By Emanuel “Mike” Polioudakis

2007, 2008, and 2012

Do not copy, reproduce, or disseminate in any manner. All rights reserved by author.


I alone am responsible for any mistakes or silliness.

I thank: my wife, Nitaya, for patience and for reading a draft; many economists for thinking so well, the chief being Adam Smith and David Ricardo; Mr. Garrett for giving me Samuelson’s textbook to read in high school; Professor Fusfeld at the University of Michigan for a reading course in the history of economics; Norm Gross, Karen Dennis, and other friends in graduate school many years ago, for putting up with selfishness while I read and thought; students at Ohio University; Rob Burling for comments on my writing style in an old draft; Marshall Burns for reading a draft and for copy editing; and Guido Hulsmann for comments on the chapter on money.


This book is a “popular” book about economics, like books of popular science. It explains the basics of economics and capitalism to a general audience. Anybody who has had an eighth grade education can follow it. Nothing depends on mathematics, charts, or graphs. All the arguments are self-contained in words. Half-a-dozen times the book uses arithmetic but you can always follow the examples and the main thread without the arithmetic. This book is for people who are not in school, for high school students, and for college students who likely will not take a regular course in economics. It is a good introduction to economics even for students that will take a regular course.

This paragraph was added in March 2012: This book was originally finished in middle 2007, and put on the Internet commercially in early 2008. In 2007, I wrote about problems in the housing market and financial market, and about a crisis on the horizon, but the crisis had not come yet, so I did not write about it specifically. Not much has really changed since 2008. We have the same underlying strengths and weaknesses. We have not changed the financial markets and housing markets that gave rise to the crisis. So this book is more relevant now than originally. If my only goal was to sell books, that fact might make me happy. Instead, I am sad that we have not gotten better, and I hope this book helps us see how to get better.

Main Tasks. The main tasks of the book are:

(1) Provide the ideas needed to understand economics and capitalism.

(2) Provide the ideas needed in case the reader later decides to take a course in economics.

(3) Evaluate the major features of modern capitalist economies. Explain what works well and what causes problems.

(4) Suggest approaches to some problems. These suggestions never get in the way of the other main tasks.

Some Points in the Book. The main points in evaluating capitalism are:

(1) On the whole, the economy does well and serves people well.

(2) Usually the economy works best when left alone.

(3) To “leave the economy alone” is not a code phrase meaning, “Neglect the poor but help business firms and the wealthy”. To “leave the economy alone” means as little government intervention as possible. It means no programs favoring business groups or special interest groups. We need almost no growth incentives, tax breaks, help for particular industries, protection, or public-funded specialty museums.

(4) Although the economy works best when left alone, the economy has flaws and problems. We have to deal with those directly. There is a tension between the need to leave the economy alone and the need to intervene. When we are not sure, we should always not interfere.

(5) The biggest need for intervention comes from unemployment and poor employment. The United States has 5% to 8% of unavoidable unemployment. No amount of economic growth, no jobs programs, or any other program, can eliminate this minimum of unemployment. We have to learn to live with this unemployment and deal with it. This unemployment sustains other serious problems, such as class conflict, racism, and sexism. We can only address these problems honestly by giving direct help to the unemployed and the poorly employed.

(6) We also need to control monopolies and other kinds of unfair competition, minimize problems with pollution, and protect nature. We have to decide what kind of regulation and to what extent. We have to carry out regulation with little favoritism toward particular groups. Advanced capitalist countries have developed institutions for appropriate regulation. Although the institutions have made mistakes in the past, through experience they have evolved toward a good minimum set of actions for their missions.

(7) Economics cannot be done without using ideas about human nature and using moral ideas about what is right and wrong. I show where such ideas commonly appear in economics.

(8) To better explain human nature and the role of morality, I borrow from modern evolutionary theory. This book is not a Darwinist version of economics and capitalism. The main source of ideas is always mainstream economics. Darwinism adds depth to the main body of economic ideas.

(9) Because some problems in economics have no definite solution, people often fall back on ideologies. The ideologies often entail hidden self-interest or hidden moral points of view. I explain some major ideologies.

(10) The stereotypical Liberal response is to assume the economy needs a lot of care and that the state is always competent to intervene. In effect, Liberals assume the contradiction that the economy is so unhealthy as to need constant care but always healthy enough to withstand the effects of care. The Liberal attitude often is an indirect way of channeling funds to ethnic groups and social groups in return for political support.

(11) The stereotypical Conservative response is to deny problems. If the problems have to be admitted, then assume that promoting business or helping the rich can cure them. Conservatives publicly promote the free market so as to deny help to the poor while privately seeking privileges for themselves from the state. The Conservative attitude often is an indirect way of channeling funds to business, wealthy people, and religious-based groups in return for political support.

(12) This book walks a harder middle ground than the stereotyped Liberal or Conservative. This book accepts both that the ideal course would be to leave the economy alone but also that we have to face the problems and deal with them honestly. It suggests approaches to the problems that require the least interference.

(13) On the whole, America is doing a good job. My outlook contrasts with the pessimism both of the strong Left and the strong Right. Americans do see some problems, such as health care, even if we have no obvious theory to tell us what to do about them. We have a strong base on which to find solutions and we are moving toward practical solutions even without a definite theory. The future will be good as long as we are not carried away by ideology or disguised selfishness.

If we are doing a good job, then why write about it? Because many of us do not know that we are doing a good job, how we are doing a good job, or why. We cannot separate real problems from contrived problems. We mistakenly feel that something is wrong with the economy when the real problem is our vulnerability to bad ideas. We need to clear our heads so we can more calmly make decisions.

This book is about ideas rather than facts. This book has almost no statistics. It is clear on issues except where the issues are not clear. It sticks to basic ideas and to straightforward logic. This book does not use citations as in the typical academic book. Instead, it guides the reader to facts and to argument elsewhere, primarily through an annotated bibliography.

Clear logic is important because the need to intervene can only be understood by the same logic that tells us to leave the economy alone. The contradiction is not in the book but in the economy. Even so, the logic is not hard, and it can be fun.

This book differs from most textbooks by taking seriously socio-economic classes, class conflict, human nature, and moral judgments. This book differs from most social science by taking the same general point of view as mainstream economics and by being sympathetic to capitalism. This book takes society more seriously than does a typical economics textbook but it does not approach economy-and-society from the Left.

During the book, and especially at the end of the book, I make suggestions for dealing with problems. This book is not a way to promote my beliefs but is a presentation of ideas so readers can make up their own minds. My suggestions are not new and they are conventional. I pick from among the good suggestions that other people have already made. I never advocate a return to the failed programs of the 1960s and 1970s. Although I say nothing new, people that are not familiar with economics might not have heard the suggestions, and they likely do not know the reasons behind the suggestions. Any reader can go now to the suggestions to see what I have in mind.

If this book aligns with any point of view, it is the view once shared by moderate Democrats and moderate Republicans, augmented by my wish for as little state interference as possible, and guided by my desire to help the poor. This is a moderate book with commonsense ideas.

Personal Inspiration. This book was written by an anthropologist rather than by an economist. The book came from living in a working class family in Oregon when I was young, from living several places in the United States as an adult, and from living many years in various areas of Thailand. It came out of experiences with my own unemployment and the unemployment of my family, friends, and neighbors.

The writing came out of teaching economic anthropology. Especially now that capitalism is the dominant world economic system, anthropology students need to understand capitalism, but they would not take a regular economics course because they feared the graphs and numbers. They were not getting a good explanation of capitalism from the post-Marxist view that dominates most social science. They need something like this book.

Most people worry when they see numbers, charts, and diagrams. I could not talk to friends and neighbors about economic problems, even when we agreed in basic outlook, because they did not have the background. This book is for all those people too.

I learned to appreciate the people that write textbooks on economics. They do their job well. Still, there is a need for a book like this. As a non-economist, I hope that I was less prone to take sides in the typical doctrinal battles. I believe that I was able to include everything of importance to all the intended readers.

Political Inspiration. Many social science books get written as reactions against ideas that the writer thinks are wrong enough to be bad. It helps the reader to understand what worries me.

Most writers that favor minimal state interference fear collectivism: communism, socialism, mild fascism, or full-blown fascism. Communism died, so we do not have to worry about it anymore. If the United States had continued the programs of the 1960s and early 1970s, then we might have to fear socialism. The worst of those programs shriveled, and what is left does not amount to real socialism. Those kinds of programs are not likely to increase. Besides, I like some of the programs such as Social Security and Head Start, and I believe we should have modest national health insurance. So I do not fear socialism much now.

Instead, I fear mild fascism; I fear fundamentalism among Christians, Muslims, and Jews; I fear the parallel fundamentalism on the Left that is called “Political Correctness”; I fear the cult of the free market and I fear its opposite, paranoia about business; I fear Conservative and Liberal endorsement of fundamentalism, whether tacit or explicit; and I fear the political and military action that goes along with fundamentalism, whether done by individuals or states.

I see little practical difference between these fundamentalisms to any normal person who is unable to live under them. Fundamentalists do not accept the natural modern world or normal people. Fundamentalists are not stupid in how they deal with the modern world and use people. They know how to manipulate wealth and to manipulate the fears and symbols of modern life. They seek to gain power by interpreting the modern world so that susceptible people commit to them and then act foolishly. They seek to remake the modern world so that they can deal with it, and so they have the power. They will impose their solutions even on groups that are not a direct threat but that merely do not go along with their agenda. Their path leads to fascism, especially when combined with a desire to promote business, religion, family values, fairness, ethnic equity, and lifestyle recognition.

The state cannot stop fundamentalists and fascism. Only ordinary normal sane moderate people of all classes and all religions, including old-style Humanists and Liberals, can stop them. To stop them, we need clear ideas.

This book hopes to give people the ideas they need to be comfortable with a commonsense approach to the economy.

Strong fascism brings up images of military machines and death squads but I do not worry about that in the United States now. The word “fascism” comes from “a bundle of sticks”: one stick breaks easily but a bundle is much stronger than any of the particular sticks. Mild fascism means that the state coordinates business firms, consumers, workers, and state programs all together for a stronger whole. The state interferes in the economy for what it calls the public good. The state plans according to some ideology of the public good and of the role of wealth for the public good. When explained this way, fascism actually sounds seductive. But it is bad and it is wrong. Yet this is the direction of the United States recently.

One policy particularly represents mild fascism: induced economic expansion. The government declares that induced growth can solve all economic problems, can solve all social problems including poverty and welfare, and can give us the material basis to be an international power. To promote growth, we should channel wealth toward the groups that save the most and that invest the most. The rich save the most and invest the most, and business invests the most, so we should redistribute wealth away from the poor and the working class toward the rich and toward business. In a modern economy such as ours, this argument is false. Several places in the book, in different ways, I explain why it is false.

Luckily, the solid middle of economic theory, general compassion, and common sense, have not disappeared, show signs of resurgence, can serve as a basis to fight fundamentalisms, and can serve as a basis for understanding and action. I hope this book helps them prevail. I was happy to see the strong middle-of-the-road candidates in the Presidential campaign of 2008.

Case Studies and Principles. There is no magic rule for when to leave things alone or when we have to involve the state.

Without a clear rule, the best way to learn about what to do is to learn principles, study many cases, practice applying the principles, and thus get a feel for the practical modifications that we have to make to the principles. That takes a long time. I do not want to give the reader that kind of book. So I leave cases to other books. The “cases” in this book are primarily imaginary simple cases to illustrate an idea. I use real cases when I can, and I present realistic cases always.

Versions. This book comes in two versions, a long and a short, with some common material. I recommend the short version first, and that is likely what you have. Both are on the Internet. The long and short versions have in common these items:

(A) This Introduction that you are reading now.

(B) A list of Suggestions about economic issues, at the back of either book.

(C) A list of Suggested Readings at the back of either book.

(1) The “long book” came first. It was finished in 2006. It is aimed at the reader who has time enough to go into the arguments. It has 9 parts, of about 12 chapters per part, of about 8 pages per chapter. It has a long Part 10 of about 25 chapters. Part 10 is a series of essays on specific economic topics, such as insurance and welfare, many of which topics explain the Suggestions. In addition to regular chapters, a few optional appendices go into more detail on important topics or they discuss related topics.

(2) The “short book” is parallel to the long book. Originally the short book was a re-writing of the long book for Internet self-publication in 2008. It was revised again in early 2012 to put on the Internet. It has 9 chapters of about 32 pages each plus the common material listed above. Each chapter in the short book corresponds to a part in the long book except there is no counterpart to Part 10. Please go to the free download of Part 10 on the Internet for more in-depth analysis of the Suggestions. If you want, you can still find the 2008 self-published version by searching my name or “First Book in Economics”.

A chapter from the short book can take the place of a part in the long book. By reading only a chapter in the short book, you will not learn as much as from the corresponding part in the long book, but you should pick up enough to go back to the long book. You could design your own medium length version of the book by reading some chapters from the short version of the book, combined with some parts from the long version of the book. You can use the short book as a basic text while seeking some fuller explanation from the long book.

Presentation. Economists commonly use made-up simplistic examples to make difficult ideas clearer, a convention that I follow. I also refer to well-known American popular culture, such as movies and TV.

I do not use the authorial plural “we” to refer to myself but instead use the simple pronoun “I”. I try not to refer to myself too often, but I sometimes use examples from my own life to illustrate ideas, and I make clear when I am stating a personal opinion.

We” appears in two senses. It can mean, “people in general”. It can also mean, “the readers of the book and I, as we reason together”.

I use what editors call “stage directions”. I tell the reader what I am doing, why I am doing it, and how we are getting along. Stage directions make the average reader comfortable and allow him-her to read more quickly.

The repetition is on purpose for clarity. Repetition allows a reader to continue on right now without having to go back to look for previous explanations, prompts us to look at the same thing from several viewpoints, groups things together that were developed separately, and summarizes in transit. Repetition might annoy some readers with good memories but even they will find the reading goes faster.

If the reader goes on to read other economics or to take courses, he-she needs some technical ideas explained in plain. To introduce terms from economics, I use the phrase “economists say”. I do not mean to distance myself from economists, make it seem as if I know more, or make it seem that I do not wish to explain ideas.

About half-a-dozen places in the long book, I comment directly to economists or to teachers, which comments I enclose in square brackets: [].

[For example: This comment is for any teacher that might be considering the book. This book stresses microeconomics over macroeconomics. It does give all the basics of macroeconomics, both scattered throughout the book and in a chapter on that topic or in a part on that topic. I like the logic of microeconomics although I definitely do not neglect system.]

I make few attempts to be “Politically Correct” (“PC”). The spirit of PC is great but the execution is often so bad that the execution completely undermines the spirit. I prefer common sense and respect for human dignity.

Still, I have long seen the bad effects on women of using only male pronouns, so I use “he-she” or “him-her” instead of just “he”, “him”, “she”, or “her”. Because I am a man, the male pronoun comes first. This “dashed” form looks awful, but it was the best alternative I could think of. I try to use about equal numbers of men and women in my examples, but, because I take examples from the real life that I know, most of the examples have to do with men. Sometimes real life stories feature a man or a woman, so, in those cases, I use only the pronouns that are appropriate to the story.

Short Book Contents

Pages are numbered within each chapter only. The first chapter begins with “1”. The first column to the right with numbers is the number of pages in the chapter. The second column of numbers is the approximate total pages to the beginning of that chapter.

Short Book Contents

General Introduction

Short Book Introduction


01 Overview 25 1

02 Classical Economics 32 26

03 Human Nature 25 53

04 Marginality Theory 1: Personal Action 36 83

05 Marginality Theory 2: Business Firms 36 119

06 Profit 31 155

07 Labor and Class 32 186

08 Money 35 208

09 Macroeconomics and The State Practice 33 243

12 Suggestions 20 276

Suggested Readings 26 296

Short Book Introduction

This Introduction was added in the spring of 2012.

The book was revised somewhat in early 2012.

At the beginning of each chapter is a synopsis, about one page long. The Suggestions have no synopsis. You can get what you need to know, and get the gist of the entire book, by reading only the synopses. You can get the entire book in about 12 pages. Then you can go on to the Suggestions. Please go back to the chapters sometime.

This book was originally finished in middle 2007, and put on the Internet commercially in early 2008. In 2007, I did write about problems in the housing market and financial market, and did write about a crisis on the horizon, but the crisis had not come yet, so I did not write about it specifically. Not much has really changed since 2008. We have the same underlying strengths and weaknesses. We have not even changed the financial markets and housing markets that gave rise to the crisis. So this book is more relevant now than originally. If my only goal was to sell books, that fact might make me happy. Instead, I am sad that we have not gotten better, and I hope this book helps us get better.

01 Overview

This chapter gives an overview of capitalism, including strengths, flaws, and problems that come from the flaws. The intent is neither to praise capitalism too much nor to blame it too much but to provide ideas so that we can be realistic about what we face, want to preserve, and need to change. This chapter also gives basic ideas about systems.

This chapter is a series of annotated lists. The sections look at the same ideas from different angles. Most sections start with a jargon statement, and then go on to examples for clarity. Do not try to memorize the lists or the jargon. Get a sense of capitalism as a whole. The rest of the book explains in more detail.

01 Overview; Synopsis. Capitalism is a system like the global ecosystem, the weather, your car, and a forest. The capital in capitalism is like the trees in the forest. Not all trees are alike but all the trees have in common that they are the basic production of the forest on which everything depends. The workers and consumers are like all the animals in the forest including deer, rabbits, bugs, snakes, ants, and even unglamorous slugs, mushrooms, and bacteria. Plants and animals are tied together in a mutually supportive and mutually limiting cycle. Plants make food for animals too eat. Animals take food from the plants, and, in return, supply nutrients through the carbon dioxide they breath out, their urine, and their excrement. Plants and animals circulate particular nutrients that we can use to understand how they are tied together, such as energy, water, oxygen, carbon dioxide, and nitrogen. These nutrients are like money in capitalism.

Usually the forest keeps its own balance. It finds its own best size and composition. If there are too many trees, animals eat them until just the right number of trees remains to feed the animals. If there are too few trees, or too many animals, then some animals die from hunger, and more trees grow, until there are just enough trees to feed the animals and just enough animals to trim the trees. If capitalists take too much wealth from the economy, then consumers can’t buy all the products, and capitalists have to pay more in wages or have to scale down. If consumers want a lot and can afford to buy it, then more factories open up until consumers are satisfied. The forest does best when left alone. Usually, that is true of capitalism as well.

Sometimes the forest does get out of balance naturally, such as after a new disease or a fire. Even then, eventually the forest restores itself. A great forest manager might be able to help a little bit in these cases but the best thing is to make sure the forest does not suffer any more shocks until it recovers by itself. This is like capitalism recovering after a moderate recession or an “oil shock”.

Some natural forests do have chronic problems, but that situation is rare. Unlike natural forests, all capitalism does have some chronic problems, such as unemployment, poor employment, and periodic booms and busts. The managers of capitalism try to correct these problems by some kind of intervention, such as by changing the rate of interest, the amount of money, the rate of taxes on some people, or the size of savings. In the forest, this would be like trying to change the amount of water, how fast water circulates, or the amount of water in air versus the amount of water in soil. Sometimes these corrections work. Too often, these corrections serve the interests of one group in the economy rather than the whole economy. If soil bacteria managed the forest, they would insist on moving water to the soil; they would say that more water in the soil is a way to help the trees grow and so to correct all problems of the forest, regardless of whether that is true. To avoid these mistakes, we have to be realistic and non-partisan.

This chapter identifies elements of the capitalist economy and describes some ways in which they fit together, leading both to a self-correcting balance and to some problems. Later chapters go into more detail.

Some Definitions. Traditionally, social science books start with a definition of the subject. Capitalism is not unique so much in what features it has as in how it develops and combines features. Social scientists have not come up with one accepted definition of capitalism. Nearly all the readers of this book live in a capitalist society, and so have a good feel for capitalism already. Formal definitions of things that we already understand often confuse us. So it is not worth trying to give a long, precise definition of capitalism here.

Capitalism includes the following features but it is not only about them because these features exist in other societies and economies:

Self-interest Fair competition An abundance of goods Wealth Greed Striving to get ahead of the neighbors Markets Merchants Money Profit Interest Savings Re-investment of wealth Secure private property Factories Ventures Links between business, science, and the arts Business firms provide all the means to life A working class that has to seek livelihood only through work in firms Class society The perpetuation of wealth across generations Big business Ties between the state and business

These features are not unique to capitalism but are characteristic of capitalism: -A “good” is any material good such as a car, any service such as a visit with a doctor, or any activity such as watching a ball game. It is easiest to phrase arguments in terms of material goods, and so most of the examples in this book use physical goods. Any idea that can be explained with physical goods is also true of non-physical goods, and could be re-phrased using non-physical goods.

-Modern economies have two main kinds of actors: individual people and business firms. The government can also be an actor. It is described below.

-People pursue goods.

-Business firms provide goods to sell to people.

-Business firms provide goods so as to be able to pursue profit.

-Goods have a subjective value to individual people. People know the value of the good for themselves. A pizza does not have the same value for everyone. Everybody knows how important a pizza is to him/her.

-Goods also have a public price (value) in general for exchanging, buying, and selling.

-Everybody pays the same public price for the good even when the subjective value of the pizza might not be the same for everybody.

-The standard price is expressed in money.

-With money, the prices of all different kinds of goods can be compared.

-Labor is a good with a value too, paid through wages.

-Capitalism has many different ventures, such as a family restaurant, a car repair shop, a shopping mall, a cable TV channel, or a software company.

-Capitalism has many instances of each kind of venture, so that there are many car repair shops or beauty parlors in the same town.

-Capitalism is pervaded by low-grade interest that applies to the purchase of many goods, such as a house, and to the undertaking of many ventures, such as building a new shopping mall.

-Low-grade, pervasive interest allows us to compare values between many goods and ventures.

-“Capital” is abstract value that is not tied to any particular good such as a house.

-Capital can “flow” to ventures and between ventures. People can invest and can disinvest.

-Most people think of capital in terms of money but capital is more often credit.

-“Capitalists” are the owners of large amounts of capital.

-Pervasive interest allows business people to compare ventures so as to seek the greatest value for their capital.

-The financial institutions in capitalism can generate large pools of value (capital) to flow into ventures and between ventures.

-Capitalism has a large class of consumers that is supposed to buy all the goods that are produced.

-Consumers and laborers are almost exactly the same group of people.

-Consumer-laborers are supposed to be able to buy all that is produced with the wages they earn from producing those same goods.

-Business firms have to sell all the goods to the same worker-consumers that they pay to make the goods.

-Some business people are called “entrepreneurs”. They take on risk, sell innovations, deal with fluctuations and problems, and keep the economy moving.

-Business firms do best by giving consumers the products that consumers want.

-Competition leads business firms to serve the interest of consumers. Fair competition makes sure that they do this. The technical word for fair competition that leads to this result is “perfect competition”.

-“Demand” is how much of a good that people generally want, particularly at certain prices. For example, people “demand” ten million Honda Accords at a price of $20,000 apiece.

-“Supply” is how much of a good that business firms are willing to provide, particularly at certain prices. For example, Honda will provide one million Accords at a price of $20,000 apiece.

-“Welfare” can mean the familiar program to help poor people, but, in economics, more often the term refers to the well being of people in general. It is the sum of satisfactions for all goods for all people. The particular meaning of “welfare” will always be clear in context.

-Besides people and business firms, government is also an actor in the economy. The term “state” means not any particular state such as Ohio but “government of all kinds, especially the central federal government”.

-“State officials” means politicians and powerful civil servants. State officials do the acting on behalf of the state.

-State officials often have “clients”, often known as “special interest groups”: business people, labor unions, opponents of abortion, proponents of gay marriage, rich people, poor people, the Religious Right, the Politically Correct, farmers, software companies, Blacks, Whites, women, and Native Americans.

-We can look at the state as if it were an autonomous single large actor with a single will of its own, as if “Uncle Sam” were a real person. More often, state officials use the mechanisms of the state to act in their own interests and in the interest of their clients. They do not always hurt the general interest when they act this way, but too often they do.

-We need to design state institutions as much as we can so that state officials act in the general interest when they act in their own interests.

-We need to design all institutions as much as we can so that people and business firms lead to the general welfare when they act in their own self-interest.

Prosperity. Capitalism brought the highest standard of living to the most people of any economic system ever. Capitalism made more people more equal in material wealth than any other system ever did. Capitalism made possible sustained political power for the masses, that is, modern democracy. Modern democracy only developed after capitalism had provided the material base (property and reliable wages) for a mass of people to feel as if they had a real voice. Capitalism has been the economic foundation for the amazing advances in science of the last two hundred years. Capitalism provided the dams, roads, airlines, buses, movie theaters, TV stations, recording studios, and all the mass communications of modern life. It created the means for the mass entertainment and mass arts. Capitalism built the schools, athletic fields, bridges, skyscrapers, and other engineering marvels for which our time will be remembered. Together with science, capitalism put reality behind the slogan “a woman can do any job a man can do”. Without capitalism and science, women would still be farmwives, housewives, domestics, low-grade clerks, grade school teachers, or giving sex services. All these achievements of capitalism do not excuse its problems or excuse the abuses by some people in capitalism, but any problems or abuses should be weighed in the balance against its benefits. The benefits far outweigh the faults. It is hard to make this point any more forcefully by extending words. The reader should keep this point in mind throughout the book.

When Capitalism Works Well: Static Ideal. To understand when real capitalism works well and when it does not, we need an ideal to compare the real to, as when we go house hunting we have an ideal house in the back of our minds to which we compare the real houses that we see. We start with a static ideal, which is called “general equilibrium”. The static ideal is like a house that is alright “as is” and needs no “fixing up” now. There are both good and bad deviations from the static ideal.

Good deviations help to create a dynamic ideal that actually works better than the static ideal. Bad deviations distort the static ideal and dynamic ideal, leading to a loss of welfare. It is hard to tell good deviations from bad ones, so we can get confused and we can be misled by ideologies. We have to be clear about the static ideal, the dynamic ideal, and bad deviations.

The static ideal and the dynamic ideal differ in the same way that a predictable trip through familiar country to a warm bed in a familiar place differs from an eventful trip through unfamiliar country to a warm bed in a new place. It is the difference between driving an old station wagon versus driving a new sports car. The dynamic ideal is what makes “road trip” movies so much fun. Both ideals are good, but in different ways. To appreciate this difference, we first have to review the benefits of the static ideal.

A precise definition of the static ideal (general equilibrium) is best put off until the middle of the book but a working definition can be given here. Some of these points will seem unrealistically good, but that is part of what it means to be an ideal. We will measure them against reality all through the book. If you see ideas that have been left out, or if you see other problems, that is good; do not worry now. Ideas will be added, and problems will be addressed, later.

The features divide into two groups: features that create the economy and features that result from the operation of the economy. “Self-regulation” is “on the cusp”. Self-regulation arises out of the first set but then it acts to create the rest of the features.

(1) Self-Interested. People are self-interested but not necessarily selfish. People seek their own desires. Business firms are also self-interested in that they seek profit.

(2) Strategic. People and business firms use the best means to achieve their interests. People and business firms are strategic, or they act strategically. People and business firms are efficient.

Economists combine the ideas of self-interest and strategic action when they say that people and business firms are “rational”.

People might be altruistic sometimes, as when they save a drowning child, and business firms sometimes make donations to charity; but we cannot understand the normal operation of the economy according to those unusual actions. We can only understand the normal operation of the economy by thinking of people and business firms as self-interested rational strategists.

(3) Freedom. People and business firms are free to participate only to the extent that they wish and are free to not participate to the extent that they wish. Everybody has to participate to some extent because, these days, people can only make their living within the system – see below. Participating means that a person can seek whatever legal good he/she wishes; can decide to work at a job as hard as he/she wishes; or can decide instead to pursue leisure as much as he/she wishes.

(4) Private Property. People, business firms, and the state, all respect private property. People and business firms feel fairly secure that they can keep what they own and what they earn. Having secure private property in most respects is important but having absolute private property in every respect in not vital.

(5) Closure. People can make a living only by getting a job or by operating a business firm. Everybody has to work within the economy. Later in this chapter, I return to this trait when I discuss systems.

In the modern world, “not participating” does not mean opting completely out of the system to “be your own person”; it does not mean living free in the wild or as a rebel on the fringes of society. Usually it means starving to death in a hovel in a slum.

(6) Consumers as Workers. Consumers and workers are the same people in different roles. People have to buy what they need only with the wages that they get from working. Business firms have to sell all that they make to the people to whom they collectively give wages. Wages have to buy all the goods that are made from giving wages.

(7) Parts Determine the Whole. The economy is made up entirely out of the strategies of people and the strategies of business firms. The economy comes entirely out of people seeking goods and seeking jobs, combined with business firms making goods to seek profit. The actors in the economy build the economy entirely from the bottom up. Later I call this feature “reductionism”.

(8) Self-Regulation. The economy self-regulates automatically. Self-regulation means that the economy can successfully respond to changes in taste, changes in the availability of resources, to political events, natural events such as hurricanes, and to innovations such as the Internet. When the economy self-regulates, it returns to a beneficial balance. The economy self-regulates through individuals and business firms pursuing their self-interest. The economy rarely needs state help. Exactly how the economy self-regulates automatically is the subject of later parts of the book.

Now we begin the characteristics that result from the features above.

(9) Partial Equilibrium. Particular markets “clear” nearly all the time. At some price, corn farmers can sell all the corn that they grow, and consumers will wish to buy all the corn that farmers grow. At some price, Toyota can sell all the Camry cars that it can afford to make at that price, and consumers will wish to buy at that price all the Camry cars that Toyota can make. At some salary level, all the trained and certified electricians can find steady jobs.

(10) General Equilibrium. When all particular markets clear nearly all of the time, the entire economy also clears: All the goods that are made can be sold to the people that wish to buy them. When the particular markets for steel, rubber, land, corn, cars, fish, computers, and labor all individual clear, then they all have to clear together too. All the goods that are made can be sold to the people that wish to buy them for what the people receive in wages by making the goods. There is full employment so that there is no unemployment. There is a set of prices, one for each market for each good, for which all this happens.

(12) Public Price System. The price of any good arises out of the operation of the economy. The price of a six-pack of soda arises out of the economy from the demand for a six-pack of soda combined with the prices of water, sugar, flavor, “fizz”, aluminum, and labor. In turn, the prices of all the ingredients arise from the demand for them combined with their availability. The prices of all goods and resources make the prices of all goods and resources. This is not a circle, once we understand how it works. Once prices arise, they keep the economy going normally. Prices arise out of the system but then keep the system going.

(A) Prices are public. The price of a good is the same for all people and all business firms, with some minor variations because of location or quantity. The price of a gallon of gasoline is about the same to everybody but does vary a bit from around the country (it is cheapest around the Louisiana refineries). The price of a loaf of bread is about the same for everybody everywhere, rich or poor.

(B) Prices are signals that tell people what they can buy and how much they can buy. Low prices mean we can buy more, such as new shoes. High prices mean we can buy less, and have to make do with something else, such as our old shoes. Prices tell business firms how much it costs to make something, and how much the firm can expect to sell of something. The price of steel tells carmakers how many cars they can make. Since wages are a price for labor, prices tell business firms how many people they can hire. Prices are the information that people and firms need to rationally strategically their best self-interests.

(C) The economy is in good static balance (general equilibrium) when a single set of stable public prices prevails. When gasoline costs the same for everybody everywhere then the economy is near general equilibrium.

(D) We can understand how the economy operates by looking at how public prices arise out of the strategies of people and business firms. Chapters Four and Five are about that topic.

(E) We can also understand problems in the economy by problems in the public price system, as we do in Chapters Six and Seven. In particular, any policy that interferes with the normal public price system is liable to cause a problem.

I say more about the public price system below.

(13) Optimum Resource Use. Resources are used most efficiently to provide just the goods that consumers wish for. Petroleum is divided in use between making plastics, heating homes, and powering cars in just the proportion that gives consumers the most benefit. Milk is divided between drinking, making yogurt, making ice cream, and use in cooking in just the proportion that gives consumers the most benefit.

(14) Greatest Capacity. Because resources are used most efficiently to make just what people want most, the economy is at greatest capacity. It makes the most out of what it has got. It provides as much as possible out of the resources that are available.

(15) Full Employment. Full capacity means that everybody can work to the extent that he/she wishes, and is paid according to the extent of his/her abilities, training, and diligence. There is full employment; there is no involuntary unemployment. Full employment arises because all markets clear, including the market for labor; and because resources are used most efficiently, including labor. Full employment does not mean that everybody gets an easy job regardless of talent, training, or laziness. Everybody has to work for a living and everybody gets a chance to work for a living by getting a job.

(16) Greatest Practical Welfare Achievable. Recall that “welfare” means “general satisfaction among all people”. The economy achieves the greatest welfare that is practically available in the real world. Everybody is better off than he/she would be otherwise. Nobody loses, and everybody benefits, even if not everybody benefits equally. The greatest number of people are as satisfied as they can practically expect.

This happy outcome of greatest practical welfare does not mean the economy achieves the greatest welfare imaginable, only the greatest welfare that is practically available. It does not mean that the total sum of satisfaction is as great as it could be but only that the total sum is as great as can be practically negotiated. Each of us can imagine good situations that are not achievable. We can imagine situations in which the whole group is better off than is practically possible, or situations in which we personally are better off. The static ideal cannot make either of those alternatives happen for sure.

(17) Fairness. This outcome of greatest practical welfare is about as fair as can be practically achieved but that does not mean that this outcome is fully fair to all people. Nobody is worse off by participating. Everybody benefits to the extent that they choose to participate. Even so, some kinds of unfairness persist through the normal operation of a good system or even arise out of the normal operation of a good system. The poor still have to spend a large share of their income on food and housing, and not everybody can afford good medical care.

(18) Equality. Achieving the greatest practical welfare does not mean that people are more equal in wealth after than before, only that everybody is better off after than before. Differences in wealth can persist even through the ideals. People are rarely less equal after than before but they do not have to be more equal and they are almost never exactly equal. The static ideal is not a great equalizer.

(19) Automatic Growth. The economy grows automatically by incorporating innovations. Innovations include new technology such as bio-technology and new ways to organize such as the Internet. The economy grows to the full extent that the innovation increases general welfare. The economy does not need to grow in any other way, such as by deliberate government stimulus. When the economy has fully implemented the innovation, it also stops growing automatically.

The following features are important aspects of the public price system.

(20) Demand, Scarcity, and Price. The price for any good reflects both the demand for the good and its natural scarcity. Generally, the greater the demand and the scarcer the good, the higher is the price, such as for gold. The less the demand for the good, and the more naturally abundant the good, the lower is the price, such as for copper.

(21) Investment and Price. The scarcity of a good can be modified to some extent by deliberate investment in producing the good. Apples are much more abundant and cheaper because of apple farms than they would be if people had to search for them in nature. Modifying scarcity also affects the price. Demand, natural scarcity, and investment all together determine price.

(22) Imputation. In the short run, the costs of a good determine the price of the good. A Lexus costs more than a Camry because it has more expensive parts and takes longer to build. In the long run, contrary to intuition, the cost of a final good such as a car does not depend primarily on the cost of its components. Rather, the demand for the final good determines the value of the components. People are willing to pay for expensive components in a luxury car because they want a luxury car, and the expensive components are part of “the package”. The price of steel depends on the price people are willing to pay for cars and for other products made of steel. The price of steel does not determine the value of cars.

Good Deviations, and the Dynamic Ideal. Good deviations from the static ideal produce a dynamic ideal in which the economy runs better than in the static ideal. There is no particular term for when the economy deviates from the static ideal in good dynamic ways. When the economy deviates from the static ideal in good dynamic ways, it should always tend to return to the static ideal. These are some good deviations:

Everything real “jumps around” a little bit. A real economy is risky. Airlines can guess how many people want to fly during the holiday season but they cannot be sure. All firms have to guess. Firms that guess well do well while firms that guess badly do badly. This is part of beneficial self-regulation.

Innovations in technology (the automobile) or in organization (the assembly line) move the economy away from the static ideal until the economy has adjusted to the new potential, and the innovations are completely absorbed. The economy makes progress through innovations. It becomes more efficient and it presents new goods. The system benefits in the long run even though it might suffer some disorder in the short run.

Unforeseen discoveries of a natural resource such as diamonds or oil are also good deviations. They cause uncertainty, and they create benefit just as does a technical innovation.

Depletions of natural resources such as oil, natural disasters such as storms, and political changes such as an election can be good deviations as long as they do not occur too fast and are not too large.

All these changes can annoy the people most affected by them but they actually help the real system to more closely approach the static ideal and are not something to worry about. Every time an electronic innovation makes our current phone obsolete, we get annoyed, but we soon see the benefit. As these good deviations work through the system, the system tends to return toward a new version of the static ideal, toward a new general equilibrium.

The economy adjusts primarily through business people making decisions to seek profit. Their actions lead to the adjustments that benefit everybody, make the system more stable, and tend to return the system back to the static ideal.

Of course, in the real world, the economy never fully returns to any static ideal but always makes adjustments.

Bad Deviations. Bad deviations also make the static ideal real. They are among the flaws of capitalism. They open the door for people to suggest schemes for the public welfare that really benefit particular groups more. A list of bad deviations appears below. This section describes a few so we can get a sense of how they allow excuses.

We can think of bad deviations as distortions and unfairness. When Microsoft captured the market for operating systems with Windows, it gave the world one operating system so that computers could more easily “talk” together – a good thing; but it also forced everybody to use Microsoft software for other uses such as “Office”, and it drove out competing firms in fields such as word processing – a bad thing. Wal-Mart delivers an abundance of low-priced goods, but it also acts as the vendor for China in America, and it drives out local “Mom-and-Pop” operations. We all value the family farm, but, to keep it going, we have built a huge system of subsidies that artificially raises the price of all land and that leads us to farm “against nature” in many ways. Unemployment and poverty never go away, and the bad from them outweighs the good.

Bad deviations do not lead to progress, and they do not tend to return the system toward the static ideal. They create lingering problems.

Some bad deviations are tolerable if the extent of the bad deviation is not too great, such as having only one company that supplies our electricity. Some bad deviations we have to tolerate because the cure is worse than the harm, such as cheap foreign labor because protection against cheap foreign labor causes more harm than the cheap foreign labor.

If we cannot avoid bad deviations in real life, then we might as well respond to bad deviations in good ways. Rather than try to sue every cigarette smoker for the cancer caused by secondhand smoke, we can ban smoking in public places. Sometimes doing nothing is the best response. Farming is unusually uncertain and difficult. Yet to give farmers greater certainty and a better living, we have to pay a high cost in farm subsidies. Instead of giving farmers subsidies, we all, including the farmers, are better off to let farmers live with uncertainty. Despite MS Windows’ flaws, it is better to have one major computer operating system even if we have to put up with Microsoft. We can always hope that Windows becomes better with each version, and more “open source” with each version.

