­ample, in 2015 about 17 per­cent(98) of em­ployed people were self-em­ployed and about 80 per­cent of work­ing mil­lion­aires were self-em­ployed in the Neth­er­lands.(99)
Four ma­jor factors con­trib­ute to the fin­an­cial suc­cess of self-em­ployed en­tre­pren­eurs.
First, they are good at identi­fy­ing and act­ing on at­tract­ive op­por­tun­it­ies that have been over­looked by oth­ers.
Second, they are will­ing to take risk. Great­er risk and the pos­sib­il­ity of high­er re­turns go to­geth­er.
To a de­gree, the high­er in­comes of self-em­ployed en­tre­pren­eurs are merely com­pens­a­tion for the un­cer­tain­ties ac­com­pa­ny­ing their busi­ness activ­it­ies.
Third, they have a high in­vest­ment rate. Self-em­ployed busi­ness own­ers of­ten chan­nel a large share of their in­come into the growth and ex­pan­sion of their busi­ness.
Fourth, they gen­er­ally love what they do and there­fore work long hours.
It should be noted that in the coun­tries of Cent­ral
and East­ern Europe (CEE) and the former So­viet coun­tries, rates of small busi­ness own­er­ship vary sig­ni­fic­antly by coun­try
and re­gion with­in coun­tries. This may re­flect gov­ern­ment policies along with cul­tur­al at­ti­tudes that in­flu­ence the abil­ity to start an in­de­pend­ent busi­ness.(100)
However, hav­ing an en­tre­pren­eur­i­al at­ti­tude will be use­ful un­der all cir­cum­stances.
Em­ploy­ees, too, can ad­opt the char­ac­ter­ist­ics that con­trib­ute to the high-in­come status and wealth of self-em­ployed en­tre­pren­eurs.
They can in­vest their sav­ings in stocks and thereby achieve the above-av­er­age re­turns that can come with the risk of busi­ness own­er­ship.
If they de­sire, they can also gen­er­ate more in­come and ac­cu­mu­late more wealth through high­er rates of in­vest­ment and more hours of work.
Per­haps most im­port­ant, em­ploy­ees can gain by “think­ing like en­tre­pren­eurs.”
Just as the in­comes of busi­ness en­tre­pren­eurs de­pend on their abil­ity to sat­is­fy cus­tom­ers,
the earn­ings of em­ploy­ees de­pend on their abil­ity to make them­selves valu­able to em­ploy­ers, both cur­rent and pro­spect­ive.
If em­ploy­ees want to achieve high earn­ings, they need to de­vel­op skills, know­ledge, at­ti­tudes, and work habits that are highly val­ued by oth­ers.
The en­tre­pren­eur­i­al way of think­ing is also cru­cially im­port­ant when mak­ing de­cisions about edu­ca­tion.
Edu­ca­tion will not en­hance your earn­ings very much un­less you ac­quire know­ledge and de­vel­op skills
that make your ser­vices more valu­able to oth­ers.
These in­clude the abil­ity to write well, com­mu­nic­ate with clar­ity, use ba­sic math tools, and col­lect and in­ter­pret data and in­form­a­tion,
as well as spe­cif­ic skills that can set you apart from the crowd and raise your pro­ductiv­ity.
De­vel­op­ing skills that make you more valu­able to oth­ers is vi­tally im­port­ant both in and out­side of the brick-and-mor­tar in­sti­tu­tions of sec­ond­ary and post­sec­ond­ary edu­ca­tion.
Today, hav­ing a uni­versity de­gree is no longer guar­an­teed to catch an em­ploy­er’s eye and res­ult in a tick­et to a high-pay­ing job.
In 2019, un­em­ploy­ment rates among uni­versity gradu­ates were close to 25% in Ar­menia and many oth­er post-com­mun­ist coun­tries. Em­ploy­ment and edu­ca­tion­al mar­kets change rap­idly.
The best way to find a job is to think en­tre­pren­eur­i­ally and dis­cov­er ways to serve oth­ers through form­al edu­ca­tion and show­cas­ing your job read­i­ness.
Massive open on­line courses, cer­ti­fic­ate pro­grams, and in­tern­ships can be help­ful in this area.
De­vel­op­ment and use of your tal­ents in ways that provide large be­ne­fits to oth­ers is a key to fin­an­cial suc­cess.
It is also cent­ral to what Ar­thur Brooks calls “earned suc­cess.”
Moreover, earned suc­cess is a cent­ral ele­ment of hap­pi­ness and life sat­is­fac­tion. No one can give you earned suc­cess; you must achieve it.
Earned suc­cess is present when your edu­ca­tion, work, and life­style choices re­flect the pur­pose of your life.
Throughout our ca­reers, we have asked our stu­dents what they want to do with their lives.
In one form or an­oth­er, the re­sponse is nearly al­ways the same: I want to do things that will make the world a bet­ter place to live.
Of course, in­di­vidu­als will dif­fer with re­gard to how they plan to do so.
But, re­gard­less of their plans, a pos­it­ive set of at­ti­tudes and an en­tre­pren­eur­i­al thought pro­cess will en­hance their abil­ity to live a mean­ing­ful, ful­filling, and happy life.

Element 4.3: Budget Your Spending and Saving

Use budgeting to help you spend your money effectively and save regularly.

Money is only a tool. It will take you wherever you wish, but it will not re­place you as the driver.
Ayn Rand, At­las Shrugged (New York: Ran­dom House, 1957): 411.
Most fin­an­cial in­sec­ur­ity today is the product of un­sound choices.
Spend­ing more than you earn, build­ing up debt without con­cern for how to re­pay it, lack of budget­ing, and oth­er un­wise fin­an­cial habits cre­ate hav­oc and cause stress.
A com­mit­ment to budget­ing is key to ob­tain­ing a healthy fin­an­cial life, build­ing wealth, and achiev­ing your per­son­al goals.
People, like na­tions, build wealth through sav­ing and in­vest­ment.
But suc­cess­ful build­ing of wealth also takes stra­tegic plan­ning.
There must be a plan in place to guide how the spend­ing, sav­ing, and in­vest­ment are dir­ec­ted to­ward wealth cre­ation.
For the in­di­vidu­al or house­hold, that plan is a budget.
A budget helps you chan­nel your funds to­ward sound spend­ing, reg­u­lar sav­ing, and di­ver­si­fied in­vest­ments in a man­ner
that will provide you with the most value from your in­come.
Ef­fect­ive budget­ing is an on­go­ing pro­cess, not a one-time event. It is com­prised of two spe­cif­ic ac­tions.
First, you must cre­ate the ini­tial budget that iden­ti­fies all of your planned or ex­pec­ted in­come and spend­ing for a peri­od of time.
Most people cre­ate a monthly budget, but a yearly budget is also com­mon.
It is im­port­ant to care­fully con­sider all of your spend­ing, not just the highly vis­ible spend­ing like gro­cer­ies, car pay­ments, and rent or mort­gage.
Don’t for­get about birth­day gifts, an­nu­al pet li­cense fees (€112.80 a year in the Hag­ue, an­oth­er good reas­on to avoid be­com­ing a war crim­in­al), magazine sub­scrip­tions, and oil changes for your car.
Es­tim­ate your monthly or an­nu­al in­come; then identi­fy where you are go­ing to spend every penny.
We re­com­mend that sav­ing and in­vest­ment be spe­cif­ic,
planned, items in your budget, not just the leftover bal­ance (if there is any).
The second ac­tion is doc­u­ment­a­tion of ac­tu­al spend­ing and mak­ing needed budget ad­just­ments.
Keep­ing track of all spend­ing and pla­cing it into the cat­egor­ies of your budget provides valu­able in­form­a­tion about your habits and the pro­gress made to­ward achieve­ment of your fin­an­cial goals.
Track­ing your spend­ing will also help you de­vel­op a bet­ter, more pre­cise budget in the fu­ture.
For ex­ample, if you fail to in­clude a spend­ing item or two in your ini­tial budget,
when that ac­tu­al spend­ing is ob­served, you can then make sure to in­clude it in your new budget next time.
Sup­pose you budget €50 for res­taur­ant meals for the month but then real­ize that you ac­tu­ally spent €80.
You will know to change your planned spend­ing some­where else to ac­count for this dif­fer­ence.
The doc­u­ment­a­tion of your ac­tu­al spend­ing provides you with a feed­back mech­an­ism
that will help you make ad­just­ments to your budget and spend­ing in the fu­ture.
Budget­ing your in­come and mon­it­or­ing your be­ha­vi­or will help you eval­u­ate your spend­ing and dir­ect it to­ward the cat­egor­ies that will provide you with the most over­all value.
Four simple steps will get you on the path to fin­an­cial sta­bil­ity:
Be­gin im­me­di­ately, set goals, get tools, and design a budget to meet your goals.
Step 1. Start now and in­crease the like­li­hood of suc­cess!
Don’t fool your­self into think­ing that budget­ing is only for people with jobs, or high salar­ies, or that you’ll start “later.”
Chil­dren re­ceiv­ing al­low­ance, stu­dents re­ceiv­ing sup­port from their par­ents, and people without dir­ect in­comes should still budget and de­vel­op goals.
Budget­ing will not be easi­er when you are older or when you are earn­ing more money.
In fact, it will prob­ably be more com­plex. It is easy to pro­cras­tin­ate.
People who budget, spend their money wisely, and save for the fu­ture gen­er­ally star­ted early when their in­comes were re­l­at­ively low.(101)
A free budget­ing app (there are many good ones on­line) can be use­ful here.
Step 2. Set goals. In­cent­ives mat­ter. Re­cog­nize this in your per­son­al life, and let your goals drive your ac­tions.
Set short-, me­di­um-, and long-term fin­an­cial goals and in­cor­por­ate them into your budget.
Short-term mile­stones can be achieved with­in the next year and provide im­me­di­ate grat­i­fic­a­tion.
De­pend­ing on your situ­ation, they might in­clude the elim­in­a­tion of the cred­it card debt on your highest in­terest rate loan,
a sig­ni­fic­ant in­crease in your sav­ings for cov­er­age of un­ex­pec­ted ex­pendit­ures,
or money for an up­grade of your phone or oth­er tech­no­lo­gic­al device.
Mid-term goals are achieved over a longer peri­od—any­where between one and three years.
Pur­chas­ing a pre-owned car with cash, put­ting 20 per­cent down on a flat or oth­er home, and build­ing a sol­id sav­ings ac­count lead­ing to a well-di­ver­si­fied port­fo­lio
are ex­amples of goals that will gen­er­ally re­quire more time to achieve.
Fi­nally, sav­ing and in­vest­ing for your chil­dren’s col­lege and for re­tire­ment, and pay­ing off stu­dent loans or a home mort­gage provide ex­amples of longer-term goals that many will want to pur­sue.
As in­dic­ated earli­er, sav­ing and in­vest­ing should be a spe­cif­ic cat­egory in your budget.
Ob­vi­ously the soon­er you start sav­ing and spend­ing stra­tegic­ally, the more wealth you will build.
What is not so ob­vi­ous is how much more wealth you can ac­cu­mu­late by start­ing early.
Even the smal­lest amount saved or in­ves­ted today can make a very big dif­fer­ence. Con­sider the fol­low­ing long-range plan.
Start reg­u­larly sav­ing €2 a day for two years when you turn twenty-two years of age.
That’s prob­ably not as much as you will spend on cof­fee, bottled wa­ter, or snacks or have in loose change at the end of the day.
Then from your twenty-fourth un­til your twenty-sixth birth­day, be­gin sav­ing €3 a day. That’s just a euro more and your in­come will prob­ably have in­creased.
Between the ages of twenty-six and thirty, bump up your sav­ings amount to €4 per day.
By not spend­ing this amount daily and put­ting it aside in an ac­count with a pos­it­ive rate of re­turn, you won’t cramp your style much.
By the time you reach thirty, you will have saved €9,490, PLUS the in­terest re­ceived—quite a nice sum. Sav­ing a small amount every day really adds up.
But here’s the real sur­prise.
By the time you re­tire at age sixty-sev­en, the sav­ing from just this early nine-year peri­od can add more than €150,000 to your wealth if in­ves­ted wisely. Even bet­ter, this amount is in today’s pur­chas­ing power.
This will be the case if you earn a rate of re­turn equal to about what the stock mar­kets have yiel­ded over the last eight dec­ades
(more on this rate of re­turn and the power of com­pound in­terest in fu­ture ele­ments).
Moreover, if you start early, you are far more likely to con­tin­ue with a reg­u­lar savings plan throughout your life.
In ad­di­tion, some of the smartest in­vestors, in­clud­ing War­ren Buf­fett and Shark Tank’s Mark Cuban,
own­er of the NBA’s Dal­las Mav­er­icks, agree that it’s im­port­ant to avoid get­ting into debt—
and start­ing early with sav­ings will help you pre­vent that.
Step 3. Get tools to as­sist with your budget­ing.
Don’t re-cre­ate the wheel by start­ing with a blank piece of pa­per to de­vel­op a budget.
With today’s web­sites, spread­sheets, and apps, budget­ing has nev­er been easi­er.
A pleth­ora of re­sources ex­ist at little or no money cost. Lit­er­ally, they are avail­able at your fin­ger­tips.
Con­duct an In­ter­net search for “budget­ing tools,” and find nu­mer­ous high-qual­ity and se­cure budget­ing op­tions.
Choose one that helps you be­come me­tic­u­lous in log­ging your ex­penses and in­come,
keeps your fin­an­cial goals in front of you, is­sues pay­ment re­mind­ers,
helps you con­trol any im­pulses to spend out­side your budget, and links you to op­tions on how to achieve those goals.
Make a habit of us­ing your se­lec­ted budget­ing tool.
Keep­ing track of your spend­ing and in­come can be easy with the right tools.
Step 4. De­vise a plan of ac­tion: Cre­ate a per­son­al budget with ac­tu­al and pro­posed items to achieve your goals.
Al­though we con­stantly think about all the things we “need” to buy,
there are very few things most of us are re­quired to have bey­ond ad­equate food, clean wa­ter, ba­sic shel­ter, and simple clothes.
The best way to see where you can be­gin to achieve your goals is by list­ing your “needs” and sep­ar­at­ing them from your “wants.”
Re­duce your wants to make way for sav­ings and in­vest­ing, and for de­vis­ing a plan with­in your budget to meet your short-, me­di­um-, and long-term goals.
This places you in the driver’s seat of your fin­an­cial life.
An ar­chi­tect does not build a house without a blue­print.
A sur­geon does not ef­fect­ively re­move a pa­tient’s ap­pendix without co­ordin­at­ing her plans with the oth­er mem­bers of the med­ic­al team.
An ath­lete does not end up com­pet­ing at the Olympics without com­mit­ting to a philo­sophy of suc­cess long be­fore reach­ing the Olympics.
De­vel­op­ing a de­tailed plan of ac­tion, stick­ing to it, and up­dat­ing it when ne­ces­sary are es­sen­tial if you are go­ing to suc­ceed in all as­pects of life, in­clud­ing your fin­an­cial life.
Each budget­ary item needs to be eval­u­ated with­in the con­text of the oth­ers.
Since you have lim­ited in­come, in­creased spend­ing in one area trans­lates into de­creased spend­ing in an­oth­er,
un­less new sources of in­come are iden­ti­fied.
As stressed in Part 1, every choice has an op­por­tun­ity cost.
Con­sider yours when mak­ing a spend­ing de­cision. Ex­am­ine the big pic­ture through your budget­ary lens.
Fig­ure out your monthly ba­sics—show how much you earn, pay in taxes, save, in­vest, spend, and face in debt.
Re­gard­less of your oc­cu­pa­tion, in­come, or po­s­i­tion in life,
the two ac­tions in the budget­ing pro­cess—the cre­ation of your budget and track­ing and ad­just­ing your spend­ing to im­prove your wel­fare—
will help you sys­tem­at­ic­ally ex­am­ine and guide your spend­ing to get where you want to go.
Make your plan crys­tal clear and be­come the CEO of you.
Com­mit to cre­at­ing a budget that or­gan­izes your spend­ing,
con­trols your debt, provides emer­gency funds, helps you meet vari­ous fin­an­cial goals, and sup­plies funds for in­vest­ing.
The next time you are think­ing about all the things you “need,” re­cog­nize that you do not really have to have many of them.
Re­mem­ber that spend­ing today costs you in terms of your fu­ture wealth.
We aren’t sug­gest­ing that you live a life of depriva­tion so you can be rich in the fu­ture.
That makes no sense. But there are many cre­at­ive ways to re­duce spend­ing and in­crease sav­ing.
Budget­ing and lay­ing out a sav­ings plan will pro­duce im­me­di­ate sat­is­fac­tion,
help you gain a sense of fin­an­cial con­trol and se­cur­ity, and build wealth for the fu­ture.
Dave Ram­sey, a lead­ing fin­an­cial ad­visor in the United States,
high­lights the im­port­ance of mak­ing a per­son­al com­mit­ment to form­ing sound money habits.
He claims: “The thing I have dis­covered about work­ing with per­son­al fin­ance is that the good news is that it is not rock­et sci­ence.
Per­son­al fin­ance is about 80 per­cent be­ha­vi­or. It is only about 20 per­cent head know­ledge.”(102)
After read­ing the en­tirety of Part 4, you will have the head know­ledge.
Are you ready to fo­cus and com­mit to align­ing your con­sump­tion,
sav­ing, bor­row­ing, and earn­ing de­cisions with those that prom­ise fin­an­cial sta­bil­ity and lead to a re­ward­ing life?
Ele­ments 4 through 12 will provide ad­di­tion­al de­tails on how to get more out of your spend­ing,
avoid im­prudent debt, plan for un­ex­pec­ted ex­pendit­ures,
earn an at­tract­ive re­turn on your in­vest­ments, and min­im­ize your vul­ner­ab­il­ity to the risks of life.

Element 4.4: Finance Wisely

Don’t finance anything for longer than its useful life.

What hap­pens when you bor­row money to pur­chase va­ca­tions, cloth­ing, or oth­er goods that are quickly con­sumed or that de­pre­ci­ate in value?
What hap­pens when you take out a forty-eight-month loan in or­der to pur­chase a used auto­mobile that will be worn out in two years?
The an­swer to both ques­tions is the same: You will soon be mak­ing pay­ments on things that have little or no value to you or any­one else.
These pay­ments will lead to frus­tra­tion, bit­ter­ness, and fin­an­cial in­sec­ur­ity.
Fin­an­cing an item over a time peri­od length­i­er
than the use­ful life of the as­set forces you to pay in the fu­ture for something that will no longer be of value to you.
As a res­ult, you will be forced to re­duce your fu­ture con­sump­tion.
Fur­ther, this strategy in­creases your in­debted­ness and you will be­come poorer in the fu­ture. It is a path to fin­an­cial dis­aster.
Does it ever make sense for an in­di­vidu­al or fam­ily to pur­chase something on cred­it?
The an­swer is “yes,” but, with rare ex­cep­tions, only if what you are buy­ing is a long-last­ing as­set and if the bor­rowed funds are re­paid be­fore the as­set is worn out.
This way you pay for what you bought as you use it.
Very few pur­chases meet these cri­ter­ia. Three cat­egor­ies of ma­jor ex­pendit­ures come to mind: hous­ing, auto­mo­biles, and edu­ca­tion.
If main­tained prop­erly, a new dwell­ing unit may provide use­ful life for forty or fifty years into the fu­ture.
Un­der these cir­cum­stances the use of a thirty-year mort­gage (if such are avail­able to you) to fin­ance the ex­pendit­ure is per­fectly sens­ible.
Sim­il­arly, if an auto­mobile can reas­on­ably be ex­pec­ted to be driv­en five or six years,
there’s noth­ing wrong with fin­an­cing it over a time peri­od of forty-eight months or less.
When long-last­ing as­sets are still gen­er­at­ing ad­di­tion­al in­come or a valu­able ser­vice after the loans used to fin­ance their pur­chase are re­paid,
some of the loan pay­ments are ac­tu­ally a form of sav­ings and in­vest­ment, which will en­hance the net worth of a house­hold.
Like hous­ing, in­vest­ments in edu­ca­tion gen­er­ally provide net be­ne­fits over a lengthy time peri­od.
Young people in­vest­ing in their edu­ca­tion through debt fin­an­cing may reap di­vidends in the form of high­er earn­ings.
The edu­ca­tion­al in­vest­ment will be a good one if, over the next twenty or thirty years, the high­er earn­ings are suf­fi­cient to pay off the bor­rowed funds.
But there are risks here: If the ad­di­tion­al edu­ca­tion does not in­crease your fu­ture earn­ings, at least not by much,
it may be ex­ceed­ingly dif­fi­cult to re­pay the bor­rowed funds. (Note: This is­sue will be con­sidered in more de­tail in Part 4, Ele­ment 11.)
For most house­holds the im­plic­a­tions of this guideline are straight­for­ward:
Do not bor­row funds to fin­ance any­thing oth­er than hous­ing, auto­mo­biles, and edu­ca­tion.
Of course, de­pend­ing on the design of health in­sur­ance in your par­tic­u­lar coun­try, it ob­vi­ously is a good idea to bor­row for crit­ic­al med­ic­al care if you have not yet had time to build up a suf­fi­cient emer­gency fund.
An ap­pendec­tomy is a good use of debt. A facelift prob­ably is not (un­less you are a TV star!)
Fur­ther­more, make sure that funds bor­rowed for the pur­chase of these items will be re­paid well be­fore the ex­pir­a­tion of the as­set’s use­ful life.
Ap­plic­a­tion of this simple guideline will go a long way to­ward keep­ing you out of fin­an­cial trouble.
An­oth­er debt-mis­match risk is bor­row­ing in a cur­rency oth­er than the cur­rency of your in­come.
The val­ues of cur­ren­cies can change re­l­at­ive to each oth­er without warn­ing.
For ex­ample, in the early 2000s, home­buy­ers in coun­tries in­clud­ing Po­land, Hun­gary, Croa­tia, and Ro­mania
were able to se­cure very low mort­gage in­terest rates by bor­row­ing in Swiss francs.
Most of their in­comes, however, were in their home cur­ren­cies.
In the 2008 fin­an­cial crisis, the value of CEE cur­ren­cies fell re­l­at­ive to the Swiss franc as the franc’s value rose in com­par­is­on to the euro and oth­er cur­ren­cies.
The Swiss tried to sta­bil­ize by peg­ging their cur­rency to the euro in 2011.
Then in 2015, Switzer­land un­pegged its cur­rency from the euro and its cur­rency spiked up­ward fur­ther.
Both times, bor­row­ers were shocked to find they owed a lot more money in their own cur­ren­cies than they had an­ti­cip­ated.
While a busi­ness might have been able to lock in its ex­change rate us­ing a for­ward con­tract,
such con­tracts are not likely to have been avail­able to in­di­vidu­als.
It is best to match the cur­rency of your spend­ing ob­lig­a­tions to that of your in­come, in or­der to avoid un­pleas­ant sur­prises.

Element 4.5: Two Ways to Get More out of Your Money

Avoid credit-card debt and consider purchasing used items.

Most of us would like to have more in the fu­ture without hav­ing to give up much today.
Many, in­clud­ing those with in­comes well above av­er­age, do two things that un­der­mine this ob­ject­ive.
First, they go into debt to buy things be­fore they can af­ford them.
Second, they in­sist on buy­ing new items even when used ones would be just as ser­vice­able and far more eco­nom­ic­al.
Im­prudent use of credit cards can be a huge stum­bling block to fin­an­cial suc­cess.
Al­though many people are care­ful with cards, oth­ers act as if an un­used bal­ance on a cred­it card is like money in the bank.
This is blatantly false and dan­ger­ous think­ing. An un­used bal­ance on your cred­it card merely means that you have some ad­di­tion­al bor­row­ing power.
If you have funds in your checking account, you can use your cred­it card to ac­cess those funds—if you pay off the bill every month.
If you don’t have suf­fi­cient funds in your ac­count, don’t make the pur­chase.
While cred­it cards and their elec­tron­ic coun­ter­parts (such as PayPal, or Yan­dex Money)
are con­veni­ent to use, they are also both se­duct­ive and a costly meth­od of bor­row­ing.
Be­cause cred­it cards make it easy to run up debt, they are po­ten­tially dan­ger­ous.
Some people seem un­able to con­trol the im­pulse to spend when there is an un­used bal­ance on their cards.(103)
If you have this prob­lem you need to take im­me­di­ate ac­tion!
You need to get your hands on a pair of scis­sors and cut up all of your cred­it cards. If you do not, they will lead to fin­an­cial mis­for­tune.
Mak­ing pur­chases on your cred­it card makes it look as though you are buy­ing more with your money,
but the bill in­vari­ably comes at the end of the month.
This presents an­oth­er tempta­tion: the op­tion to send in a small pay­ment to cov­er the in­terest and a tiny per­cent­age of the bal­ance and keep most of your money to spend on more things.
If you choose this op­tion and con­tin­ue to run up your bal­ance, however, you will quickly con­front a ma­jor prob­lem—
the high in­terest rates be­ing charged on the un­paid bal­ance.
It is com­mon for people to pay in­terest charges of 15 to 18 per­cent on their cred­it card debt.
This is far high­er than most people, even suc­cess­ful in­vestors, can earn on their sav­ings and in­vest­ments.
As we shall see in later ele­ments, you can be­come wealthy earn­ing 7 per­cent per year on your in­vest­ments.
Un­for­tu­nately, high in­terest rates on out­stand­ing debt will have the op­pos­ite im­pact.
Pay­ing 15 to 18 per­cent on your cred­it card debt can drive even a per­son with a good in­come into poverty.
Con­sider the ex­ample of Sean, a young pro­fes­sion­al who de­cides to take a few days re­lax­ing in the South of France.
The trip costs Sean €1,500, which he puts on his cred­it card.
But in­stead of pay­ing the full amount at the end of the month, Sean pays only the min­im­um,
and he keeps do­ing so for the next ten years, when the bill is fi­nally paid off.
How much did Sean pay for his trip, as­sum­ing an 18 per­cent in­terest rate on his cred­it card?
He pays €26.63 per month for 120 months, or a total of €3,195.40.
So Sean pays his cred­it card com­pany more than he paid for the air travel, hotel, food, and en­ter­tain­ment.
Sean could have taken the trip for a whole lot less by plan­ning ahead and start­ing to make pay­ments to him­self be­fore the trip, in­stead of mak­ing pay­ments to the cred­it card com­pany after the trip.
By sav­ing €75 a month at 5 per­cent per year in com­pound in­terest (we will dis­cuss com­pound in­terest in Ele­ment 7) for twenty months,
Sean could have had €1,560.89 for the trip, and not the €3,195.40 he ended up pay­ing
(in­clud­ing in­terest) for the same trip (but taken earli­er) on the cred­it card.
In oth­er words, by sav­ing and plan­ning to make his trip,
in­stead of run­ning up cred­it card debt to pay for it, Sean could take two trips for less than what he ended up pay­ing for one on cred­it.
In some cases, you may already have a size­able cred­it card bill.
It would have been bet­ter if you had avoided that debt, but it does provide an op­por­tun­ity for you to get a very high re­turn.
Everything you save to pay down a cred­it card debt ef­fect­ively earns an in­terest rate of 18 per­cent, or whatever you are pay­ing on the debt.
Look at it this way. If you put a euro in an in­vest­ment that is pay­ing 18 per­cent rather than spend that euro, then one year from now you have ad­ded €1.18 to your net worth.
If you save a euro to pay off your cred­it card debt, then one year from now it has also ad­ded €1.18 to your net worth.
Your debt will be that much lower—first, from the amount you saved that re­duced your debt ini­tially
and, second, from the 18 cents you would have oth­er­wise owed in in­terest.
Even if your cred­it card rate is less than 18 per­cent, it is still much high­er
than what you will con­sist­ently earn on any oth­er sav­ings pro­gram you will ever have, un­less you are ex­traordin­ar­ily lucky or a spec­tac­u­lar in­vestor.
Of course you may not feel as though your sav­ings are really earn­ing 18 per­cent, since the money isn’t ac­tu­ally be­ing paid into your in­vest­ment ac­counts.
But it amounts to the same thing.
The very first thing any­one who has a cred­it card debt and is ser­i­ous about achiev­ing fin­an­cial suc­cess should do is pay that debt off, from sav­ings if ne­ces­sary.
What if you do not have the funds to pay off your cred­it card bill?
Then take out a bank loan—the in­terest rate will be lower than your cred­it card rate—
and, based on the budget­ing prin­ciples presen­ted in Ele­ment 3, de­vel­op a plan to pay off the loan as quickly as pos­sible.
Of course, you also need to make sure that you do not run up any oth­er cred­it card debt.
In ad­di­tion to avoid­ing cred­it card debt or pay­ing it off im­me­di­ately, you can stretch your money by buy­ing used items when they will serve you al­most as well as new ones.
The prob­lem with buy­ing things new is that they de­pre­ci­ate or de­cline in value al­most im­me­di­ately.
Thus, while new items can be pur­chased, they can­not be owned as new items for long.
Al­most as soon as an item is pur­chased, it be­comes “used” in terms of mar­ket value.
Buy­ing things that are used—or, in today’s par­lance, pre-owned—can reap sub­stan­tial sav­ings.
Con­sider the cost of pur­chas­ing a new auto­mobile com­pared with a used one.
For ex­ample, if you buy a brand-new Toyota for about €30,000
(in 2019, this was the av­er­age price for Toyotas, which were the most pop­u­lar car in Kiev),
and trade it in after one year, you will re­ceive about €18,000, or €12,000 less than you paid for it.
If you drove the car twenty thou­sand kilo­met­ers, then your depreciation cost—the cost to you of the de­cline in the car’s value—is 60 cents per kilo­met­er.
But in­stead of buy­ing a new car, you can buy one that is a year old.
You might pay about €20,000, or €10,000 less than the cost of a new car.
This con­sists of the €18,000 the pre­vi­ous own­er got for selling it plus €2,000 in
“trans­ac­tion costs” such as ads, sales, com­mis­sions, or whatever.
Giv­en how long cars last if you take care of them,
you should eas­ily be able to get ex­cel­lent ser­vice from your used Toyota for eight years, at which time you can prob­ably sell it for about €10,000.
As­sum­ing that you drove 20,000 kilo­met­ers a year,
your de­pre­ci­ation cost per kilo­met­er will be €10,000/160,000 kilo­met­ers, or just over 6 cents.
This is 54 cents per kilo­met­er less than the cost of driv­ing a new car every year.
Stay­ing with the as­sump­tion that you drive 20,000 kilo­met­ers a year,
the de­pre­ci­ation sav­ing from the used car is nearly el­ev­en thou­sand euros every year.
Of course your re­pair bills may be high­er after the car is a few years old, but the sav­ings will still be enorm­ous from sac­ri­fi­cing that new car smell.
Many oth­er items are just as func­tion­al used as new and of­ten much less ex­pens­ive.
Clothes, fur­niture, ap­pli­ances, re­fur­bished phones, and toys come im­me­di­ately to mind.
You may want to spend some time at out­door mar­kets and second­hand stores.
The “thrill of the hunt” is, in it­self, a re­cre­ation­al activ­ity—and is free!
Giv­en the value of your time, however, there are oth­er ways to find used items.
On-line apps provide al­tern­at­ives that re­duce time spent and trans­ac­tion costs.
In a few “touches,” you can find items that are both in ex­cel­lent con­di­tion and priced sig­ni­fic­antly be­low re­tail.
Of course, there are some cases when buy­ing new is eco­nom­ic­al.
We are merely en­cour­aging you to con­sider the po­ten­tial sav­ings that can of­ten be de­rived from used pur­chases without giv­ing up much in terms of con­sumer sat­is­fac­tion.
Look for op­por­tun­it­ies to get more value from your money.
Young people world­wide are ex­plor­ing the pos­sib­il­it­ies of a post-con­sumer­ist cul­ture with green, min­im­al­ist, or zero-waste liv­ing.
Re­sources such as iFixit, RREUSE.org, makeresourcescount.eu, and many oth­er YouTube chan­nels pro­mote re­pair­ing rather
than trash­ing use­ful ob­jects, and liv­ing a fun and happy life with­in your means.
A web search for “frugal green liv­ing” will lead to many prac­tic­al re­sources and oth­er like-minded in­di­vidu­als to provide sup­port.
Cit­ies across the globe have be­gun to pro­mote the shar­ing eco­nomy.(104)
You can choose among the frugal strategies in or­der to be able to af­ford oth­er things you might want to spend money on,
or you can sub­scribe to many of them. The im­port­ant thing to real­ize is that you have many more choices than thought­lessly buy­ing new things.

Element 4.6: Plan for the Unexpected

Begin paying into a savings account for emergencies (a “rainy day” or “black day” fund) every month.

We have talked about the value of sav­ing for your fu­ture. But you also need sav­ings for emer­gen­cies.
Life has an end­less string of sur­prise oc­cur­rences: the car breaks down, the roof leaks,
a drought with­ers your crops, your child breaks an arm—just to name a few.(105)
We can’t pre­dict which ones will oc­cur, or when. But we can pre­dict that over any long peri­od of time, each house­hold will con­front such costly items.
Thus, it makes sense to plan for them.
This is what your emer­gency sav­ings ac­count is for.
It will help you deal with un­ex­pec­ted bills that could oth­er­wise put you un­der severe emo­tion­al stress and into a fin­an­cial bind.
The al­tern­at­ive is to wait un­til the sur­prise events oc­cur and then try to de­vise a plan to deal with them.
This of­ten means run­ning up cred­it card bal­ances or some oth­er meth­od of bor­row­ing funds on highly un­fa­vor­able terms.
Then you have to fig­ure out how you’re go­ing to cov­er the in­terest charges and even­tu­ally re­pay the funds.
At oth­er times it might mean turn­ing to your fam­ily and neigh­bors
who have had the foresight to as­semble their own emer­gency funds.
All of this leads to anxi­ety that is likely to res­ult in un­wise fin­an­cial de­cisions.
How much should you set aside reg­u­larly to deal with such events?
One ap­proach would be to make a list of the vari­ous sur­prises you and your re­l­at­ives and neigh­bors faced in the past year and es­tim­ate how much each one cost.
Think about car re­pairs, un­ex­pec­ted travel, doc­tor’s vis­its, a home ap­pli­ance re­placed—any­thing that was not ex­pec­ted to hap­pen last year.
Add the costs up, di­vide that num­ber by twelve, and be­gin chan­nel­ing that amount monthly into your rainy day sav­ings ac­count.
You might even want to pay some­what more than the av­er­age needs into the ac­count just in case you have un­usu­ally bad luck in the fu­ture.
After all, if you pay too much into the ac­count, you can build up a little cush­ion.
If the funds in the ac­count con­tin­ue to grow,
even­tu­ally you can use some of them for oth­er pur­poses or al­loc­ate them into your re­tire­ment sav­ings pro­gram.
The key point is to con­sider the monthly al­loc­a­tions into your sav­ings ac­count as a man­dat­ory rather than an op­tion­al budget item.
Thus, they should be treated just like your mort­gage pay­ment, elec­tric bill, and oth­er reg­u­lar ex­pendit­ures.
A sav­ings ac­count set aside for emer­gen­cies al­lows you to pur­chase a little peace of mind
rather than wor­ry­ing about the fin­an­cial bumps of life.
With such an ac­count, you will be able to deal con­fid­ently with ex­pendit­ures
that, while un­pre­dict­able as to tim­ing, can non­ethe­less be an­ti­cip­ated with a fair de­gree of ac­cur­acy.
Dur­ing peri­ods when your sur­prise ex­pendit­ures are be­low av­er­age, the bal­ance in your ac­count will grow.
When the sur­prise ex­pendit­ures are atyp­ic­ally large, the funds in your ac­count will be drawn down, but you can re­main calm be­cause you are pre­pared.
This is an im­port­ant ele­ment of what it means for you to “take charge of your money” rather than al­low­ing “money to take charge of you.”

Element 4.7: The Power of Compound Interest

Make compound interest (returns on investment) work for you.

Com­pound in­terest is the most power­ful force in the uni­verse.
Mignon McLaughlin. N.d. BrainyQuote.com. Re­trieved Oc­to­ber 24, 2015, from BrainyQuote.com web­site: http://www.brainyquote.com/quotes/quotes/m/mignonmcla158995.html. There is some con­tro­versy about wheth­er this state­ment was made by Al­bert Ein­stein, but he clearly made sim­il­ar state­ments high­light­ing the power of com­pound in­terest.
In Ele­ment 4.3 we em­phas­ized the im­port­ance of budget­ing reg­u­larly, sav­ing ha­bitu­ally, and spend­ing your money ef­fect­ively.
There are two ma­jor reas­ons for start­ing earli­er rather than later.
First, as dis­cussed, those who yield now to the many ex­cuses not to start budget­ing, sav­ing, and spend­ing wisely will have a hard time do­ing so later.
But in this ele­ment we want to talk more about the second reas­on to be­gin sav­ing right away:
the big pay­off that comes from start­ing early.
A small head start in your sav­ings pro­gram leads to a sub­stan­tial in­crease in the pay­off.
Re­call the ex­ample in Ele­ment 4.3 of the ad­di­tion­al re­tire­ment wealth a young per­son could have by sav­ing a mod­est amount from age twenty-two to thirty.
Giv­ing up just a little more than €9,000 in pur­chas­ing power for those nine years can eas­ily add over €150,000 to re­tire­ment wealth at age sixty-sev­en.
The key to con­vert­ing a small amount of money now into a large amount later is to start sav­ing im­me­di­ately to take full ad­vant­age of the “mir­acle of com­pound in­terest.”
Compound interest is not really a mir­acle, but some­times it seems that way.
It’s also not ne­ces­sar­ily just in­terest—if you keep money in­ves­ted in the stock mar­ket and re­in­vest all the gains you get, that’s also a com­pound re­turn, which we some­times call com­pound in­terest for the sake of sim­pli­city.(106)
Des­pite the fact that it is easy to ex­plain how com­pound in­terest works, the res­ults are truly amaz­ing.
Com­pound in­terest is simply earn­ing in­terest on in­terest.
If you don’t spend the in­terest earned on your sav­ings this year, the in­terest will add to both your sav­ings and the in­terest earned next year.
By do­ing the same thing each year in the fu­ture, you then earn in­terest on your in­terest on your in­terest, etc.
This may not seem like much, and for the first few years it doesn’t add that much to your wealth.
But be­fore too long your wealth be­gins grow­ing no­tice­ably, and the lar­ger it be­comes, the faster it grows.
It’s like a small snow­ball rolling down a snow-covered moun­tain. At first it in­creases in size slowly.
But each little bit of ex­tra snow adds to the size, which al­lows even more snow to be ac­cu­mu­lated, and soon it is huge, grow­ing rap­idly, and com­ing right at you.
The im­port­ance of start­ing your sav­ings pro­gram early is ex­plained by how com­pound in­terest sets the stage for its ac­cel­er­at­ing ef­fect later.
The sav­ings you make right be­fore re­tire­ment won’t add much more to your re­tire­ment wealth than the amount you save—a little but not much.
The snow­ball that starts near the bot­tom of the moun­tain won’t be much big­ger when it stops rolling.
So the soon­er you start sav­ing, the more time that early sav­ings will have to grow, and the more dra­mat­ic the growth will be.
Con­sider a simple ex­ample. As­sume a six­teen-year-old is de­cid­ing wheth­er or not to start smoking.
This is an im­port­ant choice for sev­er­al reas­ons, health con­sid­er­a­tions be­ing the most im­port­ant.
In ad­di­tion to the health factor, however, there is a fin­an­cial reas­on for not smoking.
The av­er­age price of ci­gar­ettes in Europe var­ied from about $3 to $13 a pack in 2017,(107) so let’s as­sume for sim­pli­city that it is $8 per pack.
So if our teen­ager—let’s call him Honza—de­cides against smoking, he will save $2,920 a year (as­sum­ing he would have smoked a pack a day).
Sup­pose that in­stead of spend­ing this amount on something else,
Honza in­vests it in a re­tire­ment ac­count or fund that earns 7 per­cent per year and is pro­tec­ted from in­come taxes.
As Ex­hib­it 24 il­lus­trates, if Honza keeps this up for ten years, when he is twenty-six he will have ac­cu­mu­lated $40,344 from sav­ings of $29,200.
Not bad for a rather small sac­ri­fice—one that is, in fact, good for Honza.
But this is just liftoff; the pay­off from com­pound re­turns is merely get­ting star­ted.
If Honza keeps this sav­ings plan go­ing un­til he is thirty-six, he will have $119,707 from sav­ings of $58,400.
Con­tinu­ing un­til he is forty-six will find him with $275,825 from sav­ings of $87,600. And now the af­ter­burn­ers really start kick­ing in.
By the time Honza is fifty-six he will have $582,935 from sav­ing con­tri­bu­tions of $116,800.
As Ex­hib­it 24 shows, when he re­tires at age sixty-five he will have $1,106,677 from dir­ect con­tri­bu­tions of only $143,080.
Thus, by choos­ing not to smoke and in­vest­ing the funds, Honza ac­cu­mu­lates about $1.1
mil­lion in re­tire­ment be­ne­fits—and this fig­ure is in dol­lars with today’s pur­chas­ing power.(108)
Ex­hib­it 24: Don’t Smoke—Get Rich!
A bar chart dis­play­ing the im­pact of com­pound in­terest. The graph­ic uses an ex­ample of a 16-year old choos­ing not to smoke and in­stead in­vest­ing the funds saved each year over 50 years. An ini­tial in­vest­ment of $2,920 in Year 1, with the same amount ad­ded each year and in­ves­ted in a plan yield­ing 7% in­terest per an­num, would at­tain a value of $1,106,677 by Year 50.
Source: Au­thors’ cal­cu­la­tions. As­sumes not smoking one pack per day at a price of $8 per pack, and earn­ing in­terest of 7 per­cent per year.
Al­tern­at­ively, con­sider what would hap­pen if Honza smoked from age six­teen
to twenty-six, then stopped smoking and star­ted sav­ing the price of a pack of ci­gar­ettes every day.
It is good that he stopped smoking, and he will still be­ne­fit from the sav­ings.
But by post­pon­ing his sav­ings pro­gram by ten years, in­stead of hav­ing $1,106,667 at age sixty-five, Honza will have only $542,070.
Delay­ing a forty-nine-year sav­ing pro­gram by ten years costs Honza $564,597 at re­tire­ment!
You don’t have to com­pletely give up something in or­der to achieve sub­stan­tial sav­ings.
Mak­ing small sac­ri­fices in con­sump­tion can yield equally power­ful res­ults.
In­stead of buy­ing the premi­um cup of cof­fee every morn­ing, pur­chase the gen­er­ic one or make the cup at home.
In­stead of eat­ing lunch at a res­taur­ant every day, bring your lunch one or two days a week.
Skip the high-priced min­er­al wa­ter offered at a res­taur­ant and drink free tap wa­ter in­stead
(at least in coun­tries where this is safe to do).
Walk or cycle to work in­stead of tak­ing the tram (which will even re­duce your med­ic­al care bills).
If you have a week­end cot­tage, can you get there on the bus or train?
Honza gave up smoking to save $56.00 per week and in­ves­ted it in­stead. You, too, can make changes in your con­sump­tion habits to save money.
Again, our point is not that you should live a miser­able life of aus­ter­ity and sac­ri­fice so that you can be rich when you re­tire.
Where’s the ad­vant­age in be­com­ing rich in the fu­ture by liv­ing in poverty un­til the fu­ture ar­rives?
In­stead, we are stress­ing that or­din­ary people can have a high stand­ard of liv­ing and still ac­cu­mu­late a lot of wealth
be­cause it does not take much sav­ings to get a big pay­off.
Of the $1,106,677 Honza ac­cu­mu­lated by not smoking, only $143,080 came from re­du­cing his con­sump­tion.
In­deed, people who save and in­vest will be able to con­sume far more than those who do not.
At re­tire­ment—or soon­er—Honza can start spend­ing his wealth and end up hav­ing much more than if he had nev­er saved.
All it takes is an early sav­ings pro­gram in a tax-ad­vant­aged re­tire­ment ac­count,
a little pa­tience, know­ing how to get a reas­on­able re­turn on your sav­ings
(see the next two ele­ments), and tak­ing ad­vant­age of the power of com­pound in­terest.
Note: Sharia or Is­lam­ic bank­ing
Sharia or Is­lam­ic law for­bids the pay­ment of in­terest on debt. In or­der to com­pensate lenders for the use of their money,
Sharia bank­ing has de­veloped dif­fer­ent types of fin­an­cial ar­range­ments that are in keep­ing with the law, such as profit shar­ing.
In­vest­ments in products such as al­co­hol and pork, which Muslims are for­bid­den to con­sume, are also for­bid­den for in­vest­ment.
In ad­di­tion, based on the concept of fair­ness, all parties
in­volved in a busi­ness trans­ac­tion should share profits and losses—which im­plies that in or­der to gain a re­turn on in­vest­ment,
you have to be ex­posed to busi­ness risks.
So, if you want to buy a car, for ex­ample, an Is­lam­ic bank would buy the car,
and agree to re­sell it to you for a fixed num­ber of pay­ments total­ing a slightly high­er amount.
You still have car pay­ments, and the bank still makes money on the trans­ac­tion,
and the trans­ac­tion re­mains com­pli­ant with Is­lam­ic bank­ing laws.
De­pos­its you make into a Sharia bank, in­stead of earn­ing in­terest,
will earn a set share of the bank’s profits dur­ing the time the money is de­pos­ited.
Banks that are in­volved in Is­lam­ic bank­ing must be sep­ar­ate leg­al en­tit­ies, but some big in­ter­na­tion­al banks have Is­lam­ic sub­si­di­ar­ies.

Element 4.8: Diversify Your Assets

Don’t put all your eggs in one basket.

After sav­ings ac­counts at banks, the two most com­mon fin­an­cial as­sets are stocks and bonds.
Let’s make sure you un­der­stand the nature of these two in­stru­ments.
Stocks rep­res­ent own­er­ship of cor­por­ate busi­nesses. Stock own­ers are en­titled to the frac­tion of the firm’s fu­ture rev­en­ues rep­res­en­ted by their own­er­ship shares.
If the busi­ness gen­er­ates at­tract­ive fu­ture rev­en­ues, the stock­hold­ers will gain.
The gains of stock­hold­ers typ­ic­ally come in the form of either dividends
(reg­u­lar pay­ments to own­ers) or ap­pre­ci­ation in the value of the stock.
But, there is no as­sur­ance the busi­ness will be suc­cess­ful and earn in­come in the fu­ture.
If un­suc­cess­ful, the value of the firm’s stock will de­cline.
While the stock­hold­ers are not li­able for the debts of the cor­por­a­tion, they may lose all of the funds used to pur­chase the stock.
(Note: “Equity” is an­oth­er term for stock.)
Bonds provide busi­nesses, gov­ern­ments, and oth­er or­gan­iz­a­tions with a con­veni­ent way to bor­row money.
These or­gan­iz­a­tions ac­quire funds from bond pur­chasers in ex­change for the prom­ise (and leg­al ob­lig­a­tion)
to pay in­terest and re­pay the en­tire principal (amount bor­rowed) at spe­cified times in the fu­ture.
As long as the or­gan­iz­a­tion is­su­ing the bond is solvent, the bond­hold­er can count on the funds be­ing re­paid with in­terest.
All in­vest­ments in­volve risk. The mar­ket value of a corporate stock in­vest­ment can change dra­mat­ic­ally in a re­l­at­ively short peri­od of time.
Even if the nominal return is guar­an­teed,
as in the case of high-qual­ity bonds, changes in in­terest and/or in­fla­tion rates can sub­stan­tially change the value of the as­set.
If you have most of your wealth tied up in own­er­ship of a small num­ber of cor­por­ate stocks
(or even worse, a single stock), you are es­pe­cially vul­ner­able.
You can re­duce your risk through diversification—hold­ing a large num­ber of un­re­lated as­sets.
Di­ver­si­fic­a­tion puts the law of large num­bers to work for you.
While some of the in­vest­ments in a di­ver­si­fied portfolio will do poorly, oth­ers will do ex­tremely well.
The per­form­ance of the lat­ter will off­set that of the former, and the rate of re­turn will con­verge to­ward the av­er­age.
For those seek­ing to build wealth without hav­ing to be­come in­volved in day-to-day busi­ness de­cision-mak­ing, the stock mar­ket can provide at­tract­ive re­turns.
It has done so his­tor­ic­ally. Dur­ing the last two cen­tur­ies, cor­por­ate stocks yiel­ded a real rate of re­turn
(real means ad­jus­ted for in­fla­tion) of ap­prox­im­ately 7 per­cent per year, com­pared to a real rate of re­turn between 2 and 3 per­cent for bonds.(109)
The risk with stocks is that no one can ever be sure what they will be worth at any spe­cified time in the fu­ture;
in­ev­it­ably there will be peri­ods over which the mar­ket value of your in­vest­ments is fall­ing, only to rise months or years later.
That risk, known as volat­il­ity, is a big reas­on why stocks yield a sig­ni­fic­antly high­er rate of re­turn than sav­ing ac­counts,
money market certificates, and short-term government bonds, all of which guar­an­tee you a giv­en amount in the fu­ture.
Since most people value the ad­di­tion­al cer­tainty in the yields that bonds and sav­ings ac­counts provide over stocks, the av­er­age re­turn on stocks has to be high­er to at­tract in­vestors away from their less risky coun­ter­parts with more pre­dict­able re­turns.
Mutual funds and ex­change-traded funds (ETFs) can help in­vestors di­ver­si­fy and re­duce risk.
Mu­tu­al funds and ETFs simply com­bine the funds of a group of in­vestors and chan­nel them into vari­ous cat­egor­ies of in­vest­ments,
such as stocks (equities), bonds, real es­tate, or treasury bills.
Thus, there are a vari­ety of mu­tu­al fund cat­egor­ies.
An equity mutual fund chan­nels the funds of its in­vestors into the stock of many firms.
These funds provide even small in­vestors with an eco­nom­ic­al way to achieve di­versity and re­duce risk.
The risks of stock mar­ket in­vest­ments are sub­stan­tially lowered if you con­tinu­ally add to or hold a di­verse port­fo­lio of stocks over a lengthy peri­od of time, say thirty or thirty-five years.
His­tor­ic­ally, when a di­verse set of stocks has been held over a lengthy time frame, the rate of re­turn has been high and the vari­ation in that re­turn has been re­l­at­ively small.
Reg­u­lar pay­ments into an equity mu­tu­al fund hold­ing a di­verse set of stocks provide in­vestors with a low-cost meth­od of in­vest­ing in the stock mar­ket.
Di­ver­si­fic­a­tion will re­duce the volat­il­ity of in­vest­ments in the stock mar­ket in two ways.
First, when some firms do poorly, oth­ers do well.
An oil price de­cline that causes lower profits in the oil in­dustry will tend to boost profits in the air­line in­dustry be­cause the cost of air­line fuel will de­cline.
When profits in the steel in­dustry fall be­cause steel prices de­cline, the lower steel prices will tend to boost the profits in the auto­mobile in­dustry.
Second, di­ver­si­fic­a­tion can help pro­tect you against a change in gen­er­al eco­nom­ic con­di­tions.
A re­ces­sion or an ex­pan­sion will cause changes in the value of the stocks of al­most all firms.
But di­ver­si­fic­a­tion re­duces the volat­il­ity in the value of your in­vest­ments be­cause a re­ces­sion is worse for some firms and in­dus­tries than oth­ers, and a boom is bet­ter for some than for oth­ers.
For ex­ample, the re­ces­sion that harms Max Mara (a high-fash­ion brand sold world­wide) may boost sales and profits for Zara (a lower-priced com­pet­it­or).
Sim­il­arly, re­ces­sions may im­prove the re­l­at­ive po­s­i­tion of Sko­das re­l­at­ive to BMWs.
Some em­ploy­ers of­fer re­tire­ment pro­grams that will match your pur­chases of the com­pany stock (but not in­vest­ments in oth­er firms)
or will al­low you to pur­chase the com­pany stock at a sub­stan­tial dis­count.
Such a plan makes pur­chas­ing the stock of your com­pany at­tract­ive. If you have sub­stan­tial con­fid­ence in the com­pany, you may want to take ad­vant­age of this of­fer.
After a hold­ing peri­od, typ­ic­ally three years, these plans will per­mit you to sell the pur­chased shares and use the pro­ceeds to un­der­take oth­er in­vest­ments.
As soon as you are per­mit­ted to do so, you should choose this op­tion.
Fail­ure to do so will mean that you will soon have too many of your in­vest­ment eggs in the bas­ket of the com­pany for which you work.
This places you in a po­s­i­tion of double jeop­ardy: Both your em­ploy­ment and the value of your in­vest­ments de­pend sub­stan­tially on the suc­cess of your em­ploy­er. Do not put your­self in this po­s­i­tion.
Your job may of­fer you a gen­er­al pen­sion fund that is re­quired by the gov­ern­ment. These funds can have dif­fer­ent in­vest­ments de­pend­ing on where you work.
It is im­port­ant to be aware of what your com­pany pen­sion fund is in­ves­ted in, and to make sure your own per­son­al in­vest­ments di­ver­si­fy away from the pen­sion fund’s hold­ings.(110)
We can sum­mar­ize the im­port­ance of stock in­vest­ments and di­versity this way: To achieve their fin­an­cial po­ten­tial, in­di­vidu­als must chan­nel their sav­ings into di­ver­si­fied in­vest­ments that yield at­tract­ive re­turns.
In the past, long-term in­vest­ments in the stock mar­ket have yiel­ded high re­turns.
Equity mu­tu­al funds make it pos­sible for even small in­vestors to hold a di­verse port­fo­lio, add to it monthly, and still keep trans­ac­tion costs low.
In­vest­ing in a di­verse port­fo­lio over a lengthy peri­od of time re­duces the risk of stock own­er­ship to a low level. All in­vest­ments have some un­cer­tainty.
But if the past cen­tury and a half are any guide, we can con­fid­ently ex­pect
that over the long haul, a di­verse port­fo­lio of cor­por­ate stocks will yield a high­er real re­turn
than will sav­ings ac­counts, bonds, certificates of deposit, money mar­ket funds, and sim­il­ar fin­an­cial in­stru­ments.
Own­er­ship of stock through mu­tu­al funds is par­tic­u­larly at­tract­ive for young people sav­ing for their re­tire­ment years.
Even with bank de­pos­its, which are far lower in risk than stocks or even bonds, you should be aware of the risk of bank fail­ure.
If a bank be­comes in­solv­ent and can no longer re­turn your money to you, most coun­tries of­fer na­tion­al de­pos­it in­sur­ance that will pay you money up to a lim­it, which they pub­lish.
If you have more money than the lim­it, it is a good idea to di­vide your money between two or more banks in or­der to keep the amount in each bank be­low the in­sured lim­it.
If a bank, like any in­vest­ment, is of­fer­ing you high­er than nor­mal re­turns, al­ways ask your­self “why?”
It could be that smart in­vestors are avoid­ing that bank be­cause they know trouble is likely.
This leaves the fail­ing bank des­per­ate to at­tract money. Don’t let that money be yours in pur­suit of a slightly high­er in­terest rate!
We know one very good eco­nom­ist in a post-com­mun­ist coun­try
who man­aged to lose money in three straight banks where “they were pay­ing the best (highest) rate.”
For­tu­nately, he is a the­or­ist, not a fin­ance pro­fess­or.
It’s also im­port­ant to be aware of the pos­sib­il­ity of fraud,
es­pe­cially in the cases when you are be­ing sold an in­vest­ment that pur­ports to have a high­er rate of re­turn
than the rest of the mar­ket (you could call this, “too good to be true”).
One il­lus­tra­tion of this is the Al­bani­an Ponzi (or Pyr­am­id) Schemes of 1996:
when Al­bania moved to a mar­ket eco­nomy from a com­mand eco­nomy, in­di­vidu­als were not very fa­mil­i­ar with in­vest­ments.
Cer­tain crim­in­als col­lec­ted cash in­vest­ments by prom­ising to re­turn 5% per month or more, or 60% per year;
the 60%, in­stead of com­ing from busi­ness profits, came from col­lect­ing more in­vest­ments and pay­ing the cash to the ori­gin­al in­vestors.
There­fore, each month, the crim­in­al op­er­at­ors had to col­lect more and more money to pay out on the scheme, cre­at­ing the “pyr­am­id” of the name.
Even­tu­ally these schemes were dis­covered to be fraud­u­lent, and people lost their money in the col­lapse of the scheme.(111)
Sim­il­ar schemes have emerged in many coun­tries. Ex­amples in­clude MMM in Rus­sia in the 1990s.
An­oth­er fam­ous fraud that has spread over much of the world is some­times called the “Ni­geri­an prince” scam, but it can be done by someone pos­ing as any rich per­son or per­son who has ac­cess to wealth.
In the scam, which spread by let­ter and then by fax ma­chine in the 1980s, and now spreads by so­cial me­dia or email,
you re­ceive a let­ter from a per­son whose money is trapped in a war-torn coun­try or a coun­try that is un­der­go­ing re­gime change.
The per­son says he will be happy to pay you a large sum to help him get his money safely out of his coun­try—and he asks for your bank ac­count num­ber so you can re­ceive the funds.
If you give him your ac­count num­ber, guess what hap­pens?
He uses it to trans­fer all your money to him­self, and there is very little you can do to get it back!
There are many vari­ations on this scheme; some­times the scam­mer asks for money to pay some kind of fees,
and there will be more and more fees and you will nev­er get paid back.

Element 4.9: Realize No One Can Consistently “Beat the Market”

Indexed equity mutual funds can help you beat the experts without taking excessive risk.

Des­pite the ad­vant­ages of stocks dis­cussed above, many people re­frain from in­vest­ments in stocks
be­cause they feel they do not have either the time or ex­pert­ise to identi­fy busi­nesses that are likely to be suc­cess­ful in the fu­ture.
This may be es­pe­cially true in coun­tries where cap­it­al mar­kets are just emer­ging and both in­vestors and reg­u­lat­ors have little ex­per­i­ence.
Even in long-es­tab­lished mar­kets it is dif­fi­cult to fore­cast the fu­ture dir­ec­tion of either in­di­vidu­al stocks or a broad meas­ure of their av­er­age price.
No one can say for sure what will hap­pen to either the price of any spe­cif­ic stock or the gen­er­al level of stock prices in the fu­ture.
Most eco­nom­ists ac­cept the random walk theory.
Ac­cord­ing to this the­ory, cur­rent stock prices re­flect the best in­form­a­tion
that is known about the fu­ture state of cor­por­ate earn­ings, the health of the eco­nomy, and oth­er factors that in­flu­ence stock prices.
Fu­ture changes of stock prices there­fore will be driv­en by sur­prise oc­cur­rences, things that people do not cur­rently an­ti­cip­ate.
By their very nature, these factors are un­pre­dict­able. If they were pre­dict­able, they would already be re­flec­ted in cur­rent stock prices.
Why not pick just the stocks that will do well, as Apple, Google, and Mi­crosoft have, and stay away from everything else?
That is a great idea, ex­cept for one prob­lem: The ran­dom walk the­ory also ap­plies to the prices of spe­cif­ic stocks.
The prices of stocks with at­tract­ive fu­ture profit po­ten­tial will already re­flect these pro­spects.
The fu­ture price of a spe­cif­ic stock will be driv­en by un­fore­seen changes and ad­di­tion­al in­form­a­tion
about the pro­spects of the firm that will only be­come known over time.
Count­less factors af­fect the fu­ture price of a par­tic­u­lar stock, and they are con­stantly chan­ging in un­pre­dict­able ways.
The price of Apple stock could be driv­en down, for ex­ample, be­cause of an idea a high-school kid is work­ing on in his base­ment right now.
Thus, there is no way that you can know ahead of time which stocks are go­ing to rock­et into the fin­an­cial stra­to­sphere and which ones are go­ing to fizzle on the launch pad or crash after takeoff.
You may be able to im­prove your chances a little by study­ing the stock mar­ket, the de­tails of par­tic­u­lar cor­por­a­tions, and eco­nom­ic trends and fore­casts.
For most of us, however, the best op­tion will be to chan­nel our long-term (that is, our re­tire­ment) sav­ings into an equity mu­tu­al fund.
There are two broad cat­egor­ies of equity mu­tu­al funds: man­aged funds and in­dexed funds.
A managed equity mutual fund is one in which an “ex­pert,” the fund’s port­fo­lio man­ager, de­cides what stocks will be held and when they will be bought and sold.
The fund man­ager is al­most al­ways sup­por­ted by a re­search staff that ex­am­ines both in­di­vidu­al com­pan­ies and mar­ket trends in an ef­fort to identi­fy those stocks that are most likely to do well in the fu­ture.
The man­ager seeks to pick and choose the stock hold­ings of the fund in a man­ner that will max­im­ize the fund’s rate of re­turn.
The second type of fund, an in­dexed equity mu­tu­al fund, merely holds stocks in the same pro­por­tion as their rep­res­ent­a­tion in broad in­dexes of the stock mar­ket
such as the S&P 500 (Standard & Poor’s (S&P) 500 Index of the 500 largest U.S.-lis­ted com­pan­ies), the STOXX Europe 600, or the FTSEurofirst 300.
Very little trad­ing is ne­ces­sary to main­tain a port­fo­lio of stocks that mir­rors a broad in­dex.
Neither is it ne­ces­sary for index funds to un­der­take re­search eval­u­at­ing the fu­ture pro­spects of com­pan­ies.
Be­cause of these two factors, the op­er­at­ing costs of in­dex funds are sub­stan­tially lower, usu­ally 1 or 2 per­cent­age points lower, than those of man­aged funds.
As a res­ult, in­dex funds charge lower fees and there­fore a lar­ger share of your in­vest­ment flows dir­ectly into your pur­chase of stock.
An equity mu­tu­al fund in­dexed to a broad stock mar­ket in­dic­at­or such as the S&P 500 for the United States will earn ap­prox­im­ately the av­er­age stock mar­ket re­turn for its shareholders.
The United States is not alone in hav­ing In­dex Funds.
Most large eco­nom­ies have one or more such funds and more are be­ing opened reg­u­larly.
It is pos­sible to pur­chase In­dex Funds for in­di­vidu­al de­vel­op­ing coun­tries in­clud­ing those in East­ern Europe
(iShares MSCI China ETF, Frank­lin In­dia In­dex Fund, Ex­pat Czech PX UCITS ETF or VanEck Vec­tors Rus­sia ETF.). You can also buy re­gion­al funds that track shares in a par­tic­u­lar set of coun­tries.(112)
What is so great about the av­er­age re­turn?
As noted earli­er, his­tor­ic­ally the stock mar­ket has yiel­ded an av­er­age real rate of re­turn of about 7 per­cent when held for long peri­ods.
That means that the real value, the value ad­jus­ted for in­fla­tion, of your stock hold­ings doubles ap­prox­im­ately every ten years.
That’s not bad. Even more im­port­ant, the av­er­age rate of re­turn yiel­ded by a broad in­dex fund beats the re­turn of al­most all man­aged mu­tu­al funds when com­par­is­ons are made over peri­ods of time such as a dec­ade.
This is not sur­pris­ing be­cause, as the ran­dom walk the­ory in­dic­ates,
not even the ex­perts will be able to fore­cast con­sist­ently the fu­ture dir­ec­tion of in­di­vidu­al stock prices with any de­gree of ac­cur­acy.
Over the typ­ic­al ten-year peri­od, the S&P 500 has yiel­ded a high­er re­turn than 85 per­cent of the act­ively man­aged funds.
Stud­ies of European act­ive vs. pass­ive man­agers sup­port these find­ings.(113)
Over twenty-year peri­ods, mu­tu­al funds in­dexed to the S&P 500 have gen­er­ally out­per­formed about 98 per­cent of the act­ively man­aged funds.(114)
Thus the odds are very low, about one in fifty, that you or any­one else will be able to se­lect an act­ively man­aged fund that will do bet­ter than the mar­ket av­er­age over the long run.
Just be­cause a man­aged mu­tu­al fund does well for a few years or even a dec­ade, it does not fol­low that it will do well in the fu­ture.
For ex­ample, the top twenty man­aged United States equity funds dur­ing the 1980s out­per­formed the S&P 500 In­dex by 3.9 per­cent­age points per year over the dec­ade.
But if in­vestors en­ter­ing the mar­ket in 1990 thought they would beat the mar­ket by choos­ing the “hot” funds of the 1980s, they would have been dis­ap­poin­ted.
The top twenty funds of the 1980s un­der­per­formed the S&P 500 In­dex by 1.2 per­cent­age points per year dur­ing the 1990s.
Sim­il­arly, the av­er­age re­turn of the top twenty man­aged equity funds from 1990 to 1999 out­per­formed the S&P 500 In­dex by 3.1 per­cent­age points per year,
but from 2000 to 2009 those same funds un­der­per­formed the S&P 500 In­dex by 1.3 per­cent­age points per year.(115)
The “hot” funds dur­ing the stock mar­ket bubble of the late 1990s were an even more mis­lead­ing in­vest­ment in­dic­at­or.
Over the two-year peri­od 1998–1999 the top-per­form­ing man­aged fund was Van Wag­on­er Emer­ging Growth, with a 105.52 per­cent av­er­age an­nu­al re­turn.
But over the two-year peri­od 2000–2001, this fund ex­per­i­enced an av­er­age an­nu­al re­turn of minus 43.54 per­cent, one of the low­est dur­ing this peri­od.(116)
These ex­amples ac­tu­ally un­der­state the ad­vant­age of a mu­tu­al fund in­dexed to the S&P 500 com­pared to a man­aged equity fund be­cause of the sur­viv­or­ship bias.
The S&P 500 in­dex is highly un­likely to go out of busi­ness, but over the time peri­od rel­ev­ant to sav­ing for re­tire­ment, a man­aged fund is quite likely to shut down.
A mu­tu­al fund can dis­ap­pear for two reas­ons, both re­lated to poor per­form­ance.
It may be shut down with the re­main­ing value of the fund dis­trib­uted to its own­ers,
or it may be merged into an­oth­er man­aged fund with a bet­ter re­cord.
Al­though there are thou­sands of man­aged mu­tu­al funds today, in 1970 there were only 358 in the United States.
Bur­ton Malk­iel fol­lowed those funds through 2013. Dur­ing these 43 years, 274 funds—over 75 per­cent of the total—ceased to ex­ist.
Out of the re­main­ing 84, only 4 had out­per­formed the S&P 500 in­dex by 2 per­cent­age points or more on an an­nu­al basis.(117)
The stock mar­ket has his­tor­ic­ally yiel­ded high­er re­turns than oth­er ma­jor in­vest­ment cat­egor­ies,
and in­dex funds make it pos­sible for the or­din­ary in­vestor to earn these re­turns without wor­ry­ing about try­ing to pick either in­di­vidu­al stocks or a spe­cif­ic mu­tu­al fund.
A study that com­pared 118 years of re­turns on stocks and bonds from 21 coun­tries that have data go­ing back that far showed
that stock mar­ket re­turns out­per­formed bond re­turns over the peri­od for every coun­try.(118)
They even re­turned an av­er­age of 3–6% an­nu­ally, des­pite in­clud­ing the peri­ods of the two World Wars.
Of course, there will be ups and downs and even some fairly lengthy peri­ods of de­clin­ing stock prices.
There­fore, many in­vestors will want to re­duce equit­ies as a per­cent­age of their as­set hold­ings as they ap­proach re­tire­ment (see the fol­low­ing ele­ment).
But based on a lengthy his­tory of stock mar­ket per­form­ance, the long-term yield de­rived from a broad in­dex of the stock mar­ket can be ex­pec­ted
to ex­ceed that of any oth­er al­tern­at­ive, in­clud­ing man­aged equity funds.(119)
As Ex­hib­it 25 il­lus­trates, when held over a lengthy time peri­od, a di­verse hold­ing of stocks has his­tor­ic­ally yiel­ded both a high and re­l­at­ively stable rate of re­turn.
Data for the highest and low­est av­er­age an­nu­al real rate of re­turn (the re­turn ad­jus­ted for in­fla­tion)
de­rived from broad stock mar­ket in­vest­ments for peri­ods of vary­ing length between the years 1871 and 2014 are shown here.
The ex­hib­it as­sumes that the in­vestor paid a fixed amount an­nu­ally into a mu­tu­al fund that mirrored the S&P 500 In­dex.(120)
Clearly, huge swings are pos­sible when stocks are held for only a short time peri­od.
Dur­ing the 1871–2014 peri­od, the single-year re­turns of the S&P 500 ranged from 47.2 per­cent to minus 40.8 per­cent.
Even over a five-year peri­od, the com­pound an­nu­al re­turns ranged from 29.8 per­cent to minus 16.7 per­cent.
Ex­hib­it 25: Stocks Are Less Risky When Held for a Lengthy Peri­od of Time
A series of bar charts show­ing that stocks are less risky when held for longer peri­ods. Data is taken from the Stand­ard & Poor In­dex of An­nu­al­ized Real Total Re­turns from 1871 to 2015. The chart dis­plays best and worst re­turns over peri­ods of one, five, twenty and thirty-five years and shows how these con­verge over time, ran­ging from best and worst real per­form­ance of 47.2% and -40.8% over one year to 9.5% and 2.7% over thirty-five years.
Source: Li­qun Liu, An­drew J. Rett­en­maier, and Zijun Wang, “So­cial Se­cur­ity and Mar­ket Risk,” Na­tion­al Cen­ter for Policy Ana­lys­is Work­ing Pa­per Num­ber 244 (July 2001).
The re­turns are based on the as­sump­tion that an in­di­vidu­al in­vests a fixed amount for each year in the in­vest­ment peri­od. Data are up­dated through 2015.
However, note how the “best re­turns” and “worst re­turns” con­verge as the length of the in­vest­ment peri­od in­creases.
When a thirty-five-year peri­od is con­sidered, the com­pound an­nu­al re­turn for the best thirty-five years
between 1871 and 2014 was 9.5 per­cent, com­pared to 2.7 per­cent for the worst thirty-five years.
Thus, the an­nu­al real re­turn of stocks dur­ing the worst-case scen­ario was about the same as the real re­turn for bonds.
This high and re­l­at­ively stable long-term re­turn makes stocks a par­tic­u­larly at­tract­ive meth­od of sav­ing for re­tire­ment.
The same pat­tern of vari­ance in gains fall­ing as time passes can be seen in the mar­kets of al­most every free coun­try.
(This may not ap­ply when a coun­try’s eco­nom­ic policies are con­trolled by a non-demo­crat­ic gov­ern­ment whose val­ues do not place a great deal of weight on cit­izens’ well-be­ing).
Here is the most im­port­ant takeaway from this ele­ment: Do not al­low a lack of time and ex­pert­ise to keep you out of equity in­vest­ments.
You do not have to do a lot of re­search or be a “su­per stock pick­er” in or­der to be a suc­cess­ful in­vestor.
Reg­u­lar con­tri­bu­tions into an in­dexed equity mu­tu­al fund will provide you with at­tract­ive re­turns on long-term in­vest­ments with min­im­al risk.
For most, these in­vest­ments will be an im­port­ant in­gredi­ent of a sound re­tire­ment plan.
Every large reput­able in­vest­ment firm will have sev­er­al in­dexed equity mu­tu­al funds from which to choose.
Each firm may have a slightly dif­fer­ent name for its fund,
so be sure to read the de­scrip­tion to de­term­ine the one that best fits your needs.

Element 4.10: Match the Length of Your Investments to the Timing of Your Needs

Invest in stocks for long-run objectives, but as the need for money approaches, increase the proportion of bonds or even cash.

When mak­ing long-term in­vest­ments, such as the funds al­loc­ated into a re­tire­ment plan, a stock in­dex fund is gen­er­ally your best in­vest­ment.
While the long-term re­turn of stocks is sub­stan­tially great­er than bonds, the value of the lat­ter is more stable over short time peri­ods.
As the time ap­proaches when the funds from an in­vest­ment plan may be needed,
it will make sense to shift funds to­ward in­vest­ments of more stable value.
Giv­en a five-year ho­ri­zon, pur­chas­ing a bond that ma­tures in five years, at which point you will re­ceive your ini­tial in­vest­ment plus in­terest, is a re­l­at­ively safe in­vest­ment.
As a gen­er­al pro­pos­i­tion, buy bonds that ma­ture at about the time you will need the funds, per­haps for a down pay­ment on a home or in­come dur­ing re­tire­ment.
If you aren’t sure about the tim­ing, you can spread your in­vest­ment across bonds with dif­fer­ent ma­tur­it­ies.
The risks of own­ing bonds in­clude cred­it risk (that is, the risk that you won’t get your prin­cip­al back),
unanti­cip­ated in­fla­tion, and changes in in­terest rates be­cause the gov­ern­ment is at­tempt­ing to pur­sue fisc­al policy.
If you in­vest in gov­ern­ment bonds and highest-qual­ity cor­por­ate bond funds, the greatest risk of own­ing bonds is in­fla­tion,
which lessens the value of both the prin­cip­al and the fixed-in­terest pay­ments.
However, that risk can be re­duced or elim­in­ated with the use of In­fla­tion-Pro­tec­ted Bonds,
or Ob­lig­a­tions As­sim­il­ables du Trésor (OATs) in France, which are fixed-rate Gov­ern­ment bonds in­dexed on in­fla­tion,
which means they pay a fixed in­terest rate plus com­pens­a­tion for the loss of pur­chas­ing power due to in­fla­tion.
Be­cause unanti­cip­ated in­fla­tion is one of the factors that causes the re­turn from bonds to be worth less than ex­pec­ted, buy­ing and hold­ing In­fla­tion-Pro­tec­ted Bonds will pro­tect the hold­er against that risk.
These types of bonds are par­tic­u­larly at­tract­ive for re­tir­ees seek­ing to gen­er­ate a spe­cif­ic stream of real pur­chas­ing power from their as­sets.(121)
An ad­di­tion­al risk as­so­ci­ated with bonds is the im­pact of changes in in­terest rates.
Sup­pose you buy a €1,000, thirty-year bond that pays 5 per­cent in­terest.
This bond prom­ises to pay you €50 in in­terest every year for thirty years, at which time it ma­tures and you get €1,000.
But if the over­all or gen­er­al in­terest rate in­creases to 10 per­cent soon after you buy this bond,
then your bond will im­me­di­ately fall in value to about one-half of what you paid for it.
The reas­on? At a 10 per­cent in­terest rate, an in­vestor can get €50 in in­terest every year by buy­ing a €500 bond.
So €500 is about all any­one will be will­ing to pay for your €1,000 bond.
Of course, if the in­terest rate drops to 2.5
per­cent soon after you buy your thirty-year 5 per­cent bond, then its price will ap­prox­im­ately double in value.
But this is more volat­il­ity (or risk) than you want to take if you are sav­ing for something you ex­pect to buy in five years.
If you hold the bond for the full thirty years, however, you will get back your en­tire €1,000 and the price changes that happened while you held the bond no longer mat­ter.
So this is a good reas­on to match the ma­tur­ity of the bond to when you need the money.
How long should a port­fo­lio con­sist of stocks, and when should the move to bonds be made?
That de­pends on the length of time be­fore you want to ac­cess the in­vest­ment funds.
As we sug­ges­ted above, re­l­at­ively short-term in­vest­ments may do best in bonds ex­clus­ively.
For ex­ample, a young couple sav­ing in or­der to place 20 per­cent down to buy a house or flat
may be bet­ter off avoid­ing the stock mar­ket en­tirely—for that por­tion of their sav­ings only—and in­vest­ing it in bonds. That is be­cause pur­chas­ing a house or con­domin­i­um of­ten in­volves sav­ing for just a few years.
In con­trast, a couple might save for eight­een years to fin­ance a uni­versity edu­ca­tion for a new­born or thirty-five to forty-five years to build up sav­ings for their re­tire­ment.
In these two cases, equit­ies should be an im­port­ant part of, or per­haps the en­tire, in­vest­ment fund for most of the sav­ing years.
The par­ents of a new­born who be­gin sav­ing right away for the child’s uni­versity edu­ca­tion
have more years to build wealth and to di­ver­si­fy the risk of cap­it­al­iz­ing on stocks to build it faster.
In that case, hav­ing some of that uni­versity port­fo­lio in equit­ies may make sense.
As the plunge in stock prices dur­ing the Great Re­ces­sion of 2008–2009 il­lus­trates, however, even with an eight­een-year ho­ri­zon, stock hold­ings in­volve risk.
Again, in­vestors seek­ing to re­duce risk in their uni­versity funds
can do so by hold­ing few­er stocks and more bonds, es­pe­cially as the time ap­proaches when the funds will be needed.
In­vest­ing a cer­tain amount each month has an im­port­ant role in im­prov­ing your re­turns:
If the mar­ket drops, you will be buy­ing the new stocks more cheaply, which smooths out the im­pact of the down­turn.
As people earn more and live longer, sav­ing for re­tire­ment ex­penses be­comes ever more im­port­ant.
We don’t want to drastic­ally, and neg­at­ively, al­ter our life­style upon re­tire­ment and we can­not af­ford to out­live our re­tire­ment nest eggs.
For the saver whose re­tire­ment is more than ten years ahead,
a di­ver­si­fied port­fo­lio of stocks prob­ably makes the best in­vest­ment port­fo­lio.
For the more con­ser­vat­ive saver, hav­ing 10, 20, or even 40 per­cent of one’s port­fo­lio in bonds or cash
will gen­er­ally provide more sta­bil­ity in the value of one’s re­tire­ment as­sets, even though total re­turns will prob­ably be lower in the end.
As the need for re­tire­ment in­come ap­proaches, it is prudent for all but the most wealthy among us to be­gin to switch an all-stock port­fo­lio gradu­ally into bonds.
When that switch should be­gin de­pends partly on when and how much monthly in­come is needed dur­ing re­tire­ment.
For those in­di­vidu­als with a large port­fo­lio or a good pen­sion in­come re­l­at­ive to their re­tire­ment in­come needs,
much of their sav­ings can be left longer in equit­ies to max­im­ize ex­pec­ted total re­turn.
The goal of switch­ing to bonds is primar­ily to avoid the need to sell stocks at tem­por­ar­ily low prices.
The soon­er you ex­pect to turn to your port­fo­lio to meet monthly liv­ing ex­penses,
the more im­port­ant it is to re­duce risk by mov­ing stra­tegic­ally and gradu­ally into bonds.
In many coun­tries, sav­ing for re­tire­ment is pro­tec­ted from some in­come taxes, al­low­ing your sav­ings to grow faster.
For ex­ample, in Ukraine, con­tri­bu­tions to non-state pen­sion funds are de­duct­ible from gross in­come up to 15% of the per­son’s salary,
and in­vest­ment re­turn is not taxed, so the total ac­cu­mu­lates faster.(122)
Lower taxes are a way gov­ern­ments can en­cour­age cit­izens to save for re­tire­ment;
some coun­tries, such as Bul­garia, even ex­empt sav­ings, re­turns, and dis­tri­bu­tions from private pen­sion funds from all taxes.(123)
While some CEE coun­tries do not have private pen­sion in­vest­ments avail­able yet,
there is a glob­al trend to in­crease vol­un­tary pen­sion con­tri­bu­tions through tax in­cent­ives.
If you can’t ac­cess tax-ad­vant­aged private re­tire­ment ac­counts, con­tin­ue to save;
that way, when the ac­counts be­come avail­able, you will be able to save the max­im­um al­lowed amount each year.
So far we have talked about risks from the fin­an­cial mar­ket,
but there is an­oth­er, per­haps much more im­port­ant risk in sav­ing for re­tire­ment.
No one knows for sure how much longer they will live.
All we know is the av­er­age life ex­pect­ancy (per­haps ad­jus­ted for past be­ha­vi­or such as smoking or drink­ing).
In Po­land or the Czech Re­pub­lic, a 60 year old can ex­pect to live for an­oth­er 21 years,
but some will die next year and some will live to be 100.
How do you plan for such un­cer­tainty? One pos­sib­il­ity would be to save as much as you might need if you lived a very long life.
Then, if you died soon­er, ar­range to leave your sav­ings to your fam­ily or a worthy char­ity (per­haps sup­port­ing eco­nom­ic edu­ca­tion!).
Most risk-averse people, however, choose an­oth­er op­tion.
While it is im­possible to know how long any giv­en in­di­vidu­al will live,
demo­graph­ers can pre­dict very ac­cur­ately the av­er­age re­main­ing life among any group.
Just like oth­er types of in­sur­ance dis­cussed in Ele­ment 4.12, you can in­sure your­self against liv­ing “too long.”
Since ac­tu­ar­ies can pre­cisely pre­dict how long the av­er­age mem­ber of a group will live,
why not just pool every­one’s sav­ings and let those who die soon sub­sid­ize those who live longer?
Such an agree­ment is called an “an­nu­ity.”
Our ad­vice to those seek­ing to pre­pare for fu­ture re­tire­ment can be summed up this way: start sav­ing for re­tire­ment early,
stay with di­ver­si­fied port­fo­li­os of stocks un­til the need for funds is near enough in time to jus­ti­fy gradu­al shifts to­ward lower-risk, lower-re­turn as­sets such as bonds,
and take ad­vant­age of any fa­vor­able tax treat­ment provided for re­tire­ment plans.
There are many things to watch out for in de­cid­ing how and where to in­vest. You should keep these warn­ings in mind.