Excuses. The real problem is that often we cannot tell the difference between good dynamic deviations versus bad deviations. We do not know what to do, and so we are vulnerable to ideology, manipulation, and excuses for intervention. Any deviation might fall into one of the categories below, and we cannot always tell which.

(1) Normal random fluctuations such as a new invention or a hurricane. These might be good or bad, or something that we just have to adjust to.

(2) Good deviations such as the development of microchips or solar power, or the discovery of a new oil field.

(3) Bad deviations which are tolerable such as cheap labor in poor nations, a single operating system for computers, and the depletion of oil.

(4) Bad deviations for which the cure is worse than the disease such as poor profits in family farming, cured by subsidies; the collapse of the Savings and Loan industry, cured by a massive bailout; or the housing crisis that began in 2006, also cured by massive bailouts.

(5) Bad lingering deviations from the static ideal or dynamic ideal which cause serious problems such as chronic unemployment, poverty, lack of health insurance, and some kinds of unfair competition. These deviations are not the result of any deliberate strategy but arise out of the normal operation of the economy.

(6) Bad lingering deviations from the static ideal or dynamic ideal which cause serious problems. These deviations do result from deliberate strategy focused on a problem. They include some kinds of unfair competition, intrusions into the political process to gain favors, and state intrusion into the economy such as to protect business.

Focus on the computer motherboard industry. Suppose that the labor in another country is paid less than the labor in the United States. The overseas workers use similar technology, they are well treated, and the level of pay is generous by standards there. We are pretty sure that the level of pay eventually has to rise to American standards, but that rise might take decades. In the meantime, the American motherboard assembly industry is wiped out. Taiwan did this to America in the 1990s, and now China is doing it to Taiwan. Is this a good dynamic fluctuation that brings benefit to most, or is it unfairness that hurt American workers and then hurt Taiwanese workers?

Responses. There is no magic policy by which we can sort good deviations from bad, and always respond in the best way. When faced with hard decisions about these issues, people tend to take one of these major positions about state intervention:

(1) Do nothing. Never intervene. Let the market handle everything. Tolerate problems in the short run because we say everything works out in the long run.

(2) Intervene all the time.

(3) Always intervene to help me. Do not intervene otherwise.

(4) Always intervene to help me. I do not care about other people and other interventions. If I can make a deal so that I get my intervention while somebody else gets his/her intervention too, that solution is fine with me. This is normal politics.

(5) Develop objective guidelines about when to intervene, especially for problems that derive from underling flaws. In case of indecision, always intervene.

(6) Develop objective guidelines about when to intervene, especially for problems that derive from underlying flaws. In case of indecision, never intervene.

I favor position six.

Of course, in real life, the positions get thoroughly mixed up.

Comments on the Positions. Some Conservatives argue we should never expect the economy to come close to the static ideal. They say the only bad deviations about which we can do anything are those that come from the state, and the cure is to remove state interference, such as aid to the poor or aid to business. All other deviations and problems are temporary. The loss of doing something always outweighs the gains of doing nothing. The cure is always worse than the disease. Despite problems, the dynamic ideal always leads to a better life for everyone in the long run. We should trust in the dynamic ideal regardless of any temporary deviations or problems. I have a lot of sympathy for their position because it rests on love of freedom and distrust of the state; but I cannot accept their position.

Some economists and state officials accept that bad deviations exist, and offer solutions for the deviations, without realizing the extent to which their solutions distort the system and cause further problems. Usually they have good hearts but misjudge human nature or the workings of the economy. This happened with the social programs of the 1960s and 1970s such as public housing and food stamps, and with de-regulation that led to financial abuse and the housing crisis of 2006 and afterwards.

Some economists and state officials argue as if bad deviations did not really exist. They write as if the real system were always just on the verge of achieving the static ideal: The next recovery from this temporary downturn will definitely forever solve all unemployment problems. The use of solar power or hydrogen fuel cells will forever solve all energy shortages, pollution problems, and poverty. “Drill baby drill” will forever supply us with enough oil from domestic sources only. They explain away all problems, primarily because some of the problems actually help their clients, such as “big oil”.

Some economists and state officials accept that bad deviations exist but they offer solutions that do not really address the problems. Instead the solutions help them and their clients, such as urban development projects, poorly conceived public health insurance plans, unrestrained cutting of reserved forests, or freezing interest rates for house buyers.

This book provides guidelines but it cannot give absolute rules. If we cannot tell for sure, usually it is better to do nothing until we know for sure that our proposed cure is not worse than the disease. This is why we need to understand the basic static ideal; the dynamic ways by which the static ideal improves; and the bad deviations that cause a reduction in public welfare.

Flaws. Mostly, flaws are bad deviations from the static ideal. They undermine good competition. They undermine the benefits of the static ideal, and keep the dynamic ideal from moving toward the static ideal. Some flaws have been mentioned above, but they need to be assembled here in one place.

Imperfect Competition. Imperfect competition thwarts good competition. It includes unfair competition but it is wider than that. Imperfect competition also includes any case in which goods do not receive their proper value, too few goods are produced, choice is restricted, price is higher than it might have been, or markets do not clear properly. When too few rental units exist in a good neighborhood, we have to pay too high a price. Sometimes a large chain supermarket can drive out a farmers’ market or a local “organic” food store by lowering prices below cost for a while.

Intervention. State intervention impedes beneficial competition. State intervention usually thwarts good competition. State intervention usually does not nullify imperfect competition so as to restore good competition. State intervention has helped to promote imperfect competition, such as with protection for the sugar industry and with mortgage subsidies. State interventions forcibly move resources around, set prices, set interest rates, or set the amount of goods provided. Usually the state acts for some client group, such as steel producers, steel workers, old people, teachers, ranchers, car makers, Blacks, Whites, or defenders of the environment. When we think about state intervention, we have to think about who benefits, who has to pay, and how resources are moved about.

Not all intervention is necessarily bad. If the state intervenes to correct an obvious flaw, then the intervention can actually help the poor, or the environment, and the intervention can encourage the good dynamic ideal. The problems are: (A) we often do not always know how to intervene properly, (B) even good interventions tend to go beyond their target and to last too long, and (C) good interventions open the door to bad interventions.

Uncertainty. Ebb and flow in the real world cuts both ways. In a good way, it opens the door to opportunity and to creative people. In a bad way, it invites imperfect competition and state intervention. Exactly how it invites imperfect competition is the subject of later chapters but we can get a feel for the process here. For example, to reduce confusion over food, we tend to rely heavily on a few name brands, such as Campbell’s. This kind of reliance tends to thwart the normal good competition between firms. For safety, we have the state certify doctors, dentists, and other medical people. In using the state to certify medical professionals for us, we artificially limit the number of medical care professionals and so raise the cost of medical care. We have the state supervise the stock market or else we know that the cheating of some people would create havoc. The state interferes in farming to stabilize prices for food and to make sure that we have abundant food but that interference creates a class of farmers that depend on the state.

The Business Cycle and Getting Stuck. The typical business cycle lasts for about ten years, during which time it goes through a boom phase of too much prosperity and then a bust phase of unemployment and bad sales. Sometimes the down phase can last for much longer than a few years, and can be quite severe, as in the Great Depression of the 1930s. The economy can get stuck at levels below its natural capacity and at levels well below best resource use and maximum welfare. These cases also invite state intervention. Everybody would like the economy to run at an even keel most of the time, and to run at high capacity, but nobody is quite sure what full capacity might be, how to avoid getting stuck, and how to keep the economy on even keel. Some recent state institutions such as unemployment insurance have smoothed out the bumps and have kept us from getting severely stuck.

Out of the System. In the static ideal, the costs for producing everything are all within the system, so we can assess the impact of producing any good and can respond to changes well. For example, the costs of producing a small wooden boat are entirely in the cost of growing the wood, processing the wood, cleaning up, and labor. If any of these costs change, as for example elm wood undergoes a plague and we have to switch to maple, then we can pretty much understand all the adjustments that we need to make.

Some costs lie outside the system, and so it is hard to assess their impact and to assess what effects changes might have. The technical term for most of these cases is “externality”, reflecting the idea of “external to the system”. The clearest example is pollution. Suppose that the boat factory does not spend the money and labor to turn all its wood chips into mulch to sell but instead just dumps all of its waste products in the local creek. Instead of the boat maker paying for all the hardships for boat production, now all the local fishermen, children, farmers, and residents pay the hardships through reduced ability to use the creek and through increased disease. We cannot even assign a money cost to the effects now as we could before when the boat maker had to clean up his/her own wastes. We are not sure what would happen if we tried to force the boat factory to clean up or if we tried to organize the community to clean up. Some costs of boat production now lie out of the system, with unpredictable results.

Unfairness. See above too. Although the static ideal always increases total welfare, and almost always increases the welfare of all participants, the results are not always fair in ways that we can easily live with. A rich family and a single mother both pay the same price for a loaf of bread. That is how a public price system works. But the loaf of bread means much more to the poor family, and sometimes they cannot afford the loaf of bread because they have no skills sufficient to trade for the loaf of bread. This is not fair. Yet any interference to correct the problem is likely to cause more harm than good. Later chapters show how these cases arise and speculate on what to do in these cases.

Problems. The flaws cause inevitable problems. Some of the problems we met above in the description of the flaws. Other problems include:

Imperfect competition causes poor use of resources. When gangsters controlled alcohol in the 1920s, alcohol was not produced in the most efficient way to the highest standards. The price of alcohol was much higher than it should have been. Much of the price went into corrupting state officials.

We find it hard to cure pollution because we cannot assess how bad the effects really are, and we cannot make the polluters pay. Who knows how many cases of cancer are caused each year by car exhaust, and who knows how to make car drivers pay for the sickness?

The most important case of resource misuse is unemployment, which is poor use of the resource of labor. Imperfect competition creates an inevitable minimum of unemployment. This unemployment cannot be cured once-and-for-all by causing the economy to grow through any jobs programs or through any aid. No matter how big the economy grows, the “pie” of the economy still has the same pieces; and it always has one piece missing that represents unemployment. Aid can keep the poor from leading bad lives, but usually it cannot lead them to find jobs and to support themselves.

Not only does imperfect competition create unemployment, it also promotes bad employment where some people can get jobs that are only barely enough to live on, without any health benefits or retirement benefits.

Bad employment causes other problems in turn, such as poverty, family disintegration, and discrimination by race, sex, age, and religion. It feeds class conflict in which people with decent jobs fear the poor and act against the poor. People that fear the poor prevent the poor from getting the help that the poor need such as by making welfare difficult; and people that fear the poor pass laws that make life harder for the poor such as against soft drug use. Class conflict feeds political polarization and feeds dependency on ideologies instead of supporting the use of reason.

Problems with unemployment and jobs lead politicians to promote economic expansion as a cure. Natural growth through the implementation of innovation is quite good but artificial growth through state programs almost always causes more harm than good. Yet it is hard to resist the programs because poverty will not go away.

More often than not, the growth programs are not really aimed at helping the poor but at helping clients: business firms such as the construction industry or special interest groups such as urban Blacks or suburban Whites. It is hard to assess the real impact of the programs and who the real target beneficiaries are.

We understand that we need to do something about pollution and that we need to maintain the environment such as by preserving species and habitat. But we find it hard to keep people from exploiting the environment because we mistakenly think that helping the environment denies people jobs. We incorrectly think that exploiting the environment can make more jobs and reduce poverty.

We are never sure if we as a nation can afford decent health care for people that cannot afford it themselves, can afford decent education for all children, or can afford decent retirement for all people. We feel that people should be responsible for themselves in these matters, but we know that they are not, and we do not know what to do.

When any industry, such as garment making, wishes protection against competition, it can claim that helping the industry is necessary to maintain jobs, even though this is usually not true. Congress finds it very hard to deny any particular help that is supposed to preserve jobs or create jobs.

Key Question. When we see a problem, we want to do something directly about it. We are tempted to “throw money” at problems, a tactic satirized in an IBM TV ad mimicking King Arthur and his Round Table. Sometimes doing something directly actually works, even throwing money. Yet limited success can be more of a problem in its own way than consistent failure because it fools us into thinking that intervention is a good tactic in general. The real question is not “does this particular solution seem to work?” but about the unintended results of good will. Sometimes the unintended results of good will can be worse than the original problem: “The Road to Hell (sometimes) is paved with Good Intentions”. We need to ask more deeply:

(1) Is this solution liable to cause other problems, some of which are even worse than the original problem? Is the cure worse than the disease? The classic example is welfare. We do need to help people, but we cannot do so in a way that tempts other people off work entirely and that empties the pocketbooks of hard working honest people. When foreign competition gets the jump on an American industry through innovation, as it did with steel, then it makes sense to help out the American industry for a while until it gets back on its feet or until it collapses and the workers can find jobs elsewhere. The trouble is that the helping never stops, the industry never gets back on its feet, and the workers never find jobs elsewhere. Helping becomes welfare to corporations and to well-paid union workers.

(2) Even if a solution works, and does not cause other severe problems in its immediate vicinity, is this solution liable to set a bad example for abuse in other ways and in other places? Even if helping an industry does succeed sometimes, as it did with Chrysler in the late 1970s and early 1980s, helping sets a bad example, as with the later Savings and Loan debacle and as with helping out house buyers in 2008. Other industries ask for help, including protection from competition, and then they never get better. The textile industry is the classic example. The textile industry first began to receive protection in the early 1800s, and has received protection continually ever since. Another example is tax breaks for various special interest groups of ordinary people. It makes sense to give old people a tax break on their home or to give sick people a medical deduction, but tax breaks of one kind lead to a never ending chain of tax breaks for everything. Intervention in one area opens the door to other unrelated areas. State aid to education seems like a good idea but now the federal government has the right to control the direction of much research and it has the right to insist that military recruiters be allowed on any campus that receives federal aid even if military policies on homosexuals are not acceptable to the people on that campus. It is hard to tell if interventions outside the primary problem work or not, and so we wind up with many instances of bad protectionism and bad welfare.

It is very hard not to do something about a problem, do less than we might do, or do other than we wish; but we have to work hard to think things through. If a solution is liable to cause other problems, set a bad example, or open the door to state officials and their clients, then we might have to do nothing, or we might have to find other solutions. This conclusion hurts me but I have been forced to this conclusion through abuses I have seen. Much of this book is about seeing links so that we can assess the likely full impacts of proposed solutions to urgent problems.

Systems Ideas and Terms. To think clearly, it helps to have some ideas from systems theory. Many readers know the ideas intuitively from experience, so here it is only necessary to give the ideas a name.

Reductionism and Holism. The logic of economics works from the inside out, from the bottom up, or from the part to the whole, rather than from the top down, or from the whole to the part. Economics explains in terms of the strategies and interactions of people and business firms. Economics assumes that all features of a group ultimately can be explained in terms of actions by individuals and firms. Economics assumes that no group features can dominate individuals so much that individuals cannot “break free” to do what they want, at least in the long run.

Economics does not assume that people never make mistakes, or that they are not susceptible to pressures such as advertising. It just assumes that individual action is more important in the long run.

To understand individual strategies and interactions, we have to assume that individuals are primarily self-interested rather than altruistic. We also have to assume some typical human goals such as the desire for a family. These topics are the subjects of later chapters.

In contrast to reductionism, “holism” assumes that the whole is greater than the sum of the parts, and that the whole can mold the parts so that the parts can better serve the whole. A strong version of social holism is the Borg on “Star Trek TNG”. More reasonable examples might be members of a Parent Teacher Association (PTA), the children on a YMCA soccer team, or the members of a church. Many people fear becoming a cog in a large mechanism, as when they first take a job in a large corporation or if they join a church that is very strict. Most social scientists other than economists think that holism is the norm in human life, and that the greater benefit comes through the whole rather than through individual action. Their examples of social wholes include cultures such as Western European culture or Chinese culture; societies such as Germany in the 1800s or India in the 1800s; nations such as modern England or France; tribal groups such as the Yanamamo in South America or the Nuer in Africa; or religious institutions such as churches, mosques, temples, and synagogues.

In their pure forms, holism and reductionism are not compatible. I am committed to reductionism, and most of economics is also committed to reductionism.

Reductionism does not overlook culture, society, institutions, or history; it just looks at them in terms of individual interaction. It does not assume that social life cannot guide individual action, or that social life cannot sometimes dominate individuals; it just assumes that people can work through social institutions to achieve their self-interests most of the time. It assumes that people make social institutions through interaction based on self-interest.

Reductionism seeks the institutions under which strategic self-interest can lead to the benefit of most individuals and to the benefit of the greater society at the same time. It seeks the social institutions that can be created and recreated through individual consent and that also guide individuals to serve the greater social good while they serve themselves. It takes the free market as a key example of such an institution.

Self-Regulation. This feature is really four closely related features that have always been mixed together. Self-regulation does not rule out change. It does not mean “completely stationary”. It is the ability to return to balance even after some changes. Thus it works well with both the static ideal and the dynamic ideal. I give both ecological and economic examples below to show that the logic is similar in both.

(1) The ability to return to a balance after minor changes. For a forest, this would be a return to balance after an unusually cold winter. In an economy, it would be a successful response to a cold winter or to a change in taste from last year’s fashions. This category includes the ability to respond to the ebb and flow of daily reality.

(2) The ability to return to balance after a major disruption such as a large forest fire, a war, a hurricane, or a housing bubble.

(3) The ability to adjust to long-term changes such as drying of the climate or the depletion of oil.

(4) The ability to return to balance after adopting an innovation, such as the introduction of horses to North America or the introduction of electricity to the modern world.

Economies self-regulate through: (A) consumer decisions to buy what gives them the most satisfaction, (B) people seeking the best jobs, (C) business firms seeking profit by offering goods, and (D) the flow of capital from ventures that make less profit to ventures that make more profit.

Microeconomics and Macroeconomics. Reductionism and self-regulation form the basis for what is called “microeconomics”, or looking at the economy entirely from the point of view of individual people and business firms.

In contrast, “macroeconomics” is looking at features of the whole system at a time. Instead of thinking how the decisions of individual borrowers and lenders go to make up the interest rate, macroeconomics thinks about how the total amount of money might affect the interest rate.

If macroeconomics is done without any consideration of particular strategies, or if it is done by assuming that the economic whole determines the action of people and business firms, then it is “holism”. Ideally, macroeconomists oppose holism. They believe that all large-scale patterns should be explainable in terms of small-scale actions but that sometimes it is much easier to work on the large scale without worrying about how the large scale depends on the small scale. When they are careless about how the large scale depends on the small scale, they sometimes slip into holism.

This book stresses microeconomics.

The following ideas are my way of providing a foundation for macroeconomics. They are a useful version of macroeconomics. In using these ideas, I am careful to think about the whole in terms of the parts. These ideas occur all through the book. In addition, I include two chapters on macroeconomic topics toward the end of the book. This effort balances my inclination toward microeconomics, and provides readers with the ideas about macroeconomics that they need.

Circularity. “What goes round comes round”. “Everything depends on everything else”. “Everything affects everything else”. “What A does affects B, and what B does affects A”. “The whole world is a circle”. In a forest, plants provide the food for animals, which provide the fertilizer for plants, and so on. In an economy, power from oil allows people to mine iron ore; with the iron ore, people make tools with which they drill for oil. People make all the goods in an economy; they have to buy all the goods that they make with the salaries that they get for making the goods. Business firms make all the goods in an economy; they have to be able to buy all the parts and goods from the revenue that they make from selling all the goods that they make.

Closure. This is the idea that everything that affects the system, or is affected by the system, is in the system. Complete closure only happens at the level of the universe, so we have to think in terms of degrees. Even so, most ecosystems, such as a forest or the oceans, are fairly closed; and most modern economies are fairly closed. Foxes live out their lives according to what they can hunt in the forest, and, when they die, they give their bodies back entirely to the forest. In the modern world, the very vast majority of people can only make their living at a job in a firm that makes products that other working people have to buy. Firms can only sell their goods to people that work for firms.

Externalities, such as pollution, can be exceptions to closure depending on the scale of inclusion (whole earth versus economy) and the point of view (particular business firm versus community).

Self-Reproduction. A system has to be able to make itself. A complete system is not like a car that gets made by a factory, or even like a deer that gets made indirectly with the help of the whole forest. A complete system is like the whole forest in which the parts make themselves with the help of each other, and then remake each other. Deer indirectly make trees, and trees indirectly make deer. In a modern economy, the factories have to make not only the goods that final consumers buy but also have to make the tools that make the factories. When consumers buy final goods, such as cars, they also indirectly buy the tools that make the factories that make the cars. Workers have to get paid not just enough to eat everyday but enough so that they can live well enough to be reliable workers, so that they can raise their children all the time that their children cannot work, and so that they can educate their children to be workers too someday.

Self-reproduction does not imply holism. Self-reproductive systems can be fully understood in terms of the parts looking out for themselves and in terms of the parts interacting to recreate the relations between them, as with the plants and animals in a forest. Plants make animals and animals make plants; we do not need any higher level to understand what is going on.

Together the ideas of circularity, closure, and self-reproduction help us to get a better idea of what will happen to x if we do something to y. If we shoot all the rabbits, what happens to the foxes? If we shoot all the wolves, what happens to the deer? If the steel industry goes overseas, what happens to the steel workers, to the other people in the American economy that depend on steel, and to prosperity in general?

Directionality. Systems do not only remake themselves, they also change over time, sometimes in response to major changes such as a change in climate. Changes sometimes have a direction. A pine forest becomes an oak forest over time, especially if the climate changes. Red squirrels replaced gray squirrels all over the United States in the last hundred years. The car replaced the horse, and thereby changed sex habits and vacation habits all over the world.

Progress. Not every change is for the better. Most changes just happen. Some changes are for the worse. The large majority of directed changes work out for the better in the long run because people make them that way, such as TV - but not all changes. We have yet to see if nuclear energy will work out for the best for the world, even though it certainly has caused many changes in particular directions.

People tend to evaluate all change according to their outlook on the world and according to their ideology about capitalism. If they are optimistic and they trust capitalism, then they tend to trust change, and vice versa. We need to relax with change to see if it is really worthwhile. We have to accept that a change will happen if it is valuable to a large minority even if it is something the majority does not want now and often regardless if we think that it is good. Such is likely to be the case with stem cells and other bio-technology. Many people still fear computers. I do not like cell phones, but I am learning to live with cell phones, and I can even see how they are useful when on the road a long way from home.

Spontaneous Unplanned Persistent Order. People tend to think that a beneficial arrangement such as the static ideal or dynamic ideal can arise only if it is well planned. In particular, people that advocate state intervention think only state intervention can establish and keep a benevolent order. They are wrong. Often good order arises by itself, and keeps itself, through the spontaneous action of the parts. In that case, it is beneficial “spontaneous unplanned persistent order”.

Nobody can create forests deliberately unless we give that credit to God or the Dharma. The planned forests of today are not nearly as interesting and stable as the natural forests they replaced. All ecosystems arise naturally from the action and evolution of their various species, and they persist in the same way. Only when people intervene to disturb them do we then have to keep going back to fix the problems that we caused.

Many of the best games arose spontaneously, such as golf, baseball, and American football. Nobody planned them exactly. They developed out of an accumulation of small changes from a lot of individuals and groups. Once they reached a level of “perfection” and interdependence, they tended to stabilize and to remain stable.

Economists see capitalism as a benevolent spontaneous unplanned persistent order. The economy arises spontaneously out of the actions of individuals and business firms, and the economy self-regulates in the same way to maintain itself. Nobody has to institute the economy or has to guide the economy to keep it going. Even when the economy changes over time, and even when it makes progress, an economy does so on its own without any need of external planning by the state or by clients of the state.

Some economists argue that a spontaneous order is always beneficial, and tends toward the maximum practically available welfare. The only condition is that individuals and business firms are free to participate to the extent that they want and only to that extent. The freer they are, the more likely the economy is to be spontaneous and beneficial.

Their argument would probably be true if there were no flaws or problems in the economy, but there always are, and so it is not the case that a benevolent order always arises by itself when the possibility is there, and it is not always the case that every order is benevolent. Sometimes orders do not arise for reasons that have to do with system dynamics and are too complicated to get into here. Sometimes orders do not arise because people, interest groups, or the state prevents it. Sometimes bad orders arise, particularly as a result of flaws. Sometimes flaws, or interference by state officials on behalf of clients, turn a good order bad.

When we have a bad order, we have to be careful about interfering because bad orders are tricky. It is very hard to get out of a bad order once we are in a bad order.

Capture. An order can be “captured” by a subgroup that cares more about its own welfare than about the welfare of the group as a whole, and that is willing to act unfairly.

Sometimes an order is captured by imperfect competition even when business firms act fairly – it can just turn out that way. Microsoft sold Windows mostly in accord with the rules of fairness but managed to capture the market anyway.

Special interest groups try to capture a portion of the market when they seek protection against foreign competition. Political groups try to capture a portion of the political market, as for example the Religious Right or activists that promote homosexual marriage.

Ordinarily in a beneficial spontaneous unplanned order, particular individuals and business firms are not powerful enough to capture the order. Even most normal coalitions of individuals and business firms are not powerful enough.

In one of the charming paradoxes of the static and dynamic ideals, the pursuit of self-interest actually makes the benevolent order of the ideals stronger. Individual people and business firms usually do not have to altruistically give up their self-interest to the whole to preserve the benefits of the whole. They just have to act fairly.

Most people are familiar with a particular firm gaining control of an industry as Intel once controlled the market for central processing units (CPU); an urban gang taking over a neighborhood; a political party taking over a country; a special interest group such as the Left or Big Business taking over a political party; or a special interest group such as the Religious Right taking over a political party and a country.

Subgroups that capture an order often think their own benefit coincides with the benefit of the group as a whole, and so they do not always understand that what they wish is not necessarily for the benefit of the group as a whole. They always know what is best. What is best for them is best for everybody. This attitude is typical of fundamentalists of the Left and Right. This is why we have to de-centralize and defuse power when we can.

More Terms and Ideas.

The Market. In economics, “the market” usually does not refer to a particular physical location such as a flea market, a farmer’s market, or a local auction for cattle. It refers to all the buying and selling for a particular good, regardless of where the action takes place. The market for oranges is all the buying and selling of oranges whether in California, Texas, Florida, China, or Thailand. Energetic traders carry out the market for Google stock through computers on an abstract stock market. Sometimes the idea can be more specific, as “the real estate market in Auburn, Alabama” but usually people qualify the term when they mean it that way.

Free Market. Originally a free market meant a market not encumbered by many of the traditional interferences that were practiced by agricultural states before about 1900: tariffs, travel fees, monopolies, special grants and privileges, fixed prices, fixed production targets, etc. Originally a free market meant a market in which the owners of wealth were able to invest their wealth any way they wished.

Now the term “free market” is politically charged, and discussion is confused because proponents and opponents of the free market do not mean the same thing as before. Some people, generally Liberals, argue that the market ought to be restricted so wealthy people cannot use the market to perpetuate an advantage. They deny that the market is ever truly free, and they see the “free market” primarily as an ideology that lets rich people do what rich people want. Liberals use the argument against a free market as a tactic to gain power for their clients such as Hispanics or workers worried about losing their jobs to overseas cheap labor. Conservatives publicly argue against any interference in the market yet privately they really want interference. They use the ideology of the free market to deny help to the needy or to competitors. They promote state interference that is beneficial to them such as protectionism, subsidies, and tax breaks. They use the argument for a free market as a tactic to get the kind of interference that they want and to block the kind of interference that they do not want.

When this book says “free market” it means a free market in the original sense, with as few obstacles as possible and where people can use their wealth any way they wish as long as they do not hurt other people. It does not use the term as an ideological cover to favor the rich. It does assume that a market can be free, and that a free market does not necessarily hurt the poor.

Property Rights. People have never been able to do whatever they wished with their property, especially if their actions hurt other people. At the very least, people have called on the state to enforce contracts; and laws against pollution far predate capitalism.

Yet even modest restrictions on private property tend to seriously undermine the static or dynamic ideals, and lead to serious reductions in welfare. People need to feel secure in their property, and in gains from their property, for people to undertake the ventures that lead to general benefit. People cannot live in fear that a state official, or a gangster, can seize their property. People need to trust that regulations really are for the public good, and that regulations impact all business and all special interest groups as equally as possible. People need to feel that they can use their property as they wish, and that taxes will not take away too much of what they make.

People also need to feel that great wealth does not give great political power. People need to feel free from fear that they will get hurt when other people use property, as from pollution. People need to feel that wealth will not turn private citizens into state-sponsored gangsters.

This book cannot settle abstract questions of property rights, and so for the most part will not address questions of how property rights can be limited in the public interest without hurting the normal operation of the economy and thus hurting the real public interest.

Laissez faire” is a French term that means “let it be”, “leave it alone”, “let it make (itself)”, or “let it happen (by itself)”. (It is pronounced “leh-zay fair”.) People who originally advocated a free market in the early 1800s used laissez faire as their slogan. It captured the idea that a free economy makes itself and self-regulates, and that a free economy achieves the best practically available welfare for everybody. Now the phrase is politically charged because people use it as a code to mean, “Do not interfere with business or with the wealthy. Allow them to do as they wish, even if it hurts the poor. Interfere with the poor if you wish. Interfere in the market if that helps particular business interests”. This book uses “laissez faire” as originally: “allow a truly free market”.

Free Enterprise. An “enterprise” is any business venture, such as growing apples, making shoes, practicing medicine, car repair, or putting money into a mutual fund. “Free enterprise” means being able to go into ventures at will, limited only by the normal modest restrictions on property rights that apply to all people and all kinds of property. “Free enterprise” means that investors are not subject to any special taxes on wealth or profits, and are not limited in the kinds of ventures they can undertake as long as ventures do not hurt other people.

People have the same mixed attitudes about free enterprise as they do about other ideas in this section. Sometimes “free enterprise” is seen as a slogan that allows the rich to do as they wish, and that justifies the intrusion of Western business firms into the affairs of other nations. I will not argue this issue.

An “enterprise” is a particular business venture but it is also the vehicle by which business fulfills its role in the ideals. By carrying out enterprises, business serves the consumer and the nation. “Free” enterprise is the conditions under which business fulfills this role best.

This view of free enterprise as the instrument of public welfare is a romantic image of business. This view of free enterprise often goes along with the use of “free enterprise” as a slogan not to leave people alone but instead to justify interference in the affairs of others. It is no accident that all the flagships of the Star Trek sagas have been named “Enterprise” and all have interfered in the affairs of other people despite the Prime Directive of non-interference.

Free Trade. “Free trade” means pretty much the same as free enterprise or laissez faire but usually the term applies to international exchange rather than to domestic enterprise. It can apply to both international and domestic markets. In this book, it is not restricted to international exchange.

Trade. “Exchange”, “trade”, and “reciprocity” mean pretty much the same thing in this book unless differentiated on purpose. I do not use “reciprocity” very much, and I use “exchange” and “trade” as synonyms, mostly for variety.

02 Adam Smith and Classical Economics

Economics began officially in 1776 with one of the most influential books in history, “The Wealth of Nations”, by Adam Smith, a Scott. Smith had predecessors but he publicly established the key ideas of economics. In the 1800s, Karl Marx called the thinkers of Smith’s era “Classical” economists, and the name stuck.

Economics has advanced since Smith, so it might seem not worthwhile to study ideas that emerged 200 years ago. Yet Classical economists developed nearly all the ideas of modern economics, ideas that still determine policy today; and Classical ideas are easier than modern ideas. So we can start with it and move to modern subtleties later.

02 Classical Economics; Synopsis. Classical economics began with Adam Smith in Scotland about the same time as the American Revolution in 1776. Smith pioneered the idea of a system that regulates itself. Smith saw the idea first for a capitalist economy, and then others extended the idea to other systems such as a forest.

The capitalist system depends on people and business firms competitively pursuing self-interest. People pursue satisfaction, happiness, or “utility”; business firms pursue profit. In pursuing self-interest, people and business firms automatically lead the system to provide most of what people want in about the quantities they want. People get TV sets, milk, and education, about as much as they want, just like the forest gets about as many oaks and elms as it needs.

People and firms do not have to disdain the public interest. They can serve it if they wish. They just serve the public interest about as well by pursuing their own interests. Oak trees also serve the interests of the forest when they pursue sunshine, sometimes to the detriment of other trees; and deer serve the interests of the forest when they eat apples. Oaks and deer would not help the forest more if somehow they tried to help the forest directly.

Competition drives the system to provide the most, of the best, for the least, to as many as possible. If deer did not compete for apples, apples would not spread through the forest. If coyotes did not compete for rabbits, there would be too many rabbits. Bucks compete for does. Competition makes oaks, deer, coyotes, and the forest, all healthier and stronger. In the same way, people compete to see who can be the best baker and so bakers make good quality bread at low prices for many people. Competition is not often mean and cut throat, and it often involves cooperation. Deer run in herds; workers develop software in teams.

Apple trees collect sunlight and nutrients so as to produce a large crop of ripe apples. Apple trees collect nutrients from the rest of the forest which they later return as apples. In the same way, business firms collect capital to make their products. Often firms have to borrow money (nutrients or capital) to invest. Banks collect money in the form of savings from workers and from people who make more than they need. Banks loan that money to business firms. When the economy operates correctly, the amount of money that workers and rich people put into banks as savings equals the amount that business firms borrow to invest to make products. Savings equals investment. The financial system is part of the overall balance of the whole economy.

After a large severe fire, the forest begins again. From a few trees and animals, the forest grows automatically to its proper size, and then stops by itself. Ideally a capitalist economy does the same. However, it is hard to tell the natural size of a capitalist economy, and people are often not satisfied with the natural size. People think of happiness in terms of more stuff. So people invent schemes to promote growth. Schemes for growth usually interfere with the balance of savings and investment. Often they cause more problems than they solve. Schemes for growth usually favor some groups over others.

There are other reasons to promote growth, and they get mixed up with the desire for more. The system does not work equally well for everybody. Some people even get left out despite their best honest efforts. People mistakenly think that more stuff will cure these problems. People promote growth in an effort to get more stuff so that they can direct the more stuff to the people who got left out.

Historical Highlights. A bit of history helps. More detail on these ideas will be introduced throughout the book where needed.

Agrarian Roots. Capitalism began after 1200, in Europe, in agricultural society, with peasants and landholding lords. European society was built around distinct stable socio-economic classes. Aristocratic landlords dominated politics and the military. Society was based on close ties between politics, the church, landlords, and the military. Religion justified the order. Capitalists were only a minority in numbers and power until the middle 1800s. This traditional agrarian order is the society that the original Conservatives in the 1700s and early 1800s wished to preserve, but not the society that modern Conservatives wish to preserve.

Mercantilists. Smith used a strong contrast to promote his vision of the free market. Smith portrayed the economic and political experts that preceded him as “bad guys” who constantly advocated interfering in the free market. History came to call these bad guys “Mercantilists”. They arose about the time of Shakespeare in the 1500s, and prevailed well into the 1800s. They have waxed and waned but really they have never gone away.

Mercantilists were the self-proclaimed experts of their time, the “beltway bandits” of their time. They had solutions to every economic problem; schemes to lead the country to greatness and to vanquish all foes. They advised the king to reward political clients by giving clients economic privileges.

Mercantilists are still here. Mercantilists would be happy on many talk radio shows, in particular Right Wing shows. Modern mercantilists say: we have to sell more to all countries than they sell to us; protect industries; aid farmers; protect against foreign labor; protect all American jobs; levy tariffs and erect trade barriers; carry out planned investment projects such as huge sports arena; have the state insure houses even in dangerous areas; give money to the rich so the rich have enough to invest; use the rich to create jobs; force economic growth; impose a sales tax; impose a value added tax (VAT); keep a strong military; and pass laws to help clients such as ethnic groups, manufacturers, and the Religious Right.

Imposing order is a natural attitude. This attitude is hard to root out by logic alone. In “Star Wars”, the Sith uses this mindset to get people to voluntarily help him reorder the galaxy. He creates problems, and then he offers centralized order as the solution. In “Lord of the Rings”, Boromir tries to take the Ring from Frodo because the power to order makes intuitive sense to Boromir. On a lighter note, this attitude got Lucy into trouble on “I Love Lucy” through her schemes. Mercantilism is still one of the most severe economic foes even now.

Classical Economics. Classical economists favored a completely free market, domestically and internationally. The market worked best when left alone, and any attempts to improve it inevitably hurt it. They opposed Mercantilism and all interference, including aid to business. Like the Jedi of “Star Wars”, in contrast to the Sith, they argued for self-determination and for giving up interference. They dominated economic thought from Smith’s time until about 1880 but it is not clear how much they actually influenced policy.

Role Reversal. In the middle 1800s, the rising capitalist class began to dominate society. It took over from the landlords as commanders at the top of a hierarchy. The rising capitalist class took control of politicians, the military, and the church. Before it gained control, the capitalist class had argued for changes in society, a free market, the state to stay out of affairs, and separation of church and state. After taking control, the capitalist class reversed its position. It argued for conserving social relations, and for state interference in the market. It used religion and the state to promote its interests. For example, the rising capitalist class used the state to build railroad networks in Europe and the United States. As with original Conservatives, the new dominant business class wished to preserve a hierarchical society; but it wished a different hierarchy. This era spawned modern Right Wing political parties such as the Republican Party of the United States.

Neoclassical Economics. This is modern economics, what textbooks teach now. It is called “neoclassical” because it stayed within the same framework as Classical economics but refined Classical ideas. It developed in the 1880s but did not prevail until about 1900. Despite setbacks and variants, it is still the dominant paradigm in economics now.

Neoclassical economics used the idea of diminishing returns to provide a solid logical foundation for understanding consumer choice, the strategies of business firms, the interaction of consumer strategies and business strategies, the balance of the economy, the static ideal, and the dynamic ideal.

The Great Depression and J.M. Keynes. The Great Depression was the worst economic depression in history, lasting from 1929 until 1941 in the United States. In several of those years, unemployment persisted over 25%, the worst case of “getting stuck” in economic history. The Depression made clear that the real economy did not always operate according to the ideals, and could fall seriously short of what peopled needed.

The Great Depression stimulated alternative models to the ideals given in the previous chapter, with the alternatives framed in ways that allowed the state to intervene to help as needed. John Maynard Keynes provided the logical basis for alternatives. Keynes showed how government action might be able to un-stick an economy. Most governments say that they follow Keynes at least to some extent, although I do not believe that is actually the case. Keynes was to theory in the 1900s what Smith was to the idea of the free market.