Element 4.11: Reduce Your Risks

Take steps that will reduce risk when making housing, education, and other investment decisions.

The pur­chase of hous­ing is one of the most im­port­ant de­cisions most of us will con­front dur­ing our life­time.
For most, a home pur­chase will be their largest in­vest­ment, at least ini­tially.
Buy­ing a home you can af­ford in a de­sir­able loc­a­tion and keep­ing it well main­tained can be a good in­vest­ment.
But, as is il­lus­trated by the housing crisis of 2008–2009 in the United States, there are po­ten­tial pit­falls.
Ex­am­in­a­tion of the fol­low­ing factors will help you avoid the worst prob­lems.
First, care­fully con­sider the “own versus rent” op­tion.
Many people im­me­di­ately con­clude that pur­chas­ing is a bet­ter op­tion than rent­ing be­cause pur­chas­ing can build equity.
They reas­on that their money is wasted on rent go­ing into the land­lord’s pock­et when it could be put to work cre­at­ing equity,
help­ing to build the homeown­er’s net worth as the mort­gage is paid off and the mar­ket value of the prop­erty ap­pre­ci­ates.
Dur­ing the first few years of a mort­gage, however, al­most all of the monthly pay­ment is for in­terest and very little is ac­tu­ally build­ing equity.
So if you sell the home with­in three years, for ex­ample, you will have ac­cu­mu­lated little or no equity.
You’ve simply paid the bank in­terest in­stead of pay­ing rent to a land­lord.
Second, buy­ing and selling real es­tate is ex­pens­ive and there­fore it is not a good idea to pur­chase a house un­less you ex­pect to live in it at least three years. You will need to pay realtor commissions plus VAT levied on com­mis­sions, which vary across coun­tries (in Aus­tria, 3 per­cent: Croa­tia, 3 per­cent; Italy, up to 7 per­cent).(124)
Clos­ing costs on a mort­gage are typ­ic­ally sev­er­al thou­sand dol­lars.
If you sell the house with­in a few years after the ini­tial pur­chase, the trans­ac­tion costs are likely to be great­er than your equity.
Third, do not buy a house (or flat) un­til you have saved for a down pay­ment.
In the United States, this should be at least 20 per­cent. If your down pay­ment is less than 20 per­cent, you will have to pay mort­gage in­sur­ance, also called lenders mort­gage in­sur­ance or mort­gage in­dem­nity in­sur­ance,
which in­creases your monthly pay­ment.
Mort­gage in­sur­ance pro­tects the lender from losses that oc­cur when a per­son de­faults on pay­ments.
It is com­mon in coun­tries in­clud­ing the United King­dom., Den­mark, and Aus­tralia.
Dif­fer­ent coun­tries have dif­fer­ent rules about this, so be sure you know what you might have to pay.(125)
Also, do not use a mort­gage with a low ini­tial “teas­er in­terest rate” to pur­chase your home.
These rates are fol­lowed by sharply es­cal­at­ing in­terest rates, which will sub­stan­tially in­crease your monthly mort­gage pay­ment after the ini­tial peri­od has ex­pired.
And, as men­tioned pre­vi­ously in Ele­ment 4.4, don’t bor­row in a cur­rency that is dif­fer­ent from your in­come,
be­cause if your in­come cur­rency drops in value, you could owe a lot more money than you ex­pec­ted.
Fourth, just be­cause you can af­ford a mort­gage pay­ment doesn’t mean you can af­ford the dwell­ing you are con­sid­er­ing.
The mort­gage is only the first and most ob­vi­ous pay­ment made each month. Hous­ing, however, re­quires oth­er reg­u­lar pay­ments and ob­lig­a­tions that you need to con­sider.
If they are not in­cluded in the mort­gage, prop­erty and/or land taxes must be paid. Homeown­er’s in­sur­ance is re­quired.
The roof may leak one day, the hot wa­ter heat­er, the air con­di­tion­ing unit or plumb­ing sys­tem may need re­pair, or any num­ber of oth­er items may res­ult in main­ten­ance costs.
These are all reg­u­lar ex­penses you can ex­pect as a homeown­er.
You need to factor them into your monthly budget when ex­amin­ing wheth­er home own­er­ship makes sense for you.
Lastly, as you build up equity in your home,
do not give in to the tempta­tion to take out an­oth­er mort­gage or bor­row against your equity in or­der to in­crease your cur­rent con­sump­tion.
Hous­ing prices go down as well as up. After the hous­ing crisis of 2008–2009 in the United States, many people were “up­side down” or “un­der wa­ter” with their hous­ing.
That is, the ap­praised value of their home was less than the out­stand­ing mort­gage. Some people in­curred huge losses when they sold their home.
Oth­ers simply couldn’t af­ford to sell at a loss and kept the home, hop­ing for a mar­ket re­bound.
Still oth­ers went through the pain­ful pro­cess of bank­ruptcy or fore­clos­ure.
Thus, safety dic­tates that it is im­port­ant to main­tain a size­able equity in your home.
Liv­ing by the guidelines presen­ted above will en­cour­age you to live with­in your means,
eco­nom­ize on hous­ing, and min­im­ize the risks in­volved in hous­ing de­cisions. Now, let’s turn to in­vest­ments in edu­ca­tion.
For many people, post­sec­ond­ary edu­ca­tion—that is, edu­ca­tion bey­ond sec­ond­ary school—provides an at­tract­ive in­vest­ment op­por­tun­ity be­cause it can lead to a high­er salary.
It is not, however, for every­one. Go­ing to uni­versity or col­lege is costly.
If a stu­dent in­curs the time and money cost of go­ing to uni­versity for a couple of years, then drops out without a dip­loma, the in­vest­ment is un­likely to be a prof­it­able one.
The biggest risk for a stu­dent con­sid­er­ing post­sec­ond­ary edu­ca­tion is the pos­sib­il­ity of a neg­at­ive re­turn on his or her in­vest­ment.
This would oc­cur if the high­er earn­ings achieved from the edu­ca­tion are less than the costs in­volved in ob­tain­ing the edu­ca­tion.
Even if tu­ition is sub­sid­ized (or fully paid) by the gov­ern­ment,
liv­ing ex­penses of­ten ex­ceed any grants to stu­dents and no one will re­im­burse the in­come lost from work­ing less while in school.
Ac­cord­ing to the Stat­ist­ic­al Of­fice Of The European Com­munit­ies (Euro­stat),
the me­di­an an­nu­al earn­ings in 2016 for work­ers hold­ing ter­tiary edu­ca­tion were over €10,000 high­er than for those who had only a lower sec­ond­ary edu­ca­tion
(in Croa­tia the dif­fer­ence is €4,000; in Ro­mania, €3,000; in Po­land, €4,000).(126)
But there is sub­stan­tial vari­ation in the earn­ings of uni­versity gradu­ates.
The ac­tu­al earn­ings after gradu­ation de­pend on many factors, in­clud­ing the skills ac­quired,
uni­versity ma­jor, and the over­all de­mand and sup­ply con­di­tions of a par­tic­u­lar labor mar­ket.
Ac­cord­ing to PayScale.com, which has com­piled the world’s largest data­base of salary pro­files,
the uni­versity ma­jors with the highest earn­ings po­ten­tial in­clude en­gin­eer­ing, ac­tu­ar­ial, and ap­plied math­em­at­ics,
com­puter sci­ence, phys­ics, stat­ist­ics, eco­nom­ics, and man­age­ment in­form­a­tion sys­tems.
Ma­jors with low earn­ings po­ten­tial in­clude child and fam­ily stud­ies, edu­ca­tion, so­cial work, ex­er­cise sci­ence, ath­let­ic train­ing, mu­sic, and culin­ary arts.(127)
When choos­ing a field of study, it is im­port­ant to look bey­ond earn­ings you see around you. You will have 40 or more years to work.
What oc­cu­pa­tions will be in de­mand 20 years from now? You also need to think about wheth­er you might de­cide to move some­where else.
Will the cre­den­tials you earned in your home coun­try be re­cog­nized where you end up?
An eco­nom­ist trained in Rus­sia can get a job at a Ca­na­dian uni­versity (if she is good enough),
but a phys­i­cian may have to un­der­go many ad­di­tion­al years of train­ing be­fore she can prac­tice.
It is risky to bor­row a large sum of money to fin­ance an edu­ca­tion ex­pec­ted to res­ult in low fu­ture earn­ings.
As we in­dic­ated in Part 4, Ele­ments 1 and 2, it is im­port­ant to choose a work activ­ity that you en­joy. Your choice, however, needs to be well in­formed.
Search for and dis­cov­er the ex­pec­ted earn­ings in the oc­cu­pa­tions for which you are train­ing.
We want you to make in­formed choices that will lead to the largest pos­sible re­turn on your edu­ca­tion­al in­vest­ment—
in­clud­ing the per­son­al sat­is­fac­tion you de­rive from the em­ploy­ment.
Let’s con­sider why stu­dents some­times choose edu­ca­tion­al op­tions that res­ult in neg­at­ive re­turns.
First, many stu­dents have un­real­ist­ic ex­pect­a­tions about fu­ture in­come.
With in­flated ex­pect­a­tions, they may be will­ing to pay more for their edu­ca­tion than what their fu­ture in­come can sup­port.
You should in­vest­ig­ate re­sources to keep in­formed of cur­rent and pre­dicted fu­ture labor mar­ket con­di­tions and earn­ings po­ten­tial.
You need to search for the hand­books or stat­ist­ics for your coun­try and those
to which you might pos­sibly mi­grate, which provide in­form­a­tion on main oc­cu­pa­tions, in­clud­ing their re­quire­ments, job out­look and growth pro­spects, and me­di­an pay.
Hav­ing real­ist­ic ex­pect­a­tions about fu­ture in­come is a vi­tal in­gredi­ent in mak­ing bet­ter de­cisions about post­sec­ond­ary edu­ca­tion.
In the con­text of pos­sible mi­gra­tion, it is also im­port­ant to start at an early age learn­ing use­ful lan­guages.
Do you want your op­tions to in­clude Eng­lish-speak­ing coun­tries or French-speak­ing ones? Might you find your cre­den­tials more eas­ily ac­cep­ted in Rus­sia?
Second, many stu­dents un­der­es­tim­ate the cost of edu­ca­tion.
The total cost of edu­ca­tion in­cludes the dir­ect cost of tu­ition, books, fees, and room and board, but don’t for­get about op­por­tun­ity costs.
Go­ing to school, even part-time, means giv­ing up cur­rent in­come from a job.
Make sure to prop­erly ac­count for the total cost of edu­ca­tion.
Third, stu­dents over­use debt. Some view the money provided in a stu­dent loan as “free money” and bor­row too much.
Many young people are ill pre­pared to judge
how dif­fi­cult it will be to squeeze the funds for re­pay­ment of stu­dent loans out of their monthly budget after gradu­ation.
As­sum­ing a 3 per­cent in­terest rate, you will pay €138 per month for fif­teen years to re­pay €20,000 in loans.
You will pay €276 per month to re­pay €40,000. Will your fu­ture earn­ings be suf­fi­cient to make the monthly pay­ment on your loans taken to fin­ance edu­ca­tion, with­in the con­text of your over­all budget?
Think ser­i­ously about this is­sue pri­or to tak­ing out a loan.
We are not say­ing that you should nev­er bor­row to fin­ance edu­ca­tion. There are times when this op­tion makes sense.
We are aware that edu­ca­tion is fin­anced in many dif­fer­ent ways in dif­fer­ent coun­tries
and that, in the past at least, tu­ition forms a high­er frac­tion of costs in the United States than in many oth­er coun­tries.
This is rap­idly chan­ging in trans­ition coun­tries, however,
with the rise of private uni­versit­ies and the shift in many coun­tries away from dir­ect gov­ern­ment fund­ing to tu­ition-based fin­ance of uni­versit­ies.
Col­lege edu­ca­tion is of­ten a good in­vest­ment, but like all in­vest­ments it should be ex­amined care­fully.
To fur­ther min­im­ize edu­ca­tion risks, stu­dents and their par­ents can pur­sue oth­er op­tions to fin­ance edu­ca­tion.
As a gen­er­al guideline, de­vel­op a fin­an­cial plan that has debt as the last op­tion.
Par­ents, re­l­at­ives, and friends can start their own sav­ings plans or con­sider the re­l­at­ive be­ne­fits of long-term sav­ing in dif­fer­ent forms in fin­an­cial in­sti­tu­tions.
Schol­ar­ships and grants are also avail­able. They are par­tic­u­larly at­tract­ive be­cause they do not have to be re­paid.
The United States’ Cul­tur­al Cen­ters, the of­fices of the Brit­ish Coun­cil, or the In­sti­tut Français are good places to start in­vest­ig­at­ing op­por­tun­it­ies abroad.
Make time to search for them. Each will have a spe­cif­ic set of in­struc­tions, eli­gib­il­ity re­quire­ments, and dead­lines.
Factor all of these op­tions into your de­cision to in­vest in edu­ca­tion and choose a path that makes sense for you giv­en mar­ket con­sid­er­a­tions.
While hous­ing and edu­ca­tion are likely to be the largest in­vest­ments you’ll make, oth­er in­vest­ment op­por­tun­it­ies will emerge.
There are pre­cau­tions to take when con­sid­er­ing which ones to seize. It is im­port­ant to re­cog­nize that when mak­ing in­vest­ments, you are vul­ner­able;
you must think about wheth­er your in­terests are aligned with the party of­fer­ing the in­vest­ment.
Whenev­er you are offered something that seems to be an ex­tremely at­tract­ive pro­pos­i­tion, it pays to step back and care­fully ex­am­ine the motives be­hind why this pro­pos­i­tion is be­ing presen­ted to you.
Bor­row­ers look­ing for money to fin­ance a pro­ject will ini­tially turn to low-cost sources such as bank loans.
Find­ing in­di­vidu­al in­vestors like you and prom­ising a high rate of re­turn makes no sense if fin­an­cing is avail­able from bank lenders and oth­er in­vest­ment spe­cial­ists.
High po­ten­tial re­turns on any in­vest­ment in­ev­it­ably come with high risk; that is, there is a high prob­ab­il­ity of fail­ure.
If banks and pro­fes­sion­al in­vestors are not in­ter­ested in the in­vest­ment, you should ask your­self, “Why should I be?”
The in­terests of those selling in­vest­ment al­tern­at­ives are of­ten sub­stan­tially dif­fer­ent than yours. While you want to earn an at­tract­ive re­turn,
they are likely to be primar­ily in­ter­ested in the com­mis­sion on the sale or earn­ings de­rived from man­age­ment fees or a high salary re­lated to the busi­ness ven­ture.
Put bluntly, their primary in­terest is served by get­ting their hands on your money.
They do not ne­ces­sar­ily seek to de­fraud you.
They may well be­lieve that the in­vest­ment is a genu­ine op­por­tun­ity with sub­stan­tial earn­ing po­ten­tial.
But no mat­ter how nice they are, how well you know them, or how much it ap­pears that they want to help you, their in­terests are dif­fer­ent from yours.
Moreover, once they have your money, you will be in a weak po­s­i­tion to al­ter the situ­ation.
How can you tell be­fore­hand wheth­er an in­vest­ment is a wise one?
There is no “sil­ver bul­let” that can as­sure pos­it­ive res­ults from all in­vest­ment de­cisions.
But there are things you can do that will help you avoid in­vest­ment dis­asters cost­ing you tens of thou­sands of dol­lars
(or the equi­val­ent in your loc­al cur­rency). The fol­low­ing six guidelines are par­tic­u­larly im­port­ant.
  1. If it looks too good to be true, it prob­ably is. This is an old cliché, but a val­id one.
    Some in­vest­ment mar­keters may be will­ing to do just about any­thing to ob­tain your money be­cause, once they do, they are in charge and you are vul­ner­able.
  2. Deal only with parties that have a repu­ta­tion to pro­tect.
    Es­tab­lished com­pan­ies with a sol­id repu­ta­tion will be re­luct­ant to dir­ect their cli­ents into un­sound in­vest­ments.
    For ex­ample, an ini­tial pub­lic stock of­fer­ing by an up­start broker­age firm with which only a few are fa­mil­i­ar is far more likely to res­ult in loss
    than the of­fer­ing of an es­tab­lished firm with a sub­stan­tial repu­ta­tion on the line.
  3. Nev­er pur­chase an in­vest­ment so­li­cited by tele­phone or e-mail. Such mar­ket­ing is a tech­nique used by those look­ing to prey on those in­di­vidu­als who are easy tar­gets.
    Do not let your­self be a vic­tim of scams. Nev­er share per­son­al in­form­a­tion with people you do not ex­pli­citly trust.
    Your so­cial se­cur­ity num­ber, date of birth, cell phone num­ber, and postal ad­dress should be care­fully guarded.
  4. Do not al­low your­self to be forced into a quick de­cision.
    Take time to de­vel­op an in­vest­ment strategy. Nev­er let your­self be pres­sured into a hasty de­cision.
  5. Do not al­low friend­ship to in­flu­ence an in­vest­ment de­cision. Nu­mer­ous people have been dir­ec­ted into bad in­vest­ments by their friends.
    If you want to keep a per­son as your friend, in­vest your money with an ob­ject­ive third party.
  6. If high-pres­sure mar­ket­ing is in­volved, grab your check­book and run.
    At­tract­ive in­vest­ments are sold without the use of high-pres­sure mar­ket­ing tech­niques.
    If you already have a sub­stan­tial port­fo­lio, there may be a place in it for high-risk in­vest­ments, in­clud­ing “junk” bonds and pre­cious metals.
    But those in­vest­ments must come from funds that you can af­ford to lose. If you are look­ing for a sound way to build wealth, most of your funds should be in more routine lower-risk in­vest­ments help­ing you es­tab­lish a well-di­ver­si­fied port­fo­lio.
For as long as money has ex­is­ted, people have schemed to take it away from each oth­er by fraud.
New products and fast-mov­ing mar­kets are tempt­ing to in­vest­ment fraud­sters—for ex­ample, there are many bit­coin frauds.
In some cases they of­fer a free bit­coin giveaway for a small re­gis­tra­tion fee.
Oth­er scams set up fake bit­coin ex­changes, and of­fer very com­pet­it­ive prices which lull in­vestors into think­ing they are get­ting a good deal.(128)
It is im­port­ant to edu­cate your­self about how to spot fraud­sters; Rule 3 above is a good start­ing point.
We have dis­cussed fraud ex­tens­ively, but even trans­ac­tions that are le­git­im­ate in a leg­al sense may be very bad in­vest­ments.
His­tory is full of “bubbles” when ir­ra­tion­al think­ing that the price of something that has gone up a lot is bound to con­tin­ue to do so has had dis­astrous res­ults.
In the early 1600s, spec­u­lat­ors in Hol­land drove the price of a single tulip bulb to over six times av­er­age an­nu­al in­comes.
A per­haps apo­cryph­al story tells of the des­pair of a man who came home and found
that his cook, not fa­mil­i­ar with the tulip, thought it was a new kind of onion and put it in that even­ing’s soup.
Few bubbles could match the tech­no­logy stock bubble of the 1990s. The in­tro­duc­tion of the In­ter­net triggered a massive wave of spec­u­la­tion in “New Eco­nomy” busi­nesses,
and as a res­ult, hun­dreds of dot-com com­pan­ies achieved multi-bil­lion dol­lar valu­ations as soon as they went pub­lic.
The United States NAS­DAQ Com­pos­ite, the ex­change where most of these dot-com com­pan­ies were traded,
soared from a level of un­der 500 at the be­gin­ning of 1990 to a peak of over 5,000 in March 2000.
The in­dex crashed shortly there­after, plunging nearly 80% by Oc­to­ber 2002 and trig­ger­ing a United States re­ces­sion.
In­vest­ments need to be based on an as­set’s real use­ful value, not an un­jus­ti­fied as­sump­tion about the fu­ture.

Element 4.12: Use Insurance to Protect Yourself

Teach­er point­ing at the writ­ing on a white­board, which reads: “Es­sen­tials of Risk Man­age­ment: 1. Don’t do any­thing wrong today. 2. Don’t do any­thing wrong to­mor­row. 3. Re­peat.”
Life in­volves risks. The risks of life range from the small and fin­an­cially in­sig­ni­fic­ant, like re­ceiv­ing poor ser­vice at a res­taur­ant,
to the large and fin­an­cially dev­ast­at­ing, such as a severe ill­ness or hav­ing your home des­troyed by a tor­nado.
While you can­not elim­in­ate risk, you can take steps to re­duce and man­age it.
You can make choices that will re­duce risks. Not tex­ting while driv­ing re­duces the chance of be­ing in­volved in an ac­ci­dent.
Wear­ing a seat­belt lowers the chance of in­jury if you are in­volved in a col­li­sion.
In­stalling smoke de­tect­ors and a se­cur­ity sys­tem de­creases the like­li­hood of your res­id­ence burn­ing down or get­ting burg­lar­ized.
De­creas­ing sug­ar con­sump­tion and eat­ing low-cho­les­ter­ol foods re­duce the chance of ill­ness and dis­ease.
While your choices can re­duce risk, it can nev­er be totally elim­in­ated.
How can you man­age risk and pro­tect your­self from the most ad­verse con­sequences?
In­sur­ance can re­duce the fin­an­cial loss res­ult­ing from dam­ages to pos­ses­sions
(such as your home or car), an ill­ness, loss of in­come, or oth­er harm­ful events.
In­sur­ance provides a way for a group of people to pool pay­ments
and share risks in or­der to off­set the losses of mem­bers ac­tu­ally dam­aged by an ad­verse event.
The prin­ciple of shar­ing risk is of­ten for­got­ten be­cause in­di­vidu­als pay premi­ums to an in­sur­ance com­pany and have no in­ter­ac­tion with the group mem­bers.
The in­sur­ance com­pany is an in­ter­me­di­ary, or middle­man, in the risk-shar­ing pro­cess.
The com­pany col­lects premi­ums from each mem­ber of the group (its poli­cy­hold­ers), then dis­burses pay­ments when a covered loss oc­curs.
To un­der­stand how risk shar­ing works, ima­gine the fol­low­ing situ­ation.
You and four as­so­ci­ates go to a res­taur­ant for lunch and ex­pect that the total bill will be €100.
The five of you agree to in­struct the wait­ress to ran­domly give the check to one of you at the end of the meal and that per­son will pay the en­tire amount. You and the oth­er group mem­bers can then choose between two op­tions:
(1) take a chance, and hope you are not se­lec­ted to pay the €100 bill;
or (2) pay a premi­um of €20 to an in­surer, who will pay the €100 bill if you are se­lec­ted.
Many people will prefer op­tion 2 be­cause it is less risky.
While you have to pay the €20 premi­um, you pro­tect your­self against the 20 per­cent pos­sib­il­ity of hav­ing to pay the en­tire €100 bill.
Of course, in­surers provid­ing the risk-shar­ing ser­vice in­cur costs.
They will have to as­sess risks, form­al­ize agree­ments, col­lect premi­ums, ex­am­ine and val­id­ate claims, and pro­cess pay­ments.
These hand­ling and pro­cessing costs will have to be covered, in ad­di­tion to the costs of the risk.
Thus, the in­sur­ance premi­ums will have to be some­what high­er than the ex­pec­ted costs of the loss.
For ex­ample, if an in­sur­ance com­pany were go­ing to provide mem­bers of our lunch group with pro­tec­tion against the 20 per­cent chance they might end up with the €100 bill,
it would have to charge each a little more than €20, per­haps €22, in or­der to have an in­cent­ive to of­fer the ser­vice.
In­sur­ance re­duces risk be­cause it spreads the bur­den of un­for­tu­nate events that a few people ex­per­i­ence over a lar­ger group of people.
In the lunch situ­ation, the €100 bill is com­ing with cer­tainty.
The un­cer­tainty comes from not know­ing which mem­ber of the group will re­ceive it.
A lar­ger group will in­crease the amount of the po­ten­tial loss, but it will also re­duce the chance of any in­di­vidu­al mem­ber re­ceiv­ing the bill.
When it comes to large sums, most of us are risk-averse.
That means we are will­ing to pay a premi­um in or­der to re­duce the ad­verse con­sequences of vari­ous events.
Buy­ing in­sur­ance is one way of re­du­cing ex­pos­ure to risks.
An easy way to see why this is so is to ask your­self if you would ac­cept a bet that paid you €1,000 if a fair coin(129) came up heads but would make you pay €1,000 if tails came up.
Most of us would not take such a bet even though it is “fair” in cur­rency terms. Why not?
You must value the things you would have to give up (not pur­chase) if you lost the bet more than you value those you would buy if you won. This is clear be­cause without the bet you chose the first group over the second one.
In­sur­ance, however, is not al­ways cost-ef­fect­ive. You should think care­fully about wheth­er it makes sense for you to in­sure against a risk.
Yes, you should in­sure against events that, if they oc­cur, will im­pose severe fin­an­cial hard­ship.
A severe ill­ness that pre­vents you from work­ing for an ex­ten­ded peri­od of time, a car ac­ci­dent, or a flood that dam­ages your home are ex­amples.
In­sur­ing against re­l­at­ively small ad­verse events such as a break­down of an ap­pli­ance or tele­vi­sion is gen­er­ally not cost-ef­fect­ive.
Provid­ing the risk-shar­ing ser­vice will be ex­pens­ive re­l­at­ive to the po­ten­tial harm.
Thus, it will gen­er­ally be more eco­nom­ic­al to ac­cept these risks and use a rainy day ac­count (see Part 4, Ele­ment 6) to plan for and cov­er the cost of these risks.
In con­trast, auto­mobile, hous­ing, and health­care in­sur­ance are usu­ally cost-ef­fect­ive.
In these cases, the cost of spread­ing the risks over a group of people is gen­er­ally low re­l­at­ive to the po­ten­tial dam­ages of an ad­verse event. We now turn to those top­ics.
Many coun­tries re­quire car own­ers to main­tain some level of auto­mobile in­sur­ance.
Make sure to check with your in­sur­ance com­pany so that you meet the min­im­um re­quire­ments.
Cus­tom­ers will pay a premi­um based on a num­ber of factors.
Those in­clude the driver’s re­cord, char­ac­ter­ist­ics of the driver, the type of auto­mobile,
and the spe­cif­ic cov­er­age lim­its and de­duct­ibles of the policy.
A de­duct­ible is the amount the cus­tom­er must pay first be­fore any in­sur­ance cov­er­age ap­plies.
For ex­ample, a €500 de­duct­ible means the cus­tom­er must pay €500 be­fore the in­sur­ance policy will pay for a loss.
Gen­er­ally, the high­er the de­duct­ible, the lower the premi­um.
Cov­er­age is the max­im­um amount the policy will pay in the event of a loss.
An auto policy is typ­ic­ally struc­tured with a few ba­sic cov­er­ages, or types of loss. Col­li­sion pays for dam­ages to your car in the event of an ac­ci­dent.
Com­pre­hens­ive pays for non-col­li­sion dam­ages such as theft, van­dal­ism, and acts of nature like a tree branch fall­ing on your wind­shield.
Li­ab­il­ity cov­er­age, some­times known as Mo­tor Third-Party Li­ab­il­ity (MTPL), comes in two forms.
First, it pays oth­ers for dam­ages to their per­son or vehicle caused by the op­er­a­tion of your auto­mobile.
Second, it pays dam­ages to you and your pas­sen­gers for med­ic­al ex­penses and death be­ne­fits.
For ex­ample, li­ab­il­ity cov­er­age of €500,000 means the most the in­sur­ance will pay in the event of a loss is €500,000, even if the ac­tu­al loss is great­er.
When pur­chas­ing in­sur­ance, you should con­sider care­fully the size of your cov­er­age lim­its and de­duct­ible levels.
Do you have enough in your emer­gency ac­count or oth­er funds to pay the de­duct­ible?
As dis­cussed in Part 4, Ele­ment 11, hous­ing is the largest in­vest­ment most people will make.
It makes sense to in­sure against the loss of your biggest as­set.
Some­times it is re­quired to have some level of in­sur­ance, man­dated by coun­try reg­u­la­tions or the fin­an­cial in­sti­tu­tion hold­ing a mort­gage that fin­anced your pur­chase.
Make sure to con­sult with your in­sur­ance com­pany so that you are meet­ing the re­quired min­im­um stand­ards.
Sim­il­ar to auto policies, hous­ing in­sur­ance will have de­duct­ibles and cov­er­age lim­its.
As in the case of auto in­sur­ance, if you choose a high­er de­duct­ible, your premi­ums will gen­er­ally be lower.
You should care­fully ana­lyze how much risk to bear your­self.
Health­care in­sur­ance var­ies a lot by coun­try,
and can be a com­plic­ated is­sue be­cause of the fin­an­cing and pay­ment meth­ods for cus­tom­ers and the vari­ety of plans avail­able.
Some people are in­sured by their coun­try’s gov­ern­ment, and they may or may not be able to choose ad­di­tion­al private cov­er­age. Some people ob­tain their in­sur­ance through their em­ploy­er while oth­ers buy dir­ectly from an in­sur­ance com­pany.
Some people pay all of their premi­ums while oth­ers have third parties pay (for ex­ample, the gov­ern­ment or em­ploy­er).
Plans vary, de­pend­ing on who pays and what is covered.
In the United States, the Patient Protection and Affordable Care Act, en­acted by Con­gress in 2010, ad­ded fur­ther com­plex­ity by man­dat­ing broad­er cov­er­age and im­ple­ment­ing a sys­tem of taxes, pen­al­ties, and sub­sidies.
In oth­er coun­tries, there is com­plete gov­ern­ment con­trol of the health­care sys­tem.
The com­plex­it­ies sur­round­ing health­care in­sur­ance and in­ter­na­tion­al com­par­is­ons of sys­tems are bey­ond the scope of this book,
but we want to make a few prin­ciples clear.
The pay­ments made for health­care in­sur­ance come in four forms.
First, premi­ums (or taxes) are paid to ob­tain the cov­er­age offered by the plan. Second, a de­duct­ible may ap­ply.
Third, there is the co­pay, which is a fee for a par­tic­u­lar ser­vice such as a doc­tor of­fice vis­it or pre­scrip­tion.
Fourth, coin­sur­ance is the per­cent of the med­ic­al bill the cus­tom­er must pay.
For ex­ample, a plan may re­quire the cus­tom­er to pay 20 per­cent of the bill for a hos­pit­al stay or med­ic­al pro­ced­ure.
In some coun­tries, sup­ple­ment­ary private in­sur­ance is avail­able to cov­er the co­pay or the coin­sur­ance.
There are cir­cum­stances where hav­ing in­sur­ance pro­tec­tion ac­tu­ally in­creases risk. This is known as mor­al haz­ard. Con­sider the fol­low­ing scen­ari­os.
Rachel trades in her twelve-year-old car and buys the most re­cent mod­el,
which has all the latest tech­no­lo­gic­al ad­vances and safety devices.
Since Rachel feels safer in the new car, she might ac­tu­ally drive a little less care­fully
know­ing that her chance of be­com­ing in­jured in a col­li­sion is less be­cause of the safety devices.
Jac­ob’s moth­er in­sists he wears a hel­met, knee and el­bow pads, and long pants when he rides his skate­board.
Em­boldened with a sense of se­cur­ity and pro­tec­tion, Jac­ob might at­tempt more dan­ger­ous jumps and man­euvers on his skate­board, know­ing that an in­jury is less likely.
Ivanka has not skied for sev­er­al years and is not sure how much she re­mem­bers.
With full health in­sur­ance to cov­er her broken bones, she might dare to chal­lenge the Black Dia­mond slopes.
Without in­sur­ance, she might de­cide to stick with the Blue runs.
Un­der each of these scen­ari­os, the risk in­creases be­cause of the change in be­ha­vi­or from feel­ing safer.
Oth­er types of in­sur­ance to con­sider, but not covered here, in­clude life, dis­ab­il­ity, and long-term care.
The need for these (or any type of in­sur­ance) is highly de­pend­ent on the so­cial pro­tec­tion policies of in­di­vidu­al coun­tries.
It is im­possible in a gen­er­al in­terest book to of­fer ap­pro­pri­ate ad­vice for each in­di­vidu­al’s situ­ation.
What we can say is that it is a wise policy to ex­am­ine your own situ­ation care­fully
and not merely to as­sume that “everything will be fine.”
After eval­u­at­ing your per­son­al choices that de­term­ine the level of risk in your life, care­fully ana­lyze the risks you can­not avoid but can re­duce through the ef­fect­ive use of in­sur­ance.
It makes sense to in­sure against risks with large po­ten­tial ad­verse ef­fects, but when the po­ten­tial fin­an­cial dam­ages are small,
it is gen­er­ally best to either ab­sorb their cost in your monthly budget or cov­er them with funds from your emer­gency sav­ings.
The most im­port­ant ob­ject­ive of an in­sur­ance strategy is to pre­vent dev­ast­at­ing fin­an­cial losses.
While in­sur­ance is gen­er­ally as­so­ci­ated with middle or high-in­come coun­tries and fam­il­ies,
it is usu­ally the poor who have the most to gain when they can find ap­pro­pri­ate in­sur­ance products. Many such products are cur­rently be­ing de­veloped.

Part 4 Final Thoughts

Smart fin­an­cial man­age­ment may seem com­plex, but the rules out­lined above should start you think­ing in the right dir­ec­tion.
It’s not really that com­plex. Save and spend wisely. Think be­fore you act.
Do act—it is easy to ig­nore think­ing about your fin­ances
when there al­ways seem to be more press­ing is­sues or work, fam­ily and fun.
Set aside a reg­u­lar time to re­view your situ­ation, with your part­ner if you have one.
Most of all, re­mem­ber the ad­vice of Mr. Micaw­ber, from Charles Dick­ens’ nov­el Dav­id Cop­per­field:
“An­nu­al in­come twenty pounds, an­nu­al ex­pendit­ure nine­teen and six, res­ult hap­pi­ness.
An­nu­al in­come twenty pounds, an­nu­al ex­pendit­ure twenty pounds ought and six, res­ult misery.”

Concluding Thoughts and Acknowledgments

Concluding Thoughts

Be­sides be­ing eco­nom­ists and edu­cat­ors, all of the au­thors are also par­ents, aunts, and uncles.
In ad­di­tion to leav­ing a leg­acy of know­ledge to our stu­dents and oth­er read­ers of this book,
we wish to pos­it­ively in­flu­ence the lives of fu­ture gen­er­a­tions. We are sure that you feel the same way.
We ac­com­plish this goal in many dif­fer­ent ways. At the loc­al, na­tion­al, and glob­al level we can work to en­sure
that pub­lic policies cre­ate an en­vir­on­ment where in­di­vidu­als can achieve their po­ten­tial.
At a per­son­al level we can seek to in­grain habits of suc­cess by serving as role mod­els and guid­ing our chil­dren to make sound choices.
As we have seen in this sec­tion of Com­mon Sense Eco­nom­ics, fin­an­cial se­cur­ity tends to el­ev­ate gen­er­al well-be­ing
by mak­ing ne­ces­sit­ies at­tain­able and elim­in­at­ing worry about ful­filling ba­sic needs.
Those who de­vel­op the habits of work­ing di­li­gently, set­ting goals and achiev­ing them, and avoid­ing the tempta­tions of in­stant grat­i­fic­a­tion by con­sid­er­ing the fu­ture con­sequences of cur­rent choices
are typ­ic­ally more suc­cess­ful in all walks of life than those who do not.
One of the most im­port­ant ways to teach young people re­spons­ib­il­ity is by help­ing them un­der­stand that money is earned; it is not manna from heav­en.
Chil­dren can, even at an early age, be em­powered by set­ting tasks that en­able them to earn the money to meet their de­sires.
These tasks can in­volve in­cent­ives to meet spe­cif­ic edu­ca­tion­al goals or help out around the home such as walk­ing the dog or peel­ing the pota­toes for din­ner.
Money is not just a means of get­ting more of what you want,
it is also a meas­ure of your con­tri­bu­tion in help­ing oth­ers get more of what they want.
The best way to earn more money is by serving oth­ers and find­ing ways to make them bet­ter off.
This en­tre­pren­eur­i­al les­son will pay im­port­ant di­vidends dur­ing a child’s ca­reer, no mat­ter what that ca­reer turns out to be.
Even when pay­ing for a child’s pur­chases, it is pos­sible to provide them with an un­der­stand­ing of the costs and trade-offs that are in­her­ent in all ex­pendit­ures.
Throughout their lives, all of our chil­dren will have to de­cide how they are go­ing to spend a lim­ited in­come.
If they spend more on one item, they will have to spend less on oth­ers. We all have to make trade-offs.
Be­gin­ning at an early age, we need to teach our chil­dren about this real­ity
and provide them with ex­per­i­ences that will help them learn to choose wisely.
Many par­ents (even those who give their chil­dren al­low­ances without re­quir­ing any­thing in re­turn) en­cour­age their chil­dren to set aside a por­tion of the money they re­ceive to donate to a char­ity.
These par­ents also of­ten take the time to dis­cuss with them where to dir­ect their funds
and why think­ing about oth­er people’s well-be­ing con­trib­utes to their own worth and the wel­fare of the so­ci­ety in which they live.
To a large de­gree suc­cess in life is about set­ting goals, work­ing hard to achieve them, fig­ur­ing out
how to make your ser­vices use­ful to oth­ers, sav­ing for a spe­cif­ic pur­pose, and spend­ing money wisely.
These are the key in­gredi­ents for suc­cess. Eco­nom­ics provides the re­cipe for how to live a more ful­filling life.
We are now at the end of a jour­ney. Throughout this book, our goal has been to provide you with in­form­a­tion and tools that will help you live a more suc­cess­ful life.
It is our hope that your mind has been opened to new ways of think­ing
and that you will use the in­sights gained to im­prove your life and the lives of those around you.

Acknowledgements

The au­thors would like to ex­press their ap­pre­ci­ation to sev­er­al key people who con­trib­uted to this pro­ject,
both the Eng­lish lan­guage ver­sion and the ad­apt­a­tions and trans­la­tions for use in Cent­ral and East­ern Europe and the former So­viet Uni­on.
With re­spect to the core book, we owe a ma­jor debt to Jane Shaw Stroup,
who ed­ited the en­tire manuscript and made nu­mer­ous modi­fic­a­tions that im­proved both the con­tent and read­ab­il­ity.
Signè Thomas helped with the pre­par­a­tion of the ex­hib­its and provided re­search as­sist­ance throughout.
Nu­mer­ous com­ments from fel­low teach­ers, col­lege in­struct­ors, and eco­nom­ic edu­cat­ors are in­cor­por­ated into the text.
Spe­cial ap­pre­ci­ation is due to John Mor­ton, Scott Nieder­john, Mark Schug, Wil­li­am Wood, Joe Con­nors, and Pam Cooper for their con­tri­bu­tions to the de­vel­op­ment of new sup­ple­ment­ary ma­ter­i­als.
Ad­di­tion­ally, Brandon Brice, Joab Corey, Rose­marie Fike, Nath­an Fowl­er, Fred Fransen,
Mike Ham­mock, John Kessler, and Kelly Mark­son made con­tri­bu­tions that en­hanced con­tent rel­ev­ance,
in­tro­duced new ex­amples, and strengthened the elec­tron­ic pack­age ac­com­pa­ny­ing this book.
We would also like to ex­press our ap­pre­ci­ation to Tim Bart­lett and Claire Lampen of St. Mar­tin’s Press, for their help­ful com­ments and hand­ling of the ed­it­or­i­al re­spons­ib­il­it­ies.
In ad­di­tion to the trans­lat­ors and sub­ject mat­ter ex­perts lis­ted else­where, we also want to thank Bar­bara For­bes who con­trib­uted to the pro­ject in so many ways,
es­pe­cially keep­ing us mo­tiv­ated when the pro­cess ap­peared over­whelm­ing.
Fi­nally, a spe­cial debt of grat­it­ude is owed by us and our read­ers
to the an­onym­ous donor who has sup­por­ted the pro­ject both fin­an­cially and in­tel­lec­tu­ally since its in­cep­tion.
Lit­er­ally mil­lions of people will have their lives im­proved by his ded­ic­a­tion to eco­nom­ic and polit­ic­al free­dom.
Through the years, the au­thors have had ap­prox­im­ately fifty thou­sand stu­dents in our classes.
Nu­mer­ous dis­cus­sions with stu­dents, both in and out­side of class, have provided us with mean­ing­ful in­sights and presen­ted us with chal­len­ging ques­tions.
We cher­ish these in­ter­ac­tions. With luck our paths will cross with many of you who have read this book.
Un­til we do meet in per­son, we en­cour­age you to con­tin­ue to “think like an eco­nom­ist” in your lives
and pass along the in­sights you have gained to those around you. Our fu­tures de­pend on it.

Footnotes

  1. While the tend­ency to de­vel­op mar­kets can be said to be al­most a uni­ver­sal part of hu­man nature, it is pos­sible, if a so­ci­ety tries hard enough, to re­move them from nor­mal hu­man ac­tion.
    Con­sider the early days of post-com­mun­ist trans­ition (or even of the Ro­man Cath­ol­ic Church) when cit­izens were taught that items had an in­trins­ic value
    and would of­ten re­fuse to sell for less than that sup­posed “value” even if hun­ger res­ul­ted.↩︎
  2. The most power­ful wa­ter­fall in Europe, which lies in Ice­land.↩︎
  3. Philip K. Howard, The Death of Com­mon Sense (New York: Ran­dom House, 1994): 3–5.↩︎
  4. See Char­lotte Web, “Swedes now spend more on fun than on food: study,” The Loc­al Sweden, Septem­ber 30, 2009: https://www.thelocal.se/20090930/22392.↩︎
  5. For ex­ample, if a cor­por­a­tion in­vests USD 100 mil­lion in build­ings and equip­ment to pro­duce a product, say shirts,
    it is for­go­ing what it could have earned if these funds had been in­ves­ted in oth­er ways, such as pro­du­cing mo­tor­cycles.
    The cor­por­a­tion could have simply put the USD 100 mil­lion in the bank and let it draw in­terest at, say, a 5 per­cent rate.
    In a year’s time, the in­terest earn­ings would sum to USD 5 mil­lion.
    This USD 5 mil­lion in for­gone in­terest is an op­por­tun­ity cost of the activ­it­ies of the cor­por­a­tion,
    but it will not be re­flec­ted on the firm’s ac­count­ing state­ment.
    Be­cause of this omis­sion, ac­count­ing costs un­der­state the op­por­tun­ity costs of the re­sources util­ized. There­fore, net in­come over­states profit.↩︎
  6. See Par­able of the broken win­dow, Wiki­pe­dia (last ed­ited June 2019): https://en.wikipedia.org/wiki/Parable_of_the_broken_window.↩︎
  7. Adam Smith, An In­quiry into the Nature and Causes of the Wealth of Na­tions, Volume II Glas­gow Edi­tion (In­di­ana­pol­is: Liberty Fund, Inc., [1776] 1981): 454. Also avail­able at: http://www.econlib.org/library/Smith/smWN.html.↩︎
  8. F. A. Hayek, “The Use of Know­ledge in So­ci­ety,” Amer­ic­an Eco­nom­ic Re­view 35 (Septem­ber 1945): 519–530.↩︎
  9. Henry Haz­litt, Eco­nom­ics in One Les­son (New Rochelle: Ar­ling­ton House, 1979): 103.↩︎
  10. See “SCI­ENCE WATCH: Seat Belts and Ped­es­tri­ans.” The New York Times (June 18, 1985). Sec­tion C, 9: https://www.nytimes.com/1985/06/18/science/science-watch-seat-belts-and-pedestrians.html.↩︎
  11. Lux­em­bourg: Pub­lic­a­tions Of­fice of the European Uni­on, 2012. “The Com­mon Ag­ri­cul­tur­al Policy—A Story to be Con­tin­ued” http://doi.org/10.2762/35894.↩︎
  12. See Patrick Jomini, Pierre Boulanger, Xiao-guang Zhang, Cath­er­ine Costa, and Michelle Os­borne,
    “The com­mon ag­ri­cul­tur­al policy and the French, EU and glob­al eco­nom­ies,”
    Groupe d’Économie Mon­diale (GEM), (Oc­to­ber 2009. Re­vised Feb­ru­ary 2, 2010): https://ecipe.org/wp-content/uploads/2014/12/Jomini_boulanger-The_Common_Agricultural_policy_and_the_French.pdf.↩︎
  13. See Pierre Boulanger and Patrick Jomini, “Of the be­ne­fits to the EU of re­mov­ing the Com­mon Ag­ri­cul­tur­al Policy”
    Groupe d’Économie Mon­diale (GEM), (Novem­ber 19, 2009. Re­vised Feb­ru­ary 2, 2010): https://ecipe.org/wp-content/uploads/2014/12/BoulangerJomini_removingCAP112009.pdf.↩︎
  14. This chart comes from a much lar­ger pro­ject star­ted by Hans Rosling and cur­rently main­tained by his son and daugh­ter-in-law.
    You can see many more such charts and cre­ate your own at https://www.gapminder.org.↩︎
  15. Robert E. Lu­cas Jr., “On the Mech­an­ics of Eco­nom­ic De­vel­op­ment,”
    Journ­al of Mon­et­ary Eco­nom­ics 22, No. 1 (1988): 3–42.↩︎
  16. The most widely used meas­ure of total out­put and in­come is gross do­mest­ic product (GDP).
    Changes in GDP are also widely used to meas­ure the growth of an eco­nomy.↩︎
  17. While a di­verse set of factors in­flu­ences growth and de­vel­op­ment, the mod­ern view re­cog­nizes the cent­ral role of in­sti­tu­tions and policies.
    Lead­ing con­trib­ut­ors to the mod­ern view in­clude No­bel Laur­eate Dou­glass North, Eng­lish eco­nom­ist Peter Bauer,
    Daron Acemo­glu of the Mas­sachu­setts In­sti­tute of Tech­no­logy, and James Robin­son of Har­vard.
    See Peter T. Bauer, Dis­sent on De­vel­op­ment: Stud­ies and De­bates in De­vel­op­ment Eco­nom­ics (Cam­bridge: Har­vard Uni­versity Press, 1972);
    D.C. North, In­sti­tu­tions, In­sti­tu­tion­al Change, and Eco­nom­ic Per­form­ance (Cam­bridge: Cam­bridge Uni­versity Press, 1990);
    and Daron Acemo­glu and James A. Robin­son, Why Na­tions Fail: The Ori­gins of Power, Prosper­ity, and Poverty (New York: Crown, 2012).↩︎
  18. See, for ex­ample, Ran­dall K. Filer and Jan Hanousek, “Out­put Changes and In­fla­tion­ary Bias in Trans­ition,”
    Eco­nom­ic Sys­tems, Vol. 24, Is­sue 3. Avail­able at: https://ideas.repec.org/p/wpa/wuwpma/0012010.html.↩︎
  19. Tom Beth­ell, The Noblest Tri­umph (New York: St. Mar­tin’s Press, 1998): 10.↩︎
  20. For ad­di­tion­al in­form­a­tion, see John McMillan, Re­in­vent­ing the Bazaar: A Nat­ur­al His­tory of Mar­kets (New York: W. W. Norton, 2002): 94–101.
    As McMillan points out, real privat­iz­a­tion would have been pre­ferred.
    Non­ethe­less, the move­ment to­ward private own­er­ship was still “the biggest anti-poverty pro­gram the world has ever seen.”↩︎
  21. For a dis­cus­sion of buf­fa­loes, see:
    Lueck, Dean “The Ex­term­in­a­tion and Con­ser­va­tion of the Amer­ic­an Bison”
    in The Journ­al of Leg­al Stud­ies Vol. 31, No. S2, The Evol­u­tion of Prop­erty Rights:
    A Con­fer­ence Sponsored by the Searle Fund and North­west­ern Uni­versity School of Law (June 2002), pp. S609–S652.
    There have been oth­er cases where hu­mans have hunted an an­im­al spe­cies to ex­tinc­tion.
    Pas­sen­ger pi­geons are an ex­ample. They were hunted for meat while whales were hunted mainly for oil.
    But pi­geons were such a small part of the mar­ket for meat that even as they began to dis­ap­pear,
    the price of meat did not in­crease enough to call forth either pre­ser­va­tion ef­forts or a large-scale in­crease in the pro­duc­tion of meats.
    There was no crisis. So their dis­ap­pear­ance be­came com­plete.
    If whales had been in­tens­ively hunted only for their meat, and not mainly for oil, they also might have dis­ap­peared.
    But whale oil was so im­port­ant in the mar­ket for light that when its price rose sharply,
    a sub­sti­tute was found that re­duced the de­mand for whale oil and its price, sav­ing the whales.↩︎
  22. Clair Wil­cox. Com­pet­i­tion and Mono­poly in Amer­ic­an In­dustry.
    Mono­graph No. 21, Tem­por­ary Na­tion­al Eco­nom­ic Com­mit­tee, In­vest­ig­a­tion of Con­cen­tra­tion of Eco­nom­ic Power, 76th Cong. 3d sess. (Wash­ing­ton, D.C.: United States Gov­ern­ment Print­ing Of­fice, 1940).↩︎
  23. Adam Smith. An In­quiry into the Nature and Causes of the Wealth of Na­tions, Volume I Glas­gow Edi­tion (In­di­ana­pol­is: Liberty Fund, Inc., [1776] 1981): 18. Also avail­able at: www.econlib.org/library/Smith/smWN.html.↩︎
  24. World Bank, Do­ing Busi­ness Pro­ject (doingbusiness.org). “Time re­quired to start a busi­ness (days).” https://data.worldbank.org/indicator/ic.reg.durs.↩︎
  25. For a com­pre­hens­ive ana­lys­is of the im­pact of min­im­um wage le­gis­la­tion on the poor,
    see Thomas MaCurdy, “How Ef­fect­ive Is the Min­im­um Wage at Sup­port­ing the Poor?” Journ­al of Polit­ic­al Eco­nomy 123 (2015): www.jstor.org/stable/full/10.1086/679626.↩︎
  26. For evid­ence on this point, see Ed­ward Bier­han­zl and James Gwart­ney,
    “Reg­u­la­tion, Uni­ons, and Labor Mar­kets,” Reg­u­la­tion (Sum­mer 1998): 40–53.↩︎
  27. Muravyev, A., Oshchep­kov, A. (2016) “The ef­fect of doub­ling the min­im­um wage on em­ploy­ment: evid­ence from Rus­sia.” IZA J Labor De­vel­op 5, 6.↩︎
  28. Maria Kou­menta and Mario Pagliero, 2018. “Oc­cu­pa­tion­al Li­cens­ing in the European Uni­on: Cov­er­age and Wage Ef­fects,” CEPR Dis­cus­sion Pa­per 12577, CEPR Dis­cus­sion Pa­pers Series.↩︎
  29. See the De­part­ment of Treas­ury, Of­fice of Eco­nom­ic Policy, Oc­cu­pa­tion­al Li­cens­ing: A Frame­work for Poli­cy­makers, 2015;
    Mor­ris M. Klein­er, “Why Li­cense a Flor­ist?” New York Times, May 28, 2014;
    Jac­ob Gold­stein, “So You Think You Can Be a Hair Braid­er?” New York Times, June 12, 2012;
    and Dick M. Car­penter II, Lisa Knep­per, An­gela C. Er­ick­son, and John K. Ross, Li­cense to Work: A Na­tion­al Study of Bur­dens from Oc­cu­pa­tion­al Li­cens­ing, In­sti­tute for Justice, May 2012.↩︎
  30. The sharp-eyed among you may have noted
    that the earli­est pic­ture in this se­quence comes from 1990, after the fall of the So­viet Uni­on.
    In part this is be­cause aer­i­al pho­to­graphs from So­viet air­space were not easy to take.
    More crit­ic­ally, the shrink­ing after 1990 is still largely a leg­acy of So­viet policies.
    Once a re­gion­al eco­nomy is built around schemes to force il­lo­gic­al pro­duc­tion activ­it­ies,
    it is very hard to change the in­fra­struc­ture and work­er skills in­volved.
    What will Caspi­an Sea fish­er­men do if all of a sud­den they are told,
    “No more fish­ing, find an­oth­er job?”↩︎
  31. These fig­ures are from the Cen­ter for Re­spons­ive Polit­ics, “Lob­by­ing:
    Top Spend­ers,” (2008) avail­able at: http://www.opensecrets.org/lobby/top.php?indexType=s.
    (For ad­di­tion­al de­tails, see Peter J. Wal­lis­on and Charles W. Ca­lo­miris, “The De­struc­tion of Fan­nie Mae and Fred­die Mac,” Amer­ic­an En­ter­prise In­sti­tute [2008]
  32. See Peter Nyberg (2011) Re­port of the Com­mis­sion of In­vest­ig­a­tion into the Bank­ing Sec­tor in Ire­land (Dub­lin) https://merrionstreet.ie/en/News-Room/Releases/commission-of-investigation-into-the-banking-sector.38671.shortcut.html,
    and Ron Wright Strength­en­ing the Ca­pa­city of the De­part­ment of Fin­ance (Dub­lin) https://web.archive.org/web/20110310164641/http://www.finance.gov.ie/documents/publications/reports/2011/deptreview.pdf.↩︎
  33. Note that cred­it cards (and deb­it cards) are not money.
    A cred­it card is simply a means of get­ting an auto­mat­ic loan
    that will not carry in­terest if paid back soon, while a deb­it card is merely an easy way to trans­fer bank ac­count de­pos­its, which are the real money.↩︎
  34. Of course, as eco­nom­ists like to say, “cor­rel­a­tion does not mean caus­a­tion.”
    Maybe coun­tries fa­cing high in­fla­tion simply print more money to try and keep up.
    Soph­ist­ic­ated data ana­lys­is, however, strongly sup­ports the con­clu­sion that it is ex­cess print­ing of money
    (usu­ally to pay for gov­ern­ment spend­ing without rais­ing taxes) that causes in­fla­tion.
    As Milton Fried­man fam­ously said: “in­fla­tion is al­ways and every­where a mon­et­ary phe­nomen­on.”↩︎
  35. Frye, T. (2002). “The Per­ils of Po­lar­iz­a­tion: Eco­nom­ic Per­form­ance in the Post­com­mun­ist World.” World Polit­ics, 54(3), 308–337. http://doi.org/10.1353/wp.2002.0008.↩︎
  36. The size of the ac­tu­al fall in GDP in post-com­mun­ist coun­tries is ex­tremely hard to meas­ure.
    Un­der cent­ral plan­ning, pro­du­cers had an in­cent­ive to over-re­port out­put in or­der to meet quotas.
    In a mar­ket eco­nomy the in­cent­ive shif­ted to un­der-re­port­ing to avoid taxes.
    In ad­di­tion, im­prove­ments in qual­ity to meet con­sumer de­mands in a com­pet­it­ive en­vir­on­ment were al­most im­possible to cap­ture.
    See, for ex­ample, Ran­dall Filer and Jan Hanousek (2003) “Out­put Changes and In­fla­tion­ary Bias in Trans­ition”, Eco­nom­ic Sys­tems, Vol. 24. http://dx.doi.org/10.2139/ssrn.1516073.↩︎
  37. An­ders As­lund, Ukraine:What Went Wrong and How to Fix It (Peterson In­sti­tute, 2015): 48–49.↩︎
  38. The World Bank takes ser­i­ously the concept of “one coun­try, two sys­tems,”
    and eval­u­ates Hong Kong’s tax sys­tem in­de­pend­ently from that of main­land China.↩︎
  39. Henry George, Pro­tec­tion or Free Trade (New York: Robert Schalken­bach Found­a­tion, 1980).↩︎
  40. Many of the “job savers” act as if for­eign­ers are will­ing to sup­ply goods without ever us­ing their ac­quired dol­lars or euros to pur­chase things.
    This is not the case. If for­eign­ers were will­ing to sell things to Amer­ic­ans
    for dol­lars or Europeans for euros but nev­er use the dol­lars or euros to buy products, it would
    be as though Amer­ic­ans and Europeans could write checks for im­ports without any­one ever cash­ing them
    or ex­port pretty pieces of pa­per with pic­tures of na­tion­al her­oes (United States bank notes) or even fic­tion­al bridges (Euro bank notes) on them.
    Wouldn’t that be great? In fact, however, pro­du­cers of im­por­ted goods and ser­vices do cash the checks they re­ceive.
    They don’t ac­tu­ally want the pieces of pa­per; they want the pur­chas­ing power rep­res­en­ted by them to buy things they want or to in­vest in pro­duct­ive as­sets.
    And of­ten what they want to buy are the products that Amer­ica and Europe ex­ports.
    Thus, im­ports help to gen­er­ate the de­mand for ex­ports.↩︎
  41. When the ex­change rate is de­term­ined by mar­ket forces,
    equi­lib­ri­um in this mar­ket will bring the pur­chases of goods, ser­vices, and as­sets
    (in­clud­ing both real and fin­an­cial as­sets such as bonds) from for­eign­ers into bal­ance with the sale of these items to for­eign­ers.
    Dur­ing the last couple of dec­ades, United States im­ports of goods and ser­vices have per­sist­ently ex­ceeded ex­ports.
    With mar­ket-de­term­ined ex­change rates, such trade de­fi­cits will be largely off­set by an in­flow of cap­it­al of sim­il­ar mag­nitude.
    The capital inflow will res­ult in lower in­terest rates, more in­vest­ment, and ad­di­tion­al em­ploy­ment.
    Thus, even in this case, there is no reas­on to an­ti­cip­ate that there will be a neg­at­ive im­pact on em­ploy­ment.
    Even though trade de­fi­cits were present throughout most of the 1980–2005 peri­od, em­ploy­ment in the United States ex­pan­ded by more than 35 mil­lion.↩︎
  42. The same lo­gic ap­plies to “out­sourcing,” un­der­tak­ing cer­tain activ­it­ies abroad in or­der to re­duce cost.
    If an activ­ity can be handled at a lower cost abroad, do­ing so will re­lease do­mest­ic re­sources that can be em­ployed in high­er pro­duct­ive activ­it­ies.
    As a res­ult, out­put will be lar­ger and in­come levels high­er.↩︎
  43. “Cheap” does not mean “low qual­ity.”
    We are ex­pli­citly hold­ing qual­ity con­stant. To eco­nom­ists things of dif­fer­ent qual­ity are dif­fer­ent products.
    West Texas In­ter­me­di­ate Crude Oil is a dif­fer­ent product from Louisi­ana Light, just as a Mer­cedes and a Kia are dif­fer­ent products, not a gen­er­ic “car.”↩︎
  44. S. Hong, H. Han, and C.S. Kim, “World dis­tri­bu­tion of in­come for 1970–2010,” Em­pir­ic­al Eco­nom­ics (2019). https://doi.org/10.1007/s00181-019-01657-w.↩︎
  45. As quoted in Frank Whit­son Fet­ter, “Con­gres­sion­al Tar­iff The­ory,” Amer­ic­an Eco­nom­ic Re­view, 23 (Septem­ber 1933): 413–27.↩︎
  46. Douglas A. Ir­win, “GATT’s con­tri­bu­tion to eco­nom­ic re­cov­ery in post-war West­ern Europe” in:
    Europe’s Post­war Re­cov­ery, ed. B. Eichen­green (Cam­bridge: Cam­bridge Uni­versity Press, 1995): 127–150. See text in Ir­win for ref­er­ences in charts.↩︎
  47. Ibid., p.7.↩︎
  48. Ibid., p.2.↩︎
  49. See, for ex­ample, Havryly­shyn, and Tupy (2016) “25 Years of Re­forms in Ex‐Com­mun­ist Coun­tries:
    Fast and Ex­tens­ive Re­forms Led to High­er Growth and More Polit­ic­al Free­dom,” CATO In­sti­tute Policy Ana­lys­is No. 795.↩︎
  50. These fig­ures are in 2011 “In­ter­na­tion­al Dol­lars” to make com­par­is­ons more mean­ing­ful.
    The in­ter­na­tion­al dol­lar ad­justs for dif­fer­ences in prices in dif­fer­ent coun­tries.↩︎
  51. James Buchanan was awar­ded the 1986 No­bel Prize in Eco­nom­ics for his role in the de­vel­op­ment of pub­lic choice eco­nom­ics.
    For a clear and com­pre­hens­ive present­a­tion of pub­lic choice ana­lys­is, see
    Randy Sim­mons, Bey­ond Polit­ics: The Roots of Gov­ern­ment Fail­ure (Oak­land, Cali­for­nia: The In­de­pend­ent In­sti­tute, 2011).↩︎
  52. A. C. Pigou, who many con­sider to be the fath­er of wel­fare eco­nom­ics, makes this same point.
    In his 1932 clas­sic The Eco­nom­ics of Wel­fare (Part II, Chapter 20, Sec­tion 4), Pigou stated,
    “It is not suf­fi­cient to con­trast the im­per­fect ad­just­ments of un­fettered private en­ter­prise with the best ad­just­ment that eco­nom­ists in their stud­ies can ima­gine.
    For we can­not ex­pect that any pub­lic au­thor­ity will at­tain, or will even whole-heartedly seek, that ideal.
    Such au­thor­it­ies are li­able alike to ig­nor­ance, to sec­tion­al pres­sure and to per­son­al cor­rup­tion by private in­terest.
    A loud-voiced part of their con­stitu­ents, if or­gan­ized for votes, may eas­ily out­weigh the whole.”↩︎
  53. Thomas Sow­ell, Is Real­ity Op­tim­al and Oth­er Es­says (Stan­ford: Hoover In­sti­tu­tion Press, 1993).↩︎
  54. See Jared Mey­er and Pre­ston Cooper, “Sug­ar Sub­sidies Are a Bit­ter Deal for Amer­ic­an Con­sumers,”
    Eco­nom­ic Policies for the 21st Cen­tury at the Man­hat­tan In­sti­tute, Man­hat­tan In­sti­tute (June 23, 2014). economics21.org/commentary/sugar-subsidies-are-bitter-deal-american-consumers.
    In re­cent years candy man­u­fac­tur­ers and oth­er ma­jor users of sug­ar have been mov­ing to Canada,
    Mex­ico, and oth­er coun­tries where sug­ar can be pur­chased at the world mar­ket price.
    Il­lus­trat­ing our earli­er dis­cus­sion of trade, the im­port re­stric­tions that “saved” jobs in the sug­ar-grow­ing in­dustry
    caused job losses in oth­er in­dus­tries, par­tic­u­larly those that use sug­ar in­tensely.↩︎
  55. Jef­frey Frankel, “The ar­gu­ments against food and en­ergy sub­sidies,”
  56. See Hol­man W. Jen­kins Jr., “How Uber Won the Big Apple,”
  57. See John Voel­ck­er, “Where Can Tesla Leg­ally Sell Cars Dir­ectly To You? State-By-State Map: LATEST UP­DATE.”
    Phil Ker­pen, “Tesla and Its Sub­sidies.” Na­tion­al Re­view On­line, Janu­ary 26, 2015, n.p. http://www.nationalreview.com/article/397162/tesla-and-its-subsidies-phil-kerpen.↩︎
  58. James Buchanan, The De­fi­cit and Amer­ic­an Demo­cracy (Mem­ph­is: P. K. Steidman Found­a­tion, 1984).↩︎
  59. Ash­ley Kirk, “European debt crisis: It’s not just Greece that’s drown­ing in debt,”
  60. We are in­debted to E. C. Pa­sour Jr., long­time pro­fess­or of eco­nom­ics at North Car­o­lina State Uni­versity, for this ex­ample.↩︎
  61. Euro­stat, Stat­ist­ics Ex­plained, “Gov­ern­ment ex­pendit­ure on so­cial pro­tec­tion.” http://ec.europa.eu/eurostat/statistics-explained/index.php/Government_expenditure_on_social_protection.↩︎
  62. Euro­stat, Stat­ist­ics Ex­plained, “Pop­u­la­tion struc­ture and age­ing.” http://ec.europa.eu/eurostat/statistics-explained/index.php/Population_structure_and_ageing.↩︎
  63. James R. Schle­sing­er, “Sys­tems Ana­lys­is and the Polit­ic­al Pro­cess,” Journ­al of Law & Eco­nom­ics (Oc­to­ber 1968): 281.↩︎
  64. World Bank, “Sub­sidies and oth­er trans­fers (% of ex­pense),”
    In­ter­na­tion­al Mon­et­ary Fund, Gov­ern­ment Fin­ance Stat­ist­ics Year­book and data files. https://data.worldbank.org/indicator/GC.XPN.TRFT.ZS.↩︎
  65. Euro­stat, Stat­ist­ics Ex­plained,
    “Total gen­er­al gov­ern­ment ex­pendit­ure on so­cial pro­tec­tion, 2016 (% of GDP % of total ex­pendit­ure.” http://ec.europa.eu/eurostat/statistics-explained/index.php?title=File:Total_general_government_expenditure_on_social_protection,_2016_(%25_of_GDP_%25_of_total_expenditure).png.↩︎
  66. Oth­ers at­trib­ute this state­ment to Lord Thomas Ma­caulay. The au­thor can­not be veri­fied with cer­tainty.
    For ad­di­tion­al in­form­a­tion on this top­ic, see Loren Collins, “The Truth About Tytler” at: http://www.lorencollins.net/tytler.html.↩︎
  67. See James Gwart­ney and Richard Stroup, “Trans­fers, Equal­ity, and the Lim­its of Pub­lic Policy,”
    Cato Journ­al, (Spring/Sum­mer 1986), for a de­tailed ana­lys­is of this is­sue.↩︎
  68. See, for ex­ample, Anna Kier­sztyn, “Stuck in a mis­match?
    The per­sist­ence of overedu­ca­tion dur­ing twenty years of the post-com­mun­ist trans­ition in Po­land,” Eco­nom­ics of Edu­ca­tion Re­view, 32:1 (2013), p. 78–91.↩︎
  69. For evid­ence on this point, see Lawrence Katz and Bruce Mey­er,
    “The Im­pact of the Po­ten­tial Dur­a­tion of Un­em­ploy­ment Be­ne­fits on the Dur­a­tion of Un­em­ploy­ment,”
    Journ­al of Pub­lic Eco­nom­ics 41, No. 1 (Feb­ru­ary 1990): 45–72.
    Also see Daniel Aaron­son, Bhashkar Ma­zum­der, and Shani Schechter, “What Is Be­hind the Rise in Long-Term Un­em­ploy­ment?”
    Fed­er­al Re­serve Bank of Chica­go, Eco­nom­ic Per­spect­ives (Second Quarter 2010): 28–51.↩︎
  70. Fed­er­al Safety Net, “Poverty and Spend­ing Over the Years.”
    Fig­ures ex­clude spend­ing on med­ic­al in­sur­ance for the poor (Medi­caid). http://federalsafetynet.com/poverty-and-spending-over-the-years.html.↩︎
  71. OECD Data (2019), “Fin­an­cial dis­in­cent­ive to re­turn to work” (in­dic­at­or). http://doi.org/10.1787/3ef6e9d7-en.↩︎
  72. Sey­more Dres­cher, trans­lat­or (Lon­don: Civ­itas, 1997): 27–28.↩︎
  73. Ron Haskins and Isa­bel V. Sawhill, Op­por­tun­ity So­ci­ety (Wash­ing­ton, D.C.: Brook­ings In­sti­tu­tion Press, 2009).↩︎
  74. Mi­chael Tan­ner of the Cato In­sti­tute has test­i­fied that in the United States only 30% of gov­ern­ment en­ti­tle­ments
    reach the in­ten­ded be­ne­fi­ciar­ies as op­posed to 82% of the funds of sim­il­ar pro­grams run by private char­it­ies.↩︎
  75. Adam Smith, The The­ory of Mor­al Sen­ti­ments, Glas­gow Edi­tion of Ox­ford Uni­versity Press (In­di­ana­pol­is: Liberty Fund, Inc., [1790] 1976): 233–34. Also avail­able at: https://www.econlib.org/library/Smith/smMS.html?chapter_num=7 - book-reader.↩︎
  76. Friedrich Hayek, “Pre­tence of Know­ledge.” No­bel Prize Lec­ture in Eco­nom­ics. Stock­holm, Sweden. Decem­ber 11, 1974.↩︎
  77. Jef­frey Frankel, “The ar­gu­ments against food and en­ergy sub­sidies,” World Eco­nom­ic For­um, Au­gust 18, 2014. https://www.weforum.org/agenda/2014/08/food-energy-subsidies-egypt-india-indonesia.↩︎
  78. Oby Ezek­we­sili, “Why we need to end fish­er­ies sub­sidies,” World Eco­nom­ic For­um, Oc­to­ber 2, 2015. https://www.weforum.org/agenda/2015/10/why-we-need-to-end-fisheries-subsidies.↩︎
  79. From Om­ni­po­tent Gov­ern­ment: The Rise of the Total State and Total War (New Haven: Yale Uni­versity Press, 1944).↩︎
  80. M. Czaika and C.R. Par­sons, “The Grav­ity of High-Skilled Mi­gra­tion Policies,” Demo­graphy, 54 (2017): 603.↩︎
  81. Freidman, Milton, Cap­it­al­ism and Free­dom (Chica­go: Uni­versity of Chica­go Press, 2002).↩︎
  82. Alex­is de Toc­queville, Demo­cracy in Amer­ica (New York: George Dear­born & Co., Ad­lard and Saun­ders, 1835): Volume 1, Chapter 5.
    We will not dis­cuss wheth­er the United States main­tains the same de­gree of power in loc­al gov­ern­ments today.
    This is an open ques­tion.↩︎
  83. As of late 2019 Pro­fess­or Mylovan­ov left his pro­fess­or­ship at the Uni­versity of Pitt­s­burgh to be­come Min­is­ter of Eco­nom­ic De­vel­op­ment,
    Trade and Ag­ri­cul­ture in the gov­ern­ment of Ukraine, a po­s­i­tion he held un­til March 2020.↩︎
  84. See Stefan Voigt, Stefan, Jerg Gut­mann, and Lars P. Feld (2015)
    “Eco­nom­ic growth and ju­di­cial in­de­pend­ence, a dozen years on: Cross-coun­try evid­ence us­ing an up­dated Set of in­dic­at­ors,” European Journ­al of Polit­ic­al Eco­nomy 38 p: 197–211.↩︎
  85. Of course, tech­no­logy can be a force for re­pres­sion as well, as seen by the use of fa­cial re­cog­ni­tion cap­ab­il­it­ies to track dis­sid­ents or minor­it­ies.↩︎
  86. For a dis­cus­sion of how the pos­sib­il­ity of E.U. mem­ber­ship con­trib­uted to more suc­cess­ful re­form in the post-com­mun­ist coun­tries,
    see Chapter 6 of Oleh Havryly­shyn, Present at the Trans­ition (Cam­bridge: Cam­bridge Uni­versity Press, 2020).↩︎
  87. “Buy any deans ne­ces­sary, Let­ting aca­dem­ics pick ma­gis­trates has not worked in Guatem­ala,”
  88. Yogi is also re­spons­ible for ad­vising, “When you come to a fork in the road, take it.”↩︎
  89. Ar­thur Brooks, Pres­id­ent of the Amer­ic­an En­ter­prise In­sti­tute,
    is one of the lead­ing schol­ars on the de­term­in­ants of hap­pi­ness.
    For an over­view of his views, see “A For­mula for Hap­pi­ness,” New York Times, Decem­ber 14, 2013 at: http://www.nytimes.com/2013/12/15/opinion/sunday/a-formula-for-happiness.html.↩︎
  90. Of­ten there seems a dif­fer­ence between what is highly val­ued by con­sumers and what “plan­ners” would like them to value.
    In 2019 the world’s young­est bil­lion­aire was Kylie Jen­ner.
    We make no judg­ment on her line of lip glosses oth­er than to ob­serve that cit­izens with free choice over thou­sands of al­tern­at­ives seem to se­lect them.↩︎
  91. See “What is Emo­tion­al In­tel­li­gence (EQ)?” by Mi­chael Akers and Grover Port­er at: http://psychcentral.com/lib/what-is-emotional-intelligence-eq/.↩︎
  92. One of the earli­est stud­ies es­tab­lish­ing the re­la­tion­ship between at­ti­tude traits and eco­nom­ic suc­cess was by one of the au­thors of this book.
    See: Ran­dall K. Filer, “The In­flu­ence of Af­fect­ive Hu­man Cap­it­al on the Wage Equa­tion,” in Ron­ald Ehren­berg, ed., Re­search in Labor Eco­nom­ics, Vol. 4 (Green­wich: JAI Press, 1981).↩︎
  93. Theresa Har­old, “How a former So­viet state be­came one of the world’s most ad­vanced di­git­al na­tions,” Al­phr.com, (30 Oct 2017) http://www.alphr.com/technology/1007520/how-a-former-soviet-state-became-one-of-the-worlds-most-advanced-digital-nations.↩︎
  94. Adi­das AG, Fin­an­cial Pub­lic­a­tions: https://www.adidas-group.com/en/investors/financial-reports.↩︎
  95. Mi­chael Jar­rett and Quy Nguy­en Huy, “IKEA’s Suc­cess Can’t Be At­trib­uted to One Cha­ris­mat­ic Lead­er,” Har­vard Busi­ness Re­view (hbr.org), Feb­ru­ary 2, 2018. https://hbr.org/2018/02/ikeas-success-cant-be-attributed-to-one-charismatic-leader.↩︎
  96. The World Bank, “Self-em­ployed, total (% of total em­ploy­ment) (modeled ILO es­tim­ate),” In­ter­na­tion­al La­bour Or­gan­iz­a­tion, ILOSTAT data­base data re­trieved in April 2019. https://data.worldbank.org/indicator/SL.EMP.SELF.ZS.↩︎
  97. Janene Pieters, “A Fifth Of Dutch Mil­lion­aires Are Farm­ers,” NLTimes.NL, Septem­ber 12, 2017. https://nltimes.nl/2017/09/12/fifth-dutch-millionaires-farmers.↩︎
  98. Bruno Dallago, Kier Dis­cus­sion Pa­per No. 968, “Di­ver­ging Paths of En­tre­pren­eur­ship in Post-Trans­form­a­tion Coun­tries, a Com­par­at­ive View”; Kyoto In­sti­tute of Eco­nom­ic Re­search, March 2017. http://www.kier.kyoto-u.ac.jp/DP/DP968.pdf.↩︎
  99. Thomas Stan­ley and Wil­li­am D. Danko point out in their best­seller The Mil­lion­aire Next Door (At­lanta: Long­street Press, 1996)
    that the most com­mon char­ac­ter­ist­ic of mil­lion­aires is that they have lived be­neath their means for a long time.
    Over half of them nev­er re­ceived any in­her­it­ance and few­er than 20 per­cent re­ceived 10 per­cent or more of their wealth from in­her­it­ance.↩︎
  100. See “Your Top Debt Man­age­ment Ques­tions Answered.” Dave Ram­sey. N.p., Oc­to­ber 25, 2014. https://www.daveramsey.com/blog/the-truth-about-debt-management.↩︎
  101. Some may need cre­at­ive meth­ods of con­trolling im­pulse pur­chases with a cred­it card.
    If this is the case, eco­nom­ist and fin­an­cial ad­viser Wil­li­am C. Wood sug­gests that you freeze your cred­it card in­side a block of ice in your re­fri­ger­at­or.
    By the time the ice thaws, your im­pulse to buy may have cooled.↩︎
  102. Justin Hig­gin­bot­tom, “Gov­ern­ments Fi­nally Em­brace The Shar­ing Eco­nomy,” Ozy.com, Septem­ber 30, 2018. https://www.ozy.com/fast-forward/governments-finally-embrace-the-sharing-economy/89688.↩︎
  103. Pro­fess­or Wil­li­am C. Wood calls such items “SIT ex­pendit­ures.” Wood in­dic­ates that “SIT stands for two things: (1) sit down when you get an un­ex­pec­ted bill; and (2) sur­prises, in­sur­ance, and taxes.”↩︎
  104. In ad­di­tion, for some Muslims, the pay­ment of in­terest is not al­lowed un­der Sharia law,
    and the re­turn will re­flect some type of profit shar­ing that achieves a sim­il­ar goal, as will be de­scribed at the end of this ele­ment.↩︎
  105. Nils-Ger­rit Wun­sch, “Re­tail price of a premi­um pack of 20 ci­gar­ettes in se­lec­ted European coun­tries in 2017 (in GBP),” April 3, 2019. https://www.statista.com/statistics/415034/cigarette-prices-across-europe. ↩︎
  106. Our cal­cu­la­tions as­sume that your in­vest­ments yield a re­turn of 7 per­cent every year.
    Ob­vi­ously this is un­likely to hap­pen. Even though you can ex­pect an av­er­age an­nu­al re­turn of ap­prox­im­ately 7 per­cent, this re­turn will vary from year to year.
    This can make a dif­fer­ence in how much you ac­cu­mu­late at re­tire­ment, but the dif­fer­ence is likely to be small.↩︎
  107. These av­er­age re­turns are for the United States mar­ket,
    but those in oth­er ad­vanced eco­nom­ies will be pretty much the same.
    If they were bet­ter in the United King­dom than the United States, for ex­ample, glob­al in­vestors would move funds into the United King­dom un­til this were no longer true.
    When a coun­try has con­tinu­ally high re­turns on bonds, it sug­gests that in­vestors feel that there is also great­er risk as­so­ci­ated with that coun­try,
    es­pe­cially if either de­fault (fail­ure to pay) or de­value (due to cur­rency de­pre­ci­ation).
    In oth­er words, high ap­par­ent rates of re­turn on gov­ern­ment bonds is usu­ally a strong sig­nal of bad gov­ern­ment.
    A 7 per­cent real (after in­fla­tion) rate of re­turn may not sound like much com­pared to what some stocks, such as Dell and Mi­crosoft, have yiel­ded.
    But a 7 per­cent compounded annual rate of return means
    that the value of your sav­ings will double every ten years.
    In con­trast, it will take thirty-five years to double your money at a 2 per­cent in­terest rate, the ap­prox­im­ate after-tax re­turn earned his­tor­ic­ally by sav­ings ac­counts and money mar­ket mu­tu­al funds.
    Note: You can ap­prox­im­ate the num­ber of years it will take to double your funds at al­tern­at­ive in­terest rates by simply di­vid­ing the yield (the av­er­age an­nu­al re­turn on your money) into sev­enty.
    This is some­times re­ferred to as the Rule of 70 or, for those who like a little more pre­ci­sion, the Rule of 72.↩︎
  108. Krystyna Krzyzak, “CEE: A Sys­tem In Flux,” In­vest­ment & Pen­sions Europe, Janu­ary 2018 (Magazine). https://www.ipe.com/pensions/country-reports/cee/cee-a-system-in-flux/10022463.article.↩︎
  109. Chris­toph­er Jar­vis, “The Rise and Fall of Al­bania’s Pyr­am­id Schemes,” Fin­ance & De­vel­op­ment,
    a quarterly magazine of the IMF, March 2000, Volume 37, Num­ber 1. https://www.imf.org/external/pubs/ft/fandd/2000/03/jarvis.htm.↩︎
  110. Any men­tion of spe­cif­ic funds does not mean that we think that they are prefer­able to any al­tern­at­ive.
    You should en­gage in care­ful re­search your­self be­fore you buy an in­vest­ment.
    Re­mem­ber, the fu­ture you are in­vest­ing in is yours.↩︎
  111. Di­m­it­ar Boy­adzhiev et al., Morn­ing­star Man­ager Re­search EMEA,
    “Morn­ing­star’s European Act­ive/Pass­ive Ba­ro­met­er,” Feb­ru­ary 2019. https://www.morningstar.com/en-uk/lp/european-active-passive-barometer.↩︎
  112. See Jeremy J. Sie­gal, Stocks for the Long Run, 3rd edi­tion (New York: McGraw Hill, 2002): 342–43.↩︎
  113. See Bur­ton G. Malk­iel, A Ran­dom Walk Down Wall Street: The Time Tested Strategy for Suc­cess­ful In­vest­ing (New York: W. W. Norton & Com­pany, 2015): 177–78.↩︎
  114. See Bur­ton G. Malk­iel, A Ran­dom Walk Down Wall Street: The Time-Tested Strategy for Suc­cess­ful In­vest­ing (New York: W. W. Norton & Com­pany, 2003): 189–190.
    For ad­di­tion­al evid­ence that a mu­tu­al fund yield­ing a high rate of re­turn dur­ing one peri­od can­not be coun­ted on to con­tin­ue to do so in the fu­ture, see Mark M. Car­hart,
    “On Per­sist­ence in Mu­tu­al Fund Per­form­ance,” The Journ­al of Fin­ance 52, No. 1 (March 1997): 57–82.↩︎
  115. See Bur­ton G. Malk­iel, A Ran­dom Walk Down Wall Street: The Time-Tested Strategy for Suc­cess­ful In­vest­ing (New York: W. W. Norton & Com­pany, 2003): 180–181.↩︎
  116. Ab­ra­ham Ok­usan­ya, “Les­sons from 118 years of as­set class re­turns data,” FinalytiQ, March 28, 2018. https://finalytiq.co.uk/lessons-118-years-capital-market-return-data/.↩︎
  117. Even those in­vest­ing in in­dex funds should ob­tain some ad­vice from ex­perts.
    There are tax and leg­al con­sid­er­a­tions such as tak­ing ad­vant­age of tax-de­ferred pos­sib­il­it­ies, es­tab­lish­ing wills and trusts, mak­ing wise in­sur­ance choices, etc., which do re­quire in­put from spe­cial­ists.↩︎
  118. See Li­qun Liu, An­drew J. Rett­en­maier, and Zijun Wang, “So­cial Se­cur­ity and Mar­ket Risk,”
    Na­tion­al Cen­ter for Policy Ana­lys­is Work­ing Pa­per, No. 244, July 2001.↩︎
  119. In­fla­tion-in­dexed bonds are also is­sued by the United King­dom, Ger­many, the Rus­si­an Fed­er­a­tion, and Sweden, among oth­er coun­tries.↩︎
  120. OECD, Dir­ect­or­ate for Em­ploy­ment, La­bour and So­cial Af­fairs: Pen­sion sys­tems: “Ukraine: Pen­sion sys­tem pro­file.” https://www.oecd.org/countries/ukraine/45336467.pdf.↩︎
  121. OECD Pro­ject on Fin­an­cial In­cent­ives and Re­tire­ment Sav­ings, Policy Brief N°1,
    “The tax treat­ment of re­tire­ment sav­ings in private pen­sion plans,” Decem­ber 2018. https://www.oecd.org/daf/fin/private-pensions/Tax-treatment-of-retirement-savings-Policy-Brief-1.pdf.↩︎
  122. Tranio,
    “Real es­tate agency com­mis­sion rates in dif­fer­ent coun­tries,” Septem­ber 18, 2017. https://tranio.com/articles/real_estate_agents_commissions_in_various_countries.↩︎
  123. Bank for In­ter­na­tion­al Set­tle­ments, Joint For­um, “Mort­gage in­sur­ance: mar­ket struc­ture, un­der­writ­ing cycle and policy im­plic­a­tions,” Au­gust 2013. https://www.bis.org/publ/joint33.pdf.↩︎
  124. Euro­stat, “Mean and me­di­an in­come by edu­ca­tion­al at­tain­ment level–EU-SILC sur­vey.”
  125. Pay Scale, Inc. Col­lege Salary Re­port Up­dated for 2019.
  126. Bit­coin.org, “Avoid Scams:
    Fa­mil­i­ar­ize your­self with some of the most com­monly ob­served bit­coin scams to help pro­tect your­self and your fin­ances—Free Giveaways.” https://bitcoin.org/en/scams#free-giveaways.↩︎
  127. A fair coin is one that has a 50% chance of land­ing on either side when flipped.
    The “heads” and “tails” is a con­ven­tion when coins show im­ages of kings, queens, or pres­id­ents on one side (“heads”). By con­ven­tion, on Euro coins the side with the na­tion­al sym­bol is re­garded as “heads.”
    In­ter­est­ingly some re­search has found that the typ­ic­al EU coin is not “fair,” tend­ing to more of­ten land on heads.
    (The au­thors are not re­spons­ible if you try this and end up los­ing money ☺).↩︎

Readings Featured in the Elements

The Power of Incentives

By Dwight Lee

Ques­tion for thought: As you read through this doc­u­ment, think about what in­cent­ives are and why they mat­ter.
The surest way to get people to be­have in de­sir­able ways is to re­ward them for do­ing so—in oth­er words provide them with in­cent­ives.
This is so ob­vi­ous that you might think it hardly de­serves men­tion. But it does.
You might say that people shouldn’t have to be re­war­ded (or bribed) to do de­sir­able things.
Even when you ac­know­ledge that in­cent­ives are ne­ces­sary, it is not ob­vi­ous how to es­tab­lish the ones that mo­tiv­ate de­sir­able ac­tion.
I re­cently en­countered the emo­tion­al res­ist­ance some people have to us­ing in­cent­ives to ac­com­plish good things.
I was point­ing out that the ele­phant pop­u­la­tions in Zi­m­b­ab­we and South Africa were ex­pand­ing be­cause policies there al­low people to profit from main­tain­ing ele­phant herds.
A stu­dent who had stressed his en­vir­on­ment­al sens­it­iv­ity re­spon­ded that he would rather not see the ele­phant saved if the only way to do so was by re­ly­ing on people’s greed.
In oth­er words, he was will­ing to stand on prin­ciple as long as only the ele­phants suffered the con­sequences.
His prin­ciple, one that I sus­pect was shared by oth­ers “with sim­il­ar con­vic­tions”,
was that good things should be mo­tiv­ated by com­pas­sion and con­cern, not self-in­terest.
I couldn’t res­ist telling him that I would be im­pressed with his mor­al stance
if, when he re­quired del­ic­ate sur­gery to save his life, he re­fused to go to a sur­geon and let his moth­er per­form the op­er­a­tion in­stead.
Con­vin­cing people that in­cent­ives are ap­pro­pri­ate is not nearly as dif­fi­cult as de­term­in­ing the ap­pro­pri­ate in­cent­ives.
Of course, we want in­cent­ives that mo­tiv­ate people to be­have in de­sir­able ways, but what is de­sir­able?
In some situ­ations, the an­swer is rather ob­vi­ous. But not al­ways.
Every time you do a good thing, you ne­ces­sar­ily re­duce your abil­ity to do something else good.
This is an un­avoid­able im­plic­a­tion of scarcity and is cap­tured in the concept of op­por­tun­ity cost.
There are al­ways tradeoffs, and we of­ten need in­form­a­tion from many sources to know the best course of ac­tion.
So the two im­port­ant func­tions of in­cent­ives are: (1) to com­mu­nic­ate in­form­a­tion on the best things to do and (2) to mo­tiv­ate people to do them.