Austrians and Libertarians. Neoclassical economics was founded by schools that began independently in Austria, France, and England. In contrast to the other two schools, ideas peculiar to the Austrian school did not become popular until the Conservative movement of the 1950s. The Austrians have intellectual influence but they have little influence on actual policy. They stress the dynamic ideal over the static ideal: the economy always does best in the long run if we just leave it alone, even if it has to endure short-term problems such as unfair competition and poverty. They say that all problems, even the Great Depression, result primarily from state intervention and from unavoidable state incompetence. They strongly champion the free market. They oppose even popular intrusions such as Social Security. In strong versions, they wish to privatize all state functions including the police. Libertarians are a political party that tries to put into practice ideas of strong personal freedom. They use Austrian economics as a way to justify their politics.

Prosperity and Programs. The world recovered both from World War II and the Great Depression beginning in the late 1940s. Because the rest of the world was devastated by the Depression and the War, America was effectively the only real economic power in the world from after the War until the middle 1960s. Thus the 1950s and 1960s brought the greatest era of prosperity in America ever seen, unrivalled until recent years.

Most people gave some credit for the prosperity to the ideas of Keynes and to the economic programs built on those ideas. Austrians and opponents of Keynes dispute this claim. They say that the prosperity came because of the peace and because of the free world market, and came despite the programs not because of the programs.

Building on the prosperity, Americans wished to correct long-standing economic and social problems, such as unemployment, poverty, and racism. They began the social programs of the 1960s and 1970s, such as the public housing projects that still stain the landscape, food stamps, and the Job Corps. Some of these programs did much good, such as “Head Start” for pre-school children, and school lunches. Some of these programs did no good or caused much harm, such as easy welfare.

Reality Check” of the 1970s. Americans mistakenly believed that dominating the world economically was normal for America. They believed that affluence was normal. Then several shocks in the 1970s slapped them awake. The Germans and Japanese rose as strong economic powers. Other nations such as France had recovered their ability to produce, and did not depend on America. American quality had grown comparatively inferior, and America produced some out-and-out shoddy goods such as cars. The costs of the Vietnam War began to cause inflation.

Social programs began to cause inflation. The Organization of Petroleum Exporting Countries (OPEC) increased the price of oil drastically and limited supplies of oil. All these factors combined to produce stagnation, inflation, and unemployment, which, until then, were not supposed to be able to exist at the same time. To be out of work and to face 25% per year inflation was not tolerable.

Conservative Rise. As with the Great Depression, the hard times of the 1970s led to ideas and movements that were supposed to save the day, but in the opposite way to Keynes. The hard times led to: “Supply Side” economics that gives privileges to business firms as a way to stimulate the economy; the victory of modern Conservatism; the myth of reducing government while at the same time expanding government; the rise of the Religious Right; and the alliance between the Religious Right, the Republican Party, business leaders, and secure working people. That complex still exerts much power in 2012. Hard times helped create modern mercantilism, and so brought us back to what Adam Smith had argued against.

Why “Wealth of Nations”. Smith’s book is not a justification for wealth, power, and privilege in general. Smith wrote just as small-scale industrial capitalism was developing, before factories had become large and before concentrated modern big business had developed. There were no corporations with insulated executives. Instead, there were many small firms, and the owners of a firm often worked along with the hands. Large aristocratic landowners and their politicians still dominated Smith’s society. Much as some fundamentalists fear our world, landlords feared that industrial capitalism and free trade would undermine the social order, morality, religion, and the power of England. Smith had to show that industrial capitalism and free trade would add to the wealth and power of England, and would create a better social order and moral order. That was why he called his book “The Wealth of Nations”.

Smith showed that free trade, free enterprise, solid property rights, and no interference, together allow for self-regulation of the economy and lead toward the ideals that I described in the first chapter. He showed that free individual action leads to benevolent spontaneous unplanned persistent order, and that this order satisfied the moral and political needs of English people. He showed that this order leads to greater wealth and power than the previous agricultural order, which was not spontaneous and free.

Smith set the standard. Since then, in advocating policy, social analysts try to show that the policy leads to an order that is spontaneous, benevolent, persists, has the greatest welfare, has the greatest wealth, and self-regulates.

The Invisible Hand. In a famous image, Smith called the self-regulation of the economy an “Invisible Hand”. It is best to quote several passages from the “Wealth of Nations”. These are the only extended quotes in this book. The spelling is his.

P. 14: Give me that which I want, and you shall have this which you want, is the meaning of every such offer; and it is in this manner that we obtain from one another the far greater part of those good offices which we stand in need of. 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 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. Nobody but a beggar chuses to depend chiefly upon the benevolence of his fellow-citizens. Even a beggar does not depend upon it entirely.

P. 423: As every individual, therefore, endeavours as much as he can both to employ his capital in the support of domestic industry, and so to direct that industry that its produce may be of the greatest value; every individual necessarily labours to render the annual revenue of society as great as he can. He generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By preferring the support of domestic to that of foreign industry, 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 no part of his intention. Nor is it always the worse for the society that it was no part of it. By pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it. I have never known much good done by those who affected to trade for the public good. It is an affectation, indeed, not very common among merchants, and very few words need be employed in dissuading them from it.

P. 13: This division of labour, from which so many advantages are derived, is not originally the effect of any human wisdom, which foresees and intends that general opulence to which it gives occasion. It is the necessary, though very slow and gradual, consequence of a certain propensity in human nature which has in view no such extensive utility; the propensity to truck, barter, and exchange one thing for another.

Whether this propensity be one of those original principles in human nature, of which no further account can be give; or whether, as seems more probable, it be the necessary consequence of the faculties of reason and speech, it belongs not to our present subject to enquire. It is common to all men, and to be found in no other race of animals, which seem to know neither this nor any other species of contacts.

End Quotes.

Bicycles. An example gets the ideas across better than a long explanation.

Demand” is the total amount what all consumers wish of a certain good at a certain price. Consumers “demand” 4 million washing machines per year at a price of $500 per machine.

Supply” is the total amount of what producers will provide of a good at a certain price. Manufacturers will supply 4 million washing machines per year at a price of $500 per machine.

A market “clears”, is healthy, and is in balance (partial equilibrium) when the supply at a price just matches the demand at some price. In this case, the market clears at a price of $500.

Consumer demand, and provider supply, depend on each other to make the economy work. We cannot understand the economy by looking at one alone. We have to look at their relation.

Until about the middle of the 1970s, bicycles were either what people call “clunky” or were really sophisticated. Clunky bikes were one speed with internal brakes, or three speeds with internal brakes, internal gears, and baskets. Sophisticated bikes were racing bikes as in the Tour de France.

Then two innovations in consumer taste radically changed the bike market: (1) “banana” seat bikes, low to the ground, with multiple external gears, and highly maneuverable; and (2) “mountain” bikes with many external gears, external brakes, and tires with thick treads. Any bike maker that did not hop on the bandwagons suffered bad sales. Raleigh and Schwinn used to excel at making the old style bikes, yet nearly got wiped out until they produced the new style bikes. Bike companies that did foresee the changes made a lot of money and came to dominate the market for a while.

The bike market did not change because of a state order or an arbitrary decision by bicycle makers. Hobbyists originally developed both banana seat bikes and mountain bikes. Then the bikes caught on informally among people, and their popularity spurred bike makers to bring out slicker versions. Bikes in general were not better before the change or after the change. The change is not about “better” in some abstract sense. There is only what people want. It is better because that is what people want, and because that gives people more satisfaction. Business firms respond to the taste (demand) of consumers. If this relation leads to a more effective economy or to a better world in some abstract sense, as it often does, then good; but there is no guarantee.

Smith understood the relation between consumers and business firms, but he emphasized business firms. This one-sided emphasis led to problems that we still face, as we will see in later chapters.

Technical Change: Getting Better. When the market responds to changes in taste, people feel better, but the sum total of material wealth does not necessarily go up – nor should it. Having mountain bikes instead of Raleigh 3-speeds might have made people more satisfied but it did not increase the total of material wealth.

Innovations in technology such as electricity and innovations in organization such as the Internet do increase the total of wealth, especially material wealth. They give us genuinely new goods and they allow us to do more with the resources that we have. This is what most people think of when they think how capitalism makes life better.

The implementing of technical innovations and of innovations in organization is the only way that they economy really grows. The implementing of innovations is natural economic growth. Keep in mind this idea of natural growth because it will recur throughout the book, especially in contrast to the forced expansion of state programs.

The process of implementing innovations is the same as with a change in taste, but it is worth going through the process to be sure that we understand.

Almost any modern technological invention will do. Music compact discs have a cleaner sound than vinyl, last longer, are easier to carry around, and their playing equipment is easier to carry around (try carrying a turntable to the beach as with the classic old Dual turntables). Even used compact discs sound much better than the average used vinyl record. Compared to what records would cost if compact discs had not been invented, compact discs are cheaper than vinyl, so we get all the benefits at no greater cost. Compact discs allow for cheap good quality Classical music, classical jazz, and classical blues, in a way that vinyl never could. When the technology behind music compact discs later moved to cd-roms for computers, and then was used to create DVDs, the improvements transferred over into unforeseen areas of life. Compact discs really do make life better. As I re-wrote in 2012, portable digital technology, such as jump drives, MP3, MP4, and Wave players, was doing to compact discs what they had done to vinyl, for much the same reasons.

Phillips and Sony developed compact discs not out of any mission to make the world a better place but to make a profit. Phillips has made a lot of profit through licensing. Sony will make a lot of profit through Blu(e) Ray, the upgrade of compact disc technology. Music and movie firms did not adopt the technology out of the goodness of their hearts - they did it to make a profit. Firms that quickly adopted music compact discs made a lot of profit. Firms that lagged behind lost money. As time went by, all firms adopted the new technology one way or another, and profit evened out between various firms. No state agency had to order firms to adopt compact disc technology or had to order the public to buy compact discs. Firms using technology to seek profit best served the consumer and led to a better world.

Aspects of Self-Regulation; the Invisible Hand.

Flow of Capital. The economy self-regulates by moving resources from one kind of good to another kind of good, from one-speed bikes with baskets to 12-speed mountain bikes with no baskets. Resources are part of capital, so the economy self-regulates by moving capital from one kind of enterprise to another kind of enterprise. This is how most business people think about the Invisible Hand of self-regulation. They say that capital “flows” between ventures.

Seeking Profit. Business firms shift capital (resources) in search of the greatest profit. Bike companies began making mountain bikes because that style sold the most and got the greatest profit. Bike companies stopped making clunky one-speeds and three-speeds because those styles did not make as much profit. Business people also understand the Invisible Hand and self-regulation in terms of seeking profit.

Revenue is not the same as profit. A business firm can have a high volume of sales but no profit at all as when a farmer sells 500 acres worth of wheat at a loss, or a low volume of sales but a high profit as when a car dealer sells a single Hummer. The key figure is percentage of profit in relation to the cost of the original capital. If a Ford Taurus sells for $20,000 and brings the dealer $2000 profit, then the dealer makes about 10% profit. If a dealer sells a Ferrari for $80,000 but makes only $4000 in profit, then the dealer makes only about 5% profit even though $4000 is twice $2000. Business people try to get the greatest percentage “return on invested capital” that they can.

When business firms seek the greatest return on invested capital, and there are no significant flaws in the economy, then the search for profit leads to the greatest welfare for consumers. The search for profit can be a source of much good. What matters are the market conditions under which firms seek profit. Economists study those market conditions so as to advise politicians on how to make the market work best.

Competition. Business firms compete in the search for profit. Competitors such as Huffy almost drove Schwinn and Raleigh out of business. If firms did not compete, they would not be forced to use resources effectively and to shift their capital to the use that gave the greatest satisfaction to consumers.

One particular kind of competition is important to self-regulation: price war.

At first, the makers of mountain bikes could use the high demand for that kind of bike to charge a price well above costs. They made a high return on their capital. When other companies saw the gains, they made mountain bikes too. To get a share of the market, the new firms undercut the price offered by the original firms. In cutting price this way, the second wave of bike makers got all the customers and the former makers got none. So the former makers had to cut their price as well, or they made no profit at all. A price war ensued until profit went down to a low normal rate.

Price war keeps the rate of profit in line between business firms, and drives the rate of profit down to as near cost as possible.

Opportunity Cost. Another way to look at the flow of capital and the effects of competition is through the idea of “opportunity cost”. If a firm did not switch from making one-speed bikes to making mountain bikes, then it would make less profit than it could, even if it still made some profit from selling clunky bikes. The difference between the profit the firm could have made from mountain bikes and the profit it did make from clunky bikes is like a cost. Business people feel this cost acutely when they realize that they could have made 10% on a new nature park but made only 7% on a shopping mall instead. Private people feel this cost when they could have invested in a stock that did well but instead invested in a stock that did only average. Business firms try to minimize the cost of lost opportunities by always investing their capital to get as great a return as possible. “Opportunity cost” is a term from neoclassical economics. Classical economists did not have a separate term for opportunity cost but they clearly understood the idea and used it in their explanations.

Allocation of Resources. When capital can flow freely in search of the greatest profit, and nothing interferes with competitive price war, then business firms use resources most effectively in making all the products that consumers want, not just bicycles. Self-regulation leads to efficient allocation of resources between all the kinds of goods that consumers want, and thus to the most efficient production of all the kinds of goods that consumers want. Self-regulation leads to the most productive and efficient economy practically possible.

Now there are many styles of “mountain” bikes, including bikes for girls and bikes for boys, and bikes for people of various ages. Makers have to allocate steel, rubber, plastic, paint, and other resources in the right proportion between the bikes for girls and the bikes for boys, and between big bikes and little bikes, meaning in the proportion that consumers want. If makers do not allocate in this way, they “suffer an opportunity cost” and do not make as much profit as they could have made. When they do allocate this way, they use resources to make bikes in just the proportion that people want.

The same is true of the steel, plastic, and paint used not just for bikes but also for tricycles, wagons, scooters, motorcycles, cars, pickup trucks, large trucks, trains, planes, and fire engines. Business firms allocate resources between all those uses according to how much profit they hope to make from those various goods. How much profit business firms hope to make depends on how much consumers as a whole want each of those various goods in comparison to all the others, and are willing to pay for each of those various goods in comparison to all the others.

Land allocation is a good way to think about the automatic best allocation of resources. A single farmer has 100,000 acres of land, enough land to supply all the food for a nearby town. The farmer would not plant all the land in one crop. He/she allocates the land in various crops according to what the people in the town want. The farmer gauges what the people want by what they are willing to pay for a crop. If the people as a whole want more carrots than tomatoes, they pay more, and the farmer plants more land in carrots than tomatoes. In the end, the land is allocated among the various crops so that the use of the land brings the greatest satisfaction to the consumers in the town.

The same thing would happen if there were many farmers each with only 100 acres of land, and if each planted his/her land in one crop. Farmers that saw tomatoes doing better than carrots this year would switch to tomatoes. In the end, the land would be allocated between crops so that it served the needs of all the people just as well as if one farmer allocated the land.

When business firms allocate all resources between all goods in this way, the economy uses resources most efficiently, at full capacity, to make just what consumers want. The economy makes as much as can be made of what consumers want out of the available resources. The economy is at full capacity given the natural limitations of scarce resources.

Prices. Prices supply the information that business firms use to decide where to send capital and resources. Prices result from the operation of the economy, and then tell the economy how to keep operating. A high price tells a business firm that consumers want more of a good, and so the business firm makes more of the good until the profit rate falls and the price falls. A low price tells business firms that consumers want less of a good, and so business firms make less until the price rises. A high price for a resource, such as steel, means that the firm uses less of the resource. A low price for a resource means that the firm uses more of the resource. Eventually the price of the final good, such as bikes, and the price of the resources that are used to make the final good, come into line, as we will see in the chapters Four and Five.

Interfering. Anything that interferes with competition or with prices thwarts self-regulation (the Invisible Hand), results in less efficient use of resources, and results in less-than-full capacity. Anything that interferes in the free market has these bad results even though it seems like a good idea at the time, such as giving help to farmers. We have to be sure that we interfere only to cure a problem; that the cure does not make for worse problems; and that the cure, even when useful in this one particular case, does not set bad examples for other interference. Smith castigated all interference in the free market, and wished to eliminate all barriers to production and trade.

Restless Striving. The media sometimes makes fun of business people when business people seek not just some profit but seek they greatest profit they can. It is a little odd, and can seem greedy, to give up 5% profit on this venture if a firm can make 7% profit at some other venture. It seems odd, and can seem greedy, to give up 5% profit on a bookstore to make 7% profit on a coffee shop for yuppies (see “You’ve Got Mail”). It seems a bit compulsive and intense.

We should not judge business people, or weekend stock investors, or local mechanics, as greedy or weird when they forego a little profit here to make a greater profit somewhere else. We do not judge ourselves odd when we look for cheaper laundry soap and we do not judge a mechanic odd when he/she looks for cheaper safe brake linings. To look for the best deal is not always weird or compulsive. It often makes good sense. It can indicate an adventurous personality. It also is a powerful force driving toward the most efficient use of resources, to greatest capacity, giving consumers what they want, and adoption of the new and the better.

When it takes too much time and effort to seek greater profit in another venture, then business firms should forego the greater profit to just take what they can from the present venture with lesser profit. Astute sane business people do in fact act this way.

Bigger Adjustments. Adjusting to a change in taste for bicycles is not a very big self-regulation. The Invisible Hand does pretty well even with larger problems but it tends to get weaker the larger the arena is. The flaws of capitalism make it harder for the Invisible Hand to adjust in major arenas such as global warming or the spread of nuclear technology.

The flow of capital in seeking profit is the most powerful force for the adoption of innovations, but it is not necessarily the force that thinks up innovation. Bio-tech did not arise out of business firms seeking profit but arose out of researchers seeking truth. Yet business firms seeking profit will be the agents that guide how bio-tech is developed and used. To the extent that innovations make us better off, then capital flow in seeking profit makes us better off too.

Self-regulation helps us to deal with changes such as a hard winter or a small war. It can help us deal with hurricanes such as Katrina, the depletion of oil, or big wars such as Vietnam. But because those large changes disrupt the price system, and can lead to imperfect competition, self-regulation does not always handle them smoothly.

The real question is not “does self-regulation handle everything without a hitch?” The real question is “does self-regulation handle problems better than could the state?” Could private enterprise have handled Hurricane Katrina better than did state and federal governments? This is a big question that cannot be settled here. People argue well on both sides, including the idea that there would have been a much smaller problem to begin with if the government had not misled residents by building levees. If private people had not built in bad places to begin with, the hurricane would have caused much less of a problem, one that private enterprise might have been able to handle.

Keep in mind what the Invisible Hand does not do. It does not guarantee that there are no flaws at all. It does not guarantee that the economy is necessarily fair. Hardworking poor people still cannot afford bikes for all their children. The economy need not lead to a more equal distribution of income and wealth. Successful bike firms pay their workers well but that does not mean the workers make as much as the owners. The world does not necessarily get better because of economic self-regulation. I think the world was better off with Raleigh three-speed bikes but I have no idea how to bring them back. Most people do not really take their “mountain” bike into the mountains, and real mountain bikes are not very good in the city, but it is now hard to get a good city bike. I have to make do with hybrids that imitate the “cool” of mountain bikes but do not give the performance of a real street bike. The world is better off with nuclear power but not in all respects. We do not want a free market in enriched uranium. The world is better off with many electronic gadgets but not in all respects. I dislike cell phones except for long drives in empty country. Capitalism certainly helped to cause global climate change, and it cannot do anything to undo the bad effects. In the next few decades, we will see if the world is better off with a market in bottle-reared, genetically engineered, artificial babies.

The world definitely has gotten better through capitalism. We should not think of hampering capitalism just because self-regulation does not lead to some dreamy future world or just because it cannot solve all problems. To hamper it for these reasons would undermine the benefits. Yet we also should not expect it to do what it cannot. We have to recognize what capitalism cannot do, and then we have to find the best alternative way of doing that.

Productivity. Adam Smith had to explain why factories create more wealth than farms or small workshops. He said that factories were more productive, for two reasons: the division of labor and the habits of the owners.

Smith’s second most famous image after the Invisible Hand is of a pin factory. Smith visited a small factory that made straight pins, where he was amazed by a simple lesson. The making of a straight pin was divided into about a hundred distinct tasks. By dividing up and specializing, the factory could make thousands of pins a day where an old-fashioned shop, where each person made a complete pin from start to finish, could have made only a few dozen pins a day. This is the birth of modern manufacture. The idea of the division of labor eventually allowed Americans to mass manufacture guns and so to move in on a market they have dominated since. Traditional landlords could not, or would not, adopt this division of labor, and so their farms were doomed to be less productive than emerging factories. Restrictions on trade and business often amount to restrictions on the division of labor, and thus on productivity.

Smith was correct that factories are productive but he was only partly correct about the division of labor as the source of productivity. A clever division of labor does increase productivity but it cannot be the major source of the increase in productivity of capitalism. People have been clever about dividing up tasks and about helping each other for a long time. Every peasant household has a practical division of labor between men and women, young and old, gardeners and people who plough, and between people who tend the cattle and people who tend the fields. Smith saw that increased productivity was somehow tied into new ways of thinking about the volume of production and with the new machines of his time but he did not know how a machine could lead to more efficient production. He was misled by then-current ideas about labor and machines. In our day, we can explain how scientific production methods, including both new machines and new divisions of labor, lead to more efficient production. Classical economists never completely figured out these questions, and the lack plagued them until the rise of neoclassical economics.

Even though Smith could not fully work out the source of productivity in the new factories, still, just pointing out the role of productivity, seeing one source in the division of labor, and looking for an explanation in styles of organization, were important steps forward.

In Smith’s time, landlords liked to hold lavish parties while workers liked to drink strong ale. No better illustrations exist than the novel “Tom Jones” or the novels of Jane Austen and the Bronte sisters. Neither landlord nor workers usually had much money left over to invest in factories so as to create more wealth for the future. Factory owners, on the other hand, loved to save out of their profits and loved to reinvest savings. The more profit the factory owners made, the more they would invest, and the more wealth the nation would have in the future. The more wealth was directed into the hands of factory owners by making sure that they made profit, the more wealth the country would have in the future. Wealth made more wealth by using frugal capitalists as an intermediary tool. All restrictions on the free market reduced the amount of capitalist profits, reduced the amount of their investment, and so reduced future wealth. Taxes on profits reduced investment and so reduced future wealth. These were strong arguments for free trade and for not taxing the new factories any more than anybody else, or for taxing them even less than other people. This is a theory of growth based on the personality of capitalists. Capitalists act as the midwives for wealth to give birth to more wealth.

To this day, Conservatives argue that we should reduce taxes on the wealthy so that the wealthy save more, so that more money is available for investment, so that more investment will lead to greater growth and greater wealth. They still argue that wealth makes more wealth by using rich people as its intermediary tools. I do not know if rich people know of Smith’s logic. I think they do not know Smith well but have learned to use the general drift of his argument without knowing the source and without caring if it is true. It seems to justify what they want.

Smith’s argument for supporting capitalist profits was true in Smith’s time but it is no longer true in our time. These days, capitalists can find all that they need for investment without any special treatment from the state. Also, having additional money available does not necessarily mean the money will be invested, will be invested fully, will be invested wisely, or will be invested in ways that lead to productivity and growth. The Classical version of these assumptions is called “Say’s Law”; see below. The modern version sometimes is called “supply side” economics; we will see it in a later chapter.

Smith’s argument for the free market in general is still true.

To get a sense of how the argument for supporting capitalist profits might have worked in Smith’s time, and how it might still make some sense, we need to look at money, savings, investment, and the rate of interest as Classical economists did.

Balance of Total Supply and Total Demand. This section and the next few sections together explain Classical ideas of growth, savings, investment, and the rate of interest. These ideas tie into ideas about capacity, total supply, and total demand. The terms used in these sections really belong to neoclassical economics. I use the terms for convenience and because they are not deceptive here. The ideas that the terms represent fit accurately with Classical ideas, and it is too confusing to introduce one set of terms here and then shift to another set later.

Smith’s argument about the need for profits to produce savings is really about growth. It explains how the economy might grow. It has an important truth at its core but it is misleading because it implies that growth can occur indefinitely as long as people save, and it implies that the best way to save is through rich people. Before getting directly into relations between savings, investment, and the rate of interest, we have to look at an economy in balance between demand and supply. This takes us into questions of circularity, closure, and self-reproduction.

Suppose the landowners and the workers were like the capitalist factory owners and that they saved everything that they did not need just to get by. Then who would buy all the goods that the factories make? Savings would pile up in the bank, and goods would pile up in factories and stores. Factories would have all the capital they need to make lots of stuff waiting for them in the banks, but nobody would buy the stuff. The factories would have to scale back. In scaling back, the factory would not use the savings and so the savings would lie idle. The factories would not employ any workers, and so the workers would not have any salary out of which to buy goods or to save. People have to buy, and cannot only save, for the economy to work.

On the other hand, suppose instead that factory owners were like landowners and workers, and did not save anything. Nobody saved. Everybody spent all his/her money on goods for right now. No matter how much anybody made, he/she spent it all. In that case, capitalists would focus their efforts on current production so as to meet the demand for goods right now. Two problems arise:

(1) As people want more goods, factories expand production. As factories expand production, they hire more people. As they hire more people, workers have more salaries with which to buy the additional products, so they want more products. And so on. This circle seems to continue indefinitely.

This sounds great. In fact, it sounds so good that it has served as the basis for severe mistakes about capitalism all through the history of economics: “Say’s Law” and “supply side”.

Can it really happen? Of course it cannot. As we will see in later chapters, diminishing returns set in. People get tired of working so hard to buy more goods. Factories become inefficient. It becomes more expensive to produce the same additional quantity of goods. Factories have to pay people more and more. People actually get tired of having more goods.

If we think of the economy expanding this way a few percent, we do not really think about the problems inherent in unlimited expansion against diminishing returns. To force home the idea of problems with expansion, think of the economy expanding not 15% but 100% (doubling), or expanding 10 times or 100 times.

(2) Who would replace the capital in the factories as it wore out so that the factories could keep on making the goods that everybody wanted? Where would the capitalists get any money to implement an invention so that the economy could progress? In the static ideal, capital is replaced automatically as part of the selling price of all goods. In the real world, capitalists have to borrow money to invest so as to replace capital and so as to expand sometimes. If nobody saved, where would the money come from for investment for replacement and for investment for expansion?

Before going on, we need four definitions. The ideas were around during Classical times but could not be precisely defined until neoclassical times. We will use them here, and then I will define them more precisely in later chapters. The terms here differ slightly from the standard terms in neoclassical economics.

(A) All the goods that all the business firms offer make up the “total supply” of the economy. Total supply includes all the material goods made by factories and all the services and experiences offered too.

(B) All the goods that all the consumer-workers wish to buy make up the “total demand” of the economy.

(C) All the goods that are offered by all business firms, and all the salaries paid to all workers, are together the “capacity” of the economy, the size of the economy.

(D) Full capacity comes when there is full employment, and when all the plants of all the business firms (all the factories, offices, and storefronts) are putting out as many goods as they can without straining the facilities enough to increase costs above the price of goods.

The economy can run at less than full capacity for a long time, as in a prolonged recession, but that condition produces hardships that we will meet in later chapters. The economy can run at more than full capacity for short times but that condition strains the economy and increases costs, so the economy cannot run at more than full capacity for too long.

The answer to the dilemma about savings and investment comes when two conditions coincide. This resolution is what the next few sections explain.

(1) There is at least one capacity of the economy in which total demand equals total supply. This condition is one definition of general equilibrium. There is one capacity in which the total supply of all goods equals the total demand of all goods. There is one capacity in which the price at which the capitalists can sell goods just covers the salaries that the consumer-workers have to receive in order to be able to buy all the goods. There is one size of the economy in which the circular economy is closed and self-reproduces.

(2) This one capacity is full capacity.

It is possible that there is more than one size at which this happens. The quick answer, which I do not demonstrate here, is that ordinarily there is only one good size at which this happens, and this one size is full capacity. In recessions, the economy can “get stuck” at less than full capacity when total demand equals total demand at less than full capacity, but we do not have to consider that until later chapters. It is tempting to think we can continually increase the size at which total demand equals total supply, so that we can continually increase the size of full capacity. This is the mistake noted above.

The only way to safely increase the full capacity at which total demand equals total supply is through implementing innovation in the free market. Implementing innovation is “natural growth”, so the only way to increase full capacity is through natural growth. I make this point again often in later chapters.

Interlude: The Ideal Simple Model. Before going on to consider the effects of money, interest, savings, and investment, we need to look at replacement in an ideal economy, especially one without any of those features. Consumers buy new cars not just to say in style but primarily because the old one wears out. Business firms regularly have to buy new supplies and materials too. Firms have to hire new workers as current workers get promoted, retire, quit, or die. Firms have to train the new workers that they hire. Firms have to keep some liquid reserves (cash or near cash) on hand to buffer against risks and other problems, and in case the firm wants to take advantage of an innovation. These liquid reserves are part of the normal operating capital of a business firm.

In an ideal economy, business firms do not have to borrow to get any of the resources they need for replacement, risk, or opportunities. Business firms save some of the revenue they get from selling goods normally, to use for these purposes. All business firms have to do this, so no firm gains any advantage from not doing this, and from using all revenues for production right now. If any firm did not save at the proper amount, then it would go out of business, leaving only firms that did save at the proper amount. It is not even appropriate to call the revenues earmarked for replacement, risk management, and opportunity “savings”. They are part of normal operating capital. Of course, in a real economy, this is not the case, and all business firms to have to borrow from time to time.

Balance of Savings and Investment. Nearly all Classical economists lived in the real world and thought about real world problems. They might have known of an idealized economy but they did not use it for reference much in their work. So we have to think of the balance of the whole economy in terms of what real firms need, and that includes money to borrow. Business firms get money for investment from banks. Banks get money to loan out from deposits. Deposits come mostly from the incomes of private people, the consumers and workers of the economy. The workers get the money to deposit from part of the salary that they get paid for working in the business firms. The banks serve as intermediaries between business firms and consumer-workers, using money as the “stuff” (currency) of mediation.

Now we begin to tie the two conditions above to the third condition of savings, investment, and the rate of interest. Briefly, if (1) savings equals investment, then (2) total supply equals total demand, at (3) full capacity, and it all comes together. Ordinarily this can happen at only one size of the economy.

Money, Savings, Investment, and Interest. Savings in banks cannot just lie idle. They are part of a closed and circular system. They have to be loaned out at interest. Somehow savings has to equal investment after we take account of the rate of interest. Savings has to equal investment at a particular rate of interest. Classical ideas about how savings might equal investment, taking into account interest, are simple.

The starting point is neutral money. Assume that money is not useful itself but is useful only for buying other things. It is only a neutral medium of exchange.

Banks set the rate of interest so as to keep savings as nearly equal to investment as they can. Banks perform this service not out of public spirit but, as with other business firms, in their own self-interest. This is how:

(A) Business firms need money and come to banks looking for it. Suppose that the banks do not have enough on hand right now in savings, so they raise the rate of interest both on loans that they give to business firms and on savings. The higher rate on loans reduces some demand for loans while the higher rate on savings leads people to bring more savings to the bank. People consume less but save more. The bank has more money to give to business firms. At some rate of interest, the amount of money that the banks take in as savings just balances the amount that they give out as loans.

(B) Suppose on the other hand that the banks have more savings than they can loan out. Banks reduce the rate of interest that they charge for loans and that they pay out on savings. The reduced rate on loans causes business firms to ask for more loans while the reduced rate on savings causes people to save less. People spend more and save less. The bank has less money to give to business firms. At some rate of interest, the amount of money that the banks take in as savings just balances the amount that they give out as loans.

The banks constantly adjust the rate of interest to maintain this balance. If the banks do not adjust the rate of interest this way, they do poorly. If they have too little money to loan out, they miss some profit from the missed loans – they suffer an opportunity cost. If they have too much savings, they have to pay interest on money that they do not use. Competition drives banks to act as stewards of the interest rate to make sure that savings equals investment.

Total Supply and Total Demand Again. Now we return to total supply, total demand, and capacity. In the following stories, do not worry about the exact details or even if the stories are completely correct. Try to see that there is a connection between interest, savings, investment, total production, total demand, and capacity.

(A) This case is similar to what happens when the economy “comes down” after the boom phase of the business cycle. Do not worry about investment and savings at first. Suppose business firms make more goods than people wish to buy. Total supply is greater than total demand, or total demand is less than total supply. Instead of buying, people put their salaries into savings. When firms see that they cannot sell all the goods that they make, the firms decrease production, and decrease their demand for loans for investment. The bank has to reduce the rate of interest for loans. When the bank reduces the rate of interest for loans, and with a lot of money coming in as savings, the bank finds that it has a surplus of savings over loans, so it reduces the rate for savings as well. The reduced rate for savings causes people to save less and to spend more at the same time that business firms reduce production. Total demand rises to meet a falling total supply. Eventually, people can buy all the total production, and firms make only just as much as the people demand in total. Total demand equals total supply. At that balanced level of total supply and total demand, the rate of interest again leads savings to equal investment.

(B) This case is like the recovery after the bust phase of a business cycle. Suppose business firms make fewer goods than people wish to buy. Total supply is less than total demand, or total demand is greater than total supply. Instead of saving, people buy. When firms see that they can sell all the goods that they make, the firms increase production, and increase their demand for loans for investment. The bank has to increase the rate of interest for loans. When the bank increases the rate of interest for loans, and with little money in as savings, the bank finds that it has a less savings than loans, so it increases the rate for savings as well. The increased rate for savings causes people to save more and to spend less at the same time that business firms increase production. Total demand falls to meet a rising total supply. Eventually, firms can make all the goods that people demand. Total demand equals total supply. At that balanced level of total supply and total demand, the rate of interest again leads savings to equal investment.

When banks adjust the rate of interest to insure a balance between savings and investment, they also influence consumer demand and the supply of goods made by business firms. In finding a balance between savings and investment through the rate of interest, banks also find a balance between the total amount of goods demanded by consumer-workers and the total amount supplied by business firms. In solving one problem, the banks also solve another problem. In making savings equal investment, banks also lead total supply to equal total demand.

In solving those two problems, the banks solve the problem of capacity as well. A balance of savings and investment solves the problem of supply and demand and it solves the problem only at the level of full capacity. The equalization of savings and investment brings the economy to full capacity.

Competition and the flow of capital lead savings to equal investment, lead total supply to equal total demand, and bring this all together at full capacity.

If we can take it on faith for now that the economy only increases full capacity by natural growth (implementing innovation), then four conditions come together:

(1) Savings equals investment through the mediation of the rate of interest.

(2) Total supply equals total demand at some particular size of the economy. The economy is circular, closed, and self-reproduces.

(3) The size is full capacity. Full capacity means full employment, and it means that business firms can do normal business with reasonable expectations of revenue and of continuation.

(4) Full capacity does not require any artificial growth but it does allow for natural growth through innovation. Natural growth increases full capacity, and thus increases welfare too. As it does so, natural growth brings along the other conditions with it, so that they continue to hold as well.

Classical economists analyzed primarily the first condition about savings and investment, but sensed the other conditions. Neoclassical economists later demonstrated links between the other conditions, and showed where links might break down.

This four-fold solution is so good; and deviations from it so complicated, so hard to understand, so likely to be bad, and so unstable, that economists have tended to fall back on this solution over and over again. This resolution is typical of the static ideal. It is a good base from which to begin thinking but not a good place to end thinking.

Problems. Although we cannot get into problems now, it is best not to leave this wonderful coincidence without a sense that things can get more complicated and things can go wrong. This subsection is optional. If it confuses you, skip to the next full chapter section.

(A) Savings equals investment but not where total demand equals total supply.

(B) Total demand equals total supply but not where investment equals savings.

(C) Savings does not equal investment.

(D) Total demand does not equal total supply.

(E) Total demand equals total supply, and savings nearly equals investment, but not at full capacity.

When any these major aspects of the economy do not coincide, they all upset each other so that nothing might balance. The economy can wiggle without ever settling down predictably. These cases are complicated, and great disparities from balance are not common, so I do not need to go into details here. We will return to simple versions of these cases in the last two chapters of the book on money and on policy.

It is enough just to throw out some complications.

Suppose there is not enough savings to meet investment needs. Banks raise the rate of interest. People save more, so that firms have more to invest, and firms increase production. But, as people save more, they also consume less. When business firms try to sell the increased goods that they make through increased production, firms find that consumers have less money with which to buy the goods that the firms had anticipated producing.

In contrast, suppose there is too much savings, so that firms do not want all that is available. The banks reduce the rate of interest. People save less. Firms scale back on their investment and production. But, as people save less, they wish to buy more. Business firms now find that they have more customers than they had guessed, with more demand for their products, and so now firms want more money for investment.

Not even modern neoclassical economics has been able to sort it all out, and so has fallen back on the simple idea that the rate of interest is the link between savings and investment, and that the economy is in stable peak practical capacity then (total demand equals total supply at full practical capacity).

The state has used versions of this simple Classical model to intervene in the rate of interest so as to affect savings and investment, mostly to favor business firms and investors. This intervention often does more harm than good.

Profit. Now we switch topics. The rate of profit tends to equalize between all ventures, old and new. The rate of profit tends to drop on new ventures until it reaches the general rate that prevails in the economy. In theory, the rate of profit should drop to zero for all ventures in the economy, but that does not happen in a real economy.

As firms invest more in one kind of venture, the rate of profit tends to go down in that kind of venture. For example, when “dot com” business was new, those firms made a high rate of profit. As people invested in them, the rate of profit fell. In contrast, when business firms move capital out of an old, low-profit type of venture, the rate of profit for remaining firms in the old business slowly rises. Natural textiles such as cotton used to yield only a low rate of profit, so capital shifted from them to man-made fibers such as polyester. Slowly the rate of profit on cotton edged back up. When natural fibers became popular again, then the profit rate on cotton went up even more for a while. When an innovation is still new, it tends to make a high rate of profit but the rate tends to fall as business people invest more in the innovation. When computers were still new, computers makers made a lot of money from them, as was the case with IBM, Compaq, and Dell. Now their rates of profit have fallen. The rate fell so low that IBM even got out of the PC business that it had pioneered.

Profit between different ventures tends to equalize. Business firms make about the same rate of profit on making bicycles as on growing flowers. If firms made more profit on flowers, they would move their capital from bicycles to flowers until the rate of profit on flowers fell and the rate of profit on bicycles rose. The reverse would happen if the rate of profit on bicycles was higher than the rate of profit on flowers.

Interest is a kind of profit on money. In theory, the rate of profit should fall to zero for all ventures, including the profit on money, and so including the rate of interest. Flowing capital is like flowing water. River water starts from many hills of different heights but it all flows to the same level in the river. Eventually the river flows to the “ground zero” of sea level.

Contrary to theory, in fact the rate of profit does not equalize between all ventures and it does not fall to zero for healthy businesses. There is a normal rate of profit that most firms expect to make from year to year, about 5% to 10%. Some firms expect to make as much as 20% per year, such as companies that make drugs. There is also a natural rate of interest of about 5% that seems to prevail regardless of what happens to the rate of profit.

Sustained normal profit and a natural rate of interest are something of a mystery. We will look for sources for sustained normal profit and the rate of interest in later chapters.

The mystery deepens because, if the rate of interest fell to zero, the rate of interest could not equalize savings with investment, or equalize total supply with total demand at full capacity. We need interest, but, just because we need something does not guarantee that we will have it, or that we will have it at the rate we need it. We need a theory of why profit and interest arise in the first place so that we can be sure of relations between profit, interest, investment, savings, total supply, total demand, and capacity.

Classical economists realized that profit and interest should equalize and decline but did not. They did not know what to make of the situation. They had no theory of the general origin of profit or interest although they certainly could explain them in particular cases. They could not explain why profit and interest persisted, why they persisted at particular rates, or why profit persistently differed between different ventures. Classical economists did not worry about this theoretical problem. They took profit for granted and looked at what happened when profit varied; they looked at the flow of capital in response to changes in the rate of profit. For most tasks, this is enough; but it is not enough to deal with deep problems about how the economy works. In the middle 1800s, Karl Marx, following David Ricardo, took this issue seriously, and heroically went where his answers misled him. Neoclassical economists understand the question, and have offered some good answers, but have not offered a generally acceptable answer or an alternative to the Classical model.

This book takes the question of profit and interest seriously but does not rely on Marx. I find answers in standard neoclassical ideas. Looking at the sources of profit and interest helps to understand why inequality and poverty persist in the economy, and suggest the limits of what we might do about those problems.

Sum of Costs. Ordinarily the costs of the components used to make a good add up to about the price of the good. The sum of costs for steel, rubber, plastic, etc. add up to the cost of a bicycle. The sum of chemicals used to make an over-the-counter medication add up to about the price of the medication. If we take into account a normal profit rate of 5% to 10%, then the sum of costs plus the normal profit add up to almost exactly the price of the final good.

To see why, think about what would happen if it were not so. Suppose the sum of costs was more than the cost of the good. Then the good would not get made. Suppose the sum of costs was less than the good. Then many firms would begin to make the good. The firms would pay more for components to the good so that they could make more of the good, so the price of the components would rise. At the same time, the increase in amount of the good would lower the price of the good. Cost would rise to meet falling price until the cost of making the good equaled the price of selling the good.

This is the same logic that argues for the disappearance of profit. We can fit steady profit into this situation but only after we understand more about rising costs and falling profits in the next few chapters.

When people see that the sum of costs adds up to the final price of a good, they mistakenly think that costs determine the final price. This is a natural way to think, and, in the short run, it is true; but in the long run it is wrong. In the long run, the true relation is opposite: the final price of a good determines the cost (price) of the components that make up the good.

In the short run, suppose that a major cost of lettuce is petroleum products such as diesel fuel as to power the equipment and the irrigation, chemicals to kill bugs, and chemicals to fertilize. If the price of oil goes up, then the price of lettuce goes up. We can reasonably say that the increase in the price of oil caused the increase in the price of lettuce. This is what happened during the Iraq war of the early 2000s with all goods. It began to happen again in 2012 for various reasons, including possible war with Iran.

In the long run, however, this is not true. Only if people want enough lettuce at the increased price would people pay enough for lettuce to support the increase in the price of oil that went into the increase in the price of lettuce. If people did not want that much lettuce, they would buy less lettuce, and thus less oil; and so their decisions would also affect the price of oil through affecting the price of lettuce. Eventually when the price of oil goes up enough, people will stop driving cars so much, switch to public transportation, and switch to alternatives such as electricity and natural gas. Then the price of oil will have to adjust and will quit determining the prices of lettuce and gasoline. The demand for oil will be a strong force in determining the price of oil.

The correct relation in which the demand for the final good determines the price (cost) of the resources that go into its production is called “imputation” or “derived demand”. We will see more of this relation in the chapters that follow. Smith and Classical economists saw all the aspects of this relation but they could not explain precisely why final price (final demand) determined the sum of costs, so they continued to argue as if costs determined the final price. They argued as if costs were an objective reality outside the economy that determined relations within the economy. This is a large error that produced some strange results, one of which we will see later in this chapter under “Say’s Law”. A great advance of neoclassical economics was its ability to explain all aspects of the relation between costs and price correctly.

Revolution. Regardless of modest faults, Smith succeeded fully in “Wealth of Nations”. His success amounted to a revolution in thinking about social relations. Smith established these ideas:

(1) The free market regulates itself. It needs no regulator for the vast majority of its operation. It does best when left alone. It leads to greater wealth and a better basis for good government.

(2) The free market is a (A) spontaneous unplanned persistent order, and it is (B) almost fully benevolent. The market is the first clear example of such an order in social science. The free market can provide the basis for a strong nation.

(3) The market works through self-interest. Self-interest leads not to chaos and to selfishness but to benevolent moral order. Smith inverted the normal ideas between self-interest and outcome. He showed that self-interest not only led to more wealth but also led to the morally correct outcome of freedom, cooperation, and social order.

In Smith, morality and self-interest coincide. The pursuit of self-interest leads to the greater social good, and any interference with the pursuit of self-interest detracts from the greater social good. The “pursuit of self-interest (happiness)” serves the definition of freedom given in some founding documents of America.

Since Smith, social scientists have felt the need to show that social order is (A) moral, (B) benevolent, (C) spontaneous and persistent, and (D) takes care of itself (self-regulates). Social scientists differ in whether they ground social order in the social whole or in individuals but they credit their particular vision of social order with these desired features anyway. They see any social group they do not like as deficient in these features and as corrupted. Any policy that does not promote these features is deficient too.

Many advocates of capitalism identify the free market with the pursuit of self-interest, goodness, morality, and freedom. Satisfaction, goodness and freedom can only come with the free market. Any defense of capitalism is necessarily also a defense of freedom, morality, and goodness. Any interference with their version of the free market is necessarily also an attack on order, freedom, morality, and on the wealth that is needed for a good society. For them, the state is necessarily a friend of capitalism and goodness. Any idea of the state other than their idea of the state, and any state that is not a whole-hearted supporter of capitalism, is necessarily a foe of capitalism and goodness. This attitude takes Smith too far, and is wrong.

Smith says we have to rely on the spontaneous order of the market, that we have to be willing to give up direct control. People do not like to “let go”. They like to keep their hands on the steering wheel. “Only dead fish ‘go with the flow’”. It is natural to fear letting go. It takes courage and practice. It is hard to see the benevolent order that comes of letting go, and easy to cling to the order of interference. In “The Lord of the Rings”, Galadriel saw that, with the Ring, she could force a workable order but an order in which people feared her as much as they loved her. She let go of the Ring only after gut-wrenching effort showed her that keeping the Ring would lead not only to order but also to fear, slavery, and evil. Even people that otherwise extol the free market will not let go of programs that benefit them or that control their enemies. Even people that extol the free market and call for “less government” will not let go but instead insist on using the state for their material and political goals. Not letting go is mercantilism. Smith would disapprove.

Unintended Implications. Some advocates of capitalism stress that it is not only one order particularly well-suited to our times but that it is THE ONLY social order and economic order that is also fully moral. It is the only order that has ever been fully moral and benevolent, and it has been available to people for all the time that people have been on Earth. Capitalism is THE ONE AND ONLY WAY all people should live always. These people merge capitalism with traditional religion and morality. They find the charter for capitalism in the New Testament, Luther, Calvin, the Torah, the Koran, the Vedas, the Sutras, or Confucius. Any attack on their idea of the market is an attack on their idea of God, the Dharma, or the Taoist Way. They are wrong too.

Wealth Confusion. Smith did not invent confusion about the role of wealth in human life. Capitalism did not begin confusion about the role of wealth in human life. Smith was clear about the subordinate role of material wealth to morality, and he was a person of good heart and high principle. But Smith’s argument connected wealth, morality, goodness, freedom, and social order, and those links have bolstered confusion about wealth ever since. It is easy to mistakenly think that being rich automatically makes a person good, being poor makes a person bad, and the more wealth a society has the better it is. Long before capitalism, people made these same mistakes. Smith only provided a rationale.

When people see through this error, they jump to the other pole: having wealth is bad, not having wealth is good, “the best things in life are free”, and a good society is one that cultivates spiritual values to the exclusion of material wealth.

The correct path is in the middle. It is hard to have a decent life without a solid material base; but the pursuit of material wealth alone is a trap. Material wealth is a means not an end; but an indispensable means. More wealth does make people happier in general, at least up to a point - but only up to a point. Sane people find this out for themselves despite the traps. Endless TV shows have debated this issue in terms of how much time Dad, and now Mom, should spend on work and how much time they should spend with the children. Both wrong poles, and the good middle, are celebrated in the MasterCard ads that list the prices of various goods and then end with the punch line “priceless”.

The problem is that economics gives no guidelines on this question, and it tends to reinforce the idea that “wealth is good”. In the movie “Wall Street”, this tendency jumped out when Gordon Gecko (Michael Douglas) said, “Greed is good”. There is no solid basis for all policy. We will run into this problem again in later chapters.

Adam Smith Is All. For many people, Adam Smith is all of economics, or, more exactly, the self-regulation of the Invisible Hand is all. They do not see the flaws and problems of capitalism, the need to address the problems, and how hard it is to address the problems. They see only that the system can adjust to modest changes if left alone, and mistakenly conclude that it can adjust to anything well enough, including that it can adjust to hurricanes, earthquakes, unemployment, poor employments, poverty, racism, sexism, wars, and drastic technological innovation such as nuclear power. For them, the system is always near an ideal. Progress is inevitable. Poverty is due only to laziness. All other problems stem directly from the state. Material wealth directly indicates personal goodness and social goodness, and the more wealth the better. These people pretty much ignore the rest of this book and they pretty much ignore the wisdom in Smith other than the Invisible Hand. Stephen Colbert constantly satirizes these people by saying “the market has decided, and so it is good” about preposterous situations.

People stop with simplistic Adam Smith for many reasons. Some of them stop because the rest of economics really is hard and can give even clever people headaches. Simplistic Smith works for the majority of cases, and so why make life harder by trying to get too clever? Some people stop because they see the link between simplistic Smith and personal freedom. Simplistic Smith tells us that everything works out fine if we just let people do whatever they want. Personal freedom is so important that there is no point undermining a good thing by trying to get beyond simplistic Smith. Some people stop with simplistic Smith because they benefit from the situation as it is now. They use a defense of the free market as a way to protect what they have whether what they have is really due to the free market or not. The reader needs to encounter the various people that rest on simplistic Smith to categorize them for him-herself.

Some business people invoke Smith as justification for the free market when it suits them, and as justification for mercantilism when that suits them, without realizing how consistently Smith condemned mercantilism, and without realizing the contradiction in their position. Smith would condemn tax breaks, protection, bailouts, and most of the programs that favor business.

Smithian and Non-Smithian. It helps to have a term for a market that runs well, a market that is near the static or the dynamic ideal, and that has few flaws or problems. I call such markets “Smithian”. A Smithian market is stable. It has one price nearly all the time. At that price, the sellers can sell all that they had made with that price in mind; and the buyers can buy all that they had planned to buy. The market tends to return to the price when disturbed. The market adopts innovations fairly easily, finds a new price, and returns to new stability. The markets for most small goods such as shoes, shirts, apples, etc. are pretty close to Smithian. People who rest with simplistic Smith believe that all markets are Smithian.

Some non-Smithian markets suffer the flaws of capitalism, in particular imperfect competition and externalities such as pollution. Other non-Smithian markets wobble in many ways even when they do not suffer from imperfect competition. The price is not stable, the consumers are never sure how much of the goods are available, the producers are never sure how much they can sell or how much to produce, and innovations cause long disturbances without necessarily settling down. In later chapters we will see what leads to Smithian markets or to non-Smithian markets.

Say’s Law. The remaining sections explain ideas of Classical economics that came after Smith. This section shows the need to consider circularity and closure, and shows how the Classical stress on production-supply caused misunderstanding about the balance of supply and demand.

Modern mercantilists use confusion about the balance of supply and demand to get the state to support business.

Jean-Baptiste Say was a French Classical economist of the early 1800s. He developed insights about circularity and closure. His ideas have come down in the form of two aphorisms. These aphorisms are still used today to justify policy, in particular “supply side” economics.

(1) “Supply creates its own demand”. No matter how much production expands, people will have enough income to buy the output.

(2) “There can be no general glut”. Nowadays we say, “there can be no long-term significant recession, especially a recession with over-production and over-capacity”. There might be a surplus of particular goods such as cars but there can be no surplus of all goods so that all producers cannot sell what they have and so have to stockpile for years. There should not have been a Great Depression.

The second idea rests on the first, so I focus on that. The gist of the first idea is straightforward: the economy can expand indefinitely and still balance. If a firm expands production, it has to buy materials and it has to pay workers. The money that the firm uses to expand production finds its way into the general economy. The firm has to pay for the full costs of production. It puts back into the general economy the full costs of production. So the general economy should be able to buy all the production of the business firm. Supply creates its own demand. If General Motors decides to increase production, it has to buy enough more supplies, and it has to pay its workers enough more in wages, so the general economy has enough resources to buy the increased production.

Say’s Law does not argue that the workers of any particular industry should be able to buy all of their own product. The workers that make Hummers need not be paid enough so that they can buy up all the Hummers directly themselves. Rather, the economy as a whole (total demand) can buy all the production. Hummer plants have to buy parts so that the suppliers and their workers have some money to spend on Hummers and other goods. Hummer workers spend some of their salary on rent, food, and clothes. The owners of part factories, and their workers, and the landlords, store owners, and store workers, collectively use what they receive from the Hummer factory and from the Hummer workers to buy whatever Hummers the Hummer workers could not buy. Most of the ability to buy Hummers will not come from the Hummer workers themselves but indirectly through the rest of the economy.

Notice that the idea rests on circularity and closure without being fully aware of them. All that the producer spends on new materials and on labor has to stay within the economy or the idea would not work. There can be no leaks. People can only buy from within the economy. Whatever workers get in wages they have to spend on goods, and eventually all goods can only be bought out of collective wages.

Say did not put his ideas in this way, but his ideas still carried this implication, and some of the interpretations of Say’s Law that used money brought out this implication: When the economy expands, it expands so the interest rate continues to make sure that savings equals investment and that total supply equals total demand. Each expansion represents a new full capacity where total demand equals total supply (supply creates its own demand), and where the rate of interest makes sure that savings equals investment too. Modern versions of Say’s Law rely on this interpretation.

Say’s Law makes a lot of sense. Still, we feel that it cannot be fully true, because it is not fully true.

Knowing precisely when it is true or is not true depends on knowing more than we know now about circularity, closure, diminishing returns, and proportion. We cannot go into that detail until later chapters on neoclassical economics. We can still get a feeling now by exaggerating the situation.

When the economy expands or contracts, diminishing returns set in. In case the economy expands, production per good gets less efficient and more expensive. Suppose the factory expands production from 900,000 units to 1,000,000 units, and then expands again from 1,000,000 units to 1,100,000 units. Both increases are 100,000 units but the second increase is less efficient. It takes more energy, labor, and resources for the second expansion.

Partly because diminishing returns vary between industries, and partly because consumer tastes change, when the economy expands or contracts, the internal proportions change. Suppose the car industry took up 10% of the economy, and then the economy expanded 20%. The car industry would no longer take up 10% of the economy but might take up only 8% or as much as 12%. Other industries would change their roles as well.

Both kinds of change mean that the economy might not balance as it did before, so that total buying power would not be able to buy the new production, that is total demand would not equal total supply. There is only one full capacity at which the economy balance well, total demand equals total supply, and the rate of interest keeps savings equal to investment. If we move away from that situation, we lose balance.

Suppose the Hummer factory increased production not by 1% but by 10%. Then the effect of Say’s Law might be true. The expansion of demand might be able to buy up all the expansion of supply. Suppose the Hummer factory got excited at its success, and increased production by 100%. Then the effect probably would not work out. It is just too much. More likely, people that received money from the Hummer factory would spend the money so much on other kinds of goods that not enough of it would get back to buy all the extra Hummers.

Now suppose that the entire automobile industry increased production 10%. That might work as well. But a 100% increase in production would not work. Suppliers and workers would spend too much of their increased salaries on boats and LCD large-screen TVs instead.

Now suppose total supply in the economy increased by 10%. In this case, the suppliers and workers have to spend all their money (total demand) within the economy, and so it seems as if they do have to buy all the new production. Yet the workers do not wish to work that much. They prefer some leisure instead. Or they decide to save some of the money, rather than spend it on the increased production. We might be able to force through an increase of 1% or 2% but not of 5% or 10%.

Suppose that a forced increase of production of 1% actually works. The state gets excited and decides to do it again, and again, and again. This repetition will not work, not even in small doses. Repeated small increases in production eventually amount to the same thing as one large increase in production. Eventually the small doses cannot work, and they cause imbalance and distortion. Yet this is a common state policy.

Say’s Law depends on a rigid relation between the parts of the economy, in particular on a rigid relation between supply and demand. It depends on supply and costs being something absolutely given and external to the economy – which is not true. Those conditions are almost true when we have only little changes around a healthy balance. They are not true when we have bigger changes.

When the economy expands, its efficiency declines and it changes internal proportion. When it changes internal proportion, it changes the way it interacts and balances. A forced 10% increase in supply would not lead to a new balance even if the increase were across the board.

According to Say’s Law “There can be no general glut” because whatever money was used to produce goods in general is available to buy the goods in general. New total demand is supposed to follow total supply because total supply creates enough new total demand. There might be a surplus of Hummers for a short time, but the money used to make the extra Hummers will show up in the economy somewhere and so lead to adjustments and a new balance. This too is true in short ranges around the balance of a healthy economy but it is not true of a large move away from natural full capacity, of repeated small forced increases as through tax breaks, when the economy is unhealthy, has too much imperfect competition, or suffers too much from the other flaws and problems of capitalism.

Say and Smith appreciated the balance of supply and demand. Say and Smith stressed the role of supply because the aristocratic ruling class impeded capitalist factory owners, and because capitalist factory owners were the biggest source of progress in their time. Say’s Law is a vigorous argument for letting capitalist factory owners loose. In stressing supply-production for their time, Say and Smith inadvertently created a bias in economics from that time onwards for supply over demand, and created a tendency for economics to be used as an apologetics for business. I doubt Smith would approve.

To get a better sense that we have to be careful with Say’s Law, keep in mind that it also works in reverse. Suppose we shrink production by 10%. Then the factory owners have fewer goods to sell, but they also pay their employees less in salary. The employees can still buy all the goods with their reduced salaries, and so everything still works out. The economy should balance at a lower level. People might actually be happier with fewer material goods and less stress. In fact, when the economy shrinks, we usually have a recession, the economy does not balance, and many people are unemployed. I doubt economists and business people would like to interpret Say’s Law in this opposite direction of shrinkage. Yet they refuse to see that the same imbalance occurs when we try to go the other way of continued expansion not through natural growth.

Malthus and the Landlords. Thomas Malthus was a country parson who wrote about economic issues in the first two decades of the 1800s. He had many good ideas but he did not write very well and so it is hard to tell exactly what he meant. This section tries to make sense of some of his ideas he had about demand, circularity, and closure. In a sense, Malthus was the opposite to Say because stressed demand; but Malthus expressed himself so badly that nobody listened until Keynes during the Great Depression.

To get across Malthus’ arguments, I first paint a picture of an agrarian version of the static ideal. Suppose there are no landlords and there is no rent in the economy, and the entire economy is made up of only farm managers and farm workers. Farm managers earn their salaries, and get no more than they earn. The farm managers do not collect rent. There are no farm owners to get rent. The various farms each produce one kind of good, such as corn or bacon, so the workers on one farm have to buy goods from other farms. Farm workers and farm managers can get their goods only from what they grow on their own farm or from selling (trading) the goods that they grow on their own farm. They get all that they need from their own farm and from other farms. The economy is closed, circular, and self-reproducing. They produce all that they need and all that other farms need. Pig farms get all the corn they need from corn farms. Corn farms get all the fertilizer and bacon they need from pig farms. Altogether, all the farms make exactly what everybody needs and wants, and no more. If the farms tried to make more, nobody would buy it. If anything is lacking, somebody will grow more. If not enough pigs are raised, somebody will switch from corn to pigs until just the right amount of pigs and corn are raised. All that is made can be bought with the wages of all the workers and owners, and nothing is left over. Nothing can be left over. This little scenario does not say that people live well or live poorly. It only says that everything makes everything else (circularity), what is needed comes only from the system (closure), and it all works out (self-reproducing balance).

Now introduce landlords. The landlords do not work on the farm themselves; they own the farms. Still, the landlords demand rent. The farm managers and farm workers now have to grow more pigs and corn so as to pay the landlords rent. What role does this extra production play in the economy? What role does the rental income play? In particular, is the rent given to the landlord part of the circularity, closure, and self-reproducing balance of the system?

On the one hand, if the rent given to the landlords is necessary to the system, then why could we think of the system perfectly well without the rent? What causes the rent of the landlords to be produced? Where is the rent necessary? Where does it go?

On the other hand, if the rent is not necessary, then how does it fit in once we have it? Suppose that the landlords spend what they receive. The landlord of a pig farm trades the pigs that he receives in rent to the corn grower for corn, to the cobbler for shoes, and to the apple grower for apples. Once they have gotten used to getting orders from the landlord, if these people did not receive their regular orders, then these people could not get along and the system would not balance or close. If the landlords stopped getting rent, then a large portion of the system would disappear, and, at the least, the system would have to rearrange.

We both need rent and do not need rent. Rent is both in the system and out of the system. Rent is neither quite demand nor quite supply. The system neither balances nor does not balance. The presence of rent makes the system “indeterminate”.

This problem is bigger than with rent. Rent can represent all kinds of “unearned income”, primarily from imperfect competition, including modern rent from real estate, profit from factories, from modern farms, and from state interventions. Even without the aristocratic landlords, the same problem is true of modern day capitalist economies where large firms have replaced large landlords. Large firms make profit not from rent but from control of markets. It is hard to tell if their profits are in the system or not. It is hard to tell what role their profits play in a closed, circular, self-reproducing, balanced economy. It is hard to tell what is needed to balance the system and what is not needed.

The role of unearned income (rent or profit) probably contributes to the business cycle. On the one hand, if the system is used to having unearned income flow through, and the flow is impeded, then there is not enough money to buy all the goods, there is not enough demand. The lack of demand might contribute to the business cycle. It might contribute to making the economy stick at lower than full capacity. On the other hand, if the economy were in a down phase, and landlords could spend any unearned income that they had held back, the increased demand from their new spending might help the economy out of the down phase. Malthus hinted at all this, and Keynes tried to make it all precise. In later chapters we will see that the state tries to take over the role that Malthus suggested for the landlords by increasing demand during the down phase of the business cycle.

On yet another hand, if we are not in a down phase, and the unearned income (rent or profit) is suddenly unleashed, then there is too much demand. Factories have to increase production and have to hire more workers. This effect might add to the up phase of the business cycle. In that case, the state would have to cut back on demand. Modern neoclassical economists have not studied this aspect of the situation very much.

Malthus and Population. While Malthus was alive, workers in factories did get better off but they did not get better off as fast as production increased. They seemed always to take four steps forward and three steps backward. Malthus explained it this way: People have a strong natural tendency to reproduce. When people make more money, they have more children. Instead of spending their money on a better quality of life, they spend it on more quantity of life. The working class was doomed to live always near subsistence level unless they learned to control their reproduction.

All during the time of Malthus, this was true. Then, in the middle 1800s, suddenly it was not true. Workers began to have fewer children, and the quality of life improved for everyone. Increases in production contributed to better quality of life rather than to more quantity of life. Exactly why this happened remained a mystery until modern theories of evolutionary biology made better sense of reproductive strategies after the 1960s. Classical economics and neoclassical economics could not explain it at all. We have to understand it and other important aspects of human nature if we are to make a realistic economics. This change in reproduction is important in the next chapter of the book.

John Stuart Mill and Working Class Stratification. John Stuart Mill standardized Classical economics in the middle 1800s. His textbook on Classical economics was one of the greatest, and most influential, textbooks in any subject ever. It was used until the 1890s.

Under ideal capitalism, people should flow to various jobs like capital between ventures. People should change jobs to follow wages and to follow the success or failure of various ventures. Children need not have the same jobs as their parents, and need not remain stuck in the same socio-economic class. When cars do well, farmers get jobs making cars. When computer games do well, workers on assembly lines train to get jobs programming games. The daughter of a policeman could become a welder or the mayor of the city.

In real life, it is far more likely that children have a job similar to their parents and have the same socio-economic status as their parents. The daughter of a policeman might become a beat cop, detective, or nurse but she is likely to stay in that range. In Mills’ day, children often had exactly the same job as their parents, often in the same factory. That happens as well in our day, and it was standard during the heyday of powerful unions from the 1940s through the 1970s. The son of a Teamster or an Autoworker often became a Teamster or an Autoworker, often on the same dock or on the same floor. The real job market is more organized than we would expect in a free job market. The real job market is imperfect.

Neoclassical economists call this kind of organized market “structured” whether it is for jobs or for laundry detergents. It is a form of imperfect competition, and it has the same distorting effects as unfair competition among business firms. We will see it again in the chapter on labor and wages.

Directed Savings and Investment. If we restate them in modern terms, together, the ideas of Malthus on population and Mill on labor remind us of Smith’s ideas about savings and class. Instead of talking in terms of capitalist factory owners versus landlords, we talk in terms of rich people versus working class people. Savings varies by income, and income is the biggest determiner of class. People that make little save little, both absolutely and as a proportion of their income. A person that makes $20,000 per year might save only $1000, or about 5% of his/her income. In contrast, people that make a lot save a lot, not just as a quantity of money but also as a proportion of their income. A person that makes $200,000 per year might save $50,000, or about 25% of his-her income. There are practical reasons for this disparity that we will look at in later chapters.

This relation has been used to justify giving tax breaks to rich people, even at the expense of poor people. Smith stressed the need for savings for growth and progress. If savings are important, then it seems as if we need to make sure that we maximize savings. To maximize savings, we want to direct income and wealth to the people that save the most. The people that save the most are the people who already have a lot. So we ought to redistribute wealth toward the people that are already wealthy, even if, to do so, we have to tax the people that are not wealthy.

This argument is a false distortion of Smith’s idea that the state should not overly-tax capitalist factory owners but should allow capitalist factory owners to gather their fair share of profits for reinvestment. In modern times, enough money is available for investment so that we do not have to give more money to the rich, especially at the expense of the poor. Of course, we should not over-tax the rich either. We will meet these ideas again in later chapters.

Cantillon Effect. Richard Cantillon lived in the early 1700s in Ireland and France. About 1730, he wrote a brief brilliant summary of how the market works. His book circulated informally but was not published. His writing likely influenced Smith and Classical economists but the line was never clear until the book was rediscovered in the late 1800s.

Cantillon wrote about the effects on Europe of the discovery of precious metals in the Americas. He pointed out that the effects varied by country because where the wealth entered the economy varied by country. In some countries, the wealth entered through merchants and the normal market mechanism, such as England. Those countries tended to do well. In other countries, the wealth entered through the state and the military, such as Spain. Those countries tended to do poorly. It is not necessary here to understand why they did well or poorly. It is important to keep in mind that we cannot understand the effect of any change unless we see where the change occurs and follow the chain of influences. If we want to know how computers affect the United States or China, we have to see how computers are introduced and what happens as a result. I call this need to look at places and situations the “Cantillon Effect”. A version of it is the savings problem just mentioned above where we have to think not only about the total amount of savings for investment but also from which class the wealth might come and to which class the wealth might go. We will need the Cantillon effect later in the book when we look at the business cycle and at how the state tries to manage money, growth, and capacity. Cantillon was a brilliant observer and was ahead of Classical economists in many ways. The Cantillon effect anticipates ideas from neoclassical economics.

03 Human Nature

Neoclassical economics is seductive. Like a good horror movie, once we think in neoclassical terms it is hard to think otherwise and easy to rationalize exceptions. We act like the dazed clueless victim wandering in denial, waiting for the monster or the savior. We need precautions. This chapter shows that we need some ideas of human nature, morality, and the state together with standard economic ideas about people as rational, strategic, and self-interested. This chapter is not a lecture or a sales pitch. Anybody could disagree and still do good economics. If you disagree then you have to come up with ideas of your own and have to make them explicit and clear. From now on I say “economics” for “neoclassical economics” or “economists” for “neoclassical economists”.

03 Human Nature; Synopsis. For a capitalist economy to work well for the benefit of most people, people and business firms have to compete properly. Firms have to seek profit, have to know how to seek it, and have to be adept at seeking it. That is no problem for firms or for economic theory. Likewise, people have to know what they want, know how to efficiently seek it, and they have to be adept at seeking. People have to know a lot, and they have to be good at using what they know. People have to be rationally strategic at achieving their goals. This can be a problem for both people and theory.

Mostly people are strategic but not always. We do not always know what we want or the best ways to get it. We make mistakes. We have all succumbed to vices. None of us knows enough always to be perfectly strategic. If people were perfectly individualistic, we all would differ in our desires, but, in fact, most people want similar things: family, health, success, wealth, friends, safety, good government, etc. That similarity seems to show that people are not led by rational choices but by instincts. We want things that we think are beyond rationality, such as love, God, enlightenment, goodness, duty, and honor. The market does not always provide the greatest benefit. Economists have no way to deal with all these facts at once. Stressing that people are always rational strategists sometimes leads economists into silly assertions, such as that people never make mistakes, people never succumb to vice, people always know exactly what they want and how to get it, people can never be fooled, the market always delivers the greatest benefit, and the economy never has problems unless the state interferes. Economists get trapped in circular reasoning. Their reasoning often serves the rich and powerful at the expense of the poor and weak.

To say that people are not rational enough is a way to bolster the power of the state. If people can’t take care of themselves, then the state has to take care of them, and the state has to be powerful enough to do the job. Some economists insist that people are rationale, even at the risk of over-insisting, as a way to curb the state. If people can take care of themselves, then we don’t need the state to intrude in our lives. The real issue is not whether people are perfect strategists but whether it is warranted to use the state when people are not adept enough and when the free market fails to deliver the most benefit. Usually, it is not.

Animals that have evolved through natural selection are primarily strategic, competitive, know when to cooperate, mostly want the same things, vary a bit in personal desires, and can choose adeptly most of the time. Evolved sentient-moral animals understand ideas beyond the system such as duty and love. If we look at people not as ideally rational angels but as evolved sentient-moral beings, then people know their selves well enough and can choose well enough. We can know the minds of other people well enough. We can take people as strategic enough so we can use Smith’s ideas to understand the vast majority of the economy as a self-regulating system powered by individual interaction. We can use this view of people to understand when Smith’s ideas might not apply, as with religion, and when the system might not work ideally, as with debt slavery. We can better judge the situations in which the state is needed. This way of looking at people is an exciting new field in economics.

The flaws of capitalism lead to problems such as unemployment. Suggested cures for problems often lead to other problems, sometimes worse than the original. In these situations, we have to decide, we have to use judgment. We have to look both practically and morally. Sometimes we have to do something about a problem, such as medical care for children, even when the solution carries a high practical cost. Sometimes we have to overlook a moral need, such as medical care for old people and fat people, because it costs too much. Sometimes one morality cancels out another, as when welfare makes people dependent on the state or when drug laws hurt poor people and encourage organized crime. To sort through this, it helps to have an idea of human moral nature grounded in nature in general, an idea of human nature grounded in evolution. It helps to have an idea of how human nature and the state interact.

Core Problems. This chapter is really about the following issues. These issues have been wrapped in cloudy ideological arguments since about 1900.

-Can individual free action automatically lead to the best for the group as a whole and for most people in the group? When does it lead to the best, and when does it not?

-Does human nature sometimes cause free action to fall short of the best practical good for the group as a whole and for many people? Does human nature itself sometimes lead to problems?

-What do we do when things don’t turn out for the best through free action?

-Can we be sure that a proposed solution does not cause more harm than the original problem? Does human nature sometimes cause the solutions to be worse than the original problems?

-If we see that solutions have their own problems, do we have to act anyway because of a moral compulsion? For example, do we have to feed hungry and their children, especially if we know that feeding some people will cause them to stop seeking work and will cause other people to stop working?

-Can we balance practical gain-and-loss against morality?

-Do we have to involve the state in proposed solutions? Is state involvement more likely or less likely to lead to even worse problems? Does human nature play a role in whether we involve the state and whether involving the state leads to worse problems?

-Do we more likely need the state in case of an urgent moral situation? Is human nature more likely to play a role when we bring in the state because of an urgent moral situation? Is the state more likely, or less likely, to be able to help us balance practicality versus morality?

Rationality. The only official theory of human nature and human action in economics is that people are “rational”. This is another way of saying that (1) people are necessarily strategic by nature, and (2) “being strategic” is all that people are by nature. We are always strategic and we are always only strategic. Even when we act on emotions, attachments, seeking pleasure, avoiding pain, towards our family, towards society, morally, or religiously, we act strategically. We never act except strategically.

Rational” does not necessarily mean sane and reasonable. “Rational” is a technical term. It means:

(A) People are consistent in their desire for goods. If a person likes good X more than good Y, and likes good Y more than good Z, then the person likes good X more than good Z. If Albert likes two oranges more than two bananas and likes two bananas more than two apples, then Albert likes two oranges more than two apples. Usually economists also take “rational” to mean:

(B) people can exactly order their preference for all possible combinations of goods; and

(C) people are efficient at getting higher ranked combinations in preference to lower ranked combinations. People know if they prefer a Chevrolet or a Buick, and they are adept at getting what they prefer. Or people know if they prefer the full option package Chevy to a regular Buick, and know how to get that. People know if two apples and one orange are better than one apple and two oranges, and always pick what they prefer. People know if they want a little bit of justice for other people with a lot of material wealth for themselves or if they want a lot of justice for everybody with less material wealth for themselves. People know if they want (a) to insure success for their children at the cost of some injustice to other children versus (b) strict fairness with more risk to their own children. People know if they want their children to succeed in school even if their success means other children do not get the same tax money to do well. People know if they want to enforce drug laws as strictly for their own ethnic, social, and religious group as for others.

A less strict but more useful way to put it is: (D) People know what gives them satisfaction. (E) People know what gives more satisfaction or less satisfaction. (F) People are efficient at getting the most satisfaction for their effort, and out of their available resources. (G) People are efficient at minimizing costs along with getting the most from their resources. An easy way to think about this is a trip to the grocery store. People know what gives them the most satisfaction. They are efficient at getting the most satisfaction from their food dollar. They do the best they can to avoid the eye-catching displays and checkout counter traps; and they are clever at finding the odd goodies tucked away at the side of a shelf, such as real maple syrup. They alter strategies when situations change, as when there is a sale on ground round. They do not spend too much time at the supermarket or else they lose time they could have spent watching a sit com at home. People cast their votes where their votes will do the most good-for-me however they think of good-for-me. People distribute bribe money among the officials most likely to help them. People have their elected officials spend tax money on them. People maximize their satisfaction by efficiently using resources and minimizing costs.

In the 1920s, Lionel Robbins said that economics is about the apportionment of scarce resources among competing ends (goods). We do not have all of what we need (resources) to get all of what we want (goods). We have to use what we have to get what we most want in the order that we want it. We have to make do with what is available to get the most of what we want. We have to choose.

Resources” includes not just money or material goods but also time, attention, commitment, and other non-material stuff. “Ends” includes not just a bigger car but also the safety of our children, the glory of our country, and worshipping through our religion. In theory, economics is about any strategic action of any kind, toward any end. Since people are supposed to be strategic about all action, economics offers a strategic interpretation of all human action.

Many people do not like looking at people, especially themselves, as if people were primarily strategic. They do not mind looking at how people get a job or buy gasoline in strategic terms but they do not like looking at finding a spouse, having a family, defending the country, worshipping, or seeking truth scientifically, in strategic terms.

Maybe because of that aversion, and maybe because it is easier, most people think of economics as having to do with money prices on a market and as not having to do with personal lives, social lives, national life, or morality. Money prices on the market are a big part of economics but not all of economics. Economics tries to cover as much of human action as possible. Economics does try to explain why people want a certain kind of family and why people choose to go to a Unitarian Church, Catholic Church, or Muslim Mosque. That is why we have to be clear about economics, human nature, and the state. I think we can see nearly all action strategically but economics alone does not have all the tools for the job. We have to include ideas from evolutionary biology. I return to this question after we have built a price-and-market system at the end of Chapter Five.

Utility. To make better sense of strategy, economics developed the concept of “utility”. To say that people maximize “satisfaction” is not exactly right. The word “satisfaction” implies “pleasure”, “happiness”, or “contentment” as in the song “I Can’t Get No Satisfaction”. Yet people do things that they know are good for them but that do not bring pleasure or contentment. People go to the dentist, get their colon scoped out, pay taxes, watch TV with the family during holidays, get divorced, etc. People learn to avoid things that give a lot of pleasure but that are not worthwhile in the long run such as drugs, casual sex, some religious ideas, and some political causes. Some things detract from goodness, such as a hangover, paying taxes, and having to read a hundred tedious books on economics just to get a few simple ideas straight. Goals come in rough hierarchies. We go to the dentist for the sake of our overall health. We buy a lawnmower to mow the lawn to make the house look good to keep up our status in the neighborhood so that our kids can get good dates so that they will feel successful and go to a good school and be successful. We need an idea for whatever people seek to maximize because it is good for them even if it does not feel good, an idea that can help us also to see what people avoid, and that can help us to arrange goals in proper order.

Utility” is that idea. Whatever people seek gives them utility. Whatever takes away from utility is “dis-utility” or “cost”. People seek to maximize their utility by using their resources efficiently and by minimizing their costs.

We can think of some things as both resources and costs. Time is something that we have to spend, and we minimize how we waste time so as to get the greatest utility from what we do use. We have an afternoon to spend. We minimize the time at the store so that we can spend more time listening to music. The same dual character is true of labor and even of thinking.

Sometimes it is useful to measure utility, as long as we do not get carried away. The term for a unit of utility is a “util” or sometimes “utile”. We can say that, for Harry, an apple provides 5 “utils” of utility while an avocado provides 8 utils.

Jeremy Bentham developed the idea of utility in the early 1800s so Classical economists and politicians could compare the needs of various people and thus could decide what was best for society as a whole. Whatever gave the greatest total sum of utility for all people was what society should do. When economists use the idea of utility this way, they speak of “the sum of welfare” or “welfare” without meaning the system of support for poor people. For Bentham and his followers, If the free market achieved the greatest total utility by itself, fine. If not, the state would intervene to achieve this result. This was Bentham’s way of deciding on “the greatest good for the greatest number” or, as Vulcans say it, “the needs of the many outweigh the needs of the few”.