Incentives and the Treatment of Prisoners

In some cases the de­sir­able course of ac­tion is clear, and these cases let us con­cen­trate on the power of in­cent­ives to mo­tiv­ate people.
The Brit­ish gov­ern­ment’s prac­tice of con­tract­ing with ship cap­tains to trans­port pris­on­ers to Aus­tralia in the 1860s provides a good ex­ample.
The sur­viv­al rate of the pris­on­ers shipped to Aus­tralia was only 40 per­cent, which every­one knew was much too low.
Hu­man­it­ari­an groups, the church, and gov­ern­ment­al agen­cies ap­pealed to the cap­tains on mor­al grounds to im­prove the sur­viv­al rate with more de­cent treat­ment.
Des­pite these ap­peals, the sur­viv­al rate re­mained at 40 per­cent.
Fi­nally, an eco­nom­ist named Ed­win Chad­wick re­com­men­ded a change in in­cent­ives.
In­stead of pay­ing the cap­tains a fee for each pris­on­er who walked onto the ship in Eng­land,
Chad­wick sug­ges­ted pay­ing them for each pris­on­er who walked off the ship in Aus­tralia.
The im­prove­ment was im­me­di­ate and dra­mat­ic.
The sur­viv­al rate in­creased to over 98 per­cent, as the cap­tains now faced a strong in­cent­ive to pro­tect the health of pris­on­ers by re­du­cing the num­ber crowded into each ship and provid­ing them with bet­ter food and hy­giene in pas­sage.(1)

Creating Incentives Directly and Indirectly

De­sir­able in­cent­ives can some­times be cre­ated dir­ectly, as in the case of ship­ping pris­on­ers.
You know what you want done, so you cre­ate a re­ward (say, a cash pay­ment) for do­ing it.
Un­for­tu­nately, in most cases the type of be­ha­vi­or we de­sire re­quires subtly bal­an­cing com­pet­ing ob­ject­ives.
In such cases, cre­at­ing a dir­ect in­cent­ive to do one thing can be too ef­fect­ive be­cause it causes people to ig­nore oth­er things.
The former So­viet Uni­on was full of the per­versit­ies that can res­ult from the dir­ect ap­plic­a­tion of in­cent­ives.
Man­agers re­spon­ded to in­cent­ives to in­crease the pro­duc­tion of shoes, for ex­ample,
by mak­ing only a few sizes, hardly caring which sizes best fit con­sumers.
Such in­cent­ives af­fected people’s be­ha­vi­or, but they failed to pro­mote the so­cial co­oper­a­tion ne­ces­sary for a pro­duct­ive eco­nomy.
When the ob­ject­ive is to mo­tiv­ate people to co­oper­ate, de­sir­able res­ults can rarely be real­ized by dir­ectly es­tab­lish­ing in­cent­ives.
In­stead, in­cent­ives have to be es­tab­lished in­dir­ectly through a set of gen­er­al rules that al­low them to emerge from so­cial in­ter­ac­tion.
Traffic demon­strates the im­port­ance of gen­er­al rules in mo­tiv­at­ing co­oper­a­tion.
As ag­grav­at­ing as rush-hour traffic is, traffic flows re­flect an amaz­ing amount of spon­tan­eous so­cial co­oper­a­tion.
Without that co­oper­a­tion, tens of thou­sands of com­muters in every large city would get caught in a hope­less tangle of traffic.
The ba­sic rules that al­low mo­tor­ists to so ef­fect­ively co­oper­ate with one an­oth­er are simple: (1) drive on the right side of the road;
(2) go on green, either speed up or pre­pare to stop on yel­low, and stop on red;
(3) don’t ex­ceed the pos­ted speed lim­it by more than ten miles per hour; and (4) don’t touch.
These rules con­vert our in­cent­ive to get to our des­tin­a­tions safely and con­veni­ently into a pat­tern of ac­com­mod­at­ing be­ha­vi­or that serves the in­terests of all.(2)
The mar­ket eco­nomy is the ul­ti­mate ex­ample of how a set of rules can cre­ate a set­ting
in which private in­cent­ives mo­tiv­ate so­cial co­oper­a­tion.
Mar­ket eco­nom­ies do not cre­ate in­cent­ives dir­ectly. In­deed, in a lit­er­al sense, mar­kets don’t cre­ate in­cent­ives at all.
The most im­port­ant in­cent­ives come from the sub­ject­ive de­sires of in­di­vidu­als:
the in­cent­ive to find love, to earn re­spect, to make the world a bet­ter place, to provide for their fam­il­ies.
Mar­kets are the rules of con­duct that har­mon­ize these vari­ous in­cent­ives by mak­ing it pos­sible for people to com­mu­nic­ate their de­sires to oth­ers.
The prices, profits, and losses com­monly re­ferred to as mar­ket in­cent­ives, are cre­ated by people’s in­ter­act­ing with one an­oth­er.
These in­cent­ives, which can be com­mu­nic­ated only through mar­kets, con­tain in­form­a­tion that pro­motes so­cial co­oper­a­tion.
Con­clud­ing ques­tions: Now, can you ex­plain why private in­cent­ives are able to pro­mote so­cial co­oper­a­tion through mar­kets?
Do you think private in­cent­ives make the world a bet­ter place? Why or why not?
  1. For more on this ex­ample, see Robert B. Eke­lund, Jr., and Richard Ault, In­ter­me­di­ate Mi­croe­co­nom­ics: The­ory and Ap­plic­a­tions (Lex­ing­ton, Mass.: D.C. Heath and Com­pany, 1995), pp. 21–22.↩︎
  2. The ex­ample of traffic flow comes from Paul Heyne,
    The Eco­nom­ic Way of Think­ing, 8th ed. (Up­per Saddle River, N.J.: Pren­tice-Hall, Inc.),
    chapter 1.↩︎

The Road Not Taken

By Robert Frost

Ques­tion for thought: At a cross­road, trav­el­ing one path en­tails not trav­el­ing an­oth­er.
This con­di­tion forces the trav­el­er to make a choice. While read­ing through this poem, identi­fy the cost of trav­el­ing the road taken.
Two roads di­verged in a yel­low wood,
And sorry I could not travel both
And be one trav­el­er, long I stood
And looked down one as far as I could
To where it bent in the un­der­growth;
Then took the oth­er, as just as fair,
And hav­ing per­haps the bet­ter claim,
Be­cause it was grassy and wanted wear;
Though as for that the passing there
Had worn them really about the same,
And both that morn­ing equally lay
In leaves no step had trod­den black.
Oh, I kept the first for an­oth­er day!
Yet know­ing how way leads on to way,
I doubted if I should ever come back.
I shall be telling this with a sigh
Some­where ages and ages hence:
Two roads di­verged in a wood, and I—
I took the one less traveled by,
And that has made all the dif­fer­ence.
Con­clud­ing ques­tion: Faced with the same cross­roads in life, why do people make dif­fer­ent choices?
Ex­plain in terms of sub­ject­ive costs and be­ne­fits.

Opportunities and Costs

By Dwight Lee

Ques­tion for thought: As you read through this doc­u­ment, think about why scarcity forces us to make choices.
Mar­kets work by fa­cil­it­at­ing so­cial co­oper­a­tion.
They provide people with the in­form­a­tion and mo­tiv­a­tion to pur­sue their own ad­vant­ages in ways that best cre­ate op­por­tun­it­ies for oth­ers.
My em­phas­is is on the forest rather than the in­di­vidu­al trees of eco­nom­ic un­der­stand­ing.
Now I shall be­gin look­ing at some of the key con­cepts es­sen­tial to ap­ply­ing eco­nom­ic reas­on­ing to all hu­man activ­ity. I be­gin with op­por­tun­ity cost.

Limits and Opportunities

Eco­nom­ics has been called the dis­mal sci­ence be­cause it stud­ies the most fun­da­ment­al of all prob­lems, scarcity.
Be­cause of scarcity we all face the dis­mal real­ity that there are lim­its to what we can do.
No mat­ter how pro­duct­ive we be­come, we can nev­er ac­com­plish and en­joy as much as we would like.
The only thing we can do without lim­it is de­sire more.
Be­cause of scarcity, every time we do one thing we ne­ces­sar­ily have to forgo do­ing something else de­sir­able.
So there is an op­por­tun­ity cost to everything we do, and that cost is ex­pressed in terms of the most valu­able al­tern­at­ive that is sac­ri­ficed.
But the per­vas­ive­ness of costs sug­gests that the dis­mal real­ity of lim­its is only one side of a coin with a bright­er side.
The lim­its of scarcity cre­ate costs only when there are op­por­tun­it­ies.
Elim­in­ate the op­por­tun­ity to choose among al­tern­at­ives and there are no costs.
If, for ex­ample, I am forced to live in a par­tic­u­lar house, take a par­tic­u­lar job, marry a par­tic­u­lar wo­man,
and con­sume a set bundle of goods, I in­cur no costs when I do those things.
So the bright side of costs is the op­por­tun­it­ies that cre­ate them.
Ex­pand our op­por­tun­it­ies and the costs of everything we do in­crease.
Al­though we com­monly see cost as something to avoid, in fact we are bet­ter off liv­ing in an eco­nomy
where we are forced to con­front the cost of everything we do.
I per­son­ally might be bet­ter off if I could con­sume products without hav­ing to con­sider their costs be­cause I could shift them to oth­ers.
But any ad­vant­age I could real­ize would be more than off­set if oth­ers could ig­nore the costs of their activ­it­ies and shift them to me.
As a res­ult, we would all lack the in­form­a­tion and mo­tiv­a­tion to choose wisely.
Only when the costs of choices are im­posed on those who make those choices can we best use the op­por­tun­it­ies avail­able.
This is one way of ex­plain­ing the ad­vant­age of mar­ket prices.
The prices people pay in the mar­ket­place re­flect the op­por­tun­ity costs of their choices.
You can­not gen­er­ally pur­chase a good or ser­vice in a free mar­ket for less than oth­ers are will­ing to pay for it,
or for less than the amount spent to make it avail­able, which is an im­port­ant part of the so­cial co­oper­a­tion that emerges out of mar­ket trans­ac­tions.

Special Interests Don’t Want Costs Considered

Un­for­tu­nately, many eco­nom­ic de­cisions are made not in a mar­ket set­ting in re­sponse to mar­ket prices, but by gov­ern­ment in re­sponse to polit­ic­al con­sid­er­a­tions.
This cre­ates op­por­tun­it­ies for the polit­ic­ally in­flu­en­tial to ac­quire be­ne­fits paid for by the gen­er­al pub­lic.
In­vari­ably, those seek­ing polit­ic­al be­ne­fits down­play the costs in the hope of jus­ti­fy­ing lar­ger ex­pendit­ures;
they com­monly ar­gue that some things are so im­port­ant that costs shouldn’t even be con­sidered.
Edu­cat­ors ar­gue that edu­ca­tion is too im­port­ant to be con­sidered in terms of costs;
en­vir­on­ment­al­ists ar­gue that sav­ing the earth is so im­per­at­ive
that en­vir­on­ment­al pro­grams should be im­ple­men­ted re­gard­less of the costs;
re­cip­i­ents of med­ic­al re­search grants ar­gue that hu­man health trumps any crass con­sid­er­a­tion of costs;
and people sup­por­ted by the Na­tion­al En­dow­ment for the Arts claim
that the value of “art goes to the very soul of what it means to be hu­man” and is “con­tam­in­ated when com­pared with dol­lars and cents.”
(That’s a close para­phrase of a state­ment on arts fund­ing that I heard on Na­tion­al Pub­lic Ra­dio.)
All these state­ments are best un­der­stood as at­tempts by or­gan­ized groups to cap­ture more pub­lic money.
To con­sider costs has noth­ing to do with ex­ag­ger­at­ing the im­port­ance of money.
Money provides a con­veni­ent way of ex­press­ing costs, but money is not the cost of any­thing.
When I put down a ten- dol­lar bill to pay for a meal, the money may ap­pear to be the cost,
but the real cost is the op­por­tun­ity cost—the sub­ject­ive value I forgo by spend­ing the money on the meal rather
than spend­ing it on the most valu­able al­tern­at­ive.

Silly Claims

To claim that we shouldn’t con­sider the cost of do­ing some things
is equi­val­ent to claim­ing that we should do those things without con­sid­er­ing the al­tern­at­ives.
That such a trans­par­ently silly claim con­tin­ues to be used in spe­cial-in­terest plead­ing il­lus­trates the power of de­cep­tion over lo­gic in polit­ic­al de­bate.
Not con­sid­er­ing the al­tern­at­ives to do­ing something would make sense only if it were al­ways more valu­able than any­thing else.
But this means that we should de­vote all of our re­sources to this one thing.
If it were really true that fine or­ches­tral mu­sic, for ex­ample, was so valu­able that costs shouldn’t be con­sidered,
then every­one should go home­less and hungry and spend all of their time listen­ing to or­ches­tras in the nude.
This is ob­vi­ously silly, but not one bit sil­li­er than claim­ing that something is so im­port­ant that it is in­ap­pro­pri­ate to con­sider its cost.
As soon as two or more groups claim that their pro­gram should be fun­ded without con­sid­er­ing costs, the rel­ev­ance of costs should be ob­vi­ous.
Edu­cat­ing our youth and cur­ing our sick can­not both be too im­port­ant to con­sider cost, not in a world of scarcity.
The cost of do­ing more to edu­cate our youth is do­ing less to cure our sick, and vice versa.
To ig­nore the cost of one is to treat the oth­er as un­worthy in com­par­is­on.
Of course, the real­it­ies of scarcity, and the op­por­tun­ity costs that res­ult, in­trude into the polit­ic­al pro­cess
des­pite the spe­cial-in­terest rhet­or­ic dis­par­aging con­sid­er­a­tions of cost.
Com­par­is­ons have to be made among com­pet­ing al­tern­at­ives, so op­por­tun­ity costs are con­sidered in the polit­ic­al pro­cess.
Un­for­tu­nately, im­per­fec­tions and bi­ases in the polit­ic­al pro­cess pre­vent the op­por­tun­ity cost of gov­ern­ment ac­tion from be­ing ad­equately con­sidered.
The res­ult is what one should ex­pect when al­tern­at­ives are poorly con­sidered.
Waste oc­curs as de­cisions dir­ect re­sources out of more valu­able and into less valu­able activ­it­ies,
and of­ten into activ­it­ies coun­ter­pro­duct­ive to the stated ob­ject­ives.
Mar­ket prices do not per­fectly re­flect op­por­tun­ity costs, but one can ap­pre­ci­ate
how close they get by con­sid­er­ing the per­versit­ies that arise be­cause polit­ic­al de­cisions of­ten ig­nore most of the costs of a policy.
Con­clud­ing ques­tion: Now, what dis­ad­vant­ages are as­so­ci­ated with hav­ing our gov­ern­ment ig­nore op­por­tun­ity costs
while try­ing to edu­cate our youth, provide med­ic­al be­ne­fits to our sick and re­tire­ment to our seni­or pop­u­la­tion?

Markets and Marginalism

By Dwight Lee

Ques­tion for thought: As you read through this doc­u­ment, de­term­ine how firms max­im­ize out­put and value by equat­ing at the mar­gin?
To do your best in your per­son­al activ­it­ies, you have to “equate at the mar­gin,”
which means al­loc­at­ing your time over dif­fer­ent activ­it­ies so that the mar­gin­al value of time in every activ­ity is the same.
The im­port­ance of equat­ing at the mar­gin ex­tends bey­ond in­di­vidu­als do­ing as well as pos­sible per­son­ally;
it is also cru­cial to the suc­cess of the gen­er­al eco­nomy.
And be­cause of the in­form­a­tion and in­cent­ives trans­mit­ted through mar­ket prices, people and busi­nesses, re­spond­ing to their private con­cerns,
are led to co­oper­ate in ways that are con­stantly mov­ing mar­gins to­ward equal­ity throughout the eco­nomy.
A dis­cus­sion of this pro­cess provides ad­di­tion­al in­sight into the ad­vant­ages we all real­ize from the com­mu­nic­a­tion and co­oper­a­tion mo­tiv­ated by mar­ket prices.
There are a large num­ber of firms in the eco­nomy, each con­cerned primar­ily with in­creas­ing profits.
But the de­cisions these firms make af­fect all the oth­ers.
For ex­ample, the more that one firm pro­duces, the more scarce re­sources it has to use and the less oth­er firms can pro­duce.
Ideally, each firm will pro­duce whatever amount it chooses in a way that min­im­izes the sac­ri­ficed value else­where in the eco­nomy.
Achiev­ing this ideal re­quires an enorm­ous amount of in­form­a­tion on such things as weath­er con­di­tions,
re­source dis­cov­er­ies, hos­til­it­ies between coun­tries, pro­duct­ive tech­no­lo­gies,
and the par­tic­u­lar cir­cum­stances and sub­ject­ive pref­er­ences of mil­lions of work­ers, re­source own­ers, and con­sumers.
No gov­ern­ment agency could ever ac­quire and con­stantly up­date all this in­form­a­tion and use it prop­erly.
For­tu­nately, this in­form­a­tion is com­mu­nic­ated through mar­ket prices, with the in­put prices that firms pay re­flect­ing the mar­gin­al value of those in­puts in their best al­tern­at­ive uses.
So with each firm mo­tiv­ated to choose the in­put com­bin­a­tion that min­im­izes its cost of pro­du­cing a giv­en amount of out­put
(which re­quires equat­ing the mar­gin­al pro­ductiv­ity per dol­lar cost of all in­puts(1)),
it also chooses the in­put com­bin­a­tion that pro­duces that out­put at a min­im­um sac­ri­fice of value else­where in the eco­nomy.
This equat­ing at the mar­gin re­flects an im­press­ive amount of co­ordin­a­tion,
with each firm re­spons­ive to the value of in­puts to oth­ers.

Outputs and Marginal Adjustments

But it is not enough that each firm min­im­ize the value lost (the cost) from pro­du­cing its out­put to make the best use of our lim­ited re­sources.
Each firm could be pro­du­cing its out­put at the low­est cost, with the com­bin­a­tion of all firms’ out­puts be­ing too costly.
For ex­ample, we could pro­duce dozens of dis­pos­able di­apers daily for every Amer­ic­an with the least-cost com­bin­a­tion of in­puts.
This is ob­vi­ously too many dis­pos­able di­apers be­cause the mar­gin­al costs (even though as low as pos­sible) of di­apers would be far great­er
than their mar­gin­al value—the value sac­ri­ficed to pro­duce one more di­aper is great­er than the di­aper is worth.
Pro­du­cing the com­bin­a­tion of all goods that cre­ates the greatest value for the re­sources used re­quires not only
that each good be pro­duced at least cost, but that each good be pro­duced only up to the point where its mar­gin­al value equals its mar­gin­al cost.
Again, equat­ing at the mar­gin gen­er­ates the most valu­able com­bin­a­tion of products over all firms.
And by simply re­spond­ing to mar­ket prices, each firm has ac­cess to all the ne­ces­sary in­form­a­tion.
The price of a firm’s product re­flects its mar­gin­al value, and in­put prices de­term­ine the firm’s mar­gin­al pro­duc­tion costs.
This in­form­a­tion, when used by firms try­ing to make as much profit as pos­sible, res­ults in that com­bin­a­tion of out­puts that cre­ates the most value.
Each firm in­creases its profits by ex­pand­ing out­put as long as the price it re­ceives for its product is great­er than its mar­gin­al cost
(the value sac­ri­ficed by re­du­cing the amount pro­duced by oth­er firms).(2)
So when all firms pro­duce the amount where price equals mar­gin­al cost, each firm is max­im­iz­ing its own profit and the value of the com­bin­a­tion of goods pro­duced is max­im­ized.
Be­cause mar­ket prices co­ordin­ate pro­duc­tion de­cisions, these de­cisions are equated at the mar­gin over all firms,
and it is im­possible to in­crease the value of the com­bin­a­tion of goods pro­duced by ex­pand­ing the out­put of some firms and re­du­cing the out­put of oth­ers.

The Big Advantage Is Liberty

I have dis­cussed a level of “per­fec­tion” nev­er reached in the real world.
The rel­ev­ant mar­gins nev­er reach com­plete equal­ity be­cause the count­less num­ber of pref­er­ences,
cir­cum­stances, and tech­no­lo­gies af­fect­ing the value of in­puts and out­puts con­stantly changes.
But mar­ket prices con­stantly change to provide in­form­a­tion on new con­di­tions and to re­ward be­ha­vi­or that pushes the mar­gins to­ward equal­ity.
That re­duces the cost and in­creases the value of what is be­ing pro­duced.
These mar­ket ad­just­ments do a far bet­ter job max­im­iz­ing the value of eco­nom­ic de­cisions by keep­ing all de­cision-makers re­spons­ive to oth­ers than any group of gov­ern­ment plan­ners could ever do.
But the greatest ad­vant­age of the mar­ket is the liberty it al­lows.
People can pur­sue their in­di­vidu­al val­ues and con­cerns in­stead of be­ing her­ded into broad cat­egor­ies by re­mote au­thor­it­ies and told how to be­have to pro­mote some vis­ion of the gen­er­al good.
For ex­ample, a busi­ness may not max­im­ize profits
be­cause the own­er wishes to em­ploy dis­ad­vant­aged youth or take time off for vo­lun­teer work.
Or a work­er may choose not to take the highest-pay­ing job be­cause he doesn’t want to move away from a sick par­ent.
People make these types of de­cisions every day, and the val­ues they re­flect
can nev­er be com­mu­nic­ated through the polit­ic­al pro­cess and prop­erly re­spon­ded to by polit­ic­al au­thor­it­ies.
But people can com­mu­nic­ate their val­ues and con­cerns through the ef­fect their de­cisions have on mar­ket prices.
And when people do so, they can be con­fid­ent that oth­ers will con­sider those con­cerns in their own de­cisions.
The res­ult is a pat­tern of mu­tu­al ad­just­ment and co­ordin­a­tion
that cre­ates far more wealth and op­por­tun­ity than could ever be achieved by cent­ral dir­ec­tion.
Con­clud­ing Ques­tion: Now, do gov­ern­ments or firms do a bet­ter job of max­im­iz­ing out­put and value? Ex­plain.
  1. For ex­ample, if the mar­gin­al pro­ductiv­ity for $1 of in­put X is 2 while the mar­gin­al pro­ductiv­ity for $1 of in­put Y is only 1,
    then the firm could ex­pand its use of in­put X by $1 (in­creas­ing out­put by 2 units),
    re­duce its use of in­put Y by $2 (re­du­cing out­put by 2 units),
    there­fore main­tain­ing the same out­put at a cost of $1 less.↩︎
  2. This state­ment has to be qual­i­fied if the firm is a mono­pol­ist be­cause price and mar­gin­al rev­en­ue di­verge, as ex­plained in every mi­croe­co­nom­ics text.
    But un­less per­petu­ated by gov­ern­ment, this mono­poly “dis­tor­tion” is rather be­nign when con­sidered over time.
    In­deed, dy­nam­ic eco­nomy ef­fi­ciency is in­creased when firms can strive for, and tem­por­ar­ily achieve, “mono­poly” power.↩︎

Specialization and Wealth

By Dwight R. Lee

Ques­tion for thought: As you read through this doc­u­ment, de­term­ine how spe­cial­iz­a­tion,
vol­un­tary ex­change and co­oper­a­tion can lead to wealth ac­cu­mu­la­tion.
A re­mark­able de­gree of so­cial co­oper­a­tion emerges through mar­ket com­mu­nic­a­tion.
Now, let’s con­sider some of the ad­vant­ages we real­ize from that co­oper­a­tion. At a gen­er­al level these ad­vant­ages are ob­vi­ous.
It simply makes sense that we can pro­duce more if our ac­tions are in har­mony than if we are work­ing at cross-pur­poses.
But to really un­der­stand eco­nom­ics, we must con­sider the link between co­oper­a­tion and pro­ductiv­ity in de­tail.
Wealth sel­dom comes as manna from heav­en.
It has to be pro­duced by ap­ply­ing hu­man ef­fort, in­tel­li­gence, and pa­tience to nat­ur­al en­dow­ments that yield their bounty re­luct­antly. This should be ob­vi­ous.
But one meas­ure of the suc­cess of the mar­ket­place at im­prov­ing our pro­duct­ive powers is
that it has be­come all too easy for people to as­sume that wealth is part of the nat­ur­al or­der of things.
Aca­dem­ics and policy wonks con­sider the dis­tri­bu­tion of wealth to be the primary is­sue, while dis­miss­ing any con­cern that their policy pre­scrip­tions could hamper its pro­duc­tion.
They drone on and on about the causes of poverty (or the “im­prop­er” dis­tri­bu­tion of wealth),
ap­par­ently un­aware that de­term­in­ing the causes of wealth is the ser­i­ous chal­lenge.
The suc­cess of cap­it­al­ism has blinded a re­mark­able num­ber of oth­er­wise in­tel­li­gent people to the simple truth that dis­tri­bu­tion comes be­fore pro­duc­tion only in the dic­tion­ary.

Specialization’s Special Role

When eco­nom­ics emerged as a sep­ar­ate aca­dem­ic dis­cip­line in the late eight­eenth cen­tury, it was ob­vi­ous what the eco­nom­ic prob­lem was.
Adam Smith titled his eco­nom­ics book An In­quiry into the Nature and Causes of the Wealth of Na­tions,
and his con­cern with ex­plain­ing wealth is ap­par­ent from the very first page.
Smith be­gins by ob­serving: “The greatest im­prove­ment in the pro­duct­ive powers of la­bour . . . seem[s] to be the ef­fects of the di­vi­sion of la­bour.”
He il­lus­trates the im­port­ance of spe­cial­iz­a­tion, or the di­vi­sion of labor,
by con­sid­er­ing the ad­vant­age of hav­ing each work­er in a pin fact­ory con­cen­trate on a par­tic­u­lar step in pro­duc­tion rather than pro­du­cing a pin from be­gin­ning to end.
Through spe­cial­iz­a­tion work­ers can be­come more skill­ful, use ma­chinery that in­creases their pro­duct­ive powers, and avoid the loss of time from con­stantly chan­ging activ­it­ies.
These ad­vant­ages are rather ob­vi­ous, but the in­crease in pro­ductiv­ity is far great­er than one would ex­pect.
Ac­cord­ing to Smith, ten pin-makers, by spe­cial­iz­ing in dif­fer­ent tasks, can pro­duce about forty-eight thou­sand pins a day.
But if each at­temp­ted to per­form every task in pin pro­duc­tion,
Smith doubted that they could each make twenty pins a day, or two hun­dred among them.
But it takes more than ex­tra out­put to cre­ate a real in­crease in pro­ductiv­ity.
A spe­cial­ist pro­duces much more of a product, or part of a product, than he wishes to con­sume him­self.
Pro­du­cing lots of out­put is not pro­duct­ive un­less it ends up in the hands of those who value it.
So the ad­vant­age of spe­cial­iz­a­tion can be real­ized only to the de­gree that people can co­oper­ate,
with each spe­cial­iz­ing in the pro­duc­tion of something that oth­ers want in or­der to be able to ac­quire what he wants from the spe­cial­ized pro­duc­tion of oth­ers.
The only way for this co­oper­a­tion to oc­cur, and thus the only way to real­ize the pro­ductiv­ity of spe­cial­iz­a­tion, is through ex­change.
Adam Smith re­cog­nized the cru­cial con­nec­tion between ex­change and pro­ductiv­ity when he ob­served
that “the ex­tent of this di­vi­sion [of labor] must al­ways be lim­ited by . . . the ex­tent of the mar­ket.”
If you can ex­change only with those in a small vil­lage, your abil­ity to spe­cial­ize pro­duct­ively is ex­tremely lim­ited.
For ex­ample, how many could af­ford to pur­sue ca­reers writ­ing nov­els, paint­ing land­scapes, or mas­ter­ing mu­sic­al in­stru­ments,
no mat­ter how great their tal­ents, with only a few people to ap­pre­ci­ate and re­ward their ac­com­plish­ments?
In such set­tings, most people tend to be­come “a jack-of-all trades, but mas­ter of none.”
The more lim­ited the mar­ket, the more lim­ited the pro­duct­ive po­ten­tial of spe­cial­iz­a­tion.

Expanding the Market

The link between spe­cial­iz­a­tion and the size of the mar­ket provides an­oth­er ex­plan­a­tion of the im­port­ance of mar­ket co­oper­a­tion based on private prop­erty and vol­un­tary ex­change.
Co­oper­a­tion is pos­sible without mar­kets, at least without mar­kets as we nor­mally think of them.
Fam­ily mem­bers co­oper­ate on the basis of in­tim­ate know­ledge and shared con­cerns.
Mem­bers of small firms can work co­oper­at­ively in re­sponse to a com­mon ob­ject­ive and peer pres­sures.
The same can be said for churches, clubs, and oth­er re­l­at­ively small so­cial or­gan­iz­a­tions.
The co­oper­a­tion with­in fam­il­ies, firms, and so­cial or­gan­iz­a­tions can be ex­plained as the res­ult of ex­change re­la­tion­ships.
(Gary Beck­er’s writ­ings on the fam­ily and the de­pic­tion of the firm as a “nex­us of con­tracts” are good ex­amples of such ex­plan­a­tions.)
But such re­la­tion­ships, be­cause they de­pend on per­son­al as­so­ci­ation and com­mon ob­ject­ives, are lim­ited to re­l­at­ively small groups.
A key to the pro­ductiv­ity of the mar­ket is that it greatly ex­tends the range of co­oper­a­tion,
and there­fore greatly in­creases our abil­ity to spe­cial­ize pro­duct­ively.
Ob­vi­ously the ex­pan­sion of mar­kets has de­pended on im­prove­ments in trans­port­a­tion and com­mu­nic­a­tion net­works.
But without the in­form­a­tion com­mu­nic­ated through mar­ket prices, and the co­oper­a­tion mo­tiv­ated by these prices,
im­prove­ments in trans­port­a­tion and verbal and writ­ten com­mu­nic­a­tion would be in­suf­fi­cient to real­ize much of the ad­vant­age of spe­cial­iz­a­tion.
Brazili­ans could com­mu­nic­ate their de­sire for more den­im cloth­ing
with a steady bar­rage of faxes, e-mails, and tele­phone calls to cloth­ing man­u­fac­tur­ers in every coun­try in the world, with it be­ing pos­sible to ship the cloth­ing to them overnight from any­where on the globe.
But without the in­form­a­tion com­mu­nic­ated by changes in re­l­at­ive mar­ket prices,
Brazili­ans would be un­able to mo­tiv­ate cot­ton grow­ers, ag­ri­cul­tur­al chem­ic­al pro­du­cers, dye man­u­fac­tur­ers, tex­tile work­ers, truck drivers,
air­line pi­lots, mer­chants, and count­less oth­ers to co­ordin­ate their spe­cial­ized ef­forts to make sure
that the den­im cloth­ing was made avail­able in Brazil in the de­sired quant­it­ies and pre­ferred styles.

The Impersonal Market

The mar­ket is of­ten cri­ti­cized as im­per­son­al.
It can be, but that’s why it so greatly ex­tends the range of co­oper­at­ive spe­cial­iz­a­tion.
People don’t have to know, or care for, those they are co­oper­at­ing with, or those whom their co­oper­at­ive ef­forts are serving, when they re­spond to mar­ket prices.
The mar­ket does far more to foster mul­ti­cul­tur­al co­oper­a­tion and glob­al har­mony than can ever be achieved by the per­son­al ef­forts of gov­ern­ment dip­lo­mats.
It is the co­oper­a­tion and har­mony of the mar­ket­place, and the spe­cial­iz­a­tion that it al­lows, that ex­plain the cre­ation of wealth.
Con­clud­ing ques­tion: Now, can you ex­plain why co­oper­a­tion and vol­un­tary ex­change lead to the real in­crease in pro­ductiv­ity res­ult­ing from spe­cial­iz­a­tion?

Sacrificing Lives for Profits

By Dwight R. Lee

Ques­tions for thought: Do auto­makers sac­ri­fice lives for profit?
Why can there be con­flict between value on life and profit?
Des­pite what people com­monly say about how hu­man life be­ing price­less, they put a price on their lives every day with their ac­tions.
People take chances that shorten their life ex­pect­an­cies to do things that are fun, and for the con­veni­ence and sav­ings of not tak­ing every pre­cau­tion pos­sible.
When people will­ingly ac­cept risks to ac­quire things they value, they are put­ting a price on their lives—
telling us with their ac­tions that the mar­gin­al value of their lives is less than the of­ten quite low value they real­ize from over­eat­ing, not ex­er­cising, driv­ing too fast, and so on.
Un­for­tu­nately, when people take chances they some­times have re­gret­table ac­ci­dents.
Noth­ing is more nat­ur­al than feel­ing sorry for those who have suffered ser­i­ous in­jury or death be­cause they ex­posed them­selves to risk.
But our sym­pathy for them should not blind us to the fact that we would not be do­ing adults a fa­vor by in­ter­fer­ing with their abil­ity to take risks
that, giv­en their pref­er­ences and cir­cum­stances, make sense to them.
Yet such policies are con­doned and en­cour­aged every day by well-mean­ing people who (1) fail to re­cog­nize that, at the mar­gin, hu­man life is not price­less
and (2) don’t un­der­stand how prices and profits em­power people to com­mu­nic­ate ef­fect­ively their de­sires to busi­ness firms.
These are people who are quick to ex­press mor­al out­rage when they hear the charge
that cor­por­a­tions sac­ri­fice lives to in­crease their profits by mak­ing un­safe products.
People are ac­ci­dent­ally in­jured and killed every day be­cause products are not as safe as they could be.
More than ever be­fore, the pre­vail­ing leg­al en­vir­on­ment en­cour­ages those harmed in these ac­ci­dents to sue man­u­fac­tur­ers of
“un­safe” products to com­pensate for their pain and suf­fer­ing.
An ob­vi­ous in­duce­ment for these suits is that the pay­off to plaintiffs and their law­yers can be high, oc­ca­sion­ally out­rageously high.
For ex­ample, in 1999 a $4.9 bil­lion judg­ment against Gen­er­al Mo­tors was awar­ded to six people severely burned
when their 1979 Malibu caught fire after be­ing hit by a drunk driver go­ing between 50 and 70 miles per hour.(1)
The charge that sways jur­ies and of­fends pub­lic sens­it­iv­it­ies, and helps ex­plain the large awards, is that greedy cor­por­a­tions sac­ri­fice hu­man lives to in­crease their profits.
Is this charge true? Of course it is. But this isn’t a cri­ti­cism of cor­por­a­tions; rather it is a re­flec­tion of the prop­er func­tion­ing of a mar­ket eco­nomy.
Cor­por­a­tions routinely sac­ri­fice the lives of some of their cus­tom­ers to in­crease profits, and we are all bet­ter off be­cause they do.
That’s right, we are lucky to live in an eco­nomy that al­lows cor­por­a­tions to in­crease profits
by in­ten­tion­ally selling products less safe than could be pro­duced.
The de­sirab­il­ity of sac­ri­fi­cing lives for profits may not be as com­fort­ing as milk, cook­ies, and a bed­time story, but it fol­lows dir­ectly from a real­ity we can­not wish away.
The real­ity is scarcity. There are lim­its to the de­sir­able things that can be pro­duced.
If we want more of one thing, we have to do with less of oth­er things.
Those ex­press­ing out­rage that safety is sac­ri­ficed for profit ig­nore this ob­vi­ous point.
For ex­ample, traffic fatal­it­ies could be re­duced if cars were built like Sher­man tanks.
But the ex­tra safety would come at the sac­ri­fice of gas mileage, com­fort, speed, and park­ing con­veni­ence,
not to men­tion all the things you couldn’t buy after pay­ing the ex­traordin­ar­ily high price of a Tank­mobile.
Long be­fore we in­creased auto­mot­ive safety to that of a Tank­mobile,
the mar­gin­al value of the ad­di­tion­al life ex­pect­ancy would be far less than the mar­gin­al value of what would be giv­en up.
It simply makes no sense to re­duce traffic deaths as much as pos­sible by mak­ing auto­mo­biles as safe as pos­sible.