For example, Harry and Sally need to decide whether to use the spare bedroom as a game room or to raise tropical fish. It is not possible to do both because of danger to the fish tanks. Harry gets 10 utils out of games and 12 utils out of fish. Sally gets 13 utils out of games and 8 utils out of fish. If they go with games, they get a total of 23 utils (10 + 13) while if they go with fish they get a total of 20 utils (12 + 8); so they should go with games.

If the free market always automatically led to the greatest total sum of utility for the group (greatest welfare) then we would not have to worry about the group level – we could just “turn people loose”. We can let any individual person do what he-she wants as long as he-she does not hurt other people.

For us to rely on the free market, we have to be sure that individual actions lead to the greatest welfare (greatest total utility) for the group. As anybody knows who has played “which restaurant tonight” among friends, even when people have good intentions, individual strategies do not always automatically lead to the best outcome for the group. It is hard to be sure that the free market leads to the greatest welfare, and the search for proof can lead to odd results.

If the market does not make these decisions well for us, then we have to think about what else to do. If alternatives are even worse than the market, we might have to go back to the flawed market; but we need some way of evaluating that case too.

The best way to decide whether the free market leads to the best results, or if any practice leads to the best results for a group, would be to directly measure the utility for all individuals for various practices, sum the utilities, and then compare, as Bentham wished to do. If the free market led to the greatest sum of utility, we could rely on the free market. If another method led to the greatest sum of utility, we could rely on that method.

Early neoclassical economists made calculations based on utility to try to determine directly the best outcome for a group. Then modern economists reversed policy about 1920 and refused to make such calculations. Economics is based on the idea that people are strategic but it is also based on the idea that things turn out best when people are most free. As this chapter goes along, we will be caught in a bind between freedom of action versus accuracy of analysis: On the one hand, to make decisions for the greatest welfare of the group, and to evaluate that individual action really is rational, we have to make assumptions that take away individual freedom. On the other hand, if we let people act freely, then we cannot always be sure they achieve the greatest good, and we have to allow them to act silly and badly. We have to choose between freedom and accuracy. If we choose freedom, and we want to support the idea that freedom leads to the greatest good, then we have to indulge in a strange kind of seductive circular logic. Economists chose freedom even at the risk of this seductive misleading circular logic.

Interlude: Technical Point. Game theory can show that people do not often achieve the greatest total utility for a group even when each person acts freely to try to achieve his-her own greatest utility, can show the conditions under which they do achieve greatest total utility for the group, and can show that those conditions are unusual. It takes us too far out of the way to consider the range of conditions in which groups do, or do not, achieve the greatest utility, and how the free market fits in. The free market is one condition in which people can approach the greatest total utility possible through individual rational action, so I focus on the conditions that are relevant to the market rather than consider all possibilities. Narrowing the focus cuts out some fun topics, such as the propensity of people to trust each other even under risk, but it has to be done for now.

Strategy as Maximization. It is easy to say that people are “strategic in nature” or “rational” but those phrases do not mean much unless we can be specific. We need to show that people are strategic. The best way to show this is by maximization. If an organism wants some thing, and the organism acts efficiently so as to get the most of that thing (maximize), then the organism is rationally strategic. Cats want as many mice as they can get their jaws around. Tabby can get the most mice by dividing his time between guarding the mouse hole, hiding by the refrigerator, and lurking in the pantry, in the ratio of 50%, 35%, and 15%. If Tabby actually does this, then Tabby is a rational strategic maximizer. Real hunters in the wild, human and non-human, do apportion effort this way so as to get the most kills or the most weight. We cannot evaluate strategies accurately unless we can assess the extent to which something is maximized.

For people, utility is what strategies maximize. If we can see that freely acting people maximize utility, then we can say that people act as economics expects them to act, and that economics is correct. If free people maximize utility, under the right conditions, then the sum of utility will be greatest for the group (the group will achieve greatest welfare) even If we cannot directly measure utility for individuals or for the group. If people are rationally strategic, then we have good grounds to say that the freer people are then the better off society is. We can rely on the free market to achieve greatest welfare.

Circular Subjectivity Weirdness. If we want to show that people actually are strategic, and that free strategic action leads to the best result, then we need an objective way to assess that people do maximize utility. We need to measure that the cat actually catches the most mice or measure that the person actually gets the most utility. We need to measure utility.

To validate that people are strategic in nature, we need objectively to say what gives them the most utility just as we objectively count mice. We need to be able to say that men maximize utility if they spend 50% of their time at work, 35% of their time on recreation, and 15% of their time with their family.

The problem is that we cannot measure utility apart from actual behavior like we can count mice. We have to guess that people do something because it maximizes their utility, and then we validate that it maximizes their utility because that is what they do. We reason in a circle. We say people do something because it maximizes their utility, and then we use utility maximization to explain what they do. If we wish to avoid thinking in a circle then we have to impose standards on people. Imposing standards on people takes away their freedom.

Steve actually might get the greatest utility if he spends his time in the ratio listed above but John might get the greatest utility if he spends 50% of his time at work, 20% on recreation, and 30% with his family. We do not wish to say that John is not rational because he differs from what we said he should do, from the norm, or from Steve. Yet unless we have an objective standard to measure utility that we can apply to John we cannot say that John actually maximizes his utility or that John is rationally strategic. Unless John allocates his time to get the most utility according to what we figured objectively should give him the most utility, then we cannot say he is rationally strategic, and we cannot say he is not.

If we use an objective standard to judge whether John is rationally strategic and has maximized his utility, then we take away John’s freedom of action. If John acts as we say he should act, then he is strategic but not free. If he acts as he wishes but his actions do not conform to our objective standard, then he is free but he is not rational.

We can say that John maximizes utility too by saying that he does what gives HIM the most utility regardless of what is best for Steve or for anybody else. But we have no way to show this objectively. We look at what John does to say THAT is best for him, and then decide THAT is best for him by looking at what he does. This is just a circular rationalization. Non-economists accuse economists of this kind of logic all the time.

If we could be sure that John always does what is best for him, we could rely on the free market to lead to the greatest good for the whole. We never need to check the market by measuring total utility (welfare) and never need to correct the market. If we doubt that John always does what is best, then we cannot rely on the free market. But we have no alternative that is anywhere as congenial as the free market, so we have to hope that John always does what is best for him even when his actions seem odd. This is a bit weird.

The quickest way to see the weirdness is through a trap that children often spot and have fun with. If people always do what gives them the most utility then they can never make mistakes, and can never do anything wrong. Thus people never do anything out of moral motives but always act only selfishly. Amy robs a bank because robbing banks maximizes her utility. Bob catches bank robbers because catching bank robbers maximizes his utility. Cathy saves kids from a burning building because that maximizes his utility. Dave stands outside and watches a building burn, with kids in it, because that maximizes his utility. Ed went to the market to buy soap flakes but bought cereal instead. Yet Ed did not make a mistake because buying cereal maximizes his utility. We know that buying cereal maximizes his utility because that is what he did. Fran went to the supermarket to buy puppy chow but bought lotto tickets instead because of the enticing display. We know that Fran was not seduced and that Fran maximized utility, even though her puppies go hungry, because she is rationally strategic. No matter what people do, that is always the best for them, it always maximizes their utility, they never make mistakes, and they are always rationally strategic. There can be no “Golden Rule” because people only do well unto others so that others will do well unto them or so that they will feel good themselves; people never really use the Golden Rule as a standard for what is right or wrong. Serial killers are perfectly rational as long as they know what they want to do, and do it efficiently in accord with their own symbolic worlds.

This is a trap of “circular subjectivity”. A “subject” is a person or animal or angel that can make up his-her own mind, and into whose mind we cannot see. We have to infer their motives from what they do, and then we have to validate our conclusions from what they do. We make conclusions from actions and then validate our conclusions from the actions. We claim that we can “get into a subject’s head” by watching what he-she does. We reason in a circle. Validating that people maximize utility based only on what they do is “circular subjectivity”. Economics is not the only discipline that suffers from circular subjectivity. Validating that people are moral, immoral, good, bad, seek power, or anything else, would also entail circular subjectivity. Non-economist social scientists, including anthropologists, do this all the time.

This paragraph is a dense summary but please step through it. If we want people to be free then we have to let them make up their own minds. If we let them make up their own minds then we cannot apply objective standards to them. If we cannot apply objective standards to them then we cannot validate that they are rationally strategic. If we cannot validate that they are rationally strategic then we cannot show that self-interested action leads to the best for the group in accord with the self-regulation of the Invisible Hand. If we want to validate that self-interested action leads to the best for the group then we have to apply objective standards of satisfaction (utility). Or if we want to decide what is best for the group regardless of whether or not that best comes out of self-interested action by individual people, still we have to apply objective standards of utility. In applying objective standards, we make up people’s minds for them. If we have to make up their minds for them, then people are not free. On the one hand, applying objective standards of utility can prove that people are strategic and can help us figure out the greatest good for the group but it takes away freedom. On the other hand, saying that “whatever people do is what they want to do and is what maximizes utility for the person and the group” is circular, does not guarantee the best for the group, and is often silly; but it does allow for free action. Circular subjectivity does not guarantee freedom and it undermines freedom in some ways but at least it rationalizes free action and holds out some hope. Objective standards validate freedom only if people act according to the objective standards, and that is not freedom.

Economists have to choose between freedom with all the weirdness of circular subjectivity versus objective standards. Some of the most sophisticated beautiful logic of the 1900s went to show that self-interested free action does lead to the best for everybody even if we cannot prove it with objective measures. The logic is almost successful, but not quite, and well worth studying, but I cannot go into it here.

Revealed preference” is the technical term for inferring desires from what people do, and then using the inferred desires to explain their behavior. Textbooks vary in how explicit they are about the circularity and weirdness inherent in the idea of revealed preference.

Freedom Wins. In a choice between circular-subjectivity-with-the-hope-of-freedom versus objective-validation-of-strategic-nature-without-freedom, freedom wins. Economists chose not to worry much about whether they can “get into people’s heads”, that people make mistakes, people fool each other, most people are similar, or people also differ. Amy robs banks because she likes to rob banks. All we can do about that is build better banks.

It is easy to make fun of this position but it is not a silly position. It is important to let people do what they wish. It is important not to develop theories that tell us what to like unless we have compelling reasons for those theories and have good independent evidence to support those theories.

Sort Of. Allowing free subjectivity is fine in theory but not for practical everyday use or for policy. Who can stand the idea that a teenage girl cuts herself because that is what gives her the greatest utility? Who would allow Amy to rob banks because she likes to do it even if the banks are insured and we can show that Amy causes little harm? Who would allow a rich person to control the legislature even if he-she interferes little and does little harm? Somebody has to take care of puppies rather than buy lotto tickets. We need to decide if we want a new airport and we need to decide on some basis.

So, in practice, with one hand, economists, politicians, state officials, analysts, and commentators impose their ideas of human nature, human priorities, and morality, even when, with the other hand, they stridently defend the free market. Economists use common sense ideas about what people are like, and about what is right or wrong. Sometimes they twist those ideas a little bit to fit what they want and what they think is right. For example, economists tacitly accept that most people want food more than recreational drugs and that most people want families more than brothels. The people that oppose Social Security, such as former President George W. Bush, do not oppose it only because they (wrongly) think it is on the verge of bankruptcy but also because they think Social Security is immoral. They think Social Security takes away responsibility and undermines the economy. They wish to kill Social Security as a way to force us to take more responsibility and to be more moral.

When people have to sneak in ideas about human nature and morality, they often sneak in bad ideas, and it is usually difficult to evaluate ideas fairly. The confusion about Social Security is a case in point, as is confusion about poverty, national defense, and the environment. When people do things openly, they often rely on common sense, and it is easier to evaluate ideas fairly. When people sneak in ideas, they block out common sense. When people do things openly, they can give criticism and take criticism. They can tell actions that really hurt other people. They can tell the difference between getting drunk yourself versus offering liquor to minors. They can tell the difference between mistakes and personal tastes. When people have to sneak in their viewpoints, they are belligerent about it, do not take criticism, are not open to other opinions, and cannot tell what hurts people.

Rationalize the Status Quo. To defend freedom we have to say that whatever people do is what they wish. This defense of freedom implies that whatever is, is best; whatever already is, is there because that is what people want; whatever is, gives the greatest possible welfare. This kind of rationalization is called “defending the status quo” (“status quo” means “what already is”). Some people are poor, do not have a good job, or do not have a job at all, because that is what they wish. Some people are rich because the economy rewards their superior talent.

People use a defense of freedom as a rationale for whatever already is when whatever already is favors them, including abuses such as monopoly, oppressing the poor, and serving clients. Economists did not develop ideas about human freedom as a way to justify abuses but their ideas often have been used that way, and even some economists have abused ideas about freedom. The reader should keep in mind that abuse of ideas about freedom is used to justify bad policy, and the reader should be ready to use common sense to fight against abuses and bad policies.

No Inter-Subjective Comparisons and Redistribution. Economists use technical terms that you need to recognize even if not memorize. An “inter-subjective comparison (of utility)” compares the utility of one person with the utility of another person, often over similar goods. An example is the case of Harry and Sally above deciding about fish and games. If we could compare utilities between people, we could say that Harry gets 5 utils from one apple while Sally gets 6 utils from one apple.

Nobody might care who got more utils unless we also argued that Sally should get the apple because she gets more utils, regardless of wealth, income, or what the market leads to. When we argue that way, we start battles.

A real historical instance of this argument had to do with the distribution of wealth. If we can compare utilities between people, it is not hard to show that the total sum of utility increases as the distribution of wealth gets more equal. In a society of 10 people, the wealth consists of 10 chocolate chip cookies. It is reasonable to think that each person gets about the same utility from a chocolate chip cookie as any other person. In that case, if 1 person has all the wealth (10 cookies) while 9 people have none (0 cookies), then the total utility is not as great as it could be.

If 2 people each had 5 cookies, while 8 people had 0, the total utility would be higher. If 3 people each had 3 cookies apiece, 1 person had 1 cookie, and 7 had 0,the total utility would be higher still. If 2 people had 2 cookies apiece, 6 people had 1 cookie apiece, and 2 people had 0, the total utility would be yet higher. If everybody had 1 cookie each, the total wealth would be about as high as it could be. Of course, people differ in how much utility they get from cookies, but we can intuitively see that greater equality and greater utility go along pretty well.

Ever since Jeremy Bentham in the 1800s, some economists used arguments like this to urge the redistribution of wealth: take money from the rich, and give it to the poor, because that makes society as a whole better off.

Beginning in the 1920s, other economists blocked the argument for redistribution by using a strict interpretation of subjectivity that does not allow comparison of utility between people. If we cannot compare the utility that different people get from wealth, then we have no basis to argue for any distribution of wealth other than what we have now. Under a strict interpretation, we cannot compare the utility that one person gets from a cookie with the utility that another person gets from a cookie. We cannot say that a distribution of 1-person-with-10-cookies-and-9-people-with-0 is any better than a distribution of 10-people-each-with-1. So we have to go with what we have now. Whatever we have is best because it is what we have.

When economists in general began to argue for subjectivity so that they could defend freedom, some of them also used a strict interpretation of subjectivity to argue against any inter-subjective comparisons so as to block arguments for the redistribution of wealth. They used abstract ideas about subjectivity and freedom to block a concrete policy about wealth. They used abstract ideas to defend the status quo and the rich. Since then, non-economists have accused economists of using abstract ideas about freedom and subjectivity as a cover to block any redistribution and to help the rich. Non-economists say that economists want to have their cake of subjectivity and eat it with a frosting of wealth too. The actual intent varies with the economist.

A strict interpretation of subjectivity, that blocks inter-subjective comparison, and so blocks any redistribution, might be fine in theory, but any sane sensible person can see that differences in wealth persist, are not fair, and do not lead to the best for society. The market does not lead to the greatest total welfare, and we can see where redistribution might help. Using common sense, we correctly make inter-subjective comparisons, and judge accordingly, whether neoclassical theory allows it or not. Just as we do not want teenage girls to cut themselves, we do not want society to cut itself either. Maybe the rich should pay a little more in income tax, and a little more for education.

But redistribution raises its own problems. Is interference really liable to do more good or more harm? What if we soak the middle class to pay for “welfare queens”? The real questions are not whether we can see problems and propose solutions, but (1) whether solutions definitely improve the situation and (2) whether we want the state to interfere. Those are questions in their own right apart from theoretical issues of subjectivity, utility, and comparison. Anybody with enough common sense to overcome a strict interpretation of subjectivity, and with enough sympathy to see problems of unequal wealth, also should have enough sense to think deeply about schemes for redressing grievances. Likewise, anybody smart enough to use a strict idea of subjectivity to block redistribution also should be smart enough to see real problems in the differences between rich and poor, and should wish to help if we can.

The reader has to make up his-her own mind in particular cases. We will see similar problems with fairness in several places in this book.

What We Need. We need a theory of human nature, and a moral code, that does the following:

-Validates the idea that people are strategic while it still protects freedom. -Justifies freedom but does not easily allow abuse of freedom.

-Gives us reasonable standards for what most people do but allows for much individual leeway.

-Explains how people can understand other people but does not say we always understand completely and does not justify forcing our understanding on other people.

-Allows us to compare people while recognizing variation and recognizing limits to comparison.

-Is based solidly on scientific understanding of human nature yet gives genuine status to moral decisions.

-Admits moral judgments without subjecting everybody to shallow moralizing.

-Admits common sense while recognizing that science can improve on common sense.

-Evaluates strategies, tells when people make mistakes, tells when people are fooled, suggests when to meddle, tells us when not to meddle, and tells us when to let people carry on in their folly even when we can see that it is folly.

-We need a theory of human nature and of morality that helps clarify the role of the state, the interaction of the state and individuals, and the interaction of the state and the economy.

We need a theory of human nature and a moral code that tells when we have to help the poor.

That is a lot. Probably we cannot find a theory of human nature and a moral code that can do all this.

Evolutionary Human Nature. If we ask, “Why do people have families?” most people answer “because it is natural”. If we allow that people have a nature that comes out of nature, then we have to consider what natural human nature is and we have to consider the implications of having a natural human nature.

In the modern world, the only acceptable answer is that nature evolved. We have to see nature as the result of evolution. Every thing in nature, all the birds and all the bees, and all their inter-doings, evolved. We have to understand nature in terms of evolution. Any theory of human nature either has to accept that we evolved our nature or it has to show how we got our nature despite having evolved for four billion years. The theory of human nature given here is the simplest I know that takes seriously the question of the natural origin of human nature and that meets the requirements of the section above. There is no other consistent and reliable option. Not economic insistence on full rationality, traditional religion, Marxism, or Politically Correct petulance, gives a consistent and reliable alternative. Evolutionary theory is based on Darwin. The seeds were planted in the 1930s, it flowered in the 1970s, and it has grown steadily since. Among scientists, now it is the way to understand all organisms including people. Because it goes along with common sense, the public has begun to accept it.

An evolutionary theory of human nature has about the same practical results as common sense. With it, we can assume that people are rational enough so that Smith’s ideas can apply, but also that we are not perfectly rational. We see judge problems and schemes. We can judge when to intervene or leave alone. We can argue about the role of the state. The results of evolutionary theory of human nature do not differ much from neoclassical economics mixed with reasonable common sense, which is what most economists do anyway. Then, why bother? Because it is better if we are explicit about these issues and it is better that we sneak in as little as possible.

Most people now understand that obvious physical traits such as the trunk of an elephant or the stripes of a tiger evolved. People do not yet fully appreciate that, not only did physical traits such as antlers and thumbs evolve, but so also did tendencies for behavior. The character of the deer or of the fox evolved along with antlers and red fur. The propensity of a cat to leap and run, or to pounce on a rat, evolved along with the strong hind legs and big paws that make those behaviors succeed. Human nature evolved too. We are not that much different from the deer or the fox although we are more complicated.

A large portion of evolved human nature is the ability to learn quickly. We learn easily to do what is to our biological advantage while we have a hard time learning what is to our disadvantage.

All animals, including people, evolved to be self-interested. Any animal that was not self-interested did not leave its genes in later generations. Only genes that supported self-interest lasted into later generations. We are the end result of millions of generations of self-interested genes. People seldom do what is not in their self-interest.

People tend to misunderstand self-interest among non-human animals and among people. We think it means “narrowly and stupidly selfish”. The best self-interest usually is cleverer than that. The most successful self-interest usually does not severely conflict with the self-interest of others. Self-interests often coincide to the mutual benefit of everyone, as in wolf packs. We will see more aspects of self-interest below.

The biggest part of self-interest ordinarily is the family. Families are an extension of our selves. Selves merge in the genetics of kinship. We can think of seeking self-interest usually as seeking the welfare of the family.

Contrary to myth, people and other mammals almost never seek the good of the species before the good of their own families. Actions that lead to the good of the species stem from attitudes that are based on the good of the family. Packs fight foes together because pack members are family members.

We understand an action by thinking about how it serves self or serves family.

Behaviors evolved to work well in particular circumstances. We only understand the spring of a cat when we realize how cats hunted food in the wild. The swing of an ape only makes sense when we see them in their original wild. When we take an animal out of its original wild, then its behaviors can get strange and do not always make sense. Panthers do not pace in the wild as they do in zoos. Before trying to make sense of a behavior we have to think about how it might have worked in the original wild and how it might be out of place in domesticated circumstances.

The original wild of people was hunting and gathering. We understand an action by thinking about how it might have served self or family in the original wild of hunting and gathering. Sometimes this can be hard to do because people are so removed from their original situation. Luckily, people are very good at adjusting to new circumstances, and so we can still understand most of what people do by thinking about how it might help self or family even in the wilds of Auburn, AL.

So we understand an action by thinking about how it serves self or family now, and how it might have served self or family in the original past. We understand the fact that men like to hunt not only by how much (or little) meat they bring in now but because their hunting would have brought in meat in our original past.

What exactly is the goal by which to evaluate actions? People wish to maximize the chances that their family members will grow up healthy and will themselves have families of their own that will grow up healthy.

In simple terms, we can evaluate actions by how many healthy competitive children they lead to. If working hard and staying sober leads to 3 healthy children while moving from job to job and drinking hard leads to only 1 sickly child, then we evaluate accordingly. We do not usually evaluate only by number of children but also by number of grandchildren or great grandchildren. The technical term for number of offspring of whatever generation is “reproductive success”. For example, 6 healthy children means a reproductive success of 6 in the first generation while 8 healthy grandchildren means a reproductive success of 8 through the second generation. We evaluate actions according to reproductive success through a particular generation. If hunting leads to 3 healthy grandchildren while farming leads to 5 healthy grandchildren, then we say that farming has a greater second-generation reproductive success.

Using reproductive success to evaluate an action does not mean we evaluate only according to number of children. Like most mammals, people act in accord with quality as much as quantity; and people act to succeed over the long term. Sometimes having 10 children leads to having only 2 grandchildren. Sometimes having only 3 children leads to having 9 grandchildren.

Sometimes it pays more to invest much each in a few children than to invest a little each in many. We have to think about what actions work to produce the most healthy grandchildren or great grandchildren. Reproductive success is better evaluated through grandchildren or great grandchildren, if we can get that information. This is why people are so proud of how many grandchildren they have even now in the days of small nuclear families.

People cooperate for many reasons. People cooperate as a kind of insurance. One person gives when he/she has much so that he/she can get when he/she has little. If Albert has a lot of meat after a successful hunt, he shares the meat with people that did not do well today so that in the future, when they have done well and he has not, they will share with him. Cooperation is a kind of sharing. People cooperate to do tasks that could not be done alone such as killing a bear or protecting against marauders.

Success is inherently comparative. It is not enough that I have 6 healthy, happy grandchildren if my neighbor has 8 healthy, happy grandchildren. People are attuned to think about the Joneses. People compare themselves to other family members, and they compare their whole family to other families. They compare their own families to generalized ideas about how everybody is doing. They want their families to exceed the norm. Parents have been saying, “See how smart my little Sally is” and “My Dad is better than your dad”, for a couple million years.

Despite the value of cooperation, people do compete, and people conflict in their competition. Perhaps people cooperate to hunt a bear but they compete to hunt rabbits and deer. People hunted a lot more rabbits and deer than they hunted bear. People argue when they encroach on hunting territories. People can be violent in their competition and their arguing. If they cannot resolve an argument about hunting territories, they shoot it out with arrows. Women too compete and can be violent, although they do it in different ways than men.

The balance of cooperation and competition, and the extent of violence, depends on the circumstances and on the history particular groups. I cannot go into how this works here.

Physical traits are almost always a compromise. The average height of people is about five-and-a-half feet because tall people have problems with the knees and hips while short people cannot run and chase well.

Any behavior also comes from a compromise, and depends on circumstances. People have to balance assertiveness and conciliation, gossip and truth, hunting and gathering, bravery and survival, etc. We have the propensity for various behaviors in any particular situation.

Learning hones our propensities and teaches us the right compromise for the right situation. Men and women learn to do different things in the same situation because what men do worked for men in the past and what women do worked for women in the past. Women learn to gather and men learn to hunt not primarily because those behaviors are hard-wired into genes but because men and women have learned that that division of labor works well. Children learn to do what men say but learn to seek comfort from women because that strategy works. Abstract morality is nice as an ideal; but people learn when they do well to insist on the rules against stealing or when they do better to close their eyes instead.

Unlike the idealized free market, the end result of human interaction among hunter-gatherers was not always for the obvious best. People sometimes bullied each other. Some families dominated other families. A strong family or coalition of families might capture the group and make other families do things for them. People were mean. People stole. Aboriginal human life was probably fairer than in most stratified agricultural societies but it might not have been as fair and as congenial as a comfortable American suburb.

Now that we have this much background, it makes sense to say that all human propensities can be understood by how they worked during our evolutionary past, including: love, sexual pleasure, language, imagination, drawing, music, making things, craftsmanship, marriage, religious belief, morality, friendship, cooperation, sharing, foresight, planning, sympathy, clothing, housing, earning a living, status, beauty, attraction, affairs, lying, stealing, coercion, violence, power, politics, jealousy, gossip, backbiting, etc.

Interlude: The Real Issue. Even this glimpse of evolved human nature is enough to show that people can be fooled in the capitalist world, that we are not fully rational and fully capable. Free individual action, the free market, does not always lead to the best practical outcome. There are problems. Human nature plays a role in the problems. Everybody knew this all along, even the most doctrinaire economists and Libertarians. This is not the central issue. It only points us to the central issue. Recall that the largest real issue is this: When we see a problem, and see that proposed solutions have their own problems, do we still have to act because of a moral sense? Do these moral situations likely involve the state? What role does human nature play in the original problem, proposed solutions, moral evaluation of the situation, and involving the state? Do we have to use the state to provide universal health care? Will giving universal health care lead to a greater use of resources and people, or do we have to provide universal health care regardless because it is the right thing to do? Should we provide health care only as long as it is cost effective, and no further, even though a lot of morally deserving people are left uncovered, and we still feel a moral obligation? We need to consider some implications of an evolutionary view of human nature, especially for morality.

Implications for Morality. See my other writing on the evolution of morality, and on morality and the state, mostly available on my website, usually for free.

The capacity for morality evolved, just like the capacity to tell stories, gather, and hunt. Because morality evolved, mostly it serves our evolutionary success. Fortunately, morality and practicality coincide most of the time, so we don’t usually have to contradict morality to do what is in our self-interests. Honesty really is the best policy most of the time. Usually when we are kind to people, they are kind to us.

Even though morality evolved, and serves our self-interest most of the time, it does have its own logic. We see that logic in ideas such as the Golden Rule (“do to other people what you want them to do for you”, and the maxim that moral rules should apply equally to everybody including self, kin, friends, allies, and possessions. We follow moral rules that are framed in accord with this logic, such as “do not lie”.

When we follow moral rules, sometimes we do act against our short-term self-interest, as when we tell the truth to our disadvantage even though we would not get caught. Sometimes we do see issues morally even against practicality. That situation does not arise often, but it arises often enough in the capitalist world, and with deep enough problems, to be a real issue.

Moral rules help to minimize negotiations so that people know what to expect and thus can get more done more efficiently. Moral rules promote reliability and cooperation so that a group can get the most benefit from situations without each person having to worry too much about the details of his-her own strategy or about cheating. Moral rules tend to move groups of people toward the more beneficial solution out of a range of solutions. Moral rules are often “pro-social”. Even though moral rules tend to be pro-social, they are still founded on self-interest and cannot deviate too much from self-interest. People tend to use morality for self-interest.

People use moral rules to control their own behavior and to control the behavior of other people. For example, we respond differently to moral rules according to how the rules affect our own success and the success of our family. We tend to follow rules that are good for us and for our families, and to break rules that are not in our self-interest. We get more upset when somebody steals from our brother than when somebody steals from Joe Dokes.

If we do get hurt when someone breaks a rule, we base our complaint not primarily on our loss but primarily on the abstract breach in morality. We do not complain that someone took OUR milk; we complain that someone STOLE some milk, and that milk just happened to be ours. We reinterpret strategic events in terms of morality. When we want to enforce a moral rule, we allude not to our gain or loss but to the abstract quality of morality. Usually we avoid questions of our own gain or loss, especially gain, when we argue about morality. When we want to overlook a moral rule, as when we “borrow” from the fridge, we use another moral rule as a counter, such as “follow communal spirit”, or we say that the moral rule that we want to overlook does not matter very much.

People break a particular rule according to their own need as long as breaking a lot of rules does not threaten to “take down the system” in a way that will hurt them more than they gain by breaking a particular rule. Rich people embezzle as long as they do not get caught so often that it gives the poor a license to steal.

People push for vigorous enforcement of the rules that most benefit them while they overlook the rules that do not benefit them. The poor cry out for justice and generosity. The middle class makes sure that everybody is monogamous.

When faced with a dilemma in capitalism, such as health care, all these implications mean that it is harder to decide practicality versus morality. We are not sure if people push solutions, or resist solutions, because they really believe it is the right thing to do or because their own best interests are at stake. There is no general formula to help us decide.

Other Implications.

Tendency to Trust; Vigilance Against Cheating. More than most other animals, people tend to give other people the benefit of the doubt. People want to trust other people. People want to cooperate, to share, and to exchange. People want to start out on a good foot and to keep walking on good feet if they can. People are willing to take a chance on other people, and even on being cheated, especially if the stakes are not too high, and if the people expect to encounter each other often. People forgive more than we might think from watching only action movies. People smile at strangers. This tendency inclines us to help, and to see helping in moral terms, when helping might cost more than we realize.

On the other hand, cheating and laziness can ruin a trustful situation, so people are also looking out for betrayal and for bad character. If people feel that they have been cheated, or might be cheated, or they stand to lose a lot by being cheated, people will end a hopeful relation, replacing it with a more careful relation. People not only end bad relations, they also punish cheaters even beyond the harm that cheaters have done. Cheating is not just a strategically selfish and short-sighted act, cheating is also the morally bad act “betrayal”. People see cheating morally and they punish cheating with moral fervor. This tendency inclines us to resist helping even when helping really does some good. We want to end all welfare because of a few “welfare queens” even though we know that some people need welfare and deserve welfare. We find it very hard to evaluate if welfare does more good than harm.

Sacred Way of Life. People tend to see the way of life that promotes their own reproductive success as the most moral and most sacred. People tend to see the institutions that they have developed as part of their way of life, to promote their own reproductive success, as the most moral and most sacred: monogamy in some cases or polygamy in others; being a priest, a warrior, a merchant, or a politically correct crusader; nuclear families or extended families; using sacraments or having a direct personal relation with God; being a “good girl” or being a rebel; being strict or being lax; inspired or scientific. People see other ways and other institutions as immoral or anti-sacred. Especially they tend to see the ways and institutions of any potential competitors as immoral and anti-sacred, much as residents of a country tend to see immigrants, or as members of one economic class tend to see the members of other classes. The working class and the middle class tend to see their way of life as moral and sacred and to see the poor as immoral and anti-sacred. The poor tend to see their way of life as moral and sacred and to see the rich as immoral and anti-sacred.

Using the State. When people can, they use institutions to promote the way of life that most helps their reproductive success, and people use institutions to act against competitors. People called “kin” the people who were most likely to help them. People called “strangers” the people who were least likely to help and most likely to be in other competing groups. The state is a modern institution. In our times, people use the state to promote their way of life, to reward friends, hamper competitors, punish enemies, set up conditions of trust, monitor violations of trust, and punish cheaters.

Possessions. People have possessions (some animals have basic possessions such as burrows but not like people have possessions). Aboriginal people had less “stuff” than modern people do and were more inclined to share - but they did not live communally. People know “mine” and “yours”. They recognize that a captured rabbit or a gathered basket of berries is “mine” rather than “yours”. They pilfer when they can get away with it but they recognize that they are doing something against the idea of “mine” and “yours”. This innate propensity for property does not validate the bizarre absolute property rights claimed by some advocates of free enterprise but it does show that property is not just an invention of society as claimed by some Leftists.

Exchange. As Adam Smith pointed out, people trade far more than any other animal (other animals have rudimentary kinds of trade but nothing like what people do). People know that trade is often beneficial. People seem uniquely adapted to seek trade; to know when trade continues to be beneficial; and to know when to stop trading because trade is no longer beneficial. We can see most economic systems, including capitalism, as variations on trade. Some idea of property is necessary to trade.

Knowing Others. People can legitimately claim to understand the minds of their fellows, and people have a right to act according to how they understand others. People are similar to each other. People can use understanding of self to understand other people, use observation to understand other people, and use understanding of other people to understand self. People need to anticipate what other people will do and what we will do. We never fully dispel the mystery of other minds but even our limited knowledge validates most common sense about other people. This limited knowledge is enough so that we can understand self-interest, and so that we can debate moral questions such as “do not steal”. It is enough to get over circular subjectivity.

Sabotaging Others. People can succeed comparatively through their own efforts or people can succeed comparatively by sabotaging the efforts of their fellows. Too often, we use morality to hinder the efforts of our fellows, as when rich people insist on “do not steal”; or when a poor person gets 6 years in jail for stealing a loaf of bread while a rich person gets 6 months at a “penal country club” for destroying a pension fund.

Capturing. People try to capture situations, including the economy, in many ways including violence, persuasion, lying, cheating, coercion, and unfair competition. People form subgroups so that they can capture social situations; and people use subgroups to oppress their fellows. Our aboriginal condition had less scope for capture than we have now because there were fewer enduring goods such as real estate and fewer institutions such as formal government. Even so, we should not expect social life automatically to lead to Smithian outcomes where everybody does well and life is stable and happy. Even hunter-gatherers had subgroups that sometimes took control. We have to think about the conditions that hinder capture and that allow free action to lead to the best outcome. We have to think about the institutions that hinder capture and that allow free action to lead to the best outcome.

Array of Abilities. Humans have an unmatched array of abilities for sensitivity and cooperation. We have morality. We share, cooperate to carry out tasks too large to do alone, delegate authority, give without expecting an immediate return, save for the future, plan, and create rules for general good. Although these abilities are usually subordinated to the welfare of our families, these abilities are still there on their own, available for us to call on when we need, as long as we do not push too hard against the welfare of our families.

Derived Pleasures. Most of the things that served our self-interest in our evolutionary past felt reasonably good: eating, sleeping, sex, drinking, hunting, gathering, telling stories, drawing pictures, singing songs, good craftsmanship, the sight of our children playing, and probably some mild intoxication. Out of these original pleasures, we have crafted additional pleasures to suit our times: sports, TV shows, theater, concerts, parks, and democracy. Most crafted pleasures do no harm. Some crafted pleasures might do little harm if taken in moderation but can do harm if taken too far, such as addiction to watching TV or addiction to rich foods. Some pleasures are likely to do harm in themselves, such as addiction to alcohol, tobacco, and other drugs. We tend to suppress the activities that we personally do not like, especially if we can make the case that they do harm, such as recreational soft drug use. Nature has given us a tremendous gift in the range of pleasures that we enjoyed originally and in the range of derived pleasures that we have crafted. Probably we should be lenient in allowing our neighbors their pleasures.

Practicality. We cannot rely on altruism or on our “better nature” to defeat selfishness and so to give us the best. We cannot rely on the state to give us the best. We have to construct social institutions, including the economy, as much as possible, so that self-interested action by individuals leads to the best that we can get. When self-interested action does not lead to the best outcome, we have to use our common sense knowledge of human nature, our scientific understanding of human nature, and our technical knowledge of economics, to correct the situation as best we can. When we can see that interfering causes more harm than good, we have to leave well enough alone.

Some Basic Patterns. Because there is no general formula to decide the central issues, we have to get at them through various scenarios. Most of these scenarios are familiar. Still it is worth going through the exercise because we can see how considering evolved human nature helps us think.

Lying. In our evolutionary past, lying sometimes succeeded. So the ability to lie is part of our nature. Lying is clearly immoral. Lying certainly causes a lot of trouble. Everybody would be better off in the long run if everybody told the truth, yet people gain in the short run, so we all lie sometimes. Free action does not lead to the best result. Yet we do not go to a lot of trouble to suppress lying, not even on a personal level. Most of the time people do tell the truth. It would take a lot more trouble than it is worth to suppress lying. Even though lying causes a lot of harm, it is immoral, and it is a case where free action does not lead to the best possible outcome, we do not want to ask the state to suppress all lying. We ask the state to suppress only some kinds of lying, the kinds that cause the most harm, for example breach of contract and large scale fraud. All this is an appropriate adjustment to our evolved nature.

Stealing. Stealing succeeded in our evolutionary past, and so we all have the ability to steal. Much the same is true of stealing as with lying except that stealing is usually worse than lying because the consequences are unavoidable and usually larger. We don’t have to pay attention to a lie, and a lie about our choice of shirt hurts nobody, but we have to pay attention of somebody steals our car. We overlook some cases of lying, such as pilfering paper clips, but we punish most cases of stealing, and we ask the state to get involved in many cases of stealing. When we ask the state to get involved, we argue that free action cannot be fully trusted, stealing hurts in some cases, and stealing is immoral. All this too is an appropriate response to our evolved nature.

Assault. Physical violence also worked in our evolutionary past, and so at least some of us have the ability to learn to do it. We can tolerate physical violence less than stealing. We tolerate only a little bit of violence, mostly among children and adolescents. We rightly involve the state, and we rightly use all three arguments against violence: free action is not enough, violence hurts, and it is immoral. State involvement might lead to some additional problems such as jail time for a bar fight, but, on the whole, it is better than letting everybody slug it out at will.

Child Abuse, Including Child Sexual Assault. For reasons that I can’t go into in detail, child abuse also worked sometimes in our past. Partly child abuse results from other tendencies, such as toward violence, and partly it succeeded directly, as with killing stepchildren and having sex with girls. It is part of our nature. Free action does not suppress it enough. It causes much more harm than benefit. It is clearly immoral. We rightly involve the state. State action might lead to some problems and some loss of benefit, such as wrong prosecution and ruined reputations, but, on the whole, state action is better than letting children suffer.