Communicating with Profits

But how much safety is the right amount? The an­swer var­ies among in­di­vidu­als.
Some people get so much en­joy­ment out of rid­ing mo­tor­cycles, for ex­ample, that they do so even though the chances of sur­viv­ing an ac­ci­dent are 17 times great­er in a car.
People typ­ic­ally pur­chase more safety as their in­comes in­crease and when more people are de­pend­ent on them.
When I was in gradu­ate school, I drove a battered Volk­swa­gen Bug with a door that wouldn’t close com­pletely.
I chose more edu­ca­tion at the cost of less safety.
Now that I have a fam­ily and more in­come, I am will­ing to pay for more safety,
so I drive a Sub­urb­an—not quite a Sher­man tank, but close.
How do people com­mu­nic­ate their de­mand for safety to auto­mobile man­u­fac­tur­ers?
Through the prices they are will­ing to pay for dif­fer­ent types of cars and the profits gen­er­ated by these prices.
There would be no profit in mak­ing a car as safe as a Sher­man tank be­cause nobody would buy it.
Car com­pan­ies make more profit as they get closer to in­cor­por­at­ing the in­ev­it­able tradeoffs in auto­mobile designs to the lik­ing of con­sumers.
So when car man­u­fac­tur­ers com­prom­ise on safety to in­crease profits, they are do­ing what we want them to do—re­spond­ing to our pref­er­ences.
This is not to say that mis­takes aren’t made.
Prices and profits don’t al­low con­sumers to com­mu­nic­ate every as­pect of their pref­er­ences for cars with sur­gic­al pre­ci­sion.
But the ad­vant­age of profits in mo­tiv­at­ing auto safety is
that when a car com­pany doesn’t give con­sumers what they want, profit op­por­tun­it­ies in­crease for car com­pan­ies that do.
And al­though this mar­ket pro­cess doesn’t work per­fectly, it works bet­ter than any oth­er pro­cess.
Un­for­tu­nately, with any reas­on­able level of product safety, people will be killed and in­jured in ac­ci­dents.
The cost and carnage of these ac­ci­dents are eas­ily seen,
as is the fact that the dam­age would have been less if only more safety had been built into the product be­ing used.
Not as eas­ily seen are the ad­vant­ages mil­lions of people real­ize from not hav­ing to pay for more safety than they want—
ad­vant­ages like more money to spend on edu­ca­tion, medi­cine, cloth­ing, and hous­ing.
And more edu­ca­tion, bet­ter medi­cines, and im­prove­ments in the cloth­ing and hous­ing avail­able are all as­so­ci­ated with longer life ex­pect­an­cies.
Those whose lives are cut short by ac­ci­dents are ob­vi­ously iden­ti­fi­able, while we will nev­er know
who avoided a pre­ma­ture death be­cause of the prosper­ity gen­er­ated by an eco­nom­ic sys­tem guided by mar­ket prices and profits.
But there can be no doubt that the lat­ter far out­num­ber the former.
Con­clud­ing Ques­tion: Now, how do prices and profits em­power you and oth­er con­sumers to com­mu­nic­ate your pref­er­ences to busi­nesses?
  1. The ac­tu­al set­tle­ment will be less,
    though still much high­er than jus­ti­fied by how much people value the mar­gin­al safety in­volved in the case.
    As of March 2000 the plaintiffs have offered to settle for $400 mil­lion,
    but Gen­er­al Mo­tors has re­fused so it can con­tin­ue ap­peal­ing the case.↩︎

I, Pencil, My Family Tree

By Leonard E. Read

Ques­tion for thought: While read­ing through this doc­u­ment, ex­plain how mar­kets form a net­work
that en­cour­ages and dir­ects mil­lions of people to co­oper­ate with each oth­er.
I am a lead pen­cil—the or­din­ary wooden pen­cil fa­mil­i­ar to all boys and girls and adults who can read and write.
Writ­ing is both my vo­ca­tion and my avoca­tion; that’s all I do.
You may won­der why I should write a gene­a­logy. Well, to be­gin with, my story is in­ter­est­ing.
And, next, I am a mys­tery—more so than a tree or a sun­set or even a flash of light­ning.
But, sadly, I am taken for gran­ted by those who use me, as if I were a mere in­cid­ent and without back­ground.
This su­per­cili­ous at­ti­tude re­leg­ates me to the level of the com­mon­place.
This is a spe­cies of the griev­ous er­ror in which man­kind can­not too long per­sist without per­il.
For, the wise G. K. Chester­ton ob­served, “We are per­ish­ing for want of won­der, not for want of won­ders.”
I, Pen­cil, simple though I ap­pear to be, mer­it your won­der and awe, a claim I shall at­tempt to prove.
In fact, if you can un­der­stand me—no, that’s too much to ask of any­one—
if you can be­come aware of the mi­ra­cu­lous­ness which I sym­bol­ize, you can help save the free­dom man­kind is so un­hap­pily los­ing.
I have a pro­found les­son to teach. And I can teach this les­son bet­ter than can an auto­mobile or an air­plane or a mech­an­ic­al dish­wash­er be­cause—well, be­cause I am seem­ingly so simple.
Simple? Yet, not a single per­son on the face of this earth knows how to make me.
This sounds fant­ast­ic, doesn’t it? Es­pe­cially when it is real­ized that there are about one and one-half bil­lion of my kind pro­duced in the U.S.A. each year.
Pick me up and look me over. What do you see? Not much meets the eye—there’s some wood, lac­quer, the prin­ted la­beling, graph­ite lead, a bit of met­al, and an eraser.

Innumerable Antecedents

Just as you can­not trace your fam­ily tree back very far, so is it im­possible for me to name and ex­plain all my ante­cedents.
But I would like to sug­gest enough of them to im­press upon you the rich­ness and com­plex­ity of my back­ground.
My fam­ily tree be­gins with what in fact is a tree, a ce­dar of straight grain that grows in North­ern Cali­for­nia and Ore­gon.
Now con­tem­plate all the saws and trucks and rope and the count­less oth­er gear used in har­vest­ing and cart­ing the ce­dar logs to the rail­road sid­ing.
Think of all the per­sons and the num­ber­less skills that went into their fab­ric­a­tion:
the min­ing of ore, the mak­ing of steel and its re­fine­ment into saws, axes, mo­tors;
the grow­ing of hemp and bring­ing it through all the stages to heavy and strong rope;
the log­ging camps with their beds and mess halls, the cook­ery and the rais­ing of all the foods.
Why, un­told thou­sands of per­sons had a hand in every cup of cof­fee the log­gers drink!
The logs are shipped to a mill in San Leandro, Cali­for­nia.
Can you ima­gine the in­di­vidu­als who make flat cars and rails and rail­road en­gines
and who con­struct and in­stall the com­mu­nic­a­tion sys­tems in­cid­ent­al thereto?
These le­gions are among my ante­cedents.
Con­sider the mill­work in San Leandro.
The ce­dar logs are cut into small, pen­cil-length slats less than one-fourth of an inch in thick­ness.
These are kiln dried and then tin­ted for the same reas­on wo­men put rouge on their faces.
People prefer that I look pretty, not a pal­lid white. The slats are waxed and kiln dried again.
How many skills went into the mak­ing of the tint and the kilns, into sup­ply­ing the heat,
the light and power, the belts, mo­tors, and all the oth­er things a mill re­quires?
Sweep­ers in the mill among my an­cest­ors?
Yes, and in­cluded are the men who poured the con­crete for the dam of a Pa­cific Gas & Elec­tric Com­pany hy­dro­plant which sup­plies the mill’s power!
Don’t over­look the an­cest­ors present and dis­tant who have a hand in trans­port­ing sixty car­loads of slats across the na­tion.
Once in the pen­cil fact­ory—$4,000,000 in ma­chinery and build­ing, all cap­it­al ac­cu­mu­lated by thrifty and sav­ing par­ents of mine—
each slat is giv­en eight grooves by a com­plex ma­chine,
after which an­oth­er ma­chine lays leads in every oth­er slat, ap­plies glue, and places an­oth­er slat atop—a lead sand­wich, so to speak.
Sev­en broth­ers and I are mech­an­ic­ally carved from this "wood-clinched" sand­wich.
My "lead" it­self—it con­tains no lead at all—is com­plex. The graph­ite is mined in Ceylon.
Con­sider these miners and those who make their many tools and the makers of the pa­per sacks in which the graph­ite is shipped
and those who make the string that ties the sacks and those who put them aboard ships and those who make the ships.
Even the light­house keep­ers along the way as­sisted in my birth—and the har­bor pi­lots.
The graph­ite is mixed with clay from Mis­sis­sippi in which am­moni­um hy­drox­ide is used in the re­fin­ing pro­cess.
Then wet­ting agents are ad­ded such as sulf­on­ated tal­low—an­im­al fats chem­ic­ally re­acted with sul­fur­ic acid.
After passing through nu­mer­ous ma­chines, the mix­ture fi­nally ap­pears as end­less ex­tru­sions—as from a saus­age grinder-cut to size, dried, and baked for sev­er­al hours at 1,850 de­grees Fahren­heit.
To in­crease their strength and smooth­ness the leads are then treated with a hot mix­ture
which in­cludes can­delilla wax from Mex­ico, par­affin wax, and hy­dro­gen­ated nat­ur­al fats.
My ce­dar re­ceives six coats of lac­quer.
Do you know all the in­gredi­ents of lac­quer? Who would think that the grow­ers of castor beans and the re­finers of castor oil are a part of it? They are.
Why, even the pro­cesses by which the lac­quer is made a beau­ti­ful yel­low in­volve the skills of more per­sons than one can enu­mer­ate!
Ob­serve the la­beling. That’s a film formed by ap­ply­ing heat to car­bon black mixed with res­ins.
How do you make res­ins and what, pray, is car­bon black?
My bit of met­al—the fer­rule—is brass.
Think of all the per­sons who mine zinc and cop­per and those who have the skills to make shiny sheet brass from these products of nature.
Those black rings on my fer­rule are black nick­el.
What is black nick­el and how is it ap­plied? The com­plete story of why the cen­ter of my fer­rule has no black nick­el on it would take pages to ex­plain.
Then there’s my crown­ing glory, in­el­eg­antly re­ferred to in the trade as "the plug," the part man uses to erase the er­rors he makes with me.
An in­gredi­ent called "factice" is what does the eras­ing.
It is a rub­ber- like product made by re­act­ing rape-seed oil from the Dutch East In­dies with sul­fur chlor­ide.
Rub­ber, con­trary to the com­mon no­tion, is only for bind­ing pur­poses.
Then, too, there are nu­mer­ous vul­can­iz­ing and ac­cel­er­at­ing agents.
The pumice comes from Italy; and the pig­ment which gives "the plug" its col­or is cad­mi­um sulf­ide.

No One Knows

Does any­one wish to chal­lenge my earli­er as­ser­tion that no single per­son on the face of this earth knows how to make me?
Ac­tu­ally, mil­lions of hu­man be­ings have had a hand in my cre­ation, no one of whom even knows more than a very few of the oth­ers.
Now, you may say that I go too far in re­lat­ing the pick­er of a cof­fee berry in far off Brazil and food grow­ers else­where to my cre­ation; that this is an ex­treme po­s­i­tion. I shall stand by my claim.
There isn’t a single per­son in all these mil­lions, in­clud­ing the pres­id­ent of the pen­cil com­pany,
who con­trib­utes more than a tiny, in­fin­ites­im­al bit of know-how.
From the stand­point of know-how the only dif­fer­ence between the miner of graph­ite in Ceylon and the log­ger in Ore­gon is in the type of know-how.
Neither the miner nor the log­ger can be dis­pensed with, any more than can the chem­ist at the fact­ory or the work­er in the oil field—par­affin be­ing a by-product of pet­ro­leum.
Here is an astound­ing fact: Neither the work­er in the oil field nor the chem­ist nor the dig­ger of graph­ite or clay nor any who mans or makes the ships or trains or trucks
nor the one who runs the ma­chine that does the knurl­ing on my bit of met­al nor the pres­id­ent of the com­pany per­forms his sin­gu­lar task be­cause he wants me.
Each one wants me less, per­haps, than does a child in the first grade.
In­deed, there are some among this vast mul­ti­tude who nev­er saw a pen­cil nor would they know how to use one. Their mo­tiv­a­tion is oth­er than me.
Per­haps it is something like this: Each of these mil­lions sees
that he can thus ex­change his tiny know-how for the goods and ser­vices he needs or wants. I may or may not be among these items.

No Master Mind

There is a fact still more astound­ing: the ab­sence of a mas­ter mind, of any­one dic­tat­ing or for­cibly dir­ect­ing these count­less ac­tions which bring me into be­ing.
No trace of such a per­son can be found. In­stead, we find the In­vis­ible Hand at work. This is the mys­tery to which I earli­er re­ferred.
It has been said that "only God can make a tree."
Why do we agree with this? Isn’t it be­cause we real­ize that we ourselves could not make one?
In­deed, can we even de­scribe a tree? We can­not, ex­cept in su­per­fi­cial terms.
We can say, for in­stance, that a cer­tain mo­lecu­lar con­fig­ur­a­tion mani­fests it­self as a tree.
But what mind is there among men that could even re­cord, let alone dir­ect, the con­stant changes in mo­lecules that tran­spire in the life span of a tree? Such a feat is ut­terly un­think­able!
I, Pen­cil, am a com­plex com­bin­a­tion of mir­acles: a tree, zinc, cop­per, graph­ite, and so on.
But to these mir­acles which mani­fest them­selves in Nature an even more ex­traordin­ary mir­acle has been ad­ded:
the con­fig­ur­a­tion of cre­at­ive hu­man en­er­gies—mil­lions of tiny know-hows con­fig­ur­at­ing nat­ur­ally
and spon­tan­eously in re­sponse to hu­man ne­ces­sity and de­sire and in the ab­sence of any hu­man mas­ter- mind­ing!
Since only God can make a tree, I in­sist that only God could make me.
Man can no more dir­ect these mil­lions of know-hows to bring me into be­ing than he can put mo­lecules to­geth­er to cre­ate a tree.
The above is what I meant when writ­ing, “If you can be­come aware of the mi­ra­cu­lous­ness which I sym­bol­ize, you can help save the free­dom man­kind is so un­hap­pily los­ing.”
For, if one is aware that these know-hows will nat­ur­ally, yes,
auto­mat­ic­ally, ar­range them­selves into cre­at­ive and pro­duct­ive pat­terns in re­sponse to hu­man ne­ces­sity and de­mand—
that is, in the ab­sence of gov­ern­ment­al or any oth­er co­er­cive mas­ter­mind­ing—
then one will pos­sess an ab­so­lutely es­sen­tial in­gredi­ent for free­dom: a faith in free people. Free­dom is im­possible without this faith.
Once gov­ern­ment has had a mono­poly of a cre­at­ive activ­ity such, for in­stance, as the de­liv­ery of the mails,
most in­di­vidu­als will be­lieve that the mails could not be ef­fi­ciently de­livered by men act­ing freely.
And here is the reas­on: Each one ac­know­ledges that he him­self doesn’t know how to do all the things in­cid­ent to mail de­liv­ery.
He also re­cog­nizes that no oth­er in­di­vidu­al could do it. These as­sump­tions are cor­rect.
No in­di­vidu­al pos­sesses enough know-how to per­form a na­tion’s mail de­liv­ery any more than any in­di­vidu­al pos­sesses enough know-how to make a pen­cil.
Now, in the ab­sence of faith in free people—in the un­aware­ness that mil­lions of tiny know-hows would nat­ur­ally and mi­ra­cu­lously form and co­oper­ate to sat­is­fy this ne­ces­sity—
the in­di­vidu­al can­not help but reach the er­ro­neous con­clu­sion that mail can be de­livered only by gov­ern­ment­al "mas­ter- mind­ing."

Testimony Galore

If I, Pen­cil, were the only item that could of­fer testi­mony on what men and wo­men can ac­com­plish when free to try, then those with little faith would have a fair case.
However, there is testi­mony galore; it’s all about us and on every hand.
Mail de­liv­ery is ex­ceed­ingly simple when com­pared, for in­stance, to the mak­ing of an auto­mobile
or a cal­cu­lat­ing ma­chine or a grain com­bine or a milling ma­chine or to tens of thou­sands of oth­er things.
De­liv­ery? Why, in this area where men have been left free to try, they de­liv­er the hu­man voice around the world in less than one second;
they de­liv­er an event visu­ally and in mo­tion to any per­son’s home when it is hap­pen­ing;
they de­liv­er 150 pas­sen­gers from Seattle to Bal­timore in less than four hours;
they de­liv­er gas from Texas to one’s range or fur­nace in New York at un­be­liev­ably low rates and without sub­sidy;
they de­liv­er each four pounds of oil from the Per­sian Gulf to our East­ern Sea­board—halfway around the world—
for less money than the gov­ern­ment charges for de­liv­er­ing a one-ounce let­ter across the street!
The les­son I have to teach is this: Leave all cre­at­ive en­er­gies un­in­hib­ited. Merely or­gan­ize so­ci­ety to act in har­mony with this les­son.
Let so­ci­ety’s leg­al ap­par­at­us re­move all obstacles the best it can. Per­mit these cre­at­ive know-hows freely to flow.
Have faith that free men and wo­men will re­spond to the In­vis­ible Hand. This faith will be con­firmed.
I, Pen­cil, seem­ingly simple though I am, of­fer the mir­acle of my cre­ation as testi­mony
that this is a prac­tic­al faith, as prac­tic­al as the sun, the rain, a ce­dar tree, the good earth.
Con­clud­ing Ques­tion: How does a co­oper­at­ive net­work vastly en­large a coun­try’s pro­duct­ive po­ten­tial and con­sequently provide the found­a­tion for our mod­ern liv­ing stand­ards?

Creating Jobs vs. Creating Wealth

By Dwight R. Lee

Ques­tion for thought: Should the gov­ern­ment build mil­it­ary bases and con­struct high­ways to cre­ate jobs?
Gov­ern­ment policies are com­monly eval­u­ated in terms of how many jobs they cre­ate.
Re­strict­ing im­ports is seen as a way to pro­tect and cre­ate do­mest­ic jobs.
Tax pref­er­ences and loop­holes are com­monly jus­ti­fied as ways of in­creas­ing em­ploy­ment in the favored activ­ity.
Pres­id­ents point with pride to the num­ber of jobs cre­ated in the eco­nomy dur­ing their ad­min­is­tra­tions.
Sup­posedly the more jobs cre­ated the more suc­cess­ful the ad­min­is­tra­tion.
There prob­ably has nev­er been a gov­ern­ment spend­ing pro­gram whose ad­voc­ates failed to men­tion that it cre­ates jobs.
Even wars are seen as com­ing with the sil­ver lin­ing of job cre­ation.
Now there is noth­ing wrong with job cre­ation. Work­ing in jobs is an im­port­ant way people cre­ate wealth.
So the em­phas­is on job cre­ation is an un­der­stand­able one.
But it is easy for people to for­get that cre­at­ing more wealth is what we really want to ac­com­plish, and jobs are merely a means to that end.
When that ele­ment­ary fact is for­got­ten, people are eas­ily duped by ar­gu­ments that el­ev­ate cre­ation of jobs to an end in it­self.
While these ar­gu­ments may sound plaus­ible, they are used to sup­port policies that des­troy wealth rather than cre­ate it.
I shall con­sider a few of the de­press­ingly many ex­amples.

Creating Jobs Is Not the Problem

The pur­pose of all eco­nom­ic activ­ity is to pro­duce as much value as pos­sible with the scarce re­sources (in­clud­ing hu­man ef­fort) avail­able.
But no mat­ter how far we push back the lim­its of scarcity, those lim­its are nev­er van­quished.
Scarcity will forever pre­vent us from se­cur­ing all the things we de­sire. There will al­ways be jobs to do far more than can ever be done.
So cre­at­ing jobs is not the prob­lem. The prob­lem is cre­at­ing jobs in which people pro­duce the most value.
This is the point of the apo­cryph­al story of an en­gin­eer who, while vis­it­ing China, came across a large crew of men build­ing a dam with picks and shovels.
When the en­gin­eer poin­ted out to the su­per­visor that the job could be com­pleted in a few days, rather than many months,
if the men were giv­en mo­tor­ized earth­mov­ing equip­ment, the su­per­visor said that such equip­ment would des­troy many jobs.
“Oh,” the en­gin­eer re­spon­ded, “I thought you were in­ter­ested in build­ing a dam.
If it’s more jobs you want, why don’t you have your men use spoons in­stead of shovels.”
As I tell my stu­dents at the Uni­versity of Geor­gia,
I will em­ploy every per­son in our col­lege town of Athens if they’ll only work for me cheaply enough, say a nick­el a month.
Lower the wage a bit more and I’ll hire every­one in the en­tire state of Geor­gia.
If I hired work­ers at those wages, I could make a profit hav­ing them build dams with spoons.
Of course, the stu­dents re­cog­nize that my of­fer is silly since they can make far more work­ing for oth­er em­ploy­ers,
which re­flects the more im­port­ant reas­on my of­fer is silly con­cen­trat­ing on the num­ber of jobs ig­nores the value be­ing cre­ated, or not cre­ated.
More value will be pro­duced in the high­er-pay­ing jobs my stu­dents can get than in the ones I am of­fer­ing.
A big ad­vant­age real­ized from the wages that emerge in open labor mar­kets is that they at­tract people into not just any em­ploy­ment,
but into their highest-val­ued em­ploy­ment.
An­oth­er ad­vant­age of mar­ket wages is that they force em­ploy­ers to con­sider the op­por­tun­ity cost of hir­ing work­ers
their value in al­tern­at­ive jobs and to re­main con­stantly alert for ways to elim­in­ate jobs by cre­at­ing the same value with few­er work­ers.
All eco­nom­ic pro­gress res­ults from be­ing able to provide the same, or im­proved, goods and ser­vices with few­er work­ers,
thus elim­in­at­ing some jobs and free­ing up labor to in­crease pro­duc­tion in new, more pro­duct­ive jobs.
The fail­ure to un­der­stand this source of in­creas­ing prosper­ity ex­plains the wide­spread sym­pathy with de­struct­ive pub­lic policies.

Dynamiting Our Way to More Jobs

In the 1840s a French politi­cian ser­i­ously ad­voc­ated blow­ing up the tracks at Bor­deaux on the rail­road from Par­is to Spain to cre­ate more jobs in Bor­deaux.
Freight would have to be moved from one train to an­oth­er
and pas­sen­gers would re­quire ho­tels, all of which would mean more jobs.
(This pro­pos­al was dis­cussed and de­mol­ished by the nine­teenth-cen­tury eco­nom­ist and es­say­ist
Fre­der­ic Basti­at in Eco­nom­ic Soph­isms, pp. 94-95, avail­able from Found­a­tion for Eco­nom­ic Edu­ca­tion.)
This pro­pos­al is even more ab­surd than my of­fer to hire people for a nick­el a month.
At least I would em­ploy work­ers to pro­duce something of value, rather than to par­tially undo dam­age that is in­flic­ted need­lessly.
Un­for­tu­nately, ab­surdity does not pre­vent eco­nom­ic­ally de­struct­ive policies from be­ing pro­posed and im­ple­men­ted.
Us­ing the jobs-cre­ation jus­ti­fic­a­tion, politi­cians com­monly en­act le­gis­la­tion
that in­creases the ef­fort re­quired to pro­duce a giv­en amount of value.
One of the ar­gu­ments for re­strict­ing im­ports is that it will cre­ate (or pro­tect) do­mest­ic jobs.
True, it will cre­ate some do­mest­ic jobs, just as des­troy­ing a sec­tion of a rail line will cre­ate do­mest­ic jobs.
But also like a break in a rail line, im­port re­stric­tions make it more costly to ob­tain valu­able products.
The only reas­on a coun­try im­ports products is that it is the cheapest way to ac­quire them;
it takes few­er work­ers to ob­tain the im­por­ted products through for­eign trade than by pro­du­cing them dir­ectly.
In this way trade is like a tech­no­lo­gic­al ad­vance,
free­ing up work­ers and al­low­ing them to in­crease the pro­duc­tion of goods and ser­vices avail­able for con­sump­tion.
Im­port re­stric­tions cre­ate jobs in the same way dy­nam­it­ing our rail­roads, bomb­ing our factor­ies, and re­quir­ing that work­ers use shovels in­stead of mod­ern earth-mov­ing equip­ment would cre­ate jobs.
Al­ways keep in mind that cre­at­ing jobs is a means to the ul­ti­mate end of eco­nom­ic activ­ity, which is cre­at­ing wealth.

Creating Government Jobs

Be­cause people tend to think of jobs as ends rather than means,
they are eas­ily fooled into sup­port­ing gov­ern­ment pro­grams on grounds that jobs will be cre­ated.
We have all heard people ar­gue in fa­vor of mil­it­ary bases, high­way con­struc­tion, and en­vir­on­ment­al reg­u­la­tions on busi­ness on these grounds.
To jus­ti­fy spend­ing, gov­ern­ment agen­cies com­monly per­form be­ne­fit/cost stud­ies in which the jobs cre­ated are coun­ted as be­ne­fits.
This is like count­ing the hours you work to earn enough money to buy a car as one of the car’s be­ne­fits.
The jobs cre­ated by a gov­ern­ment pro­ject rep­res­ent a cost of the pro­ject: the op­por­tun­ity cost.
The work­ers em­ployed in gov­ern­ment activ­it­ies could be pro­du­cing value do­ing something else.
The rel­ev­ant ques­tion is not wheth­er a gov­ern­ment pro­ject cre­ates jobs,
but wheth­er the work­ers in those jobs will cre­ate more wealth than they would in oth­er jobs.
This is a ques­tion ad­voc­ates of gov­ern­ment pro­grams don’t want asked.
If it were, there would be far few­er low- pro­ductiv­ity gov­ern­ment jobs and far more high-pro­ductiv­ity private-sec­tor jobs.
Con­clud­ing ques­tion: If we want to achieve a high stand­ard of liv­ing, which is more im­port­ant the cre­ation of jobs or the cre­ation of wealth?
What is the dif­fer­ence?

What Is Seen and What is Not Seen

By Frederic Bastiat (Abridged version)

The fol­low­ing art­icle is a con­densed ver­sion of Fre­der­ic Basti­at’ “What Is Seen and What Is Not Seen.”(1)
Basti­at was an eco­nom­ist who was also a mem­ber of the French par­lia­ment in the middle of the nine­teenth cen­tury.
In­ter­est­ingly, the is­sues he raises are as val­id today as they were over 150 years ago.
In the eco­nom­ic sphere an act, a habit, an in­sti­tu­tion, a law p ro­duces not only one ef­fect, but a series of ef­fects.
Of these ef­fects, the first alone is im­me­di­ate; it ap­pears sim­ul­tan­eously with its cause; it is seen.
The oth­er ef­fects emerge only sub­sequently; they are not seen; we are for­tu­nate if we fore­see them.
There is only one dif­fer­ence between a bad eco­nom­ist and a good one: the bad eco­nom­ist con­fines him­self to the vis­ible ef­fect;
the good eco­nom­ist takes into ac­count both the ef­fect that can be seen and those ef­fects that must be fore­seen.
Yet this dif­fer­ence is tre­mend­ous; for it al­most al­ways hap­pens
that when the im­me­di­ate con­sequence is fa­vor­able, the later con­sequences are dis­astrous, and vice versa.
Whence it fol­lows that the bad eco­nom­ist pur­sues a small present good that will be fol­lowed by a great evil to come,
while the good eco­nom­ist pur­sues a great good to come, at the risk of a small present evil.

The Broken Window

Have you ever been wit­ness to the fury of that sol­id cit­izen, James Good­fel­low, when his in­cor­ri­gible son has happened to break a pane of glass?
If you have been present at this spec­tacle, cer­tainly you must also have ob­served that the on­look­ers, even if there are as many as thirty of them,
seem with one ac­cord to of­fer the un­for­tu­nate own­er the self­same con­sol­a­tion:
“It’s an ill wind that blows nobody some good. Such ac­ci­dents keep in­dustry go­ing. Every­body has to make a liv­ing.
What would be­come of the glazi­ers if no one ever broke a win­dow?”
Now, this for­mula of con­dol­ence con­tains a whole the­ory that it is a good idea for us to ex­pose, flag­rante de­licto, in this very simple case,
since it is ex­actly the same as that which, un­for­tu­nately, un­der­lies most of our eco­nom­ic in­sti­tu­tions.
Sup­pose that it will cost six francs to re­pair the dam­age.
If you mean that the ac­ci­dent gives six francs’ worth of en­cour­age­ment to the afore­said in­dustry, I agree.
I do not con­test it in any way; your reas­on­ing is cor­rect.
The glazi­er will come, do his job, re­ceive six francs, con­grat­u­late him­self, and bless in his heart the care­less child. That is what is seen.
But if, by way of de­duc­tion, you con­clude, as hap­pens only too of­ten, that it is good to break win­dows, that it helps to cir­cu­late money,
that it res­ults in en­cour­aging in­dustry in gen­er­al, I am ob­liged to cry out:
That will nev­er do! Your the­ory stops at what is seen. It does not take ac­count of what is not seen.
It is not seen that, since our cit­izen has spent six francs for one thing, he will not be able to spend them for an­oth­er.
It is not seen that if he had not had a win­dowpane to re­place, he would have re­placed, for ex­ample, his worn-out shoes or ad­ded an­oth­er book to his lib­rary.
In brief, he would have put his six francs to some use or oth­er for which he will not now have them.
Let us next con­sider in­dustry in gen­er­al.
The win­dow hav­ing been broken, the glass in­dustry gets six francs’ worth of en­cour­age­ment; that is what is seen.
If the win­dow had not been broken, the shoe in­dustry
(or some oth­er) would have re­ceived six francs’ worth of en­cour­age­ment; that is what is not seen.
And if we were to take into con­sid­er­a­tion what is not seen, be­cause it is a neg­at­ive factor, as well as what is seen, be­cause it is a pos­it­ive factor, we should un­der­stand
that there is no be­ne­fit to in­dustry in gen­er­al or to na­tion­al em­ploy­ment as a whole, wheth­er win­dows are broken or not broken.
Now let us con­sider James Good­fel­low.
On the first hy­po­thes­is, that of the broken win­dow, he spends six francs and has, neither more nor less than be­fore, the en­joy­ment of one win­dow.
On the second, that in which the ac­ci­dent did not hap­pen, he would have spent six francs for new shoes and would have had the en­joy­ment of a pair of shoes as well as of a win­dow.
Now, if James Good­fel­low is part of so­ci­ety, we must con­clude that so­ci­ety,
con­sid­er­ing its labors and its en­joy­ments, has lost the value of the broken win­dow.
From which, by gen­er­al­iz­ing, we ar­rive at this un­ex­pec­ted con­clu­sion: “So­ci­ety loses the value of ob­jects un­ne­ces­sar­ily des­troyed,”
“To break, to des­troy, to dis­sip­ate is not to en­cour­age na­tion­al em­ploy­ment,” or more briefly: “De­struc­tion is not prof­it­able.”
The read­er must ap­ply him­self to ob­serve that there are not only two people, but three, in the little drama that I have presen­ted.
The one, James Good­fel­low, rep­res­ents the con­sumer, re­duced by de­struc­tion to one en­joy­ment in­stead of two.
The oth­er, un­der the fig­ure of the glazi­er, shows us the pro­du­cer whose in­dustry the ac­ci­dent en­cour­ages.
The third is the shoe­maker (or any oth­er man­u­fac­turer) whose in­dustry is cor­res­pond­ingly dis­cour­aged by the same cause.
It is this third per­son who is al­ways in the shad­ow, and who, per­son­i­fy­ing what is not seen, is an es­sen­tial ele­ment of the prob­lem.
It is he who makes us un­der­stand how ab­surd it is to see a profit in de­struc­tion.

Theaters and Fine Arts

Should the state sub­sid­ize the arts? There is cer­tainly a great deal to say on this sub­ject pro and con.
In fa­vor of the sys­tem of sub­sidies, one can say that the arts broaden, el­ev­ate, and po­et­ize the soul of a na­tion;
that they draw it away from ma­ter­i­al pre­oc­cu­pa­tions, giv­ing it a feel­ing for the beau­ti­ful,
and thus re­act fa­vor­ably on its man­ners, its cus­toms, its mor­als, and even on its in­dustry.
One can ask where mu­sic would be in France without the Théâtre-It­ali­en and the Con­ser­vat­ory; dra­mat­ic art without the Théâtre-Français; paint­ing and sculp­ture without our col­lec­tions and our mu­seums.
One can go fur­ther and ask wheth­er, without the cent­ral­iz­a­tion and con­sequently the sub­sid­iz­ing of the fine arts, there would have de­veloped that ex­quis­ite taste
which is the noble en­dow­ment of French labor and sends its products out over the whole world.
In the pres­ence of such res­ults would it not be the height of im­prudence to re­nounce this mod­er­ate as­sess­ment on all the cit­izens, which, in the last ana­lys­is, is what has achieved for them their pre-em­in­ence and their glory in the eyes of Europe?
To these reas­ons and many oth­ers, whose power I do not con­test, one can op­pose many no less co­gent.
There is, first of all, one could say, a ques­tion of dis­tributive justice.
Do the rights of the le­gis­lat­or go so far as to al­low him to dip into the wages of the ar­tis­an in or­der to sup­ple­ment the profits of the artist?
M. de Lamartine(2) said:
“If you take away the sub­sidy of a theat­er, where are you go­ing to stop on this path,
and will you not be lo­gic­ally re­quired to do away with your uni­versity fac­ulties, your mu­seums, your in­sti­tutes, your lib­rar­ies?”
One could reply: If you wish to sub­sid­ize all that is good and use­ful, where are you go­ing to stop on that path,
and will you not lo­gic­ally be re­quired to set up a civil list for ag­ri­cul­ture, in­dustry, com­merce, wel­fare, and edu­ca­tion?
Fur­ther­more, is it cer­tain that sub­sidies fa­vor the pro­gress of the arts?
It is a ques­tion that is far from be­ing re­solved, and we see with our own eyes that the theat­ers that prosper are those that live on their own profits.
Fi­nally, pro­ceed­ing to high­er con­sid­er­a­tions, one may ob­serve that needs and de­sires give rise to one an­oth­er and keep soar­ing into re­gions more and more rar­efied(3)
in pro­por­tion as the na­tion­al wealth per­mits their sat­is­fac­tion;
that the gov­ern­ment must not meddle in this pro­cess, since, whatever may be cur­rently the amount of the na­tion­al wealth,
it can­not stim­u­late lux­ury in­dus­tries by tax­a­tion without harm­ing es­sen­tial in­dus­tries, thus re­vers­ing the nat­ur­al ad­vance of civil­iz­a­tion.
One may also point out that this ar­ti­fi­cial dis­lo­ca­tion of wants, tastes, labor, and pop­u­la­tion
places na­tions in a pre­cari­ous and dan­ger­ous situ­ation, leav­ing them without a sol­id base.
These are some of the reas­ons al­leged by the ad­versar­ies of state in­ter­ven­tion con­cern­ing the or­der
in which cit­izens be­lieve they should sat­is­fy their needs and their de­sires, and thus dir­ect their activ­ity.
I con­fess that I am one of those who think that the choice, the im­pulse, should come from be­low, not from above, from the cit­izens, not from the le­gis­lat­or;
and the con­trary doc­trine seems to me to lead to the an­ni­hil­a­tion of liberty and of hu­man dig­nity.
But, by an in­fer­ence as false as it is un­just, do you know what the eco­nom­ists are now ac­cused of?
When we op­pose sub­sidies, we are charged with op­pos­ing the very thing that it was pro­posed to sub­sid­ize and of be­ing the en­emies of all kinds of activ­ity,
be­cause we want these activ­it­ies to be vol­un­tary and to seek their prop­er re­ward in them­selves.
Thus, if we ask that the state not in­ter­vene, by tax­a­tion, in re­li­gious mat­ters, we are athe­ists.
If we ask that the state not in­ter­vene, by tax­a­tion, in edu­ca­tion, then we hate en­light­en­ment.
If we say that the state should not give, by tax­a­tion,
an ar­ti­fi­cial value to land or to some branch of in­dustry, then we are the en­emies of prop­erty and of labor.
If we think that the state should not sub­sid­ize artists, we are bar­bar­i­ans who judge the arts use­less.
I protest with all my power against these in­fer­ences.
Far from en­ter­tain­ing the ab­surd thought of ab­ol­ish­ing re­li­gion, edu­ca­tion, prop­erty, labor, and the arts when we ask the state to pro­tect the free de­vel­op­ment of all these types of hu­man activ­ity without keep­ing them on the payroll at one an­oth­er’s ex­pense,
we be­lieve, on the con­trary, that all these vi­tal forces of so­ci­ety should de­vel­op har­mo­ni­ously un­der the in­flu­ence of liberty
and that none of them should be­come, as we see has happened today, a source of trouble, ab­uses, tyranny, and dis­order.
Our ad­versar­ies be­lieve that an activ­ity that is neither sub­sid­ized nor reg­u­lated is ab­ol­ished.
We be­lieve the con­trary. Their faith is in the le­gis­lat­or, not in man­kind. Ours is in man­kind, not in the le­gis­lat­or.
Thus, M. de Lamartine said: “On the basis of this prin­ciple,
we should have to ab­ol­ish the pub­lic ex­pos­i­tions that bring wealth and hon­or to this coun­try.”
I reply to M. de Lamartine: From your point of view, not to sub­sid­ize is to ab­ol­ish,
be­cause, pro­ceed­ing from the premise that noth­ing ex­ists ex­cept by the will of the state, you con­clude that noth­ing lives that taxes do not keep alive.
But I turn against you the ex­ample that you have chosen, and I point out to you that the greatest, the noblest, of all ex­pos­i­tions,
the one based on the most lib­er­al, the most uni­ver­sal con­cep­tion, and I can even use the word "hu­man­it­ari­an," which is not here ex­ag­ger­ated,
is the ex­pos­i­tion now be­ing pre­pared in Lon­don,(4) the only one in which no gov­ern­ment meddles and which no tax sup­ports.
Re­turn­ing to the fine arts, one can, I re­peat, al­lege weighty reas­ons for and against the sys­tem of sub­sid­iz­a­tion.
The read­er un­der­stands that, in ac­cord­ance with the spe­cial pur­pose of this es­say,
I have no need either to set forth these reas­ons or to de­cide between them.
But M. de Lamartine has ad­vanced one ar­gu­ment that I can­not pass over in si­lence,
for it falls with­in the very care­fully defined lim­its of this eco­nom­ic study.
He has said:
The eco­nom­ic ques­tion in the mat­ter of theat­ers can be summed up in one word: em­ploy­ment.
The nature of the em­ploy­ment mat­ters little; it is of a kind just as pro­duct­ive and fer­tile as any oth­er kind.
The theat­ers, as you know, sup­port by wages no less than eighty thou­sand work­ers of all kinds—paint­ers,
ma­sons, dec­or­at­ors, cos­tumers, ar­chi­tects, etc., who are the very life and in­dustry of many quar­ters of this cap­it­al,
and they should have this claim upon your sym­path­ies!
Your sym­path­ies? Trans­late: your sub­sidies. And fur­ther on:
The pleas­ures of Par­is provide em­ploy­ment and con­sumers’ goods for the pro­vin­cial de­part­ments,
and the lux­ur­ies of the rich are the wages and the bread of two hun­dred thou­sand work­ers of all kinds, liv­ing on the com­plex in­dustry of the theat­ers throughout the Re­pub­lic,
and re­ceiv­ing from these noble pleas­ures, which make France il­lus­tri­ous, their own live­li­hood and the means of provid­ing the ne­ces­sit­ies of life for their fam­il­ies and their chil­dren.
It is to them that you give these sixty thou­sand francs. [Very good! Very good! Much ap­plause.]
For my part, I am forced to say: Very bad! Very bad!
con­fin­ing, of course, the bur­den of this judg­ment to the eco­nom­ic ar­gu­ment which we are here con­cerned with.
Yes, it is, at least in part, to the work­ers in the theat­ers that the sixty thou­sand francs in ques­tion will go. A few scraps might well get lost on the way.
If one scru­tin­ized the mat­ter closely, one might even dis­cov­er that most of the pie will find its way else­where.
The work­ers will be for­tu­nate if there are a few crumbs left for them!
But I should like to as­sume that the en­tire sub­sidy will go to the paint­ers, dec­or­at­ors, cos­tumers, hairdress­ers, etc. That is what is seen.
But where does it come from? This is the oth­er side of the coin, just as im­port­ant to ex­am­ine as its face. What is the source of these 60,000 francs?
And where would they have gone if a le­gis­lat­ive vote had not first dir­ec­ted them to the rue de Rivoli and from there to the rue de Gre­nelle?(5)
That is what is not seen.
Surely, no one will dare main­tain that the le­gis­lat­ive vote has caused this sum to hatch out from the bal­lot box; that it is a pure ad­di­tion to the na­tion­al wealth;
that, without this mi­ra­cu­lous vote, these sixty thou­sand francs would have re­mained in­vis­ible and im­palp­able.
It must be ad­mit­ted that all that the ma­jor­ity can do is to de­cide that they will be taken from some­where to be sent some­where else,
and that they will have one des­tin­a­tion only by be­ing de­flec­ted from an­oth­er.
This be­ing the case, it is clear that the tax­pay­er who will have been taxed one franc will no longer have this franc at his dis­pos­al.
It is clear that he will be de­prived of a sat­is­fac­tion to the tune of one franc,
and that the work­er, who­ever he is, who would have pro­cured this sat­is­fac­tion for him, will be de­prived of wages in the same amount.
Let us not, then, yield to the child­ish il­lu­sion of be­liev­ing that the vote of May 16 adds any­thing whatever to na­tion­al well-be­ing and em­ploy­ment.
It real­loc­ates pos­ses­sions, it real­loc­ates wages, and that is all.
Will it be said that for one kind of sat­is­fac­tion and for one kind of job it sub­sti­tutes sat­is­fac­tions and jobs more ur­gent, more mor­al, more ra­tion­al?
I could do battle on this ground.
I could say: In tak­ing sixty thou­sand francs from the tax­pay­ers, you re­duce the wages of plow­men, ditch­dig­gers,
car­penters, and black­smiths, and you in­crease by the same amount the wages of sing­ers, hairdress­ers, dec­or­at­ors, and cos­tumers.
Noth­ing proves that this lat­ter class is more im­port­ant than the oth­er. M. de Lamartine does not make this al­leg­a­tion.
He says him­self that the work of the theat­ers is just as pro­duct­ive as, just as fruit­ful as, and not more so than, any oth­er work, which might still be con­tested;
for the best proof that the­at­ric­al work is not as pro­duct­ive as oth­er work is that the lat­ter is called upon to sub­sid­ize the former.
But this com­par­is­on of the in­trins­ic value and mer­it of the dif­fer­ent kinds of work forms no part of my present sub­ject.
All that I have to do here is to show that, if M. de Lamartine and those who have ap­plauded his ar­gu­ment have seen on the one hand the wages earned by those who sup­ply the needs of the act­ors,
they should see on the oth­er the earn­ings lost by those who sup­ply the needs of the tax­pay­ers;
if they do not, they are open to ri­dicule for mis­tak­ing a real­loc­a­tion for a gain.
If they were lo­gic­al in their doc­trine, they would ask for in­fin­ite sub­sidies;
for what is true of one franc and of sixty thou­sand francs is true, in identic­al cir­cum­stances, of a bil­lion francs.
When it is a ques­tion of taxes, gen­tle­men, prove their use­ful­ness by reas­ons with some found­a­tion, but not with that lam­ent­able as­ser­tion:
“Pub­lic spend­ing keeps the work­ing class alive.”
It makes the mis­take of cov­er­ing up a fact that it is es­sen­tial to know:
namely, that pub­lic spend­ing is al­ways a sub­sti­tute for private spend­ing,
and that con­sequently it may well sup­port one work­er in place of an­oth­er but adds noth­ing to the lot of the work­ing class taken as a whole

Questions for thought

  1. The pro­ponents of gov­ern­ment spend­ing on sports sta­di­ums of­ten ar­gue that this spend­ing ex­pands em­ploy­ment. Eval­u­ate this view.
  2. The U.S. fed­er­al gov­ern­ment spends bil­lions of dol­lars sub­sid­iz­ing ag­ri­cul­ture.
    Do these sub­sidies in­crease em­ploy­ment and out­put? Ex­plain.
  1. This pamph­let, pub­lished in July, 1850, is the last that Basti­at wrote. It had been prom­ised to the pub­lic for more than a year.
    Its pub­lic­a­tion had been delayed be­cause the au­thor had lost the manuscript when he moved his house­hold from the rue de Choiseul to the rue d’Al­gen.
    After a long and fruit­less search, he de­cided to re­write his work en­tirely,
    and chose as the prin­cip­al basis of his demon­stra­tions some speeches re­cently de­livered in the Na­tion­al As­sembly.
    When this task was fin­ished, he re­proached him­self with hav­ing been too ser­i­ous,
    threw the second manuscript into the fire, and wrote the one which we re­print.—Ed­it­or.↩︎
  2. Al­phonse Mar­ie Louis de Lamartine (1790-1869),
    one of the great po­ets of French ro­man­ti­cism and sub­sequently a dis­tin­guished states­man.
    First elec­ted Deputy in 1834, he at­tained his greatest glory at the time of the Re­volu­tion of 1848,
    when he was a prime mover in the es­tab­lish­ment of the Re­pub­lic.
    By his elo­quence he calmed the Par­is mobs that threatened to des­troy it and be­came the head of the pro­vi­sion­al gov­ern­ment.
    More an ideal­ist and orator than a prac­tic­al politi­cian, however, he soon lost in­flu­ence and re­tired to private life in 1851.—Trans­lat­or.↩︎
  3. See chap. 3 of Eco­nom­ic Har­mon­ies.—Ed­it­or.↩︎
  4. This refers to the Great Ex­hib­i­tion,
    in Hyde Park, Lon­don, in 1851, sponsored by the Lon­don So­ci­ety of Arts, an as­so­ci­ation de­voted to the de­vel­op­ment of arts and in­dus­tries.
    The first in a series of great in­ter­na­tion­al ex­hib­i­tions, or "world fairs," it was fam­ous for the Crys­tal Palace,
    a re­mark­able ar­chi­tec­tur­al struc­ture, in which the ex­hib­i­tions were dis­played.
    Al­bert, Queen Vic­tor­ia’s Prince Con­sort, presided over the ex­hib­i­tion.—Trans­lat­or.↩︎
  5. i.e., from City Hall to the the­at­ric­al sup­pli­ers on the Left Bank.—Trans­lat­or.↩︎

Gross Domestic Product—What is it and how is it measured?

Gross Do­mest­ic Product (GDP) is the mar­ket value of all fi­nal user goods and ser­vices pro­duced do­mest­ic­ally dur­ing a time peri­od (a year or quarter).
GDP is a meas­ure of pro­duc­tion – it is de­signed to meas­ure the out­put of goods and ser­vices pro­duced in an eco­nomy.
The defin­i­tion of GDP tells us a lot about what it meas­ures. It meas­ures the “mar­ket value” of the goods and ser­vices pro­duced.
The mar­ket prices paid for vari­ous items de­term­ine how much they will add to GDP.
For ex­ample, if a new auto­mobile is sold for $20,000 com­pared to $1,000 for a new tele­vi­sion set,
the auto will add 20 times as much to GDP as the tele­vi­sion set.
Goods and ser­vices are coun­ted only when pur­chased by their fi­nal users.
Many goods go through sev­er­al in­ter­me­di­ate stages of pro­duc­tion.
Pur­chases of raw ma­ter­i­als and goods as they go through these in­ter­me­di­ate pro­duc­tion stages are not coun­ted be­cause their value will be re­flec­ted in the pur­chase price paid by the fi­nal user of the good or ser­vice.
There­fore, double count­ing would res­ult if the raw ma­ter­i­als and in­ter­me­di­ate goods were coun­ted as well as the pur­chase prices paid by their ul­ti­mate users.
GDP is a meas­ure of “do­mest­ic pro­duc­tion”: the out­put pro­duced with­in the geo­graph­ic bor­ders of the coun­try re­gard­less of wheth­er it re­flects the pro­duct­ive ef­forts of cit­izens or for­eign­ers.
Pro­duc­tion out­side of a coun­try’s geo­graph­ic bor­ders by its na­tion­als is ex­cluded.
For ex­ample, the in­come gen­er­ated by an Amer­ic­an busi­ness con­sult­ant work­ing in Mex­ico would add to the GDP of Mex­ico, but not that of the United States.
Cor­res­pond­ingly, the in­come of a Ja­pan­ese chem­ic­al en­gin­eer work­ing in the U.S. would be in­cluded in the GDP of the United States, but not that of Ja­pan.
Only goods and ser­vices pro­duced dur­ing the cur­rent peri­od are in­cluded in this year’s GDP.
The pur­chase and sale of used items are omit­ted be­cause they do not re­flect cur­rent pro­duc­tion.
Their value was pre­vi­ously coun­ted dur­ing the earli­er peri­od when they were pro­duced.
For ex­ample, the sale of a 2007 auto­mobile in 2010 would not be in­cluded in the 2010 GDP be­cause it was not pro­duced in 2010.
It was already in­cluded in GDP in 2007 when it was man­u­fac­tured and in­clud­ing it again when the used item was re-sold would in­volve double count­ing.
In con­trast, the ser­vices of a per­son help­ing to ar­range for the trans­ac­tion of used items, real and fin­an­cial as­sets, and oth­er goods does re­flect cur­rent pro­duc­tion.
Thus, sales com­mis­sions and oth­er pay­ment for sales ser­vices rendered dur­ing the year are coun­ted when they are provided.
Fin­an­cial trans­ac­tions and in­come trans­fers are ex­cluded be­cause they do not in­volve pro­duc­tion.
The buy­ing and selling of stocks and oth­er fin­an­cial in­stru­ments like bonds, mu­tu­al funds, and cer­ti­fic­ates of de­pos­it
rep­res­ent a trans­fer of own­er­ship from one per­son or or­gan­iz­a­tion to an­oth­er.
Like­wise, so­cial se­cur­ity be­ne­fits, dis­ab­il­ity pay­ments, gifts, and oth­er in­come trans­fers
are merely move­ments of in­come and own­er­ship rights from one party to an­oth­er.
They do not in­volve cur­rent pro­duc­tion, and there­fore these trans­fers are not in­cluded in GDP.
GDP is a meas­ure of pro­duc­tion through mar­kets. Non-mar­ket pro­duct­ive activ­it­ies are omit­ted.
For ex­ample, pro­duc­tion with­in the house­hold such as food pre­par­a­tion and child­care ser­vices
do not in­volve mar­ket trans­ac­tions and there­fore they are not in­cluded in GDP.
Fur­ther, GDP also omits the activ­it­ies of the un­der­ground eco­nomy -- un­re­cor­ded trans­ac­tions such as those in­volving il­leg­al activ­it­ies like drug trade,
pros­ti­tu­tion, and in­come that is un­re­por­ted in or­der to evade taxes.
GDP meas­ures the out­put of goods and ser­vices pro­duced in both the private and gov­ern­ment sec­tors.
The do­mest­ic out­put of the busi­ness sec­tor is in­cluded, re­gard­less of wheth­er the firms are owned by na­tion­als or for­eign­ers.
As we dis­cussed above, gov­ern­ment­al in­come trans­fers are omit­ted.
But pur­chase and/or pro­vi­sion of goods and ser­vices by loc­al, state, and fed­er­al gov­ern­ments are in­cluded in GDP be­cause they re­flect cur­rent pro­duc­tion.

GDP Comparisons Across Time

When mak­ing GDP com­par­is­ons across time, it is im­port­ant to ad­just for changes in the gen­er­al level of prices.
There are two reas­ons why nom­in­al GDP may be high­er in one peri­od than an­oth­er:
(1) an in­crease in the gen­er­al level of prices and (2) an in­crease in the quant­ity of goods and ser­vices pro­duced.
Only the lat­ter will im­prove liv­ing stand­ards. There­fore, as nom­in­al GDP changes across time, it is im­port­ant to dis­tin­guish between GDP in­creases that merely re­flect high­er prices from those that res­ult from an ex­pan­sion in the quant­ity of goods and ser­vices pro­duced.
Eco­nom­ists use a price in­dex, the GDP de­flat­or, to ad­just the nom­in­al GDP data for the im­pact of in­creases in the gen­er­al level of prices through time.
The GDP de­flat­or is a meas­ure of the gen­er­al level of prices re­l­at­ive to a base year, which is as­signed a value of 100.
As prices rise re­l­at­ive to the base year, the GDP de­flat­or will in­crease pro­por­tion­ally.
The GDP de­flat­or can be used along with nom­in­al GDP to de­rive real GDP, which is GDP meas­ured in dol­lars of con­stant pur­chas­ing power.
Real GDP nets out the in­crease in nom­in­al GDP that merely re­flects an in­crease in the gen­er­al level of prices.
Real GDP in this time peri­od (t) meas­ured in terms of the price level of the base year, is equal to:
Real GDPt = (Nom­in­al GDPt) * 100 / (GDP De­flatort)
If prices are high­er now than dur­ing the earli­er base year, the ra­tio on the right will be less than one and it will ad­just the cur­rent nom­in­al GDP fig­ure for the high­er cur­rent level of prices com­pared to the earli­er base year.
Con­sider the GDP fig­ures for the United States in 2005 and 2009. In 2009, the nom­in­al GDP of the United States was $14,256 bil­lion com­pared to only 12,638 bil­lion in 2005.
Thus nom­in­al GDP was 12.8 per­cent high­er in 2009 than 2005.
However, a large por­tion of this in­crease in nom­in­al GDP re­flec­ted in­fla­tion rather than an in­crease in real out­put.
The GDP de­flat­or, the price in­dex that meas­ures changes in the cost of all goods in­cluded in GDP, in­creased from 100.0 dur­ing the 2005 base year to 109.7702 in 2005.
This in­dic­ates that prices rose by about 9.8 per­cent between 2005 and 2009 (109.7702 -100, ex­pressed as a per­cent­age).
In or­der to de­rive the 2009 real GDP, the 2009 nom­in­al GDP must be de­flated for the high­er gen­er­al level of prices com­pared to 2005.
Us­ing the equa­tion above, the 2009 nom­in­al GDP of $14,256.3 bil­lion is first mul­ti­plied by 100 and then di­vided by the GDP de­flat­or of 109.7702.
This yields a real GDP of $12.987.4 bil­lion [($14,256.3 *100)/ 109.7702], only 2.8 per­cent more than in 2005.
Thus, while nom­in­al GDP ex­pan­ded by 12.8 per­cent, real GDP in­creased by only 2.8 per­cent.
When com­par­ing GDP across time, us­ing real GDP rather than nom­in­al GDP is vi­tally im­port­ant.
The real GDP fig­ures factor out the changes in the gen­er­al level of prices,
leav­ing only changes in the ac­tu­al out­put of goods and ser­vices pro­duced. This makes real GDP com­par­is­ons more mean­ing­ful.
Fur­ther­more, when con­sid­er­ing liv­ing stand­ards across time, one would want to use per cap­ita GDP, that is, GDP per per­son.
In­creases in per cap­ita GDP in­dic­ate that a lar­ger quant­ity of goods and ser­vices per per­son is be­ing pro­duced over time.
Without in­creases in out­put per per­son, im­prove­ments in liv­ing stand­ards are un­likely.
In the United States, the De­part­ment of Com­merce’s Bur­eau of Eco­nom­ic Ana­lys­is (BEA) cal­cu­lates GDP quay and uses these cal­cu­la­tions to of­fer an over­view of the U.S. eco­nomy.
The BEA prrter­lo­duces eco­nom­ic stat­ist­ics that in­flu­ence de­cisions of gov­ern­ment of­fi­cials, busi­ness people, and private in­di­vidu­als.
The stat­ist­ics provided at http://www.bea.gov/index.htm of­fer a com­pre­hens­ive, up-to-date pic­ture of the U.S. eco­nomy.

Private Property and Opportunity Costs

By Dwight Lee

Ques­tions for thought: What is the eco­nom­ic link between private prop­erty rights and op­por­tun­ity costs?
Mar­kets pro­mote the gen­er­al in­terest by re­veal­ing costs while gov­ern­ments com­monly fa­vor spe­cial in­terest by con­ceal­ing those costs.
Here, I shall dis­cuss op­por­tun­ity costs by in­tro­du­cing the crit­ic­al role of private prop­erty.
Private prop­erty lies at the found­a­tion of mar­ket eco­nom­ies be­cause without private prop­erty,
and the ex­change it fosters, people would be un­able to con­sider the full costs of their de­cisions.

Too Costly to Drive

As­sume you win a Rolls Royce Sil­ver Shad­ow, with in­sur­ance, main­ten­ance, gas, and taxes paid.
While this isn’t quite as nice as win­ning the state lot­tery, the go­ing price for a Sil­ver Shad­ow is around $250,000.
That’s the good news. The bad news is that you’re prob­ably not wealthy enough to drive this car.
Your first re­ac­tion is likely: What do you mean I can’t af­ford to drive it? Everything is paid for by someone else.
True, but I still pre­dict that you will find the car too costly to drive.
Re­gard­less of how you got the Rolls Royce, the cost of driv­ing it is the price someone else is will­ing to pay for it.
And be­cause the car is your private prop­erty, you can’t ig­nore that cost.
As the own­er you can sell it at a price that re­flects the highest value someone else places on it.
So you will con­tin­ue driv­ing your Rolls only if you value it by at least as much as, or more than,
what you could buy with the ap­prox­im­ately $250,000 that some Rolls Royce afi­cion­ado is will­ing to pay you for it.
Most likely you will sell the Rolls, buy a per­fectly nice and ser­vice­able car for $20,000, and have $230,000 left over to save or spend on oth­er things.
This story is fanci­ful, or course, since you are not likely to win a Rolls Royce. But it il­lus­trates a real and im­port­ant point—
private prop­erty prompts people to con­sider the op­por­tun­ity cost (the value for­gone) of their de­cisions.
Be­cause of private prop­erty, this con­sid­er­a­tion is the hall­mark of mar­ket ac­tion and ex­plains the mar­ket co­oper­a­tion
that dir­ects re­sources and products into the hands of those who value them most.

Cooperation Between Bird Watchers and Hot Rodders

Mem­bers of the Audu­bon So­ci­ety are in­ter­ested in pro­tect­ing fra­gile hab­it­at for birds and oth­er an­im­als.
It is easy to pre­dict how it would come down on a choice between pro­tect­ing wild­life hab­it­at and in­creas­ing the avail­ab­il­ity of gas­ol­ine for high-powered cars, or any oth­er cars for that mat­ter.
For ex­ample, the Audu­bon So­ci­ety strongly op­poses off­shore drilling for oil.
Oil com­pan­ies prom­ise to, and in fact do, take ex­traordin­ary pre­cau­tions to pre­vent oil spills,
but the Audu­bon So­ci­ety is not con­vinced. Re­gard­less of pre­cau­tions, its po­s­i­tion is: No off­shore drilling—none!
How can hot rod­ders pos­sibly com­mu­nic­ate their de­sire for cheap­er gas to the Audu­bon So­ci­ety
so as to con­vince it to ac­com­mod­ate them by risk­ing wild­life hab­it­at? In fact, they have suc­ceeded at do­ing just that.
Hot rod­ders, along with all oth­er gas­ol­ine con­sumers, have con­vinced the Audu­bon So­ci­ety
that the value they place on gas is an op­por­tun­ity cost of pro­tect­ing hab­it­at that the So­ci­ety shouldn’t ig­nore.
They have done so through mar­ket com­mu­nic­a­tion based on private prop­erty.
The Audu­bon So­ci­ety owns a wil­der­ness area in Louisi­ana known as the Rainey Pre­serve.
It is an ideal hab­it­at for birds and oth­er wild­life,
but it also con­tains com­mer­cial quant­it­ies of pet­ro­leum and nat­ur­al gas that oil com­pan­ies are eager to re­cov­er.
One might con­clude that since the Audu­bon So­ci­ety owns the land and can eas­ily pre­vent oil com­pan­ies from drilling on it, they would do so.
Wrong! The Audu­bon So­ci­ety al­lows oil com­pan­ies to drill there.
Of course, it re­quires the com­pan­ies to take strong pre­cau­tions against oil leaks, but not as strong as it claims to be ne­ces­sary with off­shore drilling.
Why the dif­fer­ence? Be­cause the Audu­bon So­ci­ety owns the Rainey Pre­serve,
the money oth­ers are will­ing to pay for the oil rep­res­ents an op­por­tun­ity that would be sac­ri­ficed if it re­fused to al­low drilling.
But the So­ci­ety doesn’t face an op­por­tun­ity cost on off­shore sites be­cause it doesn’t own them.
It thus has no mo­tiv­a­tion to take the in­terest of oth­ers in off­shore oil into con­sid­er­a­tion.
Private prop­erty not only mo­tiv­ates the Audu­bon So­ci­ety to co­oper­ate with hot rod­ders,
it also mo­tiv­ates hot rod­ders to co­oper­ate with the Audu­bon So­ci­ety.
Their pur­chase of gas al­lows the Audu­bon So­ci­ety to ob­tain and pro­tect wild­life hab­it­at
that it be­lieves is more valu­able than what it sac­ri­fices in the Rainey Pre­serve be­cause of oil drilling.
Mem­bers of the Audu­bon So­ci­ety may des­pise hot rod­ders and hot rod­ders may laugh at bird watch­ers,
but be­cause of private prop­erty, each takes the con­cerns (and op­por­tun­ity costs) of the oth­er into con­sid­er­a­tion and acts to pro­mote the oth­er’s in­terests.

The Opportunity Cost of Prisoners of War

European wars dur­ing the Middle Ages were of­ten rather peace­ful af­fairs, with pris­on­ers typ­ic­ally well treated.
It was not un­com­mon for op­pos­ing armies to count the num­ber of sol­diers on each side, be­fore the smal­ler army sur­rendered.
Such non­vi­ol­ent “com­bat” oc­curred be­cause at that time sol­diers had a prop­erty right in the pris­on­ers they cap­tured.
That leg­al right in­cluded the power to sell pris­on­ers back to their fam­il­ies, cre­at­ing an op­por­tun­ity cost for the vic­tors if they killed their pris­on­ers.
Private or­gan­iz­a­tions, some of them re­li­gious or­ders, began spe­cial­iz­ing as middle­men between those
who had pris­on­ers to sell and those who wanted to pur­chase them.
Un­for­tu­nately for pris­on­ers of war, when long-range weapons be­came avail­able and hand-to-hand com­bat be­came un­com­mon,
it was less likely that in­di­vidu­al sol­diers would cap­ture pris­on­ers.
Wars then be­came more bru­tal, not only be­cause the tech­no­logy of slaughter im­proved,
but also be­cause the own­er­ship of pris­on­ers shif­ted to the state.
Be­cause op­por­tun­ity costs to in­di­vidu­als di­min­ish
when prop­erty be­longs to the state, it be­came far more com­mon to kill or mu­til­ate pris­on­ers.
Hu­man be­ings ob­vi­ously should not be treated as private prop­erty.
But be­cause of the phe­nomen­on of op­por­tun­ity cost, cap­tured sol­diers are far bet­ter off as “private prop­erty” than “pub­lic prop­erty.”
Private prop­erty is es­sen­tial to the co­oper­a­tion that emerges from mar­ket in­ter­ac­tion,
be­cause it en­sures that people con­sider the op­por­tun­ity cost of their ac­tions.
It is both sad and iron­ic that so many people blame private prop­erty for prob­lems that ex­ist be­cause of the lack of private prop­erty.
Con­clud­ing Ques­tions: Why do mar­kets re­veal costs dif­fer­ently than gov­ern­ments?
How does this dif­fer­ence im­pact mar­ket ex­change and pro­duct­ive be­ha­vi­or?

Running Out of Agricultural Land

By Dwight Lee

Ques­tion for thought: Does private own­er­ship of prop­erty provide own­ers with in­cent­ives to main­tain and con­serve re­sources? Ex­plain.
Fear that we are run­ning out of im­port­ant re­sources is per­petu­al.
Oil is a fa­vor­ite thing to worry about; land­fill space is an­oth­er, and trees yet an­oth­er.
I could con­tin­ue list­ing things (coal, cop­per, iron ore, even tin) that people have wor­ried would soon be ex­hausted.
In most cases the fear is base­less—fueled by or­gan­ized in­terests hop­ing to cap­ture ad­vant­ages by scar­ing the pub­lic,
by sloppy journ­al­ism, and by a gen­er­al lack of ba­sic eco­nom­ic un­der­stand­ing.
Where con­cern is ap­pro­pri­ate, the prob­lem is in­vari­ably the lack of private prop­erty rights in the threatened re­source.
To see the role of prop­erty rights in pre­vent­ing the de­ple­tion of re­sources,
con­sider the fol­low­ing ques­tion: have we ever run out of a non­re­new­able re­source?
I have asked dozens of audi­ences this ques­tion and have nev­er found any­one who can name one.
But aren’t non­re­new­able re­sources the ones we are most likely to run out of? After all, they are non­re­new­able.
More puzz­ling, we have run out of—driv­en to ex­tinc­tion—a num­ber of an­im­als, which are re­new­able.
Aren’t these the re­sources we should be least likely to run out of?
The puzzle is re­solved by re­cog­niz­ing that non­re­new­able re­sources just sit there;
they don’t run around, so it is easy to es­tab­lish private prop­erty rights over them.
People con­serve on re­sources they own by tak­ing their fu­ture value into ac­count.
Many an­im­als, be­cause of their fu­git­ive nature, are dif­fi­cult to own as private prop­erty,
and so people have little mo­tiv­a­tion to con­sider their fu­ture value.
So des­pite their re­new­ab­il­ity, some of these an­im­als have been ex­tin­guished.
Cre­at­ing scares that we are run­ning out of non­re­new­able re­sources
would be far more dif­fi­cult if people un­der­stood the power of private prop­erty to mo­tiv­ate the prop­er con­sid­er­a­tion of our re­sources’ fu­ture value.
But here I con­sider an­oth­er reas­on people mis­takenly fear we are run­ning out of, or dan­ger­ously de­plet­ing, re­sources—
fail­ure to dis­tin­guish mar­gin­al value from total value.

Disappearing Farmland

I had just be­gun my first teach­ing job at the Uni­versity of Col­or­ado when
I was asked to par­ti­cip­ate in a de­bate on the “prob­lem” of dis­ap­pear­ing farm­land.
Des­pite my com­pel­ling ar­gu­ments (sev­er­al in at­tend­ance who agreed with me be­fore the de­bate still agreed with me af­ter­ward)
that de­creas­ing farm­land was the res­ult of mar­ket forces work­ing prop­erly, con­cern over lost farm­land has con­tin­ued.
For ex­ample, Lester Brown of World­watch In­sti­tute puts out an an­nu­al re­port
pre­dict­ing that food sup­plies will fall be­hind pop­u­la­tion growth,
a prob­lem he sees caused partly by the loss of farm­land to de­vel­op­ment.
While it is true that glob­ally few­er acres are used for ag­ri­cul­ture today than in the past, but this
“loss” of farm land is not a crisis or even a cause for con­cern.
In­stead, it is good news.
In Po­land, for ex­ample, the share of land de­voted to ag­ri­cul­ture has fallen by 28% since the late 1960s, yet food out­put has ris­en by al­most 70%.
When less land is used for farm­ing, more land can re­vert to open space and forest.
You won’t hear this from the crisis crowd, but there is more forest land in the United States now than 80 years ago.(1)
Second, farm­land has been paved over for shop­ping cen­ters and high­ways, con­ver­ted into sub­urb­an hous­ing tracts, covered with amuse­ment parks,
de­veloped into golf courses, and oth­er­wise con­ver­ted be­cause con­sumers have com­mu­nic­ated through mar­ket prices
that de­vel­op­ment is more valu­able than the food that could have been grown on the land.

Food or Golf

Why would con­sumers will­ingly sac­ri­fice food for golf courses, shop­ping cen­ters, and park­ing lots?
Isn’t food more valu­able than golf­ing or park­ing? Of course—in total value.
If the choice is between eat­ing and no golf or play­ing golf but no eat­ing, even the most avid golfer would choose eat­ing.
But eco­nom­ic choices are not all-or- none choices.
In­stead, we make de­cisions at the mar­gin, de­cid­ing if a little more of one op­tion is worth sac­ri­fi­cing a little bit of an­oth­er.
And at the mar­gin it isn’t clear that food is more valu­able than golf or many oth­er things we can live without.
Golfers are com­mu­nic­at­ing through greens fees that an­oth­er golf course is at least as valu­able as the ad­di­tion­al food sac­ri­ficed.
At the mar­gin, golf is cer­tainly more valu­able than food
would be if mil­lions of acres of farm­land had not been “lost” to de­vel­op­ment.
In 1900 most of the horsepower used on the farm was really horse power, or mule power,
and tens of mil­lions of acres were needed to grow the food for these an­im­als.
Trucks, tract­ors, har­vesters, and oth­er gas­ol­ine-powered farm ma­chinery have ef­fi­ciently sub­sti­tuted for these an­im­als and the acres needed to feed them.
Also, much less land is needed now to feed the same num­ber of people
be­cause im­prove­ments in fer­til­izers, pesti­cides, ir­rig­a­tion, seeds, and weath­er fore­cast­ing al­low more food to be grown per acre,
and im­prove­ments in har­vest­ing, pack­aging, stor­age, and trans­port­a­tion al­low more of what is grown to get to the din­ner table.
If we still de­voted as much land to farm­ing as we did in 1900, with today’s tech­no­logy we would be knee-deep in can­ta­loupe.
In this situ­ation, how valu­able would an­oth­er few acres of can­ta­loupe be com­pared to an­oth­er golf course
that could be con­struc­ted on those acres?
We don’t have nearly as much farm­land as we did in 1900 be­cause as food pro­duc­tion in­creases,
its mar­gin­al value de­creases re­l­at­ive to that of houses, shop­ping cen­ters, golf courses, and more.
Con­sumers com­mu­nic­ate this change in re­l­at­ive value with pur­chases
that cause food prices to de­cline re­l­at­ive to the prices for oth­er uses of farm­land.
This mo­tiv­ates a de­crease in farm­land that con­tin­ues as long as the mar­gin­al value of land is great­er in non­farm uses than in ag­ri­cul­tur­al pro­duc­tion.
But don’t ex­pect the farm­land “crisis” to dis­ap­pear.
Pub­lic agen­cies hop­ing for big­ger budgets, and private or­gan­iz­a­tions hop­ing for more re­search fund­ing or lar­ger sub­sidies,
are al­ways anxious to identi­fy crises to scare the pub­lic.
Crisis cre­ation wouldn’t be so easy if more people un­der­stood the dif­fer­ence between total value and mar­gin­al value.
Con­clud­ing Ques­tion: Why do se­cure prop­erty rights pro­mote eco­nom­ic pro­gress?
Why do com­mon own­er­ship and in­sec­ure prop­erty rights hinder eco­nom­ic pro­gress?
  1. Gregg East­er­brook, A Mo­ment on the Earth (New York: Vik­ing, 1995), pp. 10-13.↩︎

Censoring Pleas for Help

By Dwight R. Lee

Ques­tion for thought: Why do people take so many dif­fer­ent po­s­i­tions on the role of gov­ern­ment in the eco­nomy?
Ask people if they fa­vor gov­ern­ment cen­sor­ship and the re­sponse will be a nearly un­an­im­ous no!
Yet if you ask the same people if they fa­vor gov­ern­ment price con­trols, the re­sponse will be much more mixed.
Ask them if the gov­ern­ment should con­trol prices to pre­vent “price gou­ging” after nat­ur­al dis­asters, and the re­sponse will be a nearly un­an­im­ous yes!
These re­sponses re­flect an un­for­tu­nate ig­nor­ance of how mar­kets al­low us to com­mu­nic­ate with one an­oth­er.
Once mar­ket prices are re­cog­nized as a means of com­mu­nic­a­tion,
we have an­oth­er power­ful way of un­der­stand­ing why gov­ern­ment price con­trols are a par­tic­u­larly harm­ful form of cen­sor­ship.
And the harm is greatest in the times of nat­ur­al dis­asters be­cause the vic­tims are des­per­ate to com­mu­nic­ate their need for help.
The com­mu­nic­a­tion per­mit­ted by mar­ket ex­change and the res­ult­ing prices cre­ates a re­mark­able de­gree of so­cial co­oper­a­tion.
There are no bet­ter ex­amples of the be­ne­fits of this com­mu­nic­a­tion and co­oper­a­tion than nat­ur­al dis­asters.
The vic­tims need not only the as­sist­ance of people out­side the dis­aster area, but also the co­oper­a­tion of one an­oth­er if they are to re­cov­er as soon and com­pletely as pos­sible.
Un­for­tu­nately, when nat­ur­al dis­asters strike, gov­ern­ments are most likely to out­law the price sig­nals
that make this co­oper­a­tion pos­sible—and to do so with the sup­port of pub­lic opin­ion.
After a nat­ur­al dis­aster, prices gen­er­ally in­crease sharply for labor, con­struc­tion ma­ter­i­als,
elec­tric gen­er­at­ors, and a host of oth­er products needed for re­cov­ery and com­fort.
The com­mon ex­plan­a­tion for these price in­creases is that un­scru­pu­lous sup­pli­ers are prof­it­eer­ing at the vic­tims’ ex­pense.
Sup­pli­ers may be profit­ing, but not at the ex­pense of the vic­tims.
Those whose homes are dam­aged and lives dis­rup­ted are vic­tims of the nat­ur­al dis­aster,
not of those who sup­ply them with needed goods and ser­vices af­ter­ward.
High prices are bet­ter ex­plained as the best way for vic­tims to com­mu­nic­ate their need for help to those who are most able to provide it.
High prices also in­sure that pleas for help will be met with a quick and ef­fect­ive re­sponse.

Sending Lumber to Miami

I heard an in­ter­est­ing ex­ample of such a re­sponse when I was giv­ing a talk in Ohio in 1992,
not long after Hur­ricane An­drew ripped through south­ern Flor­ida.
I had men­tioned the storm and its af­ter­math to il­lus­trate the im­port­ance of price com­mu­nic­a­tion,
and a gen­tle­man in the audi­ence told a story about his son, a build­ing con­tract­or out­side Clev­e­land
who had star­ted build­ing the house he and his wife had dreamed of for years.
The found­a­tion had been laid and the lum­ber was be­ing de­livered as An­drew hit Miami.
With the news of the dis­aster, he de­cided against us­ing the lum­ber him­self and (des­pite his wife’s op­pos­i­tion) shipped it to Miami in­stead.
Why? Be­cause the news he found most com­pel­ling came in the form of high prices
for lum­ber, in­form­ing him that the de­mand for his lum­ber was great­er in Miami than in Clev­e­land.
Was the Clev­e­land con­tract­or an un­scru­pu­lous prof­it­eer? Hardly.
He did far more good for the vic­tims of Hur­ricane An­drew than those who sat around ex­press­ing con­tempt for price “gougers.”
True, a few people helped the hur­ricane vic­tims by send­ing sup­plies to Miami for free. Cer­tainly these people should be com­men­ded.
But their help was in­sig­ni­fic­ant com­pared to the help giv­en by sup­pli­ers from all over the coun­try (in­deed, the world)
who re­spon­ded to high­er prices by provid­ing more of the things
An­drew’s vic­tims in­dic­ated (through high­er prices) they most des­per­ately needed.
Those who ex­press con­tempt for people who sell products to nat­ur­al-dis­aster vic­tims at high prices should look closer to home for someone to cri­ti­cize.
Their cri­ti­cism (born of eco­nom­ic ig­nor­ance)
and the pub­lic opin­ion they in­flame fre­quently pro­voke price con­trols, which muzzle those cry­ing out for help.
The At­lanta Journ­al-Con­sti­tu­tion poin­ted out last April that Geor­gia has a “price gou­ging” law
that for­bids sup­pli­ers from char­ging “one penny more than they charged the day be­fore the dis­aster struck.”
This law was fa­vor­ably men­tioned, with no hint of irony, in an art­icle re­port­ing
that build­ing con­tract­ors and con­struc­tion sup­plies from sev­er­al states had poured into At­lanta im­me­di­ately after it suffered massive tor­nado dam­age.
Can any­one ser­i­ously be­lieve that this help would have poured in from far away if the “price gou­ging” law had been per­fectly en­forced, or that the help was not re­duced by the en­force­ment that had oc­curred?
(Pen­al­ties for price gou­ging in Geor­gia range from one to ten years in pris­on and fines of $5,000.)

The Electric Shaver

Vic­tims of nat­ur­al dis­asters need to com­mu­nic­ate with one an­oth­er also. Mar­ket prices are the only prac­tic­al meth­od.
Every­one in the stricken area will value the products be­ing made avail­able,
but people will want those products to go to those they be­lieve can put them to the best use.
Price con­trols pre­vent this from hap­pen­ing by cen­sor­ing com­mu­nic­a­tion among vic­tims.
A friend of mine who lived in Char­le­ston, South Car­o­lina, when Hur­ricane Hugo hit in 1989 saw firsthand the harm done by this cen­sor­ship.
Elec­tri­city was out for sev­er­al days in my friend’s area, and so lots of people were anxious to get gas- powered elec­tric gen­er­at­ors.
Un­for­tu­nately, the loc­al hard­ware store had only two and was un­able to get more be­cause of price con­trols.
But there was an­oth­er prob­lem with the price con­trols—one that ac­tu­ally be­nefited my friend’s fam­ily, though at great cost to oth­ers.
Be­cause his fath­er was a good friend of the loc­al hard­ware-store own­er, he got one of the elec­tric gen­er­at­ors at the con­trolled price.
The store own­er couldn’t leg­ally sell the gen­er­at­or to any­one else at a high­er price, so why not let his buddy have it?
My friend’s fath­er was de­lighted be­cause he could con­tin­ue to shave with his elec­tric shaver.
Un­for­tu­nately, gro­cery stores in town re­quired elec­tri­city des­per­ately to pre­vent thou­sands of dol­lars’ worth of food from spoil­ing.
Without price con­trols, one of those stores would have offered a high­er price for the gen­er­at­or,
ef­fect­ively com­mu­nic­at­ing (on be­half of cus­tom­ers) that it had a more ur­gent use for it than my friend’s fath­er had.
One per­son would have had to suf­fer the in­con­veni­ence of lath­er­ing up to shave, but hun­dreds of his neigh­bors would have per­suaded him,
through a high price for the gen­er­at­or, that their de­sire for fresh food should take pre­ced­ence.
Of course, without price con­trols, all the stores and my friend’s fath­er (had he still wanted one)
would have quickly se­cured elec­tric gen­er­at­ors be­cause they would have been able to com­mu­nic­ate with sup­pli­ers out­side the dis­aster area.
Nat­ur­al dis­asters provide a par­tic­u­larly vivid ex­ample of the harm done by price con­trols.
Un­for­tu­nately, gov­ern­ments do not need nat­ur­al dis­asters to jus­ti­fy un­der­min­ing so­cial co­oper­a­tion and des­troy­ing wealth by dic­tat­ing prices.
Gov­ern­ments have a long his­tory of im­pos­ing price con­trols on a wide range of goods and ser­vices.
And they will con­tin­ue to do so un­til it be­comes widely re­cog­nized that such con­trols are a par­tic­u­larly per­ni­cious form of cen­sor­ship.
Con­clud­ing ques­tion: Should gov­ern­ment set price ceil­ings dur­ing nat­ur­al dis­asters if it im­pedes the flow of goods, ser­vices and re­sources into the dev­ast­ated areas?