Various Sexual Acts. Many Americans don’t know that, until recently, many sexual acts were illegal in the United States and people were prosecuted for them, such as oral sex and anal sex, any sex between two people of the same sex (gender), and any sex involving more than two people. In our evolutionary past, most sex probably was stereotyped genital sex between two people of opposite gender. But sex is fun in itself because in our evolutionary past it led to children, it is easily generalized outside the stereotype, and sexual activity outside the stereotype likely did reduce reproduction unless it became an obsession, like golf or computers.

Why the change in attitudes and in state involvement? The moral right to privacy contradicts state involvement in sexual acts. We now judge the moral right to privacy more important than any immorality that might arise through most consensual sexual acts. Besides, it is not clear that any sex act is immoral if it does no harm. Sex acts cause little practical harm, and various sex acts likely add to the sum of utility. So, in this case, because sex is fun, free action does lead to greatest benefit. Free action goes along with morality. State involvement would be expensive, do little good, detract from the total sum of utility, impose a lesser morality over a greater morality, and likely lead to considerable abuse. So argument to involve the state fails on all three grounds: free action, practicality, and morality.

Prohibition. People evolved to tolerate alcohol because we use to forage on fruit, and often some pieces of fallen fruit have fermented. A bit of alcohol is in our nature. The Prohibition of alcohol in the United States in the 1920s is the most famous case of misapplied zeal, nearly everybody knows the story, and so I won’t go into it much. Suppose that people in general really would be practically better off if we could get everyone to stop drinking, so Prohibition passes one test for needed action. Even so, Prohibition fails overall because of our evolved nature. As long as alcohol does not disappear from Earth, people will want it, even though they know we would all be better off if they did not want it. As long as some people want it, then other people, gangsters and corrupt politicians, will supply it. The demanders and suppliers will corrupt the state, and, in the end, cause more harm than good. We lose the practical benefit. The moral good that might have been achieved cannot be met, so we lose moral benefit too.

Besides, it is not clear that banning alcohol would in fact lead to a greater total benefit. Despite the fact that some people abuse alcohol, sometimes badly, overall, alcohol probably does more good than harm. So, free action alone is enough to lead to the best practical benefit. Drinking is not intrinsically immoral. It is immoral only if abused. So there is no need to involve the state.

Mild regulation works much better than strict control. While they might need more regulation than alcohol, the same is almost certainly true of “soft drugs” such as marijuana and of gambling.

It is immoral for the state to protect us against ourselves as long as the only people that we affect very much is ourselves. For the state to protect us against ourselves is to take away our status as people, as rational beings and moral agents. It is to take away the underlying rationale for the free market itself. Of course, many vices, including alcohol, harm people other than the personal abuser, often children and dependents. In those cases, we have to review the argument in light of the considerations here. Even then, we have usually found that heavy state involvement to stop use is not the best response. Rather, the state does better by helping the innocent victims.

Forced Development and Renovation. The United States has been forcefully renovating urban neighborhoods since the 1950s. I don’t know how much of this action is based on our evolved nature. To the extent that the action is based on the desire of merchants for gain, of politicians for power, and of middle class people to be surrounded by other people like themselves, then it probably does a solid evolutionary basis. For those people, natural urban development clearly has failed, the result is harmful, and immoral too. So they ask the state for help. But it is not clear that they are correct. To residents of poor neighborhoods, sometimes the neighborhood was good enough and not immoral. Either way, state involvement often did cause more harm than good, and did not always promote morality. People were displaced who could not find a similar decent place to live. Often the renovations were not sustainable because they did not result from free underlying action. Business did not improve as it should have. The net result was bad.

Unforced “Gentrification”. “Gentrification” occurs when many people with good incomes go to live in run-down areas of cities. They create a new neighborhood. Usually they do this on their own, with help from aggressive real estate developers. Sometimes the state provides support through increased police protection. I do not push the evolutionary basis for this action other than that people like to live near other similar people and like to live well. I do not argue whether the net result is practically good or bad, or morally good or bad. The point is that gentrification is done without much state involvement. If it does cure a practical problem and/or lead to increased moral good, then it is a case of free action working out. If it does not lead to overall benefit, because it displaces residents of poor neighborhoods in favor of people who could afford to live elsewhere, then the situation is sad, but it still does not call for state involvement. The state could do little in this case to protect the previous poor residents without making everything worse for all involved. Sometimes the world changes on its own.

Modern Library. Pretend people still read paper books. People also read books on electronic reading devices (Kindle and Nook), people like to play computer games, and some video games are educational. It has become clear to everyone in a certain city that children are not reading enough, and that children are not getting enough education by going through the usual school system, especially poor children. Private schools don’t bridge the gap. So the state builds a library system. From the libraries, anybody can borrow books or games. Many people do. Free action has not delivered the most benefit, has not solved a problem, and might have made things worse. There is a practical call. There is a moral call. The state steps with appropriate action. That seems to do the trick.

Then things begin to go bad. Children check out far more games than books, and far more games without educational content than with educational content. People abuse the paper books so that the paper books wear out quickly and have to be replaced. Paper books are expensive now. People make illegal copies of the e-books and the games. People check out the books, e-books, games, and then sell them for a cheaper-than-market price. People abuse the disks and jump drives on which the electronic material comes. Disks come back scratched and jump drives come back unreadable. The library has to replace materials much more often than planned. People who used to buy their own books and games, and can afford it, now no longer buy their own but get their material from the library, and even these people abuse the material. Use is heavier than planned. People stop donating to the library; the state had counted on donations, and the community had promised. The whole project becomes much bigger and more expensive than anticipated, and much less effective. The practical goal is not being met. The moral goal is not being met. People abuse the system even though they know they do more harm than good overall. In abusing the system, people act as strategic rationalists seeking their own-self interest. The project fails.

The project does not fail because the state carried it out. In fact, the state should have gotten involved, the state did the right thing, and it did a good job. The project fails because of human nature.

If the state made any mistakes, it was to not anticipate human nature correctly. Maybe it made a mistake in not having run the original educational system so that children really did get what they needed, and so a big-target library system was needed.

Debt Slavery. I grew up with working class people who bought everything on credit and were in chronic debt. That was a bad way to arrange family finances. I admired the middle class who saved up before they bought anything, did without until they had cash, always paid cash, and never were in debt except for houses. I was appalled when Americans went the other way after the rise of Reaganism and the rise of credit cards, and sank into debt slavery. It got worse under the second Bush administration and the housing crisis. Don’t fool yourself; modern debt slavery is real slavery just as bad as most other slavery in human history. Although the state made this situation worse, the state is not the only actor to blame and not the worst actor. At the heart of the issue is human greed. People want stuff. They want stuff in itself and they want more stuff than their neighbors. They want it now. They are not good at judging what debt means, and they are susceptible to bad debt bargains. All this behavior has roots in our evolved history. Free strategic action does not lead to the best outcome. This is like the library. The problem is both moral and practical. Even though the state helped cause the problem in the past, it seems we should ask the state to help stop the problem now, and we have to make sure the state does not again promote the problem in the future.

The problem itself, and asking for any help from the state, puts us in a bind. Debt slavery takes away our status as free human beings. Free human beings willingly negate their freedom by getting into debt slavery. They choose to be slaves; they choose to lose the ability to choose. To compound the situation, if anybody intervenes to save them from self-imposed negation, then that actor (the state) says to them, “You are not free enough to make yourself free. By setting you free, I say you are not good enough to be free. To set you free this way is to confirm your status as not free”. Either way, people lose freedom. It is very hard to save people from themselves. There is a moral issue here but it is hard to pin down and harder to know what to do. The debt crisis incurs a moral obligation to help, a moral obligation that is only made worse by adequate help.

This might be a case where practical considerations trump moral considerations, and we have to invite the state to manage the rules of debt because we can’t manage it for ourselves. For the practical good of the economy, and everybody in it, including the people who are not debt slaves, likely the state has to write debt laws so that foolish people cannot get into debt slavery. People won’t like it, credit companies won’t like, and I don’t like it, but it might have to be.

Lessons. Economists, and people who care about these issues, need to see human nature naturally, even if they do not become students of evolution. We need to appreciate that people are strategically self-interested but also that we are not perfectly adept. We need to see how much people have in common so we can appreciate individual differences and freedom. We need to know the particular weaknesses of humans under capitalism so we can lessen the bad effects in the best ways possible.

Sometimes free action (the free market) leads to the greatest overall good, and sometimes not. We have to assume that people act in their self-interest even if that does not lead to the overall best outcome, even if it hurts the overall outcome, and even if people know that. We can see such situations if we think about them for a while with level heads and if we call on past lessons. Some issues really have moral considerations. Not every problem is a moral issue. Don’t make problems moral issues just to get your own way. When morality is involved, we have to balance practicality with morality, whether we like doing that or not. We should avoid using the state if we can help it. Sometimes we have to use the state. The state can do a good job. How well a state project succeeds depends on the project, planners, and doers. If we find a project is not working, then stop the project and start over. Sometimes we have to put up with the original bad situation because proposed solutions are unworkable or eventually worse.

Free market zealots have to accept that sometimes free action does not work. They have to separate cases where the free market does not work from cases in which alternatives are worse than the free market. They have to stop saying the free market always works as a way to block projects they don’t like. They have to admit that most projects to promote business are simply state-interference mercantilism, and are contrary to the ideals of the free market. Free market opponents have to admit the free market works most of the time, and that proposals to correct problems with the market often are worse than the original problem. They have to admit that people are not angels, and real human nature often undermines proposals to correct problems. They have to stop denouncing the free market as a way to promote groups and projects that they like. Both groups have to sharpen their moral sense and have to practice balancing morality with practicality.

When people have a project that they personally want, they see it as with child abuse. They invoke practicality, morality, and the state, even if unwarranted. They say morality is on their side, and that morality cannot be compromised with practicality in this case. When people are told of the problem of another group, they see it as with lying: although there might be a small practical issue, cures are worse than the disease, there is no real moral issue, and we should not get the state involved. Even if there is a small moral issue, practicality outweighs morality in this case, and still we should not get the state involved. For example, people who argue for health care see it as urgently as child abuse. People who oppose it see it as something regrettable but not urgent, like lying. It is hard to untangle all the threads, put aside our own involvement, and come to a right decision. The same is true of welfare, Social Security, national defense, projects to promote business, tax breaks, and many other issues.

Please see the Suggestions at the back of the book.

04 Marginality Theory 1: Personal Action

Neoclassical economics accepted the basic Classical self-maintaining system that leads toward the greater good through free action. It used marginality theory to give a much better account of strategic action and of how the system actually works. Marginality theory is a formal version of the idea of diminishing returns. This chapter and the next explain the logical guts of neoclassical marginality theory. This chapter explains personal action. The next explains the strategies of business firms, and describes the system that arises out of the strategies of people and firms. These chapters can get detailed, but we need them, so please be patient.

To build the best foundation, the argument in these chapters does not depend on money. It relies on trade only. These chapters bring in money sparingly when money is not misleading.

To make the examples easier, mostly I use goods for which many units can be easily found, each unit is fairly small, and each unit is pretty much like any other unit, such as corn and tomatoes. I know most people do not live on farms now but it is hard to find simple suitable goods from the daily experience of city people. It is not hard to extend the ideas to other kinds of goods: small goods that are not exactly alike such as movies discs of various genres; large indivisible goods such as cars; unusual goods such as tickets to the Super Bowl; and expensive goods such as Rolex watches. But this kind of extension is too much for here. Just keep in mind that apparent exceptions really are not, and that they do not invalidate the argument.

04 Marginality Theory 1: Personal Action; Synopsis.

For the economy to work well, most of the time people have to rationally pursue self-interest, on the basis of available information. On what information do people base action? People act according to prices. People choose more or less of various things according to the comparative prices of the things: apples versus peaches versus smart phones versus cars. In choosing by price, people reinforce the price system; and that is how the economy becomes a dependable system that delivers a lot of benefit.

Classical economics could not explain the price system. For example, water is important but cheap while movies are a luxury but rather expensive. Explaining prices, the basis for strategic action, the price system, and the interlinked replicating economy, was the main task of marginality theory. The details are tedious but the central idea is not hard if you take it by steps. Instead of thinking about how much we benefit from the total amount of anything, think about how much we benefit from the last one of whatever we buy. Instead of thinking about how much we benefit from all the apples we ate this year, think about how much we benefit from the last pound of apples we eat regardless of all the pounds that went before. That last pound sets the price for all the pounds of apples that went before and for apples in general. Instead of thinking about how much we benefit from all the movies we saw this year, think about how much we benefit from the last movie we see this year. That last movie sets the price for all the movies we see this year and for movies in general. With this information, we can compare the price of movies with the price of apples to see if we would rather to see another movie or rather buy a large bag of apples to make a pie. When the movie makers and farmers know what the consumers are likely to do, they adjust their production accordingly. Production comes to match what consumers want, and so production prices-costs come to match what consumers want. Consumers see about the price they expected. The price system duplicates itself, everybody knows just about what to do, and the economy continues on.

Once we understand the price system, we can to think about the results of the economy and why they turn out that way. We can understand why we make HD-DVD instead of regular DVD; make so many cars and so many pickup trucks; why professional quarterbacks get paid more than doctors, and doctors more than mechanics; we have so many doctors and so many mechanics; so much of the total wealth goes to the electronics industry, the car industry, or to labor; more land goes to cattle ranching than nut growing; more energy goes to cars than to education; the economy grows or does not grow; and the economy grows this large and no larger. We can see why intervening is likely to do more harm than good, especially intervening to force growth.

Basic Questions. Textbooks often start by posing four standard question clusters, to which I add five more question clusters. These questions tell us what to look for. The next chapter provides the answers given by marginality theory to the first four questions.

(1) What gets made and in what quantities? Why do we make SUVs at all? Why do we grow organic food? Why do we grow so many tons of organic carrots and so many tons of non-organic carrots? Why do we make so many SUVs and so many mid-sized sedans? Why does the United States now provide a lot of services such as family counseling rather than make more material goods such as cars?

(2) How do we make anything? Do we use resources efficiently? Why do we have business firms make things for us? Why does it take all those technicians in a dentist’s office or a hospital? Why do we use so much diesel fuel, and so little labor, to grow a basket of corn?

(3) Who gets what we make? Why do CEOs and medical doctors make so much while retail clerks make so little? How is the wealth in the economy distributed? How do rich people get rich and stay rich? How do poor people get poor and stay poor?

(4) Why does the economy grow? How does it grow? How much can it grow? Does growth solve problems? How can we make it grow? Should we make it grow?

The answer in simple terms: The actions of individuals and business firms automatically lead to making particular goods in particular amounts, efficient use of resources, appropriate distribution of wealth according to productivity, and to all the natural growth that people want at the pace they want. This chapter and the next fill in the details. The chapters after that show how this simple answer is not fully correct.

The following question clusters are the ones that I add.

(5) Where does profit come from? How do the sources of profit influence what gets made and who gets the wealth?

(6) Why do socio-economic classes arise and persist? How does employment affect class, and vice versa? What are the relations between classes? Do all the poor really deserve to be poor? Why do we blame the poor for being poor? Why are so many poor people in jail? Why do the poor get longer jail sentences for the same crime? Why does the upper middle class seem overly sympathetic to the poor while the working class seems overly hostile? Why are people so intense about some issues such as abortion and drugs?

(7) Does the economy actually lead to the greatest welfare and to the greatest fairness?

(8) Is the economy stable and reliable? Does it self-regulate? Is it circular and closed? Does it reproduce itself? Where is it going in the future?

(9) What about things that cannot be fit into the system such as pollution and preserving the environment? How do we deal with these problems?

The first four question clusters imply that, under good conditions (near perfect competition), we could not change anything without making things worse. We could not move resources around without using resources less efficiently, and thus reducing total benefit. We could not force more production of any particular good, such as cars, without reducing other goods, such as refrigerators, and without also reducing the total wealth and total satisfaction available. We could not build fighter planes, build cheap housing for the poor, support farmers, or bail out the housing market, without necessarily moving resources away from other goods and thus changing total welfare. Even if we take away only a little bit from many other activities to support one activity, we still reduce the total welfare.

The first four question clusters also imply that we cannot make the economy bigger by moving resources, such as through tax breaks for the wealthy and business firms. Such measures might work for a while but they cannot work very long without causing worse problems than they solve.

We can only change the pattern of production, or increase total production, if we act in response to an obvious flaw and if we act without making the situation worse. This is true regardless of whether we see the problems among the poor or among business.

Growth does not solve all problems. It does not solve the problem of unemployment and under-employment. Growth makes a bigger pie but it does not change shares within the pie, including a zero share of unemployment. To solve employment problems, we have to move resources in a way that hurts the economy least and causes the least other problems.

Utility and Money. Although having more money usually allows a person to get more utility, money and utility are not the same. Alabama does not have a lottery while Georgia does. Sometimes when I drive to Georgia, I buy a lottery ticket. I can calculate the odds, and so I do not expect to get a decent return on my ticket in terms of money. But I do get a lot of fun. My action is silly financially but makes sense in terms of utility. “Money can’t buy me love”, but there is love in the world and we can seek it. The difference between utility versus money is why we have to be clear about what happens without money first before allowing money in. We have to think about how prices form a public system and about how prices get to be expressed in money. When we understand this, we can use money as a proxy for utility.

Mutual Benefit in Free Trade. Classical economics could not explain subjective consumer taste, consumer choice, or consumer demand, and could not explain the role of consumer choice in the economy, so it emphasized production and objective conditions. Neoclassical economics advanced by taking seriously subjective consumer taste, choice, and demand. We can see the need to understand consumer action through a long-standing problem: why do people trade items of equal market value?

Carl comes to the farmers’ market with large baskets of corn while Teresa comes with small baskets of tomatoes. 1 large basket of corn (2 pounds) and 1 small basket of tomatoes (1 pound) both fetch a loaf of bread in exchange, so that the two goods have equal value (price). Carl and Teresa decide to exchange 3 baskets. They both leave with exactly the same value in goods as they had before but they both feel as if they benefited. If the corn and the tomatoes have the same value, why do Carl and Teresa benefit? Why do they stop with 3 baskets instead of 4 or 5? Why does Carl not give 4 baskets of corn for 3 baskets of tomatoes or 5 baskets of tomatoes? People can sense the general answers to these questions but the challenge is to give precise answers.

Even though the pubic market values of corn and tomatoes are equal, for Carl and Teresa the personal values of corn and tomatoes are not equal because Carl has one without the other while Teresa has the other without the one. We have to see how personal situations govern trade, and then how trade becomes a system with public prices (values) the same for everyone.

Before going on to that, we have to make a point about mutual benefit in trade. Choice depends on having a free market. One way of expressing freedom of the market and the role of choice is to say people engage in trade only to the extent that they wish, and people only continue to trade to the extent that they benefit, that is, to the extent that they gain utility. Carl only trades to the extent that he gains utility. Teresa only trades to the extent that she gains utility. When either stops gaining utility, he-she is free to stop trading. If he-she continues to trade beyond the point where he-she benefits, then he-she is harmed. In a free market, people never harm themselves. People are free to trade up to the point of maximum utility, and then stop; and that is just what they do. Free trade always results in gain, and always results in the most gain. In later chapters, we use this idea of free trade to understand investing, education, and wages. We can also see how free trade leads to conditions that undermine free trade, to flaws and problems.

The logic of mutual benefit in free trade is a powerful argument for free trade both within nations and between nations, and is a powerful argument for capitalism. We need to understand the argument well enough to see both its power and its limitations.

Marginality and Subjectivism. The term “margin” refers to the latest in a series, such as the latest five minutes of the 35 minutes that have gone by so far since I woke up, the sixth cookie out of the six that I have eaten so far, the latest half hour sitcom so far out of an evening wasted in front of the tube, the latest book read, or the latest chore done at work. The “latest” is not necessarily “the final” because I might read another book, eat another cookie, or watch more TV. It can help to think of the latest as “the last” in the usual sense of that term as “the most recent and thus the latest of a series”, as in “the last camp ground we were at”. The “latest” means “this one right now”.

Marginality theory pays attention to how people use the latest in a series so as to get the most out of the whole series. People use the latest in a series so they can compare different series and can get the most out of several different series, such as reading books, watching TV, and playing cards. Marginality theory uses the common idea behind “diminishing returns”, “don’t throw good money after bad” and “pay attention to what is going on now”.

We have to see how marginality guides the choices of one person before we see how it guides interaction.

We start with the idea of “diminishing returns”. Over the Fourth of July weekend, there was a marathon of the classic original Star Trek series. As I watched more episodes, each additional (marginal) episode gave me less satisfaction. As I ate more bowls of ice cream while watching, each additional (marginal) bowl gave less satisfaction. As a car buff puts more work into his-her car, the performance and appearance of the car improves less with each additional (marginal) hour of work. As a gardener puts more labor into his-her garden, the yield of tomatoes, berries, and zucchinis diminishes with each additional (marginal) hour of work. As a dentist puts more money into his-her practice, the profit from the practice diminishes per each additional (marginal) dollar invested. Diminishing returns on additional marginal units is true of almost everything.

Ralph is listening to the radio on a rainy Sunday afternoon. He has a choice of half-a-dozen stations. He starts with alternative rock, his favorite. As Ralph listens to one station long enough, he gets tired of that kind of music. That kind of music suffers from diminishing returns. The utility that he gets from one kind of music declines as he listens to that music longer. The utility from that kind of music “diminishes” as he “consumes” more of the music. Eventually Ralph switches from rock to jazz, and then the same thing happens with jazz. Ralph goes from station to station, sometimes returning to a station a couple of times before making it through the whole dial. This behavior is typical of what people do for all goods, and typical of what consumers in general do in the economy in general.

Ralph’s behavior listening to the radio is a small system. By the time Ralph has listened through the whole afternoon we see patterns. Ralph does not listen to all the stations for equal amounts of time. The total amount of time that Ralph spends on one station represents about the value of that station for Ralph. If Ralph listens to rock for three hours while he listens to jazz for two hours, then we can say rock is about one-and-a-half times as valuable to Ralph as jazz.

The last few minutes of listening to rock gives about the same utility as the last few minutes of listening to jazz, classical, country, or any other kind of music. Ralph listens to each kind of music so that the utility of the last few minutes of listening is the same for each kind of music. When Ralph quits listening to any particular kind of music, he has gotten about as much pleasure from it as he can and he is about as tired of that kind as he is with any other kind of music.

The last few minutes of listening are the “marginal” minutes. The utility from the marginal minutes is the “marginal” utility. Ralph listens to each kind of music so that the marginal utility from any kind of music about equals the marginal utility from any other kind. The last ten minutes of listening to rock about equals the last eight minutes of listening to jazz which about equals the last seven minutes of listening to country, and so on. When we have a system, it is typical that the marginal utility from any one good is about the same as the marginal utility from any other good in the system.

What is true of one person with several goods to choose from also is true of a system made up of many traders each with labor, corn, beans, or other goods to trade. The marginal utilities tell us that we have a system, how the system looks, and that we are in equilibrium or out of equilibrium.

Something I saw among peasants helps to get across the idea of marginal quantities. Peasants brought to morning market a few handfuls of peppers, a few fish, a few bamboo tubes of sticky-rice candy, or a few eggs, to trade (sell). They did not bring the whole of what their gardens, fields, or boats could make in a season, but only what they had available right now, the marginal quantities that arose each day. These little bits of what they could bring each day set the trading rates of fish for eggs, or eggs for peppers, or of stick rice candy for fish, for that day. It was not how big a woman’s fields were in total, how big a woman’s garden was, or how big a man’s boat was, but how much could be taken from them to the market that day. The value of fish was how many small fish would exchange for so many eggs, or how many small fish it took to get one tube of sticky rice candy. The value, or price, of any one good was the exchange rate of that good for any other good. The exchange rate of that good for any other good was set by the marginal amounts that were offered for exchange among a group of traders.

Quantity and Utility in Trade. Now we can return to Carl and Teresa trading corn and tomatoes so we can get a more precise understanding of how marginal utility sets exchange rate and thus sets price-value. Assume that Carl and Teresa already have made adjustments to take cost into account. We can leave cost in the background for a while.

We need some facts about quantities and utility. Suppose that Carl has 10 baskets of corn. Because all the baskets are pretty much alike, it does not exactly make sense to say that there is a “latest” (marginal) basket. So we can think of any basket as the “latest” (marginal) basket, whichever one Carl happens to grab at the time. We can see what happens as Carl adds baskets to his stock or takes baskets from his stock.

Because of declining marginal utility (diminishing returns), the more of a good that a person has, the less utility he-she gets from the marginal basket. The more corn that Carl has, the less utility he gets from the last basket of corn. He can more easily spare the last basket when he has 30 baskets than when he has 5. On the other hand, the less of a good a person has, the more utility the last marginal (last) basket has. If Carl had only 5 baskets of corn, the last basket would have more utility to him than if he had 30 baskets.

As a person gets more units of a good, the total utility of all the good increases but the marginal utility of the latest (marginal) unit goes down. Carl starts with 10 baskets. Carl gets another basket of corn, so that he now has 11 baskets of corn. The total utility from all the corn has gone up, but the extra (marginal) utility from the 11th basket is not as much as from the 10th basket. If Carl gets a 12th basket, the total utility goes up again, but not as much from the 12th basket as from the 11th basket; and so on. When Carl has 99 baskets of corn, he will have much more total utility than when he had only 10, but the utility of the 100th (marginal) basket of corn will be very small.

The same thing happens in reverse. As a person loses units of a good, he-she has less of that good, so the total utility from the good goes down. Yet each particular unit (the marginal unit) gets more important so that the utility of the latest (marginal) unit increases. Carl has 10 baskets of corn again. If he loses a basket so that now he has only 9 baskets, the total utility of the corn decreases but the utility of the 9th basket increases from the marginal utility that the 10th basket used to have. If Carl loses another basket so that now he has only 8 baskets, the total utility declines again, but each basket becomes more precious, so that the marginal utility of the 8th basket becomes even greater than was the marginal utility of the 9th basket; and so on. If ever Carl were down to his last basket of corn, he would have less total utility than when he had 10 baskets, but the marginal utility of the only basket would be great.

Even though the first basket of corn is physically exactly like the 100th basket of corn, they are not alike in their value to Carl. Keep this fact in mind during trading.

During trading, people trade out some of the goods that they have, so that their stock of goods-traded-out continually diminishes, and the marginal utility of their goods-traded-out continually increases. At the same time, people trade in some of the goods that they did not have before, so that their stock of goods-traded-in continually increases, and the marginal utility of their goods-traded-in continually decreases.

Classical economists intuitively understood the inverse odd relation between total utility and marginal utility, but they did not know how to fit it precisely into their analyses. They tended to think that exchange rates (prices and values) should depend on total utilities. Nearly all people think this way until an economist forces them to think otherwise. Non-economist social scientists, such as anthropologists, still make this mistake. Learning to separate total from marginal utility, and forcing yourself to think in terms of this odd inverse relation, was part of the advance of neoclassical economics.

Mutual Benefit in Trade Again. Assume that corn and tomatoes have no price yet, not even in terms of loaves of bread; Carl and Teresa will set the price through trade.

We do not know how much corn Carl brings to the market or how many tomatoes Teresa brings. They line their baskets up in a row behind them. As they trade, each person takes the last basket from the row to give to his-her trading partner, and receives the last basket from the row of his-her trading partner. The last basket in the row is the marginal basket of corn or of tomatoes. Carl brings large baskets of corn while Teresa brings small baskets of tomatoes.

Now Carl trades with Teresa. Carl gives 1 large basket of corn to Teresa, who gives 1 small basket of tomatoes to Carl in return. For Carl, corn is the good-traded-out while tomatoes are the good-traded-in. We can focus on Carl. The same is true of Teresa in mirror image.

At first, the small basket of tomatoes that Carl trades in has more utility than the large basket of corn that Carl trades out. The marginal basket (last basket in the row) of tomatoes traded in has more utility than the marginal basket (last basket in the row) of corn traded out. Carl gains in utility.

Because Carl gained from the exchange of the first basket, Carl and Teresa trade another basket. The marginal small basket of tomatoes-traded-in still has less more for Carl than the marginal large basket of corn-traded-out. Carl still gains in utility. They trade another basket because Carl and Teresa still benefit. They are now up to 3-for-3.

Both Carl and Teresa gained in total utility. The tomatoes that replaced corn for Carl have more total utility for Carl than the corn-traded-out, while the corn that replaced tomatoes for Teresa has more utility than the tomatoes-traded-out.

Stopping. Teresa wishes to trade at least 1 more basket because, for her, 1 more large basket-of-corn-in would have more utility than 1 more small basket-of-tomatoes-out. For Carl, this is not the case. The marginal (additional) large basket-of-corn-out would have more utility than another marginal small basket-of-tomatoes-in. Teresa suggests that she give 2 more small baskets of tomatoes for 1 more large basket of corn. Carl agrees. The 2 more small (marginal) baskets-of-tomatoes-in have more utility for Carl than the 1 more large (marginal) basket-of-corn-out. The 1 more (marginal) large basket-of-corn-in for Teresa has more utility than the 2 more (marginal) small baskets-of- tomatoes-out. At this point, they have traded 4 large baskets of corn for 5 small baskets of tomatoes.

Here they stop trading. Carl wants no more tomatoes because the marginal utility of “corn out” exceeds the marginal utility of “tomatoes in”. The marginal utility of tomatoes has diminished so that more tomatoes are no longer worth the lost corn to him. Teresa wants no more corn because the marginal utility of “tomatoes out” exceeds the marginal utility of “corn in”. The marginal utility of corn has diminished so that more corn is no longer worth it to her.

Both traders have benefited through trading, and they have benefited as much as they possibly could under the circumstances.

How do we know that Carl and Teresa have benefited and that they have benefited as much as they can? Because Carl and Teresa choose to trade in this way, and they are free not to trade if trade does not benefit them. Their behavior only makes sense if we assume that they benefit, and that they benefit as much as they can. This is reasoning in a circle, but it still makes sense enough given the explanations of the previous chapter.

By not paying attention to money, and by thinking in terms only of goods, we see how two people can exchange goods of equal value and yet benefit. The goods that a person does not have carry more utility than the goods a person does have, even though the market value is the same. In later sections we need to see how this process sets the market value.

Return to the recently modern world temporarily: George is in a music store, George wants to buy some compact discs, and George has some cash in his pocket. George buys 5 discs for $75 in total. The value of the compact discs just equals the value of the $75. Again we have a case where equal value exchanges for equal value. So we have to understand why George did that. We break down George’s action disc-by-disc and $15-by-$15 so that we can see marginal utility in the background guiding the choice. The marginal utility of the $15 that George spends on the first compact disc is less than the marginal utility of the compact disc. By buying the disc, George gains more utility than he loses. With each additional disc and each additional $15, the marginal utility of the disc decreases and the marginal utility of the $15 increases. For the fifth disc, the utility gained from the disc still is just barely more than the utility lost from the $15. For the sixth disc, the utility to be gained from the disc is less than the utility to be lost from the $15, so George does not buy the sixth disc. People actually behave this way in stores. You can see them pick up discs and put discs down until they have just as many discs as justifies spending the money on the last one.

Because ordinarily George buys five discs for $75 all at once, it is hard to see what is going on, why the five discs were more important to George than the $75 even though both had the same market value. It is easy to get misled by totals and to overlook decisions based on marginality. A subjective decision based on declining marginal utility lies behind the seeming all-at-once total decision. When we break it down disc-by-disc, and $15-by-$15, we more easily see what is going on. We see how marginal utility guides George’s subjective choice.

This is the breakthrough of marginal utility theory, the breakthrough that lets us see subjective choice behind actions. It might not seem like much but it was a revolution that allowed modern economists to logically close the Classical model.

Free Trade Again. The idea that people gain through free trade even when they trade goods of equal value is perhaps the most powerful argument for free trade. Classical economists used the argument even when they could not quite explain how it worked. When neoclassical economists could explain why it worked, the idea contributed powerfully to the ideology of free trade, as it does to this day. The argument might seem simple, and of course we can see problems with it in the real world, but the core remains true. It remains more powerful than any counter-arguments advanced against it. Free trade works. It works well. We should encourage it when possible.

Nearly all the actions in this book that go to building up an economy can be seen as a variation of trade, including seeking a job, hiring people, paying wages, and forming a large business firm.

So the argument for free trade in this case applies to nearly all aspects of an economy. The more actions are free, then the more that everybody benefits – as long as we all respect some basic rules of fairness and decency, take account of flaws and problems, and intervene only minimally and properly.

Avoiding a Mistake: Simplistic Free Market. Now we know how people gain by exchange, and know that people always gain from exchange as long as they are free to start and stop when they wish. Strong proponents of the free market use these outcomes to argue that people always and only do what is best for themselves. A free market always works perfectly. There can be no flaws and problems. Thus we should make the market as free as possible and never interfere. They make one of the mistakes of subjective circularity. They act as shills for business. They excuse whatever is now as the best that can be, and in particular they excuse whatever business firms do as good for everybody in general.

We saw in Chapter Three that people do make mistakes, even when they are free, such as when they are duped by advertising. Common sense tells us the economy has flaws and problems. Denying these facts by using the argument from free trade only undermines the strength of the argument for free trade. The real question is: When we see flaws and problems, can we make things better by interfering? In most cases, even where the market has flaws and problems, we cannot make things better by interfering.

We can use the idea that free trade is often beneficial to understand when it is not beneficial, why we usually should leave well enough alone, and where we should interfere. We should not use the benefits of free exchange as an excuse.

General Exchange Rate, Value, Price, and Cost. This section makes the most important point from marginality theory because it shows how marginal utility determines value and price. From now on, we can accept that Carl and Teresa trade regularly at the rate of 4 large baskets of corn for 5 small baskets of tomatoes. At this rate, neither can gain any more without losing more than he-she gains. Neither Carl nor Teresa can force the other further or entice the other further.

Now we have an exchange rate. The exchange rate sets values. Now we know the values of corn and tomatoes: the value of 4 large baskets of corn is 5 small baskets of tomatoes while the value of 5 small baskets of tomatoes is 4 large baskets of corn. You should practice thinking of value as an exchange rate.

This exchange rate is based on the marginal utilities of corn and tomatoes to Carl and Teresa, not on the total utilities of corn and tomatoes to Carl and Teresa. We did not even know how many total baskets Carl had, or how many total baskets Teresa had, so we cannot even guess about the total utility of corn and tomatoes to either. We can only see the results from marginal utilities, but that is enough for exchange rates and for all properties of a free trade economy. It will guide us to understand the flaws and problems as well.

This section describes the key point. It is a bit counter-intuitive. It probably prevented Classical economists from seeing how utility set an exchange rate. It is the basic statement of value-price in neoclassical economics. I cannot offer strong logical argument in favor of it here. I describe it, and hope that is enough. Assume that most people have about the same tastes as Carl and Teresa. Carl has more than 4 baskets of corn and Teresa has more than 5 baskets of tomatoes. The remaining baskets of corn do not have exactly the same marginal utility for Carl as the ones he already traded, and the same is true for Teresa for tomatoes. Carl trades with people other than Teresa, and Teresa trades with people other than Carl. Even so, once the rate of exchange for corn and tomatoes has been set by the marginal utilities, then Carl trades all corn at that rate and Teresa trades all tomatoes at that rate. Even though the remaining baskets of corn might have a higher marginal utility for Carl, still he trades with other people at the rate of 4 baskets of corn for 5 baskets of tomatoes. The same is true of Teresa. The value of all sets of 4 baskets of corn is set by the marginal utility of that last (marginal) lump of 4 baskets, and the value of all sets of 5 baskets of tomatoes is set by that last (marginal) lump of 5 baskets. Now all sets of 4 baskets of corn have a value of 5 baskets of tomatoes, and all sets of 5 baskets of tomatoes have a value of 4 baskets of corn. I restate this result in several ways through the rest of the chapter.

So we can see how a trading rate can set and stay among a group of people, again assume that most people have about the same tastes as Carl and Teresa. We can use Carl and Teresa to represent general demand for corn and tomatoes. We can assume that people in general trade in the ratio of 5 baskets of tomatoes to 4 baskets of corn.

If people in general trade at the rate of 4 baskets of corn to 5 baskets of tomatoes, that rate will remain the same for the group even though a few people do not enjoy corn and tomatoes in those ratios, even though those ratios do not represent equal marginal utilities for some people in the group. Suppose some non-average people like corn much more than tomatoes, and are willing to trade more than 5 small baskets of tomatoes for 4 large baskets of corn. They might temporarily affect conditions, but soon their particular small reserves are gone, and then the general taste prevails again. On the other side, suppose some non-average people like tomatoes more than corn, and are willing to trade more than 4 large baskets of corn for 5 small baskets of tomatoes. Soon their small reserves are gone too, and the general taste prevails again. In fact, the people who like corn more than tomatoes cancel out the people who like tomatoes more than corn, and vice versa, so that the general rate prevails precisely because some people deviate from the general rate on both ends. That is what it means to have a general rate. The fact that people have various tastes actually makes the general rate more stable, but it is too much to show this result strongly here.

Eventually, a kind of “average marginal utility” emerges for corn and tomatoes among the traders at the market in general. The average marginal utility, among all traders, of 4 large baskets of corn, is about the same as the average marginal utility, among all traders. of 5 small baskets of tomatoes. The average marginal utilities of goods determine the exchange rates for goods. The term “average marginal utility” is not used in neoclassical economics textbooks but it is useful here as a shorthand. It will not lead you astray.

After people have sorted it all out and have come to trade on the basis of average marginal utility, all traders know they have to give 4 large baskets of corn to get 5 small baskets of tomatoes or have to give 5 small baskets of tomatoes to get 4 large baskets of corn. When they know, they adjust their own personal trading strategies to that rate, so they still manage to gain the most utility for themselves given that is the prevailing rate. Some people trade more than the average while others trade less. The people that trade more cancel out the people that trade less, and vice versa.

In adjusting their own personal strategies to the going rate, traders again reinforce that rate as the standard prevailing public price of corn and tomatoes in the market for everybody. They establish a public price. The public price becomes something to which people adjust. In adjusting to the public price, people reinforce the public price. Now we have a real price system, at least for corn and tomatoes.

Avoiding a Mistake: Total, Average, and Marginal. Total quantities and average quantities do not set exchange rates, value, prices or costs. Marginal quantities set them. We do not know how much corn or tomatoes that Carl and Teresa had. We could not know the average utility or corn or tomatoes for Carl or Teresa. We do not know the average utility of 4 baskets of corn, or of 5 baskets of tomatoes, for Carl or Teresa. All we know is that the marginal utility of 5 small baskets of tomatoes equals the marginal utility of 4 baskets of corn. That is all we need to know.

People naturally tend to think more in terms of totals and averages than of marginal quantities. It is hard to think in terms of marginal quantities even when we use them all the time. Classical economists thought skillfully in terms of total quantities and average quantities but could not make the formal jump to marginal quantities. I do not know why this is true of people in general or of Classical economists in particular. Mathematicians can relate total, average, and marginal. It is possible to rephrase marginal arguments in terms of total or average quantities. But that is not what is really happening at the basic level, and so it is a good idea to avoid it here.

People also get confused about total and average in a way that is actually likely when thinking in terms of margins. We see that 5 baskets of corn exchange for 4 baskets of tomatoes, and we think: 4 in total exchange for 5 in total; or 4 on average exchange for 5 on average; or there is an average in 4 (say “2”) and an average in 5 (say “2.5”) that exchange directly. All this is natural too but still wrong.

Total quantities do affect strategies at the margin. If Carl routinely came to the market with only two baskets of corn, his strategy would differ than if he routinely came with 10. If Carl routinely came with 100 baskets, his strategy would differ than if he routinely came with 10. The difference in the first case could be important but we can assume it does not come up much. The difference in the second case is not too important, and it takes a lot of groundwork to cover it thoroughly, especially ground work about cost, so we can ignore it for now. It will come up again when we think about the effects of interfering in a market.

Marginal analysis plays a big role only in Chapters Four and Five. Marginal quantities lead quickly to exchange rates, and from there to the normal prices, values, and costs with which we are comfortable. As long as we get the basics down in Chapters Four and Five, we can switch to more natural ways of thinking later.

Reinforcement. We need more examples of how marginal utility sets the price-value. Here I give some examples without going through the details. Practice seeing that it is not the average utility, or the total utility that sets the price-value, but the marginal utility.

Joe has many bicycles. He and Amy agree that Amy can use 1 bicycle for 1 day in exchange for 1 basket of peaches. 1 basket of peaches exchanges for 5 small baskets of tomatoes or for 3 pints of blueberries. So Joe lets anybody rent 1 bicycle for 1 day in exchange for 1 basket of peaches, 5 baskets of tomatoes, 4 baskets of corn, 3 pints of blueberries, or any equivalent. Joe does this for any 1 of his bicycles. Joe takes in exchange any appropriate equivalent amount of food, from anybody, no matter how much that other person has. Other people who own many bicycles learn to do the same. There is now a “going price” for bike rental.

George has a large collection of high density DVDs. He decides to rent them out each for 5 days at a time. He does the same thing as Joe did for bicycles, at the same rates. 1 DVD for 5 days exchanges for 1 basket of peaches, and so on. In addition, now we know that 1 DVD for 5 days exchanges for 1 bicycle for 1 day.

Larry needs help on his small farm. He asks 5 people to work on his farm for 1 day. If Larry had hired the people 1 at a time, he knows this: The first person would have been the greatest benefit (gained for Larry the greatest marginal utility); the second person would have increased the total benefit to Larry, but not as much as the first (declining marginal utility); the third person would have increased the total benefit to Larry, but not as much as the second; and so on. Larry knows that the fifth person gives him about the same benefit as does1 large basket of rice. Larry agrees to give the fifth person 1 large basket of rice in exchange for 1 day’s labor. He also agrees to give each person the same amount. Since it is hard to tell among the 5 which person is the first worker and which is the last, this seems reasonable. Most of the time, Larry needs 5 workers, not 4 and not 6. From now on, all daily workers get 1 large basket of rice in trade for 1 days’ labor, not just at Larry’s farm but at all farms.

Crimes and Grimes, the average law firm in the average city, usually employs 10 young lawyers. The last (marginal) of the 10 young lawyers, whichever lawyer that might be, brings to the firm the equivalent of 10 wagons of produce every month in business. So, all young lawyers, at this firm and at all other comparable firms, get paid 10 wagons of produce every month. If a particular young lawyer can demonstrate that he-she brings in more than the marginal lawyer, the Crimes and Grimes might consider raising his-her particular salary.

(C1) Cost. A good not only has a utility but a cost. Cost affects utility and therefore value-price, especially production cost. The next few short sections address cost. They are labeled with a “C” before the section name.

Listening to the radio has little cost for Ralph. Cost affects value because cost detracts from utility. In real life, most utilities have greater costs than passive listening. Sometimes the costs are material, sometimes trouble, sometimes non-material such as risk, and sometimes non-material as foregone opportunities (lost time) that we could have spent doing something else.

In “The Fellowship of the Rings”, Merry and Pippin like to steal mushrooms from a farmer’s field but do not steal as much as they might steal because the farmer sets his dogs to guard the fields. The dogs are a cost that detracts from the intrinsic utility of the mushrooms. The final utility that Merry and Pippin actually get equals the raw utility that they would have gotten without the dogs minus the fear the dogs put into them. Merry and Pippin steal as many mushrooms as they can, but when the raw-utility-minus-the-fear-cost declines far enough, they stop.

Mark sets off to steal fruit from various neighbors. (1) The apple trees are not guarded at all, (2) the pear trees are guarded by dogs that are slow and not very ferocious, (3) the peach trees are guarded by dogs that are fast but not ferocious, and (4) the cherry trees are guarded by dogs that are both fast and ferocious. Without the dogs, Mark would get 2 pounds of apples, 3 pounds of pears, 6 pounds of peaches, and 8 pounds of cherries. With the dogs, Mark gets 6 pounds of apples, 4 pounds of pears, 2 pounds of peaches, and 1 pound of cherries. Cost matters. In real life there are many kinds of costs and they all have different effects.

When cost changes, we adjust what we choose. One day the dogs guarding the peach trees are off visiting the owner’s grandchildren, and so Mark takes 5 pounds of peaches instead of 2, and he takes fewer pears and apples. We do the same thing when peaches go on sale at the supermarket.

(C2) Scarcity, Cost, and Prices. The idea of cost includes the idea that nearly all the goods that people want are scarce, are not in unlimited supply.

Some goods, such as air, are almost in unlimited supply, and are called “free goods” – although this too is likely to change with global warming and increased pollution. Already good quality air is not a free good in large cities where people pay for the cost of clean air by buying filters.

Nearly all other goods have a cost because they are scarce. We have to search for the right pair of shoes and we have to trade something for them (buy them) once we find them. Resources are a type of good too, so that resources have their costs. The cost of resources and goods affects in how we use them and in how we choose between them.

One definition of economics is “the study of how people strategically pursue scarce goods through limited means (resources)”. This definition is not the only one but it does show the importance of choice, the need to allocate, and the role of cost.

We will see that value, cost, and price are all aspects of the same thing: trade ratios. Because all goods and resources are scarce, they are all tied together into one system for everybody at the same time, the system of pubic prices. All goods and resources have a price. The price is the same thing as the cost to somebody that wishes to use the good or resource. The prices of goods and resources are signals that tell people about the relative importance of goods and resources, and that help people to decide how much of any good or resource they want and in what order they want them. The system of pubic prices that arises from the scarcity of goods and resources is the backbone of an economy. We can see many things about how the economy works by looking at how the system of public prices arises and how it operates.

(C3) Public Prices; Private Utility. The free trading of many goods gives rise to a public price system and to related features that deserve special mention. Here are two. First, once a system of prices is set up, the price of any good is the same to a person no matter who that person is and no matter how much he-she buys (I do not look at apparent exceptions such as “volume discount” here because they are not really exceptions but take too long to explain). Whether a person is Bill Gates or a single mother, the price of a loaf of bread is the same. If Bill Gates buys six loaves and the mother buys six loaves, the price is the same for the six loaves for both of them. Prices are public, not private.

Second, money (value, price, or cost) is not the same as utility, so the utility of a loaf of bread to a rich person is not the same as the utility of a loaf of bread to a poor person – yet both pay the same public price for the loaf of bread, for the same good. Prices come out of the search for utility, constrained by costs, yet price diverges from utility in clear and systematic ways. We have to explain both how price arises from utility and cost and explain how it can consistently diverge from utility.

(C4) Objective Cost and Subjective Value. It helps to appreciate the role of choice if we are clear about how cost does not influence value. We tend to think that something is more valuable because we (or somebody) puts more labor into getting it or making it. It seems that a handmade table is more valuable than a factory made table because the handmade table took more labor, tools, and resources to make. In fact, the opposite is true: we will pay more for something because we like it more (get more utility from it); and so some persons or business firms are willing to put more labor and resources into goods that consumers will pay more for. Some people will pay more for a handmade table and so some other people are willing to put the labor into making the table. Nobody would pay a lot of money for handmade silly things of no use, such as string balls. I had a friend who liked precious stones, which to me were just pretty rocks. I could never see why people would pay as much as they did for an opal. He said I would see why if I could go down into an opal mine in Australia and appreciate what it took to get a good opal. I tried to explain that the opposite is true: miners are willing to go into the pit to get the opals because some people are wiling to pay a lot for the opals. An opal does not increase in value simply according to the amount of trouble it takes to find the opal. A work of art, such as a painting, is not more valuable in proportion to the labor that went into it but in proportion to how people see beauty (utility) in it regardless of how long it took to paint.

Subjective satisfaction (utility) is the basis for value. We adjust the labor and resources that go into a good according to what people are willing to give in exchange for the good. People are willing to give more when they get more subjective satisfaction. Cost modifies the effect of subjective satisfaction but it does not change the fundamental role of subjective satisfaction.

(C5) Adjusting Cost. Because we live in an advanced money economy where the price of goods is pretty much fixed (a pair of shoes costs what the sticker says it costs), we tend to think of cost as something that is just there and about which we can do little, as something objective. That is not true. We can do something about some costs even though cost is not completely malleable. Final cost is a mixture of what nature imposes on us and of what we can do about nature. How much we want to do about cost depends on how much we like the good, that is, it depends on the intrinsic utility the good has for us. The more we like a good, the more we are willing to work on cost to reduce cost so that we can have more of the good. The more nature allows us to do, the more gets done.

Wild trees did not bear fruit in the same abundance as cultivated trees bear now. Thousands of years ago, people worked on wild trees to make them bear more. People worked on types of trees according to the extent that they prefer that fruit and according to the extent that tree species can respond to selection. People like apples, and apples responded pretty well to selection, so apples are much bigger now than they were in the wild, and we have dozens of varieties of apples. It would be nice to do the same for cherries but nature allows only so much.

We also make adjustments in different ways. A farmer has 20 acres of land on which she plants fruit trees according to how the yield satisfies her family. She plants 8 acres in cherry trees, 6 acres in peach trees, and 3 acres each in pears and apples. If demand for fruit changed, then she would change allotments of land to respond to the demand. This is another aspect of economic self-regulation. If the cost of cultivation changed, that would also change the amount planted and the final result on the market. If cherry and peach trees could be made hardier against frost, and thus the cost reduced, we would have more peaches and cherries, and the cost of peaches and cherries would decline. Fruit growers would switch some land from apples and pears to peaches and cherries.

(C6) Investment. The effort and resources that went into developing fruit trees is investment. The allocation of so much land to cherries or to apples is investment. Switching from cherries to apples according to taste or to what a grower gets in return is investment. Investment requires that people guess about the future. Investors try to invest so that they get an equal return in utility, or money, from all of the alternatives.

(C7) Objective Costs. The “objectivity of costs” means that costs are fixed and cannot be changed according to investment. If the number of pine trees was absolutely fixed, and the yield would not respond to selection, spraying, or more labor, then pine trees would have an unvarying cost. This cost would be an objective fact to which furniture makers, hobbyists, house builders, and all other people that used pine would have to adjust. There are almost no costs like this in the long run, although in the short run it seems as if almost every cost is like this. To Classical economists, it seemed as if many costs were objective like this, especially labor costs. This is one of the biggest differences between Classical and neoclassical economics.

(C8) Overcompensation. Classical economists stressed supply and objectivity of cost because they did not have the ideas to understand the role of subjective value, demand, the role of investment, and the role of capitalists in changing costs. When neoclassical economists figured out how to describe subjective choice after the 1880s, they overstressed the role of the subject, that is, the role of demand. Since then, the balance has swung forth between production (supply) and demand, objectivity and subjectivity.

When Conservatives want to stress subjective choice and overlook the role of cost, they show how cost can be changed through research, development, investment, state interference, and chance. They point to the resilient flexibility of nature. They say we need not worry about deficits, oil depletion, pollution, or the environment because we can always adjust cost.

When Liberals want to stress the role of subjective choice and overlook the role of cost, they say, “We can do anything we want”. We can end all poverty and social inequality forever. We can give every child the finest education that only the rich can afford now. We can provide the means for all people to develop their full potential in multiple ways.

Conservatives overlook the limitations imposed by nature that determine costs while Liberals overlook that human nature is a part of objective nature. We can change costs to some extent and we can redirect human nature to some extent; but we can only go so far.

Value, Price, and Cost. Now we are done with a focus on cost, and return to the main thread. The fact that average marginal utilities set exchange rates lets us see different aspects of exchange in the same way: The value of 4 baskets of corn is 5 baskets of tomatoes. The price of 5 baskets of tomatoes is 4 baskets of corn. The cost of 4 baskets of corn is 5 baskets of tomatoes. The price of 4 baskets of corn is 5 baskets of tomatoes. Not only does exchange rate determine value, but it also sets price and cost, and it makes sure that “value”, “price”, and “cost” really are all aspects of the same thing. They all should be seen in terms of exchange ratios. We have to keep the basic role of exchange rate in mind in later chapters when we deal with money because money easily hides what is going on at the level of goods.

Resource Cost. The outcome of trade sets not only the value of the particular goods traded but also influences the value of the resources used to make the goods. The outcome of trade for final goods (corn) sets the value of the resources used to make the goods (land, labor, water, and fertilizer). The outcome of trade for final goods works with natural abundance to determine the value of the resources used to make the final goods.

The desire for handmade tables affects the cost of the tables – the cost of the materials to make the tables does not directly set the cost of the tables or the price of the tables. The scarcity and quality of resources does affect the value of final goods somewhat – if good hardwood was easier to find then hardwood tables would be less expensive. Foresters need resources to grow good hardwood; foresters need the right kind of land in the right kind of climate.

Land can represent the role of resources behind exchange. Suppose that land grows corn more abundantly than tomatoes. It takes less land to grow corn than tomatoes. There is more corn available than before. The marginal utility of corn goes down compared to the marginal utility of tomatoes. Corn growers have to trade away more corn before the marginal utility of their remaining corn rises to equal the marginal utility of the tomatoes they receive. The new trade rate might be 6 baskets of corn for 5 baskets of tomatoes.

Now assume that land grows tomatoes more abundantly than corn. Tomatoes are now more abundant and have a lesser marginal utility in trading. Tomato growers can give more tomatoes before the marginal utility of their tomatoes declines to the marginal utility of corn. The exchange rate might be 4 baskets of corn for 6 baskets of tomatoes.

Single Market Equilibrium. When average marginal utilities for corn and tomatoes have emerged, and the exchange rate for corn and tomatoes is stable, then the market for corn and tomatoes is in “equilibrium”, or in balance. In the early days of neoclassical theory, one of the pioneers, Leon Walras, used the image of an imaginary auction to portray market equilibrium. This is a variation on his image:

Suppose that all the corn growers are on one side of a large hall while all the tomato growers are on the other side. An auctioneer stands in the middle. The auctioneer calls out exchange ratios of corn and tomatoes. For each ratio, the auctioneer asks how many pounds of tomatoes the tomato growers are willing to supply and how many pounds of corn the corn growers are willing to supply. When the amount of corn supplied equals the amount of corn demanded, and the amount of tomatoes supplied equals the amount of tomatoes demanded, then the market is in balance. The market is Smithian.

For example, to begin, the auctioneer suggests 8 baskets of corn for 2 baskets of tomatoes. At this rate, the tomato growers all offer a lot of tomatoes but few corn growers offer any corn. The auctioneer suggests 3 baskets of corn for 6 baskets of tomatoes. At that rate, the corn growers offer a lot of corn but few tomato growers offer any tomatoes. Somewhere in the middle, the auctioneer finds a rate at which the total amount that all corn growers offer equals the total amount that all tomato growers wish, and the total amount that all tomato growers offer equals the total amount that all corn growers wish.

This rate should be 4 large baskets of corn for 5 small baskets of tomatoes, the same rate as determined by the balanced average marginal utilities. I do not explain here why they coincide, but they do coincide except in cases of flaws in a market.

Modern economists describe the auction in terms of the balance between one good with money: All the corn growers are one side of the room. All the people that want to get corn, the consumers, are on the other side of the room with their money. The money is in grains of silver. The auctioneer calls out 20 grains of silver for 1 basket of corn. At this rate, the corn growers offer vast amounts of corn but no consumer wants to give any money. The auctioneer calls out 1 grain of silver for 3 baskets of corn. At that rate, the corn growers are unwilling to give any corn but the consumers want as much as they can get. Somewhere in the middle the auctioneer will find a rate so that the amount of corn offered equals the amount of corn that consumers want. The price of 3 grains of silver is 4 large baskets of corn while the price of 4 large baskets of corn is 3 grains of silver.

In other words, the average marginal utility of 3 grains of silver just equals the average marginal utility of 4 large baskets of corn.

When a market is in balance this way, economists say the market “clears” or is in “single market equilibrium” or is in “partial equilibrium”. When all markets are in partial equilibrium together, the entire economy is in “general equilibrium”, and “everything affects everything else”.

There is no difference between trading-corn-for-tomatoes versus trading-corn-for-grains-of-silver as long as we think of grains of silver as a good too. The price-value-cost of 4 large baskets of corn is either 3 grains of silver or 5 small baskets of tomatoes. Modern people do not think of trading silver for corn in the same way as they think of exchanging tomatoes for corn. They think of using silver to pay the price-cost of corn. They think that the silver rate is a true price in a way that the tomato rate is not a price. That kind of thinking makes sense given our daily experience but it is not correct on the deep level that we need. Superficial daily experience can confuse people. When people think of the tomato price, they have to think about how cost affects the growing of tomatoes and the price, and they have to think about how the taste of tomatoes affects the price. When they think about the silver price, they can ignore the cost of silver or the demand for silver.

Equilibrium Price. There is only one particular price at which a market clears. This is called the “equilibrium price”. We can understand a lot about a market by knowing its equilibrium price. Economists search for this price as a key feature of the market. This idea of an equilibrium price is one of the basic ideas for the public price system.

When economists began to see links between markets and began to develop the idea of general equilibrium, they saw there would be one coherent set of linked prices, one price for each market, in which all markets would clear at once, and the entire economy would be in general equilibrium. This set of prices is the public price system. Real economies rarely find this set all at once, but they tend toward it. We can understand how real economies work, and their flaws, by how closely they approach a workable set of public prices.

Magic of the Big and Small. The biggest effect of a public price system I call the “magic of the big and small”. Any one person can always trade as much as he-she wishes. No matter how much or how little any one particular person trades, his-her trading does not change the public price of the good for everybody, and it does not change the amount of goods that are available to everybody. If a person wishes to trade a lot, he-she can always find trading partners to provide as much as he-she needs. If Carl could not find Teresa with whom to trade corn for tomatoes then he could have found Ursula or Vernon or Wanda because there are a lot of traders in a public price system. Carl could have traded for zero baskets of tomatoes, 3 baskets, or 3000 baskets without changing the price of corn or tomatoes and without causing a shortage for other people that want to get corn or tomatoes. People can always trade until they are satisfied, and they need trade only until they are satisfied.

Action on the little level of the individual person and the particular business firm gives rise to results on the big level of the whole system of public prices. Then people and firms (the little level) respond to the results they created (the big level) to reproduce their strategies (the little level) and to reproduce the results on the big level. The little level and the big level make a circle of mutual creation. To understand the circle properly, we have to look at the little level first. All the people and firms in the little level as a whole build the big level but no one person or business firm can alter the big level all by itself. It appears as if the big level determines the little level, especially in the short run. But really the little level determines the big level. We have to see the basic role of the little level to understand either level. Usually we can see it more clearly over the long run. We will be able to understand the flaws and problems of capitalism as violations of these relations and results.

The magic of the big and small is not really magic. It comes from logical relations that are too hard to go into here but that are not magic. I call it magic because to say that is convenient. If it bothers you not to have an explanation here, please see the bibliography.

Transitivity. If 4 large baskets of corn exchange for 3 grains of silver, and 5 small baskets of tomatoes trade for 4 large baskets of corn, then 5 small baskets of tomatoes should trade for 3 grains of silver too. The transfer of trade ratio from one good to another is “transitivity”. Transitivity binds together the economy as a whole and leads to a general balance (general equilibrium) of all markets rather than just particular markets.

Transitivity helps hold together value, price, and cost. To a lover of barbecued corn on the cob, the value of the corn is 3 grains of silver or the price of the corn is 3 grains of silver. To a baker of corn bread, the cost of the corn in the corn bread is 3 grains of silver. What is value or price from one view is price or cost from another view. The value given to the corn bread from the corn is the same as 3 grains of silver.

Transitivity pertains both when a good is consumed directly (barbecued corn on the cob) and when a good is used as a resource (corn) to make another good (corn bread). This is important in business strategies, how we understand value, and how we understand economic growth.

Try to see transitivity and its results without using money as a crutch. It might be easier to think in terms of pounds. 4 large baskets of corn weigh 20 pounds (5 pounds per basket) while 5 small baskets of tomatoes weigh 10 pounds. 1 pound of peanuts exchanges for 2 pounds of tomatoes. 5 pounds of peanuts exchange for 10 pounds of tomatoes (5 small baskets). In that case, 5 pounds of peanuts should exchange for 20 pounds of corn or 4 large baskets of corn. From the other way around: 5 pounds of peanuts exchange for 20 pounds of corn (4 large baskets), so 5 pounds of peanuts exchange for 10 pounds of tomatoes (5 small baskets).

Public Price Remakes Itself: Big and Small Again. Each pair of goods has its own exchange rate and public price, corn and peas, tomatoes and peas, or wine and olive oil. Because of transitivity, all the prices (exchange rates) for all goods are tied to the prices for all other goods. Together, all exchange rates for all goods, is the system of public prices. People make the system of public prices through strategies, and then people adjust their strategies to conform to the system of public prices. In adjusting their strategies to conform to the system of public prices, people remake the system.

Fairness 1. Everybody benefits from the public price system yet the pubic price system is not all we want in fairness.

Suppose David has only a small patch of land while Emily has a large patch of land. David and Emily are both better off through trading what they can grow on their land to exchange for other goods but that does not make them equal or make them equally better off. Emily is always richer than David. Free trade makes people better off but it is not a “great equalizer”. David might benefit more in proportion from trade than Emily but we cannot prove that, and it would not make their plots of land (their basic wealth) more equal anyway. Whether one person benefits more than the other person does not take away from the fact that both David and Emily benefit. We could not do much to make the situation better even if we could figure out that one benefited more. As long as both benefit and neither is hurt, there is no point in interfering.

Whether any difference in wealth is compatible with fairness depends on how big the difference is to begin with, if it gets bigger along the way, and if the difference is ever so big that it endangers the life chances of David and his family. If Emily is twice as wealthy as David, we probably don’t care. If she is 1000 times as wealthy, and gets wealthier everyday by somehow absorbing all the little David’s around her, we should be worried.

Peanut Money. With transitivity, anybody can use any good to get any other good. To see how, it helps to use temporary money. Peanuts keep better than corn or tomatoes. People acquire peanuts not just to eat but also to use to get other goods. One day Carl brings his corn to the market looking for tomatoes but Teresa does not come. So, instead, Carl trades his corn for peanuts, which he does not eat but keeps. The next week, Carl has no corn but he brings the peanuts to market. Teresa is there, and is willing to trade her tomatoes for Carl’s peanuts. With the peanuts, Teresa can get corn from someone else is she wants that, or she can just eat the peanuts if that is what she wants. In this way, Carl gets his tomatoes, but indirectly. This is one of the ways in which money arose. The next chapter gives a formal term for this aspect of money. I introduce this aspect here to make a particular point.

Opportunity Cost, Transitivity, and System. Opportunity cost is what we pay when we could have gotten something else, especially when the something else is better (has more utility for us) than what we did get. Opportunity cost is the force that comes of trying to get the best out of a range of choices, and that comes of seeing what we did not get. The “cost” refers to what we lose if we do not take the best choice. It is the sting we feel when an office mate says that he got his smart phone on sale for half what we paid. Opportunity cost drives transitivity; keeps cost, price, and value linked; and ties together exchange rates into a system. Do not focus on the numbers below. Focus on the ideas.

Example 1. One afternoon, Richard goes to the market to exchange filberts (hazel nuts) for eggs. The usual rate is one pound of nuts for one dozen eggs, but today there was a shortage of eggs, so Richard had to give two pounds of nuts for one dozen eggs. Because he had one pound less nuts for other exchanges, he was not able to get the pound of bacon that he wanted to cook with his eggs the next morning. Richard is unhappy at the opportunity cost.

Example 2. The next week, the same thing happened again. This time Richard was angry, and determined to do something. So he came early the next day when eggs were abundant, and traded all his filberts for eggs at a reasonable rate. Then he took the eggs home and put them in a cool place in the basement where they would not spoil and would look fresh. The day after that, anticipating a shortage of eggs in the afternoon, Richard took the eggs to the market, where he traded them for filberts, bacon, and whatever else he wanted, at a rate that made up for what he had lost two days ago. This time he was on the gaining end. By minimizing opportunity cost, Richard helped restore the more general exchange rates.

Example 3. Richard was not the only victim of circumstance. Other people suffered opportunity cost from the fluctuating exchange rate for eggs. So other people did the same as Richard. Soon, there was always a steady supply of eggs at the market, the exchange rate for eggs and other goods remained stable, and people did not suffer much of an opportunity cost except that sometimes they had to store eggs to make sure of the price.

Example 4. This example is longer and more complicated. Frank has a huge peanut farm that yields a large supply of peanuts, and that Frank likes corn much more than he likes tomatoes. Several dairy farmers make cheese. Ordinarily, these rates prevail: 5 pounds of peanuts for 20 pounds of corn or for 10 pounds of tomatoes or for 5 pounds of cheese. Frank decides that he will give 8 pounds of peanuts for 20 pounds of corn but still only give 5 pounds of peanuts for 10 pounds of tomatoes or for 5 pounds of cheese. What happens?

-As many corn farmers as possible try to trade with Frank, resulting in less corn available to trade for other goods.

-People stop trading their goods for anything but corn. People want corn so that they can trade it to Frank for peanuts. With the peanuts they can trade for other goods and get more of those other goods than before. For example, a cheese farmer no longer trades cheese directly for peanuts or for tomatoes. Instead, the cheese farmer trades the cheese for corn, and then trades the corn for whatever else he-she needs such as tomatoes. Suppose originally the cheese farmer traded cheese directly for tomatoes, at a rate of 5 pounds of cheese for 10 pounds of tomatoes. Now, the cheese farmer trades 5 pounds of cheese for 20 pounds of corn. The cheese farmer takes the 20 pounds of corn to Frank, and gets 8 pounds of peanuts instead of the 5 pounds at the old going rate. With the 8 pounds of peanuts, the cheese farmer can get 10 pounds of tomatoes (or more) and still have some peanuts left over to eat or to trade for something else entirely.

-If the cheese farmer did not do this, then the cheese farmer would not be getting the greatest benefit (utility) from trading. The cheese farmer would “suffer an opportunity cost” of 3 pounds of peanuts.

-Eventually Frank discovers that he gets less corn than anybody else and he gets less of any other good too. By trading more peanuts for corn than the going rate, Frank has fewer peanuts left over to trade for other goods. Frank suffers the opportunity cost of other goods that are lost such as tomatoes and corn. Frank can trade peanuts for tomatoes or cheese with which to get more corn, and still be better off than he would be giving a special rate of peanuts for corn.

-Frank might keep up his unusual rate for a brief period but eventually the loss of other goods exceeds any benefit he might get from more corn, and Frank is best off trading at the prevailing rate.

Exchange rates transfer between all goods in a system. Opportunity cost makes sure that no unusual exchange rate can hold up for long. The thought of what we might have gotten but did not get (opportunity cost) is a powerful force driving us to seek as much as we can get. Eventually exchange rates form a single whole system of public prices-costs-values. Public prices tell people what is going on, and allow people to adjust strategies to get the most for themselves.

Sum of Costs Again. The sum of costs for the components of a good equals the price of a good. Transitivity helps to keep the relation “in line” for all goods throughout the economy. The cause runs from final good to resource cost rather than from resource cost to final good.

Symptoms. We can anticipate flaws and problems of the economy by looking at the symptoms that Frank produces when he disturbs the public price system. We use these symptoms in later chapters to recognize flaws and problems:

(1) Goods do not cost the same for everybody. The price system is not public. Some people pay more for the same good while some people pay less for the same good.

(2) Some goods are in short supply. Even when people are willing to pay what the correct public price, people cannot buy enough of the good.

(3) Some goods are in surplus. Producers cannot sell all they make at the price they expected to be able to sell. People do not want all of the good at the usual price.

(4) The costs of production do not equal the selling price. Some producers make unusual profits while other producers go bankrupt.

Sometimes these problems arise from the normal business cycle and sometimes they arise from imperfect competition. Sometimes the state causes them.

Sometimes the state steps in to correct these problems, even if it was the original cause of the problem. Usually an attempted correction is like trying to freeze the system in some way, to thwart the normal dynamic process of self-regulation. It is as if the state guaranteed that Frank could buy at his price and everybody else could buy at his-her price, and the state would take care of any disparities. Beginning in the 1920, the United States actually tried to do something like this with agricultural prices, as a response to what happened to farmers in the Depression. This is very hard to maintain in practice.

Biggest Difference at the Margin. We are not done understanding strategies yet. We need two more conceptual tools to talk about how people choose and about the implications.

The first tool consists of directing our attention to whatever makes the biggest difference in utility “at the margin”. Return to peanut money, and suppose that Steve goes shopping at the market. Steve has parceled out his peanuts into little one-pound bags. He has 30 bags with which to trade for what he needs.

With each bag, Steve thinks, “How can I trade this particular bag to get the most utility?” Each particular bag is the bag “at the current margin”. The utility that Steve gets with each bag is the current marginal utility for each. Steve assesses his options each time so as always to trade his good (peanuts) for whatever brings him the greatest marginal utility. Whatever brings Steve the greatest marginal utility is whatever makes the biggest difference to Steve at the time, or “at the margin”. Steve chooses whatever makes the biggest difference at the margin.

Suppose Steve starts by trading 5 bags of peanuts for 2 large fish. Those fish represent the greatest marginal utility that could come to Steve at this point in the trading process, and also represent the greatest difference in utility that Steve could make by using his marginal good-for-trade (bags of peanuts).

After the first 5 bags, Steve then trades 4 bags for 12 eggs. Those eggs represent the greatest marginal utility that could come to Steve at this point in the trading process, and also represent the greatest difference in utility that Steve could make by using his marginal good-for-trade. If Steve got any other good, or if Steve did not trade at all, he would get less utility for his peanuts and Steve would make less of a difference in his total utility.

After those 4 bags, Steve trades another 4 bags for cabbage and carrots to go with the fish and eggs. Those cabbage and carrots represent the greatest marginal utility that could come to Steve at this point in the trading process, and also represent the greatest difference in utility that Steve could make by using his marginal good-for-trade. If Steve did anything else, he would get less utility, and he would get less utility overall.

We can usually figure out what would bring in the greatest total utility over a variety of trades by looking at what maximizes our current marginal utility. We can usually get a good sense of what maximizes our current marginal utility by looking at what would make the greatest difference at the margin. So we can maximize our total utility by continually getting what makes the greatest difference at the margin. We don’t even have to think directly in terms of maximizing our total utility. In later chapters, we will see that these ideas also apply to using resources most efficiently and to maximizing profit.

Cost Effectiveness. “Cost effectiveness” is the second tool. The technical terms for maximizing at the margin are “maximizing marginal utility product” for people and “maximizing marginal revenue product” for business firms. Business people do not use maximizing “marginal revenue product” but instead more often use the term maximizing “cost effectiveness”. The same logic lies behind the business person’s idea of cost effectiveness and the idea of a person maximizing utility through making choices at the margin.

The term “cost effectiveness” is used in two related ways. People sometimes confuse them.

(1) Something is “cost effective” when it brings in more utility than it costs to get. It is cost effective to continue to hunt for rabbits as long as we get more utility than we lose through fatigue and annoyance. I call this use of the term “more gained than lost”.

(2) The idea of opportunity cost tells us this is not the whole story. It is not enough to get something; we have to get the most utility out of the range of alternatives. If not, we “suffer an opportunity cost”. If we make a choice that leads to less than the most utility now, then we effectively lose utility. Then we are not fully cost effective. Suppose we can choose between hunting rabbits, squirrels, or doves. As long as hunting any of them brings in more utility than we lose, we can say that hunting is cost effective in a way; but it is not the fullest way. If we wish to be most cost effective, we need to hunt rabbits when that brings in the most, then switch to squirrels or doves in case one of them should bring in the most, and then switch again if that works. In this way, we always make the biggest difference in utility at the margin, and we always maximize our total utility too.

We do the same thing when we switch between dials on the radio, or go from table to table at a yard sale, or think about what course to take in school. When we gain the most among available alternatives, we almost always also gain more than we have lost.

This second use of the term “cost effective” means “most gained among available alternatives”. The second use almost always includes the first use.

People use the term “cost effective” to mean both “more gained than lost” and “most gained among available alternatives” without always being clear what they mean. Usually people really mean “most gained among available alternatives” when they think they mean “more gained than lost”, probably because “most gained among available alternatives” includes “more gained than lost”. In this book, I always mean “most gained among available alternatives” unless I specify “more gained than lost”. I use the term “cost effective” as a way to summarize the idea of strategically seeking the greatest utility, including taking into account opportunity cost. It will become shorthand for all the major tools for understanding strategy.

It helps modern people to understand cost effectiveness to think in terms of allocating time. Josh finds himself idle at 4 o’clock on a Saturday afternoon. He finished most of what he really needs to do for the day. He has two hours before dinner. He can use the two hours in many ways: watch football; read a book for fun; read for his work; get a jump on something he has to do for work; fix the garbage disposal; wash the car; watch a classic movie on TV; watch a bad action movie on TV; help his wife with dinner; etc. Whatever he does, he cannot also do something else. Whatever he gains in utility from one thing, he will miss in utility from other things. Josh needs to spend his last two free hours of the day getting whatever maximizes his utility in those last two hours. If Josh does that, he is using his last two hours cost effectively. If Josh spent them in some other way, even so that he gained utility but did not gain the most utility that he could have gained, then he would be using his hours in the first sense of cost effective: “gain exceeds cost” – but he would not be using them in the second sense of cost effective “most gain over cost”. Josh has to compare alternative uses of his time. If Josh spent his two hours any other way, he would “suffer an opportunity cost”. Josh is most cost effective when he most minimizes opportunity cost. Opportunity cost and cost effectiveness work the same way. Pre-modern people think of allocating effort rather than of allocating time while modern business people think of allocating capital or of allocating money.

People strive to be cost effective in their lives by being smart consumers, by getting the best jobs, and by getting the best for their children.

Summary: Perfect Competition. We can summarize the chapter so far by listing the features of perfect competition. Only under the right conditions does individual strategic pursuit of utility guide interaction to the best outcome, without need of interference. The right conditions are called “perfect competition”. Luckily, in a developed economy, it is not hard to approach the right conditions. The flaws and problems of capitalism come when the economy is not near the right conditions. The right conditions occur when the magic of big and small works well to set up and maintain a public price system and to keep the economy moving towards general equilibrium.

The interaction of many free individuals leads to balanced markets that clear for all particular goods (partial equilibrium) and to a balance between all markets too (general equilibrium). “All markets” includes the markets for finished goods and the markets for resources. The interaction of many independent individuals leads to a system of public prices. Once set up, the system of public prices seems to be something outside of individuals to which individuals have to adjust. It takes on a life of its own.

A good to one firm (electrical supply store) can be resource to another (electrician). The idea of a public price means that the price of any good-resources is the same for anybody in the economy regardless of their own situation or their use for the good-resource. The cost of corn bread is the same to a poor person or to a rich person, and the same to a household or to a restaurant (with allowances made for wholesale and retail that do not affect the fundamental argument). The price of a good to one person or firm is the cost of the good to another person or firm.

Price” and “cost” are another way to say “value”. Value comes from exchange ratios based on marginal units. Transitivity and opportunity cost help to hold the system together, to insure that prices are public, and to insure that “exchange ratio”, “value”, “price”, and “cost” all mean the same thing.

In a public price system, no particular individual or particular business firm can by itself influence the price of a good (or resource) or influence the quantity of a good produced. Each particular person or particular business firm is so small in relation to the system as a whole that it cannot change the system. No matter how much corn bread any family orders, or any restaurant orders, they cannot change the price of cornbread. Nor do their orders change the total quantity of corn bread made in the system. No matter how much corn bread any bakery makes, it cannot reduce the general price of corn bread, and its production does not change the total production of the entire economy. No matter how much any bakery withholds corn bread production, it cannot change the price of corn bread or change the total amount of corn bread baked in the economy as a whole. Behind this balance, all consumers together and all producers together set the price (exchange rates) and quantities for all goods and resources.

No business firm or group of workers by itself can influence the price of a good or the quantity of the good offered. No business firm or group of laborers by itself can change the rate of wages for any occupation or the number of people that get jobs.

If perfect competition held throughout the economy, there would be no flaws or problems. In particular, employment would be full and, in a modern developed economy, all people would make enough to live decently.

Perfect competition requires that individuals and firms act independently. Firms have to compete fairly. Groups of consumers, groups of workers, and groups of business firms cannot collude.

Imperfect Competition. Imperfect competition arises when any of the conditions above are not met. Imperfect competition arises whenever any business firm or group of workers can influence the price or the quantity of a good offered. Imperfect competition arises whenever any business firm or group of laborers can influence wages or the number of people that are hired. Imperfect competition also arises when any coalition of business firms, or of workers, or of consumers can influence the price of any good or the quantity of any good.

We can understand the effects of imperfect competition in terms of the same effects we saw above when we interfered in a market: odd prices, shortages of some goods, and surpluses of other good – including wages and workers.

Whenever imperfect competition gives rise to problems such as unemployment, we are tempted to interfere. The interference is another source of imperfect competition. Unless the interference cures the problem, and we can limit the interference only to the effects of the problem, then likely we cause more problems and more harm than by doing nothing. This is a hard lesson, but one of the major lessons of neoclassical economics.