Markets and Freedom

By Dwight Lee

Ques­tion for thought: How do free­dom of ex­change and wealth re­in­force each oth­er in mar­ket eco­nom­ies?
The so­cial co­oper­a­tion that emerges in free mar­kets per­mits the spe­cial­iz­a­tion on which prosper­ity de­pends.
We would be much poorer without the spe­cial­iz­a­tion
that is pos­sible only when large num­bers of people can co­ordin­ate pro­duc­tion and con­sump­tion through mar­ket ex­change.
But even more im­port­ant than the ma­ter­i­al wealth we real­ize from the mar­ket­place is the be­ne­fit of free­dom.
We would soon be de­prived of most of our free­dom without the ac­count­ab­il­ity and dis­cip­line pos­sible only in mar­ket eco­nom­ies.
Free­dom is easy to take for gran­ted, es­pe­cially in the United States where we have en­joyed what people in many oth­er coun­tries can only dream about.
Free­dom is a lot like good health: people tend not to ap­pre­ci­ate it un­til they lose it.
Just as healthy people can des­troy their health by yield­ing to short-run tempta­tions, free people can des­troy their free­dom
by opt­ing for short-run polit­ic­al ad­vant­ages that un­der­mine the con­di­tions on which free­dom de­pends.
Also, as im­port­ant as wealth is, it is sec­ond­ary to both good health and free­dom.
Wealth is of lim­ited value to those without the health or the free­dom to en­joy it.
Fur­ther­more, good health and free­dom are im­port­ant ele­ments in the pro­duc­tion of wealth, with free­dom be­ing ab­so­lutely es­sen­tial.
Sick people can be pro­duct­ive, but without free­dom the pro­duct­ive co­oper­a­tion of the mar­ket­place is im­possible.
So I shall dis­cuss two sep­ar­ate but re­lated points here. First, the pro­duct­ive co­oper­a­tion of the mar­ket­place de­pends on free­dom,
and second, free­dom de­pends on the pro­duct­ive co­oper­a­tion of the mar­ket­place.
Eco­nom­ists typ­ic­ally have the un­pleas­ant task of point­ing to the tradeoffs that are the in­ev­it­able con­sequence of scarcity.
But with wealth and free­dom, there is no tradeoff; they re­in­force each oth­er in mar­ket eco­nom­ies,
with it gen­er­ally im­possible to have one without the oth­er.(1)
At­tempts to in­crease wealth with polit­ic­al policies that re­duce free­dom in­vari­ably end up re­du­cing both.

Markets Require Freedom

Mar­kets work their ma­gic by al­low­ing people to com­mu­nic­ate the be­ne­fits they real­ize from the ef­forts of oth­ers and the costs of their ef­forts to be­ne­fit oth­ers.
Ul­ti­mately, all be­ne­fits and costs are sub­ject­ive, de­pend­ing on people’s pref­er­ences and cir­cum­stances, which only they can ac­cur­ately eval­u­ate.
This is ob­vi­ous in the case of be­ne­fits. Who but the per­son who con­sumes a good, or avails him­self of a ser­vice, is in a bet­ter po­s­i­tion to judge the value of the be­ne­fits real­ized?
But if be­ne­fits are sub­ject­ive, then so are costs, which are noth­ing more than the value of for­gone be­ne­fits.
And since they are sub­ject­ive, people can ac­cur­ately com­mu­nic­ate costs and be­ne­fits to one an­oth­er
only by hav­ing the free­dom to enter into, or exit, dif­fer­ent mar­kets as they see fit, and to buy and sell at any mu­tu­ally agree­able price.
Gov­ern­ment price con­trols re­strict our freedoms as both buy­ers and sellers,
and des­troy wealth by cen­sor­ing our com­mu­nic­a­tion with one an­oth­er.
Cent­ral plan­ning fails be­cause people don’t have the free­dom to act on the loc­al in­form­a­tion that only they pos­sess.
When the cent­ral dir­ec­tion of polit­ic­al au­thor­it­ies is sub­sti­tuted for the mar­ket choices of in­di­vidu­al pro­du­cers and con­sumers,
eco­nom­ic de­cisions are ne­ces­sar­ily made in an in­form­a­tion­al va­cu­um.
A pro­duct­ive eco­nomy re­quires the use of in­form­a­tion that is dis­persed throughout the pop­u­la­tion,
and that in­form­a­tion can­not be used without in­di­vidu­al free­dom.
Des­troy free­dom and you des­troy the in­form­a­tion flows that are the es­sence of mar­ket eco­nom­ies.

Freedom Requires Markets

The con­nec­tion between free­dom and mar­kets also runs the oth­er way. Just as the mar­ket de­pends on free­dom, so free­dom de­pends on the mar­ket.
Cer­tainly private prop­erty, which is fun­da­ment­al to all mar­ket eco­nom­ies, pro­tects in­di­vidu­al free­dom.
If the state owns all of the aud­it­or­i­ums and print­ing presses, how much free­dom do you have to speak out against gov­ern­ment policy?
If the state owns all the means of pro­duc­tion, how much free­dom do you have to launch your own busi­ness?
Start elim­in­at­ing private prop­erty, and un­der­min­ing the mar­ket that de­pends on it, and you start elim­in­at­ing free­dom.
But the mar­ket also pro­tects free­dom by es­tab­lish­ing the only set­ting in which it can be tol­er­ated.
Free­dom without re­spons­ib­il­ity is mere li­cense, in­dul­gence, and priv­ilege, and will not long be tol­er­ated.
Real free­dom, and the only free­dom that can sur­vive, is ex­er­cised in ways ac­count­able to the con­cerns of all.
The only free­dom that sat­is­fies this re­quire­ment is that which is sub­ject to the dis­cip­line of the mar­ket­place.
Elim­in­ate mar­kets, and you elim­in­ate the ac­count­ab­il­ity ne­ces­sary for free­dom to sur­vive.
For ex­ample, pol­lu­tion prob­lems res­ult dir­ectly from not hav­ing mar­kets in the use of the en­vir­on­ment as a dump.
If such mar­kets ex­is­ted, pol­luters would have to pay prices that re­flec­ted the cost their emis­sions im­posed on oth­ers.
Pol­luters would be ac­count­able to oth­ers, and we could tol­er­ate the free­dom to dis­charge waste products into the en­vir­on­ment.
But be­cause we don’t have pol­lu­tion mar­kets, we ac­cept gov­ern­ment re­stric­tions on pol­lut­ing activ­it­ies
that would be un­ac­cept­able in most areas of our lives.

Our Freedoms Are Vulnerable

Freedoms are sel­dom taken away all at once. They are typ­ic­ally lost a little at a time, with people sel­dom no­ti­cing the loss.
Even when free­dom is re­duced dir­ectly, as when gov­ern­ment im­poses oc­cu­pa­tion­al li­cens­ing in the name of pro­tect­ing con­sumers,
few people no­tice, and even if they do, they don’t see the re­stric­tions as af­fect­ing them.
But as the great Aus­tri­an eco­nom­ist F. A. Hayek poin­ted out, “The be­ne­fits I de­rive from free­dom are . . . largely the res­ult of the uses of free­dom by oth­ers.”(2)
For ex­ample, those who suf­fer the most when people lose their free­dom to be­come barbers without hav­ing to pass state ex­ams on the chem­ic­al com­pos­i­tion of hair are not as­pir­ing barbers, but people who need hair­cuts.
Also, there is an in­si­di­ous dy­nam­ic to the loss of free­dom. Dir­ect re­stric­tions al­ways re­duce free­dom by more than is ap­par­ent
be­cause every re­stric­tion im­per­cept­ibly un­der­mines the ac­count­ab­il­ity of the mar­ket­place that makes free­dom pos­sible.
Thomas Jef­fer­son was cor­rect when he said, “Etern­al vi­gil­ance is the price of liberty.”
People are more likely to ex­er­cise vi­gil­ance in pro­tec­tion of their free­dom
when they un­der­stand the in­ex­tric­able con­nec­tion between it and the mar­ket.
Con­clud­ing ques­tions: How do trade re­stric­tions and taxes af­fect free­dom of ex­change? How do they ef­fect wealth cre­ation?
  1. I have qual­i­fied this state­ment to ac­count for the situ­ation
    where a coun­try pos­sesses great wealth be­cause of nat­ur­al re­source en­dow­ments and has an auto­crat­ic polit­ic­al re­gime, sup­press­ing the freedoms of its sub­jects.
    But even in this case, the lack of free­dom pre­vents the coun­try from real­iz­ing the full be­ne­fit from its re­sources,
    and un­der­mines the pro­ductiv­ity ne­ces­sary to ex­pand, or even main­tain, its wealth.↩︎
  2. See F.A. Hayek, The Con­sti­tu­tion of Liberty (Chica­go: Uni­versity of Chica­go Press, 1960), p. 32.↩︎

Unfair Competition with the Sun

By Frederic Bastiat (A condensed version of ‘The Petition of the Candlestick Makers’)

Ques­tion for thought: Politi­cians of­ten ar­gue that cheap im­ports are bad for the eco­nomy.
Think about this view as you read through this doc­u­ment.
“Gen­tle­men,—You are on the right road. You re­ject ab­stract the­or­ies, and have little con­sid­er­a­tion for cheapness and plenty.
Your chief care is the in­terest of the pro­du­cer.
You de­sire to pro­tect him from for­eign com­pet­i­tion, and re­serve the na­tion­al mar­ket for na­tion­al in­dustry.
We are suf­fer­ing from the in­tol­er­able com­pet­i­tion of a for­eign rival, placed, it would seem, in a con­di­tion
so far su­per­i­or to ours for the pro­duc­tion of light that he ab­so­lutely in­und­ates our na­tion­al mar­ket with it at a price fab­ulously re­duced.
The mo­ment he shows him­self our trade leaves us—all con­sumers ap­ply to him;
and a branch of nat­ive in­dustry, hav­ing count­less rami­fic­a­tions, is all at once rendered com­pletely stag­nant.
This rival, who is no oth­er than the sun, wages war to the knife against us, and we sus­pect
that he has been raised up by per­fi­di­ous Al­bion (a good policy as times go);
inas­much as he dis­plays to­wards that haughty is­land a cir­cum­spec­tion with which he dis­penses in our case.
What we pray for is, that it may please you to pass a law or­der­ing the shut­ting up of all win­dows, sky­lights, dormer-win­dows,
out­side and in­side shut­ters, cur­tains, blinds, bull’s- eyes, in a word, of all open­ings, holes, chinks, clefts, and fis­sures,
by or through which the light of the sun has been in use to enter houses, to the pre­ju­dice of the mer­it­ori­ous man­u­fac­tures
with which we flat­ter ourselves we have ac­com­mod­ated our coun­try—a coun­try, which, in grat­it­ude, ought not aban­don us now to a strife so un­equal.
We trust, Gen­tle­men, that you will not re­gard this our re­quest as a satire, or re­fuse it without at least pre­vi­ously hear­ing the reas­ons which we have to urge in its sup­port.
And, first, if you shut up as much as pos­sible all ac­cess to nat­ur­al light, and cre­ate a de­mand for ar­ti­fi­cial light,
which of our French man­u­fac­tur­ers will not be en­cour­aged by it?
We fore­see your ob­jec­tions, Gen­tle­men, but we know that you can op­pose to us none
but such as you have picked up from the ef­fete works of the par­tis­ans of Free Trade.
We defy you to ut­ter a single word against us which will not in­stantly re­bound against yourselves and your en­tire policy.
You will tell us that, if we gain by the pro­tec­tion which we seek, the coun­try will lose by it, be­cause the con­sumer must bear the loss.
We an­swer:
You have ceased to have any right to in­voke the in­terest of the con­sumer for, whenev­er his in­terest is found op­posed to that of the pro­du­cer, you sac­ri­fice the lat­ter.
You have done so for the pur­pose of en­cour­aging work­ers and those who seek em­ploy­ment. For the same reas­on you should do so again.
You have yourselves ob­vi­ated this ob­jec­tion. When you are told that the con­sumer is in­ter­ested in the free im­port­a­tion of iron, coal,
corn, tex­tile fab­rics—yes, you reply, but the pro­du­cer is in­ter­ested in their ex­clu­sion.
Well, be it so; if con­sumers are in­ter­ested in the free ad­mis­sion of nat­ur­al light,
the pro­du­cers of ar­ti­fi­cial light are equally in­ter­ested in its pro­hib­i­tion.
If you urge that the light of the sun is a gra­tu­it­ous gift of nature, and that to re­ject such gifts is to re­ject wealth it­self un­der pre­tense of en­cour­aging the means of ac­quir­ing it,
we would cau­tion you against giv­ing a death-blow to your own policy.
Re­mem­ber that hitherto you have al­ways re­pelled for­eign products,
be­cause they ap­prox­im­ate more nearly than home products to the char­ac­ter of gra­tu­it­ous gifts.
Nature and hu­man labor co-op­er­ate in vari­ous pro­por­tions (de­pend­ing on coun­tries and cli­mates) in the pro­duc­tion of com­mod­it­ies.
The part which nature ex­ecutes is very gra­tu­it­ous; it is the part ex­ecuted by hu­man labor which con­sti­tutes value, and is paid for.
If a Lis­bon or­ange sells for half the price of a Par­is or­ange, it is be­cause nat­ur­al,
and con­sequently gra­tu­it­ous, heat does for the one what ar­ti­fi­cial, and there­fore ex­pens­ive, heat must do for the oth­er.
When an or­ange comes to us from Por­tugal we may con­clude
that it is fur­nished in part gra­tu­it­ously, in part for an oner­ous con­sid­er­a­tion;
in oth­er words, it comes to us at half- price as com­pared with those of Par­is.
Now, it is pre­cisely the gra­tu­it­ous half (par­don the word) which we con­tend should be ex­cluded.
You say, how can na­tion­al la­bour sus­tain com­pet­i­tion with for­eign la­bour,
when the former has all the work to do, and the lat­ter only does one-half, the sun sup­ply­ing the re­mainder.
But if this half, be­ing gra­tu­it­ous, de­term­ines you to ex­clude com­pet­i­tion,
how should the whole, be­ing gra­tu­it­ous, in­duce you to ad­mit com­pet­i­tion?
If you were con­sist­ent, you would, while ex­clud­ing as hurt­ful to nat­ive in­dustry what is half gra­tu­it­ous, ex­clude a for­tiori and with double zeal, that which is al­to­geth­er gra­tu­it­ous.
One more, when products such as coal, iron, corn, or tex­tile fab­rics are sent us from abroad,
and we can ac­quire them with less la­bour than if we made them ourselves, the dif­fer­ence is a free gift con­ferred upon us.
The gift is more or less con­sid­er­able in pro­por­tion as the dif­fer­ence is more or less great.
It amounts to a quarter, a half, or three-quar­ters of the value of the product,
when the for­eign­er only asks us for three- fourths, a half or a quarter of the price we should oth­er­wise pay.
It is as per­fect and com­plete as it can be, when the donor (like the sun is fur­nish­ing us with light) asks us for noth­ing.
The ques­tion, and we ask it form­ally, is this:
Do you de­sire for our coun­try the be­ne­fit of gra­tu­it­ous con­sump­tion, or the pre­ten­ded ad­vant­ages of oner­ous pro­duc­tion?
Make your choice, but be lo­gic­al; for as long as you ex­clude as you do, coal, iron, corn, for­eign fab­rics,
in pro­por­tion as their price ap­prox­im­ates to zero what in­con­sist­ency it would be to ad­mit the light of the sun,
the price of which is already at zero dur­ing the en­tire day!”
Con­clud­ing ques­tions: Do trade re­stric­tions such as tar­iffs and quotas in­crease do­mest­ic em­ploy­ment?
Do the re­stric­tions help Amer­ic­ans achieve high­er in­come levels? Why or why not?

Not Yours to Give

from the Life of Colonel David Crockett
By Edward Ellis (Abridged)

Ques­tion for thought: Is sup­port for in­di­vidu­als and fam­il­ies in a dis­tressed situ­ation best channeled through gov­ern­ment or giv­en per­son­ally by in­di­vidu­als from their own money?
One day in the House of Rep­res­ent­at­ives, a bill was taken up ap­pro­pri­at­ing money for the be­ne­fit of a wid­ow of a dis­tin­guished nav­al of­ficer.
Sev­er­al beau­ti­ful speeches had been made in its sup­port.
The Speak­er was just about to put the ques­tion when Crock­ett arose:
“Mr. Speak­er–I have as much re­spect for the memory of the de­ceased, and as much sym­pathy for the suf­fer­ings of the liv­ing, if suf­fer­ing there be, as any man in this House,
but we must not per­mit our re­spect for the dead or our sym­pathy for a part of the liv­ing to lead us into an act of in­justice to the bal­ance of the liv­ing.
I will not go into an ar­gu­ment to prove that Con­gress has no power to ap­pro­pri­ate this money as an act of char­ity.
Every mem­ber upon this floor knows it. We have the right, as in­di­vidu­als, to give away as much of our own money as we please in char­ity;
but as mem­bers of Con­gress we have no right so to ap­pro­pri­ate a dol­lar of the pub­lic money.
Some elo­quent ap­peals have been made to us upon the ground that it is a debt due the de­ceased.
Mr. Speak­er, the de­ceased lived long after the close of the war; he was in of­fice to the day of his death,
and I have nev­er heard that the gov­ern­ment was in ar­rears to him.
Every man in this House knows it is not a debt. We can­not, without the grossest cor­rup­tion, ap­pro­pri­ate this money as the pay­ment of a debt.
We have not the semb­lance of au­thor­ity to ap­pro­pri­ate it as a char­ity.
Mr. Speak­er, I have said we have the right to give as much money of our own as we please. I am the poorest man on this floor.
I can­not vote for this bill, but I will give one week’s pay to the ob­ject,
and if every mem­ber of Con­gress will do the same, it will amount to more than the bill asks.”
He took his seat. Nobody replied. The bill was put upon its pas­sage, and, in­stead of passing un­an­im­ously, as was gen­er­ally sup­posed,
and as, no doubt, it would, but for that speech, it re­ceived but few votes, and, of course, was lost.
Later, when asked by a friend why he had op­posed the ap­pro­pri­ation, Crock­ett gave this ex­plan­a­tion:
“Sev­er­al years ago I was one even­ing stand­ing on the steps of the Cap­it­ol with some oth­er mem­bers of Con­gress,
when our at­ten­tion was at­trac­ted by a great light over in Geor­getown.
It was evid­ently a large fire. We jumped into a hack and drove over as fast as we could.
In spite of all that could be done, many houses were burned and many fam­il­ies made home­less, and, be­sides, some of them had lost all but the clothes they had on.
The weath­er was very cold, and when I saw so many wo­men and chil­dren suf­fer­ing, I felt that something ought to be done for them.
The next morn­ing a bill was in­tro­duced ap­pro­pri­at­ing $20,000 for their re­lief.
We put aside all oth­er busi­ness and rushed it through as soon as it could be done.”
“The next sum­mer, when it began to be time to think about the elec­tion, I con­cluded I would take a scout around among the boys of my dis­trict.
I had no op­pos­i­tion there, but, as the elec­tion was some time off, I did not know what might turn up.
When rid­ing one day in a part of my dis­trict in which I was more of a stranger
than any oth­er, I saw a man in a field plow­ing and com­ing to­ward the road.
I gauged my gait so that we should meet as he came to the fence. As he came up, I spoke to the man.
He replied po­litely, but, as I thought, rather coldly.”
“I began: “Well, friend, I am one of those un­for­tu­nate be­ings called can­did­ates, and–”
““Yes, I know you; you are Col­on­el Crock­ett, I have seen you once be­fore, and voted for you the last time you were elec­ted.
I sup­pose you are out elec­tion­eer­ing now, but you had bet­ter not waste your time or mine. I shall not vote for you again.”
“This was a sock­dol­a­ger . . . I begged him to tell me what was the mat­ter.”
““Well, Col­on­el, it is hardly worth-while to waste time or words upon it.
I do not see how it can be men­ded, but you gave a vote last winter which shows that
either you have not ca­pa­city to un­der­stand the Con­sti­tu­tion, or that you are want­ing in the hon­esty and firm­ness to be guided by it.
In either case you are not the man to rep­res­ent me. But I beg your par­don for ex­press­ing it in that way.
I did not in­tend to avail my­self of the priv­ilege of the con­stitu­ent to speak plainly to a can­did­ate for the pur­pose of in­sult­ing or wound­ing you.
I in­tend by it only to say that your un­der­stand­ing of the Con­sti­tu­tion is very dif­fer­ent from mine;
and I will say to you what, but for my rude­ness, I should not have said, that I be­lieve you to be hon­est. . . .
But an un­der­stand­ing of the Con­sti­tu­tion dif­fer­ent from mine I can­not over­look, be­cause the Con­sti­tu­tion, to be worth any­thing, must be held sac­red, and ri­gidly ob­served in all its pro­vi­sions.
The man who wields power and mis­in­ter­prets it is the more dan­ger­ous the more hon­est he is:
““I ad­mit the truth of all you say, but there must be some mis­take about it,
for I do not re­mem­ber that I gave any vote last winter upon any con­sti­tu­tion­al ques­tion.”
““No, Col­on­el, there’s no mis­take. Though I live here in the back­woods and sel­dom go from home,
I take the pa­pers from Wash­ing­ton and read very care­fully all the pro­ceed­ings of Con­gress.
My pa­pers say that last winter you voted for a bill to ap­pro­pri­ate $20,000 to some suf­fer­ers by a fire in Geor­getown. Is that true?”
““Well, my friend; I may as well own up. You have got me there.
But cer­tainly nobody will com­plain that a great and rich coun­try like ours should give the in­sig­ni­fic­ant sum of $20,000 to re­lieve its suf­fer­ing wo­men and chil­dren,
par­tic­u­larly with a full and over­flow­ing Treas­ury, and I am sure, if you had been there, you would have done just as I did.”
““It is not the amount, Col­on­el, that I com­plain of; it is the prin­ciple.
In the first place, the gov­ern­ment ought to have in the Treas­ury no more than enough for its le­git­im­ate pur­poses. But that has noth­ing to do with the ques­tion.
The power of col­lect­ing and dis­burs­ing money at pleas­ure is the most dan­ger­ous power
that can be en­trus­ted to man, par­tic­u­larly un­der our sys­tem of col­lect­ing rev­en­ue by a tar­iff,
which reaches every man in the coun­try, no mat­ter how poor he may be, and the poorer he is the more he pays in pro­por­tion to his means.
What is worse, it presses upon him without his know­ledge where the weight cen­ters,
for there is not a man in the United States who can ever guess how much he pays to the gov­ern­ment.
So you see, that while you are con­trib­ut­ing to re­lieve one, you are draw­ing it from thou­sands who are even worse off than he.
If you had the right to give any­thing, the amount was simply a mat­ter of dis­cre­tion with you,
and you had as much right to give $20,000,000 as $20,000.
If you have the right to give to one, you have the right to give to all;
and, as the Con­sti­tu­tion neither defines char­ity nor stip­u­lates the amount,
you are at liberty to give to any and everything which you may be­lieve, or pro­fess to be­lieve, is a char­ity, and to any amount you may think prop­er.
You will very eas­ily per­ceive what a wide door this would open for fraud
and cor­rup­tion and fa­vor­it­ism, on the one hand, and for rob­bing the people on the oth­er.
No, Col­on­el, Con­gress has no right to give char­ity. In­di­vidu­al mem­bers may give as much of their own money as they please,
but they have no right to touch a dol­lar of the pub­lic money for that pur­pose.
If twice as many houses had been burned in this county as in Geor­getown, neither you nor any oth­er mem­ber of Con­gress would have thought of ap­pro­pri­at­ing a dol­lar for our re­lief.
There are about two hun­dred and forty mem­bers of Con­gress.
If they had shown their sym­pathy for the suf­fer­ers by con­trib­ut­ing each one week’s pay, it would have made over $13,000.
There are plenty of wealthy men in and around Wash­ing­ton who could have giv­en $20,000 without de­priving them­selves of even a lux­ury of life.
The con­gress­men chose to keep their own money, which, if re­ports be true, some of them spend not very cred­it­ably;
and the people about Wash­ing­ton , no doubt, ap­plauded you for re­liev­ing them from the ne­ces­sity of giv­ing by giv­ing what was not yours to give.
The people have del­eg­ated to Con­gress, by the Con­sti­tu­tion, the power to do cer­tain things.
To do these, it is au­thor­ized to col­lect and pay moneys, and for noth­ing else. Everything bey­ond this is usurp­a­tion, and a vi­ol­a­tion of the Con­sti­tu­tion.”
““So you see, Col­on­el, you have vi­ol­ated the Con­sti­tu­tion in what I con­sider a vi­tal point. It is a pre­ced­ent fraught with danger to the coun­try,
for when Con­gress once be­gins to stretch its power bey­ond the lim­its of the Con­sti­tu­tion, there is no lim­it to it, and no se­cur­ity for the people.
I have no doubt you ac­ted hon­estly, but that does not make it any bet­ter,
ex­cept as far as you are per­son­ally con­cerned, and you see that I can­not vote for you.”
“I tell you I felt streaked. I saw if I should have op­pos­i­tion, and this man should go to talk­ing,
he would set oth­ers to talk­ing, and in that dis­trict I was a gone fawn-skin.
I could not an­swer him, and the fact is, I was so fully con­vinced that he was right, I did not want to.
But I must sat­is­fy him, and I said to him:
““Well, my friend, you hit the nail upon the head when you said I had not sense enough to un­der­stand the Con­sti­tu­tion.
I in­ten­ded to be guided by it, and thought I had stud­ied it fully.
I have heard many speeches in Con­gress about the powers of Con­gress,
but what you have said here at your plow has got more hard, sound sense in it than all the fine speeches I ever heard.
If I had ever taken the view of it that you have, I would have put my head into the fire be­fore I would have giv­en that vote;
and if you will for­give me and vote for me again, if I ever vote for an­oth­er un­con­sti­tu­tion­al law I wish I may be shot.”
“He laugh­ingly replied: “Yes, Col­on­el, you have sworn to that once be­fore, but I will trust you again upon one con­di­tion.
You say that you are con­vinced that your vote was wrong. Your ac­know­ledg­ment of it will do more good than beat­ing you for it.
If, as you go around the dis­trict, you will tell people about this vote, and that you are sat­is­fied it was wrong,
I will not only vote for you, but will do what I can to keep down op­pos­i­tion, and, per­haps, I may ex­ert some little in­flu­ence in that way.”
““If I don’t,” said I, “I wish I may be shot;
and to con­vince you that I am in earn­est in what I say I will come back this way in a week or ten days, and if you will get up a gath­er­ing of the people, I will make a speech to them.
Get up a bar­be­cue, and I will pay for it.”
““No, Col­on­el, we are not rich people in this sec­tion, but we have plenty of pro­vi­sions to con­trib­ute for a bar­be­cue, and some to spare for those who have none.
The push of crops will be over in a few days, and we can then af­ford a day for a bar­be­cue.
This is Thursday; I will see to get­ting it up on Sat­urday week.
Come to my house on Fri­day, and we will go to­geth­er, and I prom­ise you a very re­spect­able crowd to see and hear you.”
““Well, I will be here. But one thing more be­fore I say good-by. I must know your name.” ““My name is Bunce.”““Not Hor­a­tio Bunce?”““Yes.”
““Well, Mr. Bunce, I nev­er saw you be­fore, though you say you have seen me, but I know you very well.
I am glad I have met you, and very proud that I may hope to have you for my friend.”
“It was one of the luck­i­est hits of my life that I met him.
He mingled but little with the pub­lic, but was widely known for his re­mark­able in­tel­li­gence and in­cor­rupt­ible in­teg­rity,
and for a heart brim­ful and run­ning over with kind­ness and be­ne­vol­ence, which showed them­selves not only in words but in acts.
He was the or­acle of the whole coun­try around him, and his fame had ex­ten­ded far bey­ond the circle of his im­me­di­ate ac­quaint­ance.
Though I had nev­er met him be­fore, I had heard much of him,
and but for this meet­ing it is very likely I should have had op­pos­i­tion, and had been beaten.
One thing is very cer­tain, no man could now stand up in that dis­trict un­der such a vote.
“At the ap­poin­ted time I was at his house, hav­ing told our con­ver­sa­tion to every crowd I had met, and to every man I stayed all night with,
and I found that it gave the people an in­terest and a con­fid­ence in me stronger than I had every seen mani­fes­ted be­fore.
“Though I was con­sid­er­ably fa­tigued when I reached his house, and, un­der or­din­ary cir­cum­stances, should have gone early to bed,
I kept him up un­til mid­night, talk­ing about the prin­ciples and af­fairs of gov­ern­ment,
and got more real, true know­ledge of them than I had got all my life be­fore.
“The next morn­ing we went to the bar­be­cue, and, to my sur­prise, found about a thou­sand men there. I met a good many whom I had not known be­fore,
and they and my friend in­tro­duced me around un­til I had got pretty well ac­quain­ted–at least, they all knew me.
“In due time no­tice was giv­en that I would speak to them. They gathered up around a stand that had been erec­ted. I opened my speech by say­ing:
““Fel­low-cit­izens–I present my­self be­fore you today feel­ing like a new man.
My eyes have lately been opened to truths which ig­nor­ance or pre­ju­dice, or both, had here­to­fore hid­den from my view.
I feel that I can today of­fer you the abil­ity to render you more valu­able ser­vice than I have ever been able to render be­fore.
I am here today more for the pur­pose of ac­know­ledging my er­ror than to seek your votes.
That I should make this ac­know­ledg­ment is due to my­self as well as to you. Wheth­er you will vote for me is a mat­ter for your con­sid­er­a­tion only.”
“I went on to tell them about the fire and my vote for the ap­pro­pri­ation and then told them why I was sat­is­fied it was wrong. I closed by say­ing:
““And now, fel­low-cit­izens, it re­mains only for me to tell you
that the most of the speech you have listened to with so much in­terest
was simply a re­pe­ti­tion of the ar­gu­ments by which your neigh­bor, Mr. Bunce, con­vinced me of my er­ror.
““It is the best speech I ever made in my life, but he is en­titled to the cred­it for it.
And now I hope he is sat­is­fied with his con­vert and that he will get up here and tell you so.”
“He came upon the stand and said:
““Fel­low-cit­izens–It af­fords me great pleas­ure to com­ply with the re­quest of Col­on­el Crock­ett.
I have al­ways con­sidered him a thor­oughly hon­est man, and I am sat­is­fied that he will faith­fully per­form all that he has prom­ised you today.”
“He went down, and there went up from that crowd such a shout for Davy Crock­ett as his name nev­er called forth be­fore.
“I am not much giv­en to tears, but I was taken with a chok­ing then and felt some big drops rolling down my cheeks.
And I tell you now that the re­mem­brance of those few words spoken by such a man, and the hon­est, hearty shout they pro­duced, is worth more to me
than all the hon­ors I have re­ceived and all the repu­ta­tion I have ever made, or ever shall make, as a mem­ber of Con­gress.
“Now, sir,” con­cluded Crock­ett, “you know why I made that speech yes­ter­day.
“There is one thing now to which I will call your at­ten­tion. You re­mem­ber that I pro­posed to give a week’s pay.
There are in that House many very wealthy men–men who think noth­ing of spend­ing a week’s pay, or a dozen of them, for a din­ner or a wine party
when they have something to ac­com­plish by it.
Some of those same men made beau­ti­ful speeches upon the great debt of grat­it­ude which the coun­try owed the de­ceased–
a debt which could not be paid by money–and the in­sig­ni­fic­ance and worth­less­ness of money, par­tic­u­larly so in­sig­ni­fic­ant a sum as $10,000, when weighted against the hon­or of the na­tion.
Yet not one of them re­spon­ded to my pro­pos­i­tion. Money with them is noth­ing but trash when it is to come out of the people.
But it is the one great thing for which most of them are striv­ing,
and many of them sac­ri­fice hon­or, in­teg­rity, and justice to ob­tain it.”
Hold­ers of polit­ic­al of­fice are but re­flec­tions of the dom­in­ant lead­er­ship–good or bad– among the elect­or­ate.
Hor­a­tio Bunce is a strik­ing ex­ample of re­spons­ible cit­izen­ship.
Were his kind to mul­tiply, we would see many new faces in pub­lic of­fice;
or, as in the case of Davy Crock­ett, a new Crock­ett.
For either the new faces or the new Crock­etts, we must look to the Hor­a­tio in ourselves!
Con­clud­ing thoughts. What do you think about Le­onard E. Read’s com­ments on this read­ing?
Hold­ers of polit­ic­al of­fice are but re­flec­tions of the dom­in­ant lead­er­ship--good or bad--among the elect­or­ate.
Hor­a­tio Bunce is a strik­ing ex­ample of re­spons­ible cit­izen­ship.
Were his kind to mul­tiply, we would see many new faces in pub­lic of­fice; or, as in the case of Davy Crock­ett, a new Crock­ett.
For either the new faces or the new Crock­etts, we must look to the Hor­a­tio in ourselves!

Politics and Foreign Trade

By Dwight Lee

Ques­tion for thought: Why do gov­ern­ments tax and re­strict trade?
The case for free trade is over­whelm­ing, both the­or­et­ic­ally and em­pir­ic­ally, when one ap­plies the con­cepts of op­por­tun­ity costs and com­par­at­ive ad­vant­age.
Even if the people of a coun­try have an ab­so­lute ad­vant­age in pro­du­cing everything,
they still gain from for­eign trade be­cause they can­not have a com­par­at­ive ad­vant­age in pro­du­cing everything.
Ample em­pir­ic­al evid­ence backs up the the­or­et­ic­al ar­gu­ments in fa­vor of free trade.
The more that coun­tries per­mit in­ter­na­tion­al trade to dir­ect their pro­duct­ive ef­forts into their com­par­at­ive ad­vant­ages,
the more they prosper re­l­at­ive to those that re­strict trade.
Des­pite this evid­ence, al­most no coun­try has fol­lowed a policy of free trade.
With rare, and typ­ic­ally short-lived ex­cep­tions,
gov­ern­ments re­duce eco­nom­ic pro­ductiv­ity and their cit­izens’ prosper­ity by either tax­ing or im­pos­ing quotas on im­ports.
Why? An­swer­ing that ques­tion is the pur­pose of this es­say.

Cooperation vs. Confiscation

Giv­en the ad­vant­ages of free trade, no gov­ern­ment would erect bar­ri­ers to im­ports if the polit­ic­al pro­cess al­lowed the same de­gree of so­cial co­oper­a­tion as the mar­ket pro­cess.
When trade re­stric­tions are elim­in­ated con­sumers gain but some work­ers and in­vestors lose, most tem­por­ar­ily but some per­man­ently.
Even those who would lose per­man­ently from elim­in­at­ing their in­dustry’s trade pro­tec­tions would still be bet­ter off liv­ing in an eco­nomy with com­pletely free trade
than in one where all do­mest­ic in­dus­tries were pro­tec­ted.
Even though in­di­vidu­als may be­ne­fit from their in­dustry’s pro­tec­tion,
they would lose far more as con­sumers from the pro­tec­tions of every­one else.
Those in an in­dustry sub­ject to in­tense for­eign com­pet­i­tion will want gov­ern­ment to pro­tect them if they don’t have to con­sider the costs it im­poses on oth­ers.
But pro­tec­tion­ism would not oc­cur if an in­dustry had to pay these costs be­cause the bur­den to con­sumers is al­ways great­er than the be­ne­fits to the pro­tec­ted in­dustry.
Un­for­tu­nately, when people ob­tain be­ne­fits from gov­ern­ment they do not have to pay prices re­flect­ing their costs, as they do for be­ne­fits re­ceived in the mar­ket­place.
The co­oper­a­tion of the mar­ket­place comes from the mar­ket’s abil­ity to col­lect, ag­greg­ate, and com­mu­nic­ate costs that are widely dis­persed over many people
so that they are taken into con­sid­er­a­tion by those re­spons­ible for them.
In sharp con­trast, when the costs from polit­ic­ally provided be­ne­fits are dis­persed over many people, those costs are likely to be ig­nored.
So gov­ern­ment com­monly be­comes the means by which people can gain private ad­vant­age through con­fis­ca­tion rather than through co­oper­a­tion.

Weakness of the Many

A trade re­stric­tion con­cen­trates be­ne­fits on the few in the pro­tec­ted in­dustry at costs that are thinly dis­persed over the en­tire con­sum­ing pub­lic.
With the cost of a trade re­stric­tion spread over mil­lions of con­sumers,
few if any will be aware of the little ex­tra they are pay­ing for the pro­tec­ted product.
After all, con­sumers buy hun­dreds of dif­fer­ent products,
and a little in­crease in the price of one product typ­ic­ally has little im­pact on the well-be­ing of any one of them.
Even if a con­sumer is aware of the ex­tra cost, she will sel­dom know that it is caused by a trade re­stric­tion.
And if by some chance she does know the reas­on for the ex­tra cost, she has little mo­tiv­a­tion to re­spond polit­ic­ally.
Even if she could elim­in­ate the trade re­stric­tion, the ef­fort might cost as much as or more than the re­stric­tion.
While the total be­ne­fit from elim­in­at­ing the re­stric­tion is huge,
most of it would go to oth­er con­sumers wheth­er they took polit­ic­al ac­tion or not.
But her polit­ic­al ac­tion is un­likely to do any good if she acts alone.
Of course, if a large per­cent­age of the con­sumers act in uni­son they would surely have a de­cis­ive polit­ic­al in­flu­ence.
But be­cause the num­ber of con­sumers is so large, with each hav­ing such a small stake in the out­come,
it is al­most im­possible to or­gan­ize them for polit­ic­al ac­tion.
As is of­ten the case, the lar­ger the num­ber of people harmed by a policy, the weak­er their polit­ic­al in­flu­ence.

Power of the Few

On the oth­er hand, be­cause a re­l­at­ive few be­ne­fit from a trade re­stric­tion, they will be ef­fect­ive in lob­by­ing for it.
The be­ne­fit to each per­son will be sig­ni­fic­ant, and each will be aware of both his own gain and the source of that gain.
Also, be­cause of the small num­ber of be­ne­fi­ciar­ies, they are re­l­at­ively easy to or­gan­ize for polit­ic­al ac­tion.
In­deed, they will gen­er­ally be or­gan­ized already through in­dustry and oc­cu­pa­tion­al as­so­ci­ations.
So when a trade re­stric­tion is be­ing con­sidered, politi­cians will hear plenty from those fa­vor­ing the re­stric­tion and little if any from those harmed by it.
The res­ult is a bias to­ward provid­ing con­cen­trated be­ne­fits and ig­nor­ing much lar­ger, but dis­persed costs.
There­fore, it is of­ten the case that the smal­ler the num­ber of people be­ne­fit­ing from a policy,
the more power­ful their polit­ic­al in­flu­ence in its fa­vor.
With small, or­gan­ized groups able to cap­ture be­ne­fits at the ex­pense of the gen­er­al pub­lic through re­stric­tions on trade (and many oth­er spe­cial-in­terest policies),
little so­cial co­oper­a­tion is achieved through the polit­ic­al pro­cess.
For that reas­on, gov­ern­ment is a con­stant threat to the so­cial co­oper­a­tion that comes from free-mar­ket activ­ity.

Considering Some Costs

The costs of trade re­stric­tions are more dif­fi­cult to identi­fy than in­dic­ated above.
Con­sider re­stric­tions on steel im­ports. Few people buy steel dir­ectly.
Rather they pay for it in­dir­ectly when they buy products made from steel.
Also, when an im­port re­stric­tion in­creases steel prices,
em­ploy­ment op­por­tun­it­ies are re­duced in in­dus­tries re­ly­ing on steel as an in­put.
Those who don’t get jobs be­cause of a trade re­stric­tion will sel­dom know the reas­on.
It has been es­tim­ated that lim­it­ing steel im­ports to 15 per­cent of the U.S. mar­ket would cost Amer­ic­an con­sumers $189,000 a year for each steel job saved,
and that for every U.S. steel job saved, over 3.5 U.S. jobs would be des­troyed be­cause of high­er steel prices.(1)
Con­clud­ing ques­tions: Which leads to more so­cial co­oper­a­tion? Mar­kets or gov­ern­ment ac­tion?
Does the de­gree of so­cial co­oper­a­tion af­fect eco­nom­ic pro­gress and the liv­ing stand­ards of people? Ex­plain your re­sponse.
  1. See Ar­thur Den­zau, “Amer­ic­an Steel: Re­spond­ing to For­eign Com­pet­i­tion,” Cen­ter for the Study of Amer­ic­an Busi­ness, Wash­ing­ton Uni­versity, St. Louis, Mo., Feb­ru­ary 1985.↩︎

Energy Production versus Conservation

By Dwight Lee

Ques­tion for thought: Can gov­ern­ments de­term­ine how much en­ergy pro­duc­tion and con­ser­va­tion is ap­pro­pri­ate and ef­fi­cient? Ex­plain.
One of the most im­port­ant in­sights in eco­nom­ics was made by F.A. Hayek in a fam­ous art­icle titled
“The Use of Know­ledge in So­ci­ety” (Amer­ic­an Eco­nom­ic Re­view, Septem­ber 1945).
Hayek’s in­sight was simple, but power­ful: the in­form­a­tion ne­ces­sary for mak­ing sens­ible eco­nom­ic choices
is far too d