Perfect competition is not just hard striving between business firms or between applicants for a job. Perfect competition is not just the absence of cheating. Perfect competition requires the magic of the big and small, and requires that the economy move toward general equilibrium. Imperfect competition does not arise only out of cheating; in fact, cheating likely is not the most important cause. Often imperfect competition arises when firms do strive mightily. Imperfect competition just arises sometimes when any firm or group can influence the quantity or price of a good to deviate from the ideal market price, whenever the magic of big and small does not apply. The conditions under which it arises are the subject of Chapters Six and Seven.

Practical Guidelines. It is one thing to say that a business firm, a group of firms, or a group of workers, ideally should never influence price or quantity in any market. It is another thing to specify practical measurable guidelines as to when influence does not occur, does occur, occurs but is tolerable, and occurs to the extent that we have to intervene. Providing guidelines is part of what professional economists do. Guidelines vary by market and by situation but I can give some general ideas here. Basically, the guidelines say that markets should remain Smithian, and that no firm, group of firms, or labor union, can capture a market for its benefit.

To remain near perfect, a market should have at least six providers of any good. There should be at least six automobile makers, tire makers, toaster makers, or beer brewers. There should be at least six independent workers in any given field such as brewer, or there should be at least six independent labor unions for every occupation.

Even if the market has at least six providers, power should not be concentrated in any one provider. Competition would not be perfect if one firm controlled 90% of the market while five other firms had to share the remaining 10%. The largest business firm should not provide more than 40% of the goods for any market. The largest labor union should not provide more than 40% of the labor for the market. The largest automobile maker should not sell more than 40% of the cars. The largest automobile workers’ union should not provide more than 40% of the automobile workers.

No coalition of firms or of unions should act as if it were one large provider. No coalition of firms should control more than 40% of the market. No coalition of labor unions should control more than 40% of the jobs. If two or more firms together supply more than 40% of the market, they cannot cooperate in any way. If Ford and GM together supply more than 40% of the cars, then they cannot cooperate in any way.

These conditions are not always met in real life. In particular, workers have to get together to control most of the jobs in a market so they can deal with powerful business firms. Hopefully, these conditions are met well enough most of the time so that we are better off not interfering. Chapters Six through Nine look into when conditions are not met and into responses. Another big part of the job of professional economists is trying to understand deviant situations and advise people what to do.

Fairness 2. It is worth repeating that even perfect competition does not always satisfy our need for fairness. When perfect competition is not fully fair, it is hard to know how to make things fairer because any interference with perfect competition leads to less total wealth and less total utility, even if the interference makes some people better off. To make a situation fairer for some people, we have to distort markets (exchange rates), and that makes things unfair for other people. The comments in this section depend on perfect competition. The flaws of imperfect competition almost always make things even worse.

To see how unfairness persists under perfect competition and the public price system, we need to understand an odd relation between public price and marginal utility cost. Suppose Jim has 10 cans of soup while John has 1000 cans of soup. The marginal utility of a can of soup is less for John than for Jim, more for Jim than for John. The public value-price-cost of 1 loaf of bread is 1 can of soup, the same for everybody. When Jim gives 1 can of soup for 1 loaf of bread, he gives more in marginal utility (more in benefit) than when John gives 1 can of soup for 1 loaf of bread. The bread costs Jim more in utility than John even though they both pay the same price. When everybody is middle class, or everybody has about the same wealth, we don’t pay much attention to this effect. Even when some people have five times the wealth of other people, this effect usually is not very important. This effect becomes important when some people have so little wealth that they are struggling for the basics of life, or when some group in the economy has dozens of times the wealth of other people. This effect becomes critical when the mass of people are poor and one group is rich and powerful.

There is a counterargument, but it does not have much force. Suppose Jim is not as wealthy as John. Jim not only has less soup than John but less bread too. Say Jim has 1 loaf of reserve bread in his pantry while John has 6 loaves. If you don’t want to think of reserve loaves of bread, think of pounds of hamburger in the freezer. The loaf of bread that Jim gets in exchange for the 1 can of soup has more marginal utility (more utility) than the loaf of bread that John gets in trade for 1 can of soup. Jim pays out more, but he also gets more back. This is one way the public price system stays public and stable. Still, the somewhat greater utility that Jim gets from the loaf of bread does not make up for the greater utility that he lost compared to John. It would take too long to step through the reasons, and the reasons work best when we allow an “inter-subjective comparison of utility” (see Chapter Three). To get a feel for what is going on, substitute dollars for cans of soup. Jim has 10 dollars while John has 10,000,000 dollars. The dollar that Jim gives out for 1 can of soup has a lot more marginal utility for him than the dollar than John gives out. The increased utility that Jim gets from the can of soup compared to John does not make up for the big difference in utility lost.

One price for everybody means that a single working mother pays the same price for a loaf of bread as does a rich person. We can be sure the dollar that the poor mother pays for the loaf of bread has much greater marginal utility for her than for a rich person. In effect, the mother pays a much higher price-cost (marginal utility for exchange) for the same loaf of bread than does the rich person. The same public price-cost for everybody does not mean that everybody pays the same utility price-cost. This is not fair in a way that hurts and offends. One reason to study marginality theory is to understand this situation clearly.

Of course, the plight of the poor mother is always better under perfect competition than it would be under other conditions (except direct private charity), and the situation of the mother will get better over time as well because of how efficiently perfect competition adopts innovation. As long as the poor mother really has enough for her and her children to get by safely, and for her children to get a decent education, we probably do not want to risk interfering.

Likely, the poor mother will not get better off over time compared to the rich person. Her situation in comparison to the wealth of the rich person might get less, stay the same, or increase, but is most likely to stay about the same. Perfect competition does not guarantee that people get more equal in wealth over time. Perfect competition is not necessarily a universal leveler over time. Again, as long as she keeps her head well above water, we still probably don’t want to interfere.

How great a disparity we can stand is an additional important question. When answering this question, we have to consider if the disparity gets worse, if the disparity leads to other problems, and if our interference will really help. In the real world, we also have to keep in mind that competition is imperfect, and that disparities in wealth play out in the context of an imperfect economy. It might be that interfering would not help in the ideal world of perfect competition but could really help in the real world of imperfect competition.

To give good answers to these questions, we have to disentangle unfairness that might persist in perfect competition from unfairness under the dynamic ideal and from unfairness due to flaws and problems of imperfect competition. To do that, we have to look at the strategies of business firms in Chapter Five, and at the sources of profit and imperfection in Chapter Six.

Natural Growth. Natural growth is the implementation of innovation, by business firms, so as to sell products, to consumers, as long as implementation adds to the utility of the consumers. It happens by itself. It stops by itself. Promoting growth other than natural growth does not solve the problem of fairness and does not solve flaws and problems such as with employment. Yet some economists, and many politicians, promote forced growth as a way to solve all problems with wealth, the economy, and society. Chapter Nine looks at policy directly. Before getting there, we need some background that depends on marginality theory. It is best to provide the background here while marginality theory is still fresh in our understanding.

To anticipate the conclusions: I recommend the state not interfere in the market to induce any growth. Let natural growth do its own job. The state can help natural growth through subsidizing research that business firms could not otherwise carry out, as with the technologies that came from the space program.

Diminishing returns imply natural limits to growth. Implementing innovation adds to productivity, wealth, and utility for a while, but, as common sense and experience tell us, not forever. A new innovation adds a lot. As time goes by, the innovation “experiences diminishing returns” and so adds less and less. In the end, the innovation is completely absorbed into the economy. While the innovation is implemented, it creates natural growth. Recent examples include computers and digital imaging equipment such as cameras and modern phones.

We cannot force the economy to grow by interfering. We cannot magically undo the effects of diminishing returns through interference. It is hard to see what the state could do to make an innovation continue to add to utility after it had stopped adding any more than any other product. The state could not increase consumer utility more by forcing Apple to make more pads (“iPads”), and forcing consumers to buy them, than consumers already add to their own utility simply by buying the pads that Apple offers. The state could not add to consumer utility by forcing the dairy industry to produce more milk and forcing consumers to buy it.

Decreasing Efficiency and Productivity. Robert has three comfortable chairs already in his apartment. Another chair adds to Robert’s total utility but not as much as did the previous chairs. This result is basic diminishing returns and marginality theory. In the same way, in a healthy mature free market economy, adding additional resources to an industry might increase the total output of the industry but not by as much as did previous doses of resources of the same amount. As every gardener knows, at some point, adding more labor, fertilizer, water, and chemicals to a plot of land reaches serious diminishing returns. Eventually additional inputs are no longer worth it. Diminishing returns reduce the efficiency and productivity of all industries. Suppose the laptop industry already is worth 10 billion dollars. Putting another 1 billion dollars of engineers, screens, chips, cases, and advertising into the industry would increase total output and sales but not by as much as any of the previous billion dollar investments. People who advocate forced investment or forced savings to stimulate growth often overlook this fact.

Forced Transfer of Resources. When people buy more smart phones, they buy fewer big screen TVs. When people buy more hybrid cars, they buy fewer gas-guzzling SUVs. When people save more from their salaries, they spend less. At least in the short run, and often in the long run, any increase in one part of the economy is a decrease in other parts. Any increase in one part of the economy is a movement of resources from other parts to that part. As that part receives more resources, it becomes less and less efficient. People who advocate forced investment or forced savings often overlook these facts as well.

Sooner or later, state revenues (taxes) have to pay for all state expenditures. Sooner or later somebody has to “pay for it all” through taxes. As a result, when somebody pays less in taxes, somebody else has to pay more in taxes. Tax breaks for one industry are, in effect, a forced movement of resources from consumers, and/or from other industries, into that industry. Tax breaks for one group of tax payers is an extra burden on other groups of tax payers. Tax breaks follow the same rules as other forced movement of resources.

Marginality, Diminishing Returns, and Say’s Law. People can believe in Say’s Law (“Supply Creates Its Own Demand”) only when they think that cost and production are rigid and objective. If you give farmers 100% more resources (double the farm budget), and force farmers to use all the resources, then farmers will produce 100% more food, farmers will pay their to their workers and to related industries 100% more, and consumers will buy all the 100% of more food that is made using the 100% more resources.

This is obviously false. Only if there are no diminishing returns can you always get back in (demand) exactly what you put out (supply). Say’s Law only works if diminishing returns is not true. Just by thinking about Say’s Law in terms of the food industry rather than, say, the car industry, we can see that diminishing returns thwarts Say’s Law. Americans already eat too much. We could not force ourselves to eat more, and the state could not force us to eat more. Already American farms are about as productive as they can be. The extra labor and resources that was forcibly applied to farms would not be as productive as the resources and labor already applied. The additional labor and resources that were spent on related industries such as farm equipment, insurance, and chemicals would not be as productive as the resources and labor that were already used on those industries. Consumers would not, and could not, buy the additional farm production.

This paragraph is finicky. The result above puts us in a theoretical bind. If diminishing returns is not true, then marginality theory cannot be true. Without marginality theory, we cannot describe how particular markets come into partial equilibrium or how the economy as a whole comes into general equilibrium. But Say’s Law can only be true in a circular, closed, self-reproducing system that tends toward general equilibrium. If we are not in such a circular, closed, self-reproducing system that tends toward general equilibrium, then nothing like Say’s Law could be true. On the one hand, if Say’s Law is true, then marginality theory (diminishing returns) is not true, we do not have a system, and thus Say’s Law cannot be fully true. On the other hand, if marginality theory (diminishing returns) is true and the economy works well, then Say’s Law cannot be fully true. Either way, we cannot force the economy to grow by forcing an increase in production.

Say’s Law can still be approximately true around equilibrium, and can still help out in some short term, limited-scope policy actions. But it cannot be the basis for policy in general, and especially it cannot be the basis for induced expansion.

Say’s Law can still be approximately true for modernizing economies such as China or India that are a long way from reaching diminishing returns. There it can make sense to force production. But the governments in established capitalist economies such as the United States cannot take new economies as examples of what to do and how much growth can be achieved.

Mutual Influence in Production. Production often is mutual. One industry affects a second, the second affects the first, and they mutually reinforce each other. The circle can include more than two industries. For example, iron tools help to dig and process the iron ore that makes the tools that dig the ore, and so on.

Mutual reinforcement seems to defeat diminishing returns. Yet even this process succumbs to diminishing returns in the long run. I saw the development of fishing, shrimp farming, and catfish farming in a couple areas of the world. These new industries not only grew through adopting innovation, they also stimulated developments in other industries that provide innovations to them: developments in fish biology; food processing; feed; pond, water, and land management; mechanical aeration; and various chemicals. All of these developments in turn helped catfish farming and shrimp farming. In the early decades, all the linked industries almost exploded, and it seemed as if the process would never slow down - but it did. Now we have as many shrimp farms and catfish farms as we need. In traditional Southeast Asia, pig farming and rice farming always spurred each other when a new tract of land opened up. The rice provided food to the pigs, leftover from what people would not eat, and the pigs provided fertilizer for gardens and fields. When a new tract of land opens up, for a while life booms; but eventually that mutual support process slows down through population growth (people, pigs, and rice plants) to find some balance.

Modern mercantilists see mutual stimulation of industries, especially new industries, and decide that diminishing returns can be defeated along the lines of Say’s Law. Every additional amount of investment seems to create more than the investment, not slightly less. In the short run, that can be true, but in the long run it cannot. Modern mercantilists take short run experience in some industries as a general warrant for continual intervention to promote expansion, and as a way to get state programs to serve their clients. We have to be clear that there is always an ultimate ceiling of diminishing returns, even when different activities mutually help each other along, even in new industries.

Reduction in Utility from Transfer of Resources. People buy more smart phones and fewer big screen TVs because that is what gives them the greatest utility. That is one definition of a free market. People save at a particular rate because that also is what gives them the greater utility. People would save more and consume less, or save less and consume more, only if they got more utility from the change. It is reasonable to assume that whatever people save now is pretty much what gives them the greatest utility.

Assume people already achieve the greatest utility from the current ratio of hybrids to SUVs, and from all other choices, trade-offs, and market balances. Forcing the SUV industry to grow moves resources from other industries to the SUV industry. Moving resources from other industries reduces the utility that people get from those industries. Moving resources to the SUV industry increases the amount of SUVs past the point where the average marginal utility says it should be, so that the utility gained from additional SUVs is not worth the cost of the SUV. We have moved resources from where they created appropriate amounts of utility to where they have created lesser amounts of utility. Even if this is somehow growth as measured in SUV units, or even in some money currency like dollars, it cannot be growth in utility and so cannot be real growth.

Every forced growth is a forced movement of resources away from where they already produce the greatest utility to where they produce less utility, and so cannot be real growth.

Forced Savings as Transfer of Resources. Savings are a resource too. If the state forces savings (resources) into one industry, it deprives other industries of savings (resources). If the state forces savings (resources) into one industry from others, it reduces the utility that consumers gain from the other industries more than it increases the utility that consumers gain from the target industry. We do not always think of these effects from savings because savings are not obviously goods with a utility such as SUVs, hybrids, and computer tablets, but savings are a resource, and the result is the same.

In a healthy free banking market, the amount of savings in the banks about equals the amount of investment in the rest of the economy. It is tempting to think that forcibly increasing the amount of savings automatically also increases investment because more money (resources) is available to invest. Because investment equals savings at equilibrium, if we increase savings, we can force an increase in investment, and thus cause growth. Like Say’s Law, that might be true a little, but the increase is not in the right proportion, and the net result is a loss of utility.

If the state forces people to save more than people wish, in effect the state moves resources from other industries into savings. Savings give people utility too or they would not save. When the state forces savings into other industries, it reduces the utility from savings more than it causes a gain in utility from other resources. The same is true in reverse in case the state forces people to save more. It deprives other industries of resources in order to move those resources into savings. The utility lost from the other resources is greater than the utility gained from increased savings.

Usually the state causes savings to increase or decrease by changing the rate of interest. An increase in the rate of interest leads to more savings while a reduction leads to less. The rate of interest is what keeps savings equal to investment in a natural health banking market. If the state raises the rate of interest to attract savings, it also raises the rate of interest in nearly all other industries, and that means nearly all other industries are not as efficient as they were. They cannot make as much, so they provide less utility to consumers. They cannot produce as much even if they borrow some of the extra savings that are available now. The loss of utility from other industries more than destroys any increase in utility from the higher interest rate and the increased savings.

Sacrifice as Savings and Investment. Sometimes people wrongly think increased savings has to produce increased investment, more than enough to make up for any loss from the increased savings, because of an honest mistake, and because of confusion about terms. “Savings” can mean:

(1) What we sacrificed in the past so as to do even better now. This is real growth.

(2) What we forego now so as to do even better in the future. This is real growth.

(3) The money in the bank that business firms can borrow from so as to meet current needs and maybe so as to take advantage of an innovation. This might or might not be the basis for real growth.

When state officers force an increase in savings type (3), they have in mind the first two cases, in which a sacrifice did result in an even greater gain. Forced savings of type (3) is not the same as the first two types, and does not usually lead to even greater gain in productivity and growth than the savings. The above sections explained why. It helps to look at cases of types (1) and (2) to see how state officers could be misled.

If farmers had never invested in better varieties of corn in the past, how much they put into corn farms would be different now. If farmers had never developed good varieties of tomatoes in the past, the effort that current gardeners put into tomatoes would not produce the frequent gifts to neighbors now. Investment can delay diminishing returns.

Never eat your seed corn”. Past investment required some kinds of savings. Ancient farmers had to save the best wheat for seeds and the best calves for breeding stock. They had to clear the land, during which time they could not be plowing the land or gathering a harvest. When modern business people invest they usually borrow somebody else’s savings or reputation so as to get the resources to invest.

Usually, the more that is invested the better the final return. More investment requires more savings and less immediate consumption. The better the land is cleared in the beginning, the better the final harvest in the end. The more a herder puts into selective breeding, the less he-she eats of his-her own cattle, the better the breed in the long run.

Jack and Diane want a car. If they buy a car “on time”, they pay $20,000 for the original price of the car and another $10,000 in interest over five years. If they ride bicycles, take the bus, and take taxis, for three years, they can save enough to buy the car outright. During the three years, they sacrifice, and they have to pay for bicycles, bus passes, and taxi rides in the total amount of $1500, but they get the car. By sacrificing now, they gain $8500.

Harold has saved $20,000 for a vacation cruise. Then he sees he could invest the money in his motorcycle business by taking on another brand, say by adding BMW. In doing so, over the next three years, he would more than make up the $20,000, and then he would make $10,000 a year more income every year thereafter. Harold sacrifices current consumption to make even more in the future than what he gives up now.

Yet even savings, foregone consumption, and investment have their diminishing returns. Every farmer knows that there is only so much good to clearing the land. A successful farm usually does not look like a flower garden. If the farmer puts all his-her energy into clearing the land and does not plant anything for five years, the entire family will die and all the early sacrifice, savings, and investing goes for nothing. You have to eat as you go along, and eventually heavy sacrifice no longer pays for itself in the future. Students know that they have to give up some fun to study so as to get good grades, but that too much study wears a person out, a little fun helps us perk up, and then we make even better grades. Martial artists know not to practice more than about four or five hours a day or they actually do backwards.

Forced savings into banks now (3) is not like the other cases of savings-for-investment. In cases (1) and (2), people clearly see alternatives, see that sacrifice now definitely would lead to even bigger gain in the future, and can tell when to stop saving-investing and start doing. Forced saving at the hands of the state is just forced savings. It is not necessarily an investment now. It is not necessarily an investment now that leads to an even bigger payoff later. It is not often real growth. There are not necessarily any great opportunities waiting to use the forced savings. If the financial market was free to begin with, there is a good chance that all the efficient ways to use savings have already been taken. Any investment as a result of forced savings is likely to be less efficient than previously and less efficient than hoped for. There is no way to know when to stop saving-and-investing appropriately. There is a kind of heroic mythic aura about saving now for even greater benefit later, I applaud individuals who do that, and I applaud states that save up in good times to help the economy in bad times. But we should not be misled into thinking that it must work in all cases.

Production Possibility Frontier (Curve)”. During the time of the Cold War, arguments about forced growth often used an idea called the “production possibility frontier”. It is related to the idea of mutuality in production. I do not discuss this idea here. I mention it for completeness. I return to it later in Chapter Nine when it makes more sense there.

No Beneficial Intervention? Are there no ways in which the state can circumvent diminishing returns so as to intervene to cause real benefit, including sometimes real growth? Should we simply rely on the market in all cases? Are there no flaws and problems in capitalism? All state action can be seen as interference, including all taxes and all spending. All taxes and all state spending forcibly move resources from one group to another, from one industry to another. Yet few people advocate abolishing the state in favor of pure private enterprise. We need the police, courts, fire department, environmental protection, emergency management, and many other useful state services. Some state services actually do contribute more in the long run than they take out in taxes. They are like the beneficial savings of Jack and Diane above. I think the police force is like that.

There are some cases where state intervention in the economy is warranted and can produce more good than harm, particularly interference to alleviate problems from the business cycle. The state can even interfere sometimes in savings and investment without causing more harm than good. The state is welcome to sponsor research that private business cannot carry out. But these cases are so tricky, and so prone to abuse, that it is best to avoid interference if possible. It would be too much of a diversion to go into them here. I return to them in Chapter Nine and in the Suggestions.

05 Marginality Theory 2: Business Firms

This chapter continues from the previous one. Using marginality theory, this chapter describes how a business firm works and describes the results for the economy. This topic is called the “theory of the firm”.

05 Marginality Theory 2: Business Firms; Synopsis.

Individual people decide what to buy on the basis of the price system and according to how much benefit (utility) they receive from their latest purchase of any particular thing. If my ten dollars give me more satisfaction from some peaches than from another jump drive, I buy the peaches.

For business firms, the counterpart to utility is profit (or revenue). In offering goods to consumers, business firms decide whether to make movies or TV shows according to how much more profit they can make on one more or one less TV show or movie. Business firms allocate resources according to how much more profit they can make by giving the resource to one use as opposed to another use. A movie studio decides how to use its young star according to whether the studio is likely to make more money with her in another action movie or in another romantic comedy. A car maker decides whether to use steel or plastic in the body of its car according to whether the last few kilograms of steel or of plastic is likely to bring in the most money over cost.

When particular business firms independently decide on this basis, all business firms together also automatically set for the whole economy: what will be made; how much will be made; the price-cost-value of raw materials such as wood and wire; the wages for particular occupations; the price of final consumer goods; how many people work in a particular occupation; how large a factory, office, or storefront will be; how much of the total wealth (capital) of the economy goes to what use; how fast to grow the economy; and how much to grow it. All the business firms acting together replicate the price system on which consumers and business firms originally based their actions, and so replicate the economy.

When the economy works as it should, two unexpected things happen. First, no one firm can do this by itself. Particular individual business firms have only very little leeway to set prices. The independent action of all business firms together sets a price to which any one firm responds as if that price was given to the firm. The firm buys materials from other firms at the going market price and sells its final goods to consumers at the going market price. To the average American now, it seems as if business firms just set the price at whatever they like and we have to pay, but that is not true. The system sets the price, and the business firm has to sell for the going rate. If Amazon sells its Kindle too high, then Barnes and Noble jumps in with Nook to drop the price to the proper place. The business firm is a consumer when it buys raw materials to make products to sell. As a consumer of raw materials, business firms face a market price just like consumers face a market price for finished goods. Economists say that consumers and business firms are “price takers”.

Second, there is no profit in the long run, and little loss. “No profit” does not mean all business firms go bankrupt, or all owners make nothing. Business firms continue acting rationally, always seeking profit, but always just breaking even. Employees and managers get paid according to how much they contribute to the business. Owners make a good salary as high level managers. Owners always have the right to use their capital to seek profit temporarily in new ventures. Apologists for bad capitalism and for the accumulation of wealth dislike this conclusion. Wise conservatives and liberals learn to live with it.

Money as a Convenience. The previous chapter introduced peanuts as a medium of exchange, a kind of money. For rigor, mostly I stick to barter but sometimes it is easier to use money. We can use most metals, such as copper and silver, as money. Here, money has no features of its own other than the features that it has accidentally as a good in itself. Silver as money has no features as money other than what silver has as a good in itself. Money is only a neutral medium of exchange. There is no interest on money, as in real economies. In later chapters, we will see that money does have traits of its own even when it is only symbolic paper money, and that these traits affect the economy.

Types of Business Firms. The modern corporation defines most aspects of modern lives. From it we get nearly everything we buy and all that we earn, from cradle to grave. It provides jobs for the vast majority of people. It is not a good idea to get on the bad side of a corporation if we need a job or we want to be a business person. With modern corporations, we also get the franchises, dealerships, and the “storefronts” that present the “face” of most corporations and with which we are most familiar (any particular Wal-Mart store or Burger King restaurant).

We tend to think of the corporation almost as a natural force, like rain, that has been around forever. Yet corporations have played their dominant role only for a bit over 100 years. Before modern corporations, business was done by various kinds of firms: ownership by one person; ownership by a family such as the Du Pont family or Rockefeller family; and partnerships such as with a clinic of dentists. The type of firm influences how business is conducted but not so much that the question needs to be considered here. We can think of all business firms as having the traits listed in the section below.

Business Firm Traits and System Features Condensed. Here is a second longer synopsis. This section presents the chapter as a list, in jargon. The rest of the chapter fleshes out the list. The reader can return to the list for reference. Unless stated otherwise, all the features arise under near perfect competition.

Individuals wish to maximize utility; business firms seek to maximize profit.

Revenue is how much a business firm takes in while cost is how much a firm pays out. Profit comes when revenue exceeds cost.

A good can be physical good such as a toaster, a service such as medical care, or an experience such as going to the Super Bowl.

To gain revenue, and to seek profit, business firms offer a good for trade (sale) on the market.

A particular kind of business is the selling of a particular good, such as “the bread business” or “the computer business”. A firm is one unit in a particular business, such as Apple or Dell in the personal computer business.

A “venture” or an “enterprise” is the efforts of a business firm in a particular kind of business. Developing and marketing a particular computer game, such as “Prince of Persia”, is a venture. Selling apples at a corner fruit stand is a venture. Opening a corner dry cleaner is a venture.

To maximize profit, it helps to minimize costs. Business firms seek to use their resources as cost effectively as possible. Business firms also seek to minimize opportunity cost by looking for the most profitable way to use their resources. Firms allocate their resources so as to use them most cost effectively, minimize opportunity cost, and maximize profit.

For people, there is no objective measure of utility, and people can seek utility in many different ways. In contrast, for business firms, there is an exact and absolute measure of success: profit. Business firms have to do only one thing: seek profit as measured by money. Business firms do very well the one thing they do.

People work for business firms so that people can indirectly gain utility through their wages. For people, the pursuit of utility should be above the pursuit of profit.

Yet people tend to internalize the values and methods of the institutions in which they live, including the firms for which they work. People can mistakenly put the pursuit of profit (money) above the pursuit of utility. This can be a mental illness. Thankfully, contrary to popular myth, this type of confusion does not happen often enough to make a point of it in this chapter.

Business firms can engage in more than one venture at a time. Dell sells whole computers and parts too; and Nestle deals in raw foods, the processing of food, and finished foods. Business firms switch ventures. They abandon old ventures and take up new ventures. In Asia, Singer now sells refrigerators and it hardly makes sewing machines at all. Business firms do all this to minimize opportunity cost and maximize profit. Still, for now in this chapter, it is easier to think of one venture at a time per business firm.

In seeking to use resources best in the pursuit of profit, business firms reinforce the public price system. They reinforce the fact that any good has the same price-cost-value for everybody. They reinforce that value, price, and cost are all aspects of exchange ratios.

Imputation” (also called “derived demand”), means that the demand for a final good determines the price-cost-value of the resources that compose the final good, and that the cost of resources does not determine the value of the final good. The demand for apples determines the cost of apple trees; the cost of apple trees does not determine the value of apples. In seeking to use resources best in the pursuit of profit, business firms reinforce imputation.

The sum of the costs of the components for a final good equals the price of the final good. The price-value of my refrigerator equals the sum total of the costs to make the refrigerator. This relation is not true because the costs determine the price of the final good but because of imputation, because the value-price of the final good determines the value-cost of components.

The activity of business firms reinforces the fact that the cost of the resources that are used to make a final good adds up to the value of the final good.

The fact that the costs of resources add up to the value of the final good means that ordinarily in perfect competition there is no sustained profit. If there were, imputation would not hold. Business firms pursue profit, and sometimes make real profit, but, ironically, their pursuit of profit insures that real profit disappears.

In a real economy, profit does not disappear. In later chapters, we will use the sources of profit to understand a real economy in contrast to an ideal economy.

Business firms do not seek to maximize the quantity of profit by itself but seek to maximize the “rate of return on invested capital”. They seek to maximize the rate of profit. It is better to get a 10% return on a slightly smaller total amount of capital than to get a 5% rate of return on a slightly larger total amount of capital.

Business firms move capital from one kind of business to another kind when the other kind makes a greater rate of return than the present kind of business.

Although in theory business firms seek to maximize the rate of return, sometimes they just seek to maximize the amount of profit, especially in the short run. Business people that speculate in bonds can make a great deal of money on a fraction of a percent when they deal in hundreds of millions of dollars all at once.

Over a moderate time span, business firms seek to maximize the rate of return within particular kinds of businesses, such as making plastic food containers. It is a lot of bother and expense to switch between different kinds of ventures, so firms tend to stick with what they know best.

Over a longer time frame, business firms move capital from one kind of business to another kind when the difference in rate of profit is enough. If a firm can make a greater rate of return by selling mainframe computers than by selling micros, it moves resources. Opportunity cost drives firms sometimes to switch from one kind of venture (electronics) to another (movies) when the difference in profit is high enough.

There is a “magic of small and big” with business firms too. No business firm by itself can determine: the price of a final good, the total quantity offered on the market by all firms, the cost of resources, or the total quantity demanded of any resource by all business firms. Yet all firms together determine those features. Business firms, with consumers, together create the markets for final goods and resources. Business firms then respond to the markets that they created. In responding to market characteristics, firms and consumers recreate market characteristics.

The magic of big and small among business firms is a powerful force in making the public price system; in maintaining the imputed relations between final goods and resources; and in keeping the identity between price, cost, and value.

Maybe the biggest reasons we need to know that cost effectiveness sets the price-value-cost of any good or resource are: (1) labor is a resource and (2) the price-cost-value of labor is wages. We need cost effectiveness to understand labor, wages, employment, and class relations later.

Although profit disappears in idealized economies, we can still understand the actions of business firms, and the results of their actions, in terms of pursuing potential profit.

Deviations from perfect competition show up with deviations away from the magic of small and big, distortions in the public price system, distortions in imputation, and when the sum of costs for a good does not equal the price of the good.

Resources and Input Factors. “Resources” are also called “input factors” because firms take in resources (wood or iron) so as to out put goods (furniture or cars). In this chapter, I use the term “resources” more often because readers are more familiar with it while in later chapters I use the term “input factors” more often for technical reasons. Labor is a resource and an input factor. A thing can be a good at some times but an input factor at others, as a car is used for pleasure, for business, and for family errands.

The “finished good” for one type of business is the input factor for another type of business, as when a smelting plant provides sheet metal to a carmaker. The output from one business is the input for another business, and so on through the line from raw resources, to intermediate input factors, until we get to a final consumer good. For convenience, in this chapter, I argue mostly in terms of the last step from processed resources to final consumer goods, as when a Dairy Queen turns cream into treats. I describe the strategies of the firms that take that last step.

Few firms start with raw materials to produce finished goods. Firms start with the output from other firms. Most firms are part of long chains in which raw materials become finished goods only through many steps. Even apparently raw materials, such as lumber or corn, require inputs that are processed products, such as fertilizer and bug spray. Raw materials are part of the circularity of the entire economy.

Consumers choose among goods so as to achieve greatest utility. Firms choose among input factors so as to achieve greatest potential profit.

In the same way that the needs of consumers determine the value-price-cost of final goods, so the needs of firms determine the value-price-cost of input factors. This is true not just in the final step from some input factors to a finished good, as when a factory assembles a computer, but for every intermediate step from raw materials to input factors to finished goods, and for all the circular connections among the intermediate steps.

Best Use of One Resource. In jargon: A firm best uses a resource when it allocates the resource so that the return it gets from each marginal use of the resource in any alternative use is the same for all alternative uses. In this way, a firm maximizes its return from the resource, and maximizes any potential profit it might make from the resource.

An example: Barney runs a bakery. To his baked goodies, he adds raspberries from his garden: directly in the batter, as part of the filling, or as an icing. Barney uses raspberries in tarts, pies, cakes, turnovers, cheesecakes, fruit bars, and other stuff. He spends time and labor growing raspberries and picking them. Barney hates to do all housework such as vacuuming, mopping the floor, cleaning the bathroom, and laundry. Barney can tinker on cars but needs professional help sometimes. Barney needs help with his webpage. Barney trades his baked goods for help with work of all kinds. Barney has to think about how to allocate the raspberries from his garden into his baked goods in the best way so as to get people to do the most work for him in return. Barney has to use raspberries cost effectively to get the greatest return.

Barney uses raspberries cost effectively by putting the correct amount in the various baked goods. Everyday, Barney has about 20 cups of raspberries from his garden that he can allocate among the various baked goods so as to please the customers and so as to make them wiling to trade their labor in exchange for his goodies.

Barney could directly follow his own sweet tooth (his own utility). He could put a lot of raspberries into a chocolate cheesecake while putting few into a standard pound cake. If he does this, he is likely to end up eating most of what he made and end up not getting much in exchange for his goods. He cannot run a business firm this way. He has to please his customers or other bakers will do it instead. As a business firm, Barney has to pursue only the maximum return for his goods, as measured in some objective way such as the number of hours people are willing to trade for his goods or the number of silver coins people are willing to trade for his goods. This is the difference between acting as a private individual versus acting as a business firm.

Barney starts by dividing 15 cups of raspberries into various uses, in large lumps to each use. This is the “part that goes before”, the part that is not on the margin, the part to which marginality theory does not pay much attention (marginality theory can deal with this allocation as well but to do so here would not be very helpful and would take a lot of space).

That leaves 5 cups to allocate. Barney does not allocate this amount in large lumps such as a cup at a time. Rather, he allocates just a few spoonfuls at a time, carefully considering where each few spoonfuls will do him the most good. This is the marginal amount, the amount “right now”, with which marginal theory is most concerned.

Barney thinks, “Where can I put a few spoonfuls so as to get the greatest interest in my baked goods? Where can I put a few spoonfuls so as to inspire people to trade the most for my baked goods? Should I put three more spoonfuls in the cheesecake, two more spoonfuls in the tarts, and one more spoonful in glazes? Then, if I have more left over, I can put more into other various uses.” Barney does this with each spoonful until the raspberries are all gone.

Another way to see Barney’s strategy is: “Where can I put this marginal spoonful of raspberries so as to most enhance the appeal of a particular goodie so as to get people to exchange the most labor in return for this marginal spoonful of raspberries? How can I use each marginal spoonful of raspberries so as to maximize the marginal return I get from labor in exchange?” This is how a business firm thinks about using resources except that it thinks in terms of maximizing profit in return rather than in terms of maximizing labor in return.

By allocating the raspberries so that Barney gets the maximum return on each marginal spoonful of raspberries, Barney gets the maximum total return on the raspberries as a whole.

When Barney has finished allocating his raspberries so as to get the maximum total return on raspberries, the return that Barney gets on every last (marginal) spoonful of raspberries is about the same as he gets on any other marginal spoonful of berries. The return that Barney gets from the last (marginal) spoonful of berries in the cheesecake is about the same as the return that Barney gets from the last (marginal) spoonful of berries in the glaze for a chocolate tort. If this were not so, Barney would not be getting the greatest total return – Barney would suffer an opportunity cost. If this were not so, Barney would move one spoonful from here to there until it was true.

Typically in balanced strategies, balanced markets, and all kinds of balances in economics, the return from marginal units is the same for every use to which they are put.

To be precise, I would have to take cost more into account than I have done with Barney, but that complication would not change the basic principle of equal returns from all marginal uses of all resources. This is one way we can recognize a balanced situation.

By getting the maximum return out of any resource in the same way, Barney maximizes his total return of labor in exchange for his baked goods. By allocating cream, sugar, butter, milk, white flour, wheat flour, nuts, raisins, eggs, and all resources in the same way, Barney maximizes the return that he gets on the marginal use of each particular resource, on the total use of each particular resource, and on the total use of all his resources. Real bakeries, and real firms in other businesses, actually go through these kinds of considerations when they think about how to run their ventures.

Why does Barney allocate exactly 20 cups of raspberries? Why does he not use 12 cups or 25 cups? Barney has to work in his garden to get the berries that he allocates. The work is a cost to Barney. The more that Barney works in his garden, the greater is the cost while the lesser is the reward. Barney gets labor from his customers in return for his own labor in the garden. As Barney gets more labor from his customers, that source of utility declines. Eventually, the return of labor from his customers does not make up for the labor that Barney has to expend himself in his own garden. At that point, it is no longer worth it to Barney to cultivate more raspberries to put in goods to exchange for labor from his customers. There is a certain amount of raspberries that maximizes the gain that Barney gets from trading his labor for the labor of others; that is 20 cups of raspberries per day.

All firms do the same thing to the extent they can allocate resources between uses. If a firm has only one resource that it transforms into only one good, then it acquires the resource, and transforms it, until the gain from selling the finished product only just makes up for the cost of the resource. A woodcarver buys wood and carves it only as long as the gain from the sale of the carvings makes up for the cost of the wood (leaving out of consideration the cost of tools, medical care, advertising, etc.).

Most firms can use resources in various ways, even within one venture. A woodcarver can make little pink flamingoes or can make copies of Michelangelo’s “David”. Firms acquire a resource up to the point where the gain in exchange only just makes up for the cost of the resource. Firms allocate the resource between various uses so as to maximize return. They use the marginal return from alternative uses to guide them to the maximum return. A woodcarver carves various figures. A house builder first puts wood into those parts of a house where he-she has to put wood such as the frame and the underlay for floors. Then the house builder allocates wood in various less critical uses such as banisters, window frames and cabinets. In so doing, the builder gets the most out of the uses of the wood. Hospitals allocate nurses between units while school districts allocate teachers between schools.

In Money Terms. Now that we have introduced silver money above, we can use it to restate Barney’s actions in more familiar terms.

Barney spends 100 silver grains on 20 cups of raspberries. He wants to allocate the berries so that he gets the most silver grains in exchange for them.

Barney does exactly the same thing except that he thinks in terms of silver grains instead of labor. Barney starts out by using 15 cups in obvious places. Then he allocates the last 5 cups spoonful by spoonful so that he gets the most in return for each spoonful. If he puts too much in the tart fillings and not enough in the cheesecake, then customers will not pay as much as he asks for either, and will not buy all of them.

Why does Barney buy only 20 cups for 100 silver grains? Barney has learned that the most additional return that he can get for all uses of raspberries is 100 silver grains, and that he needs 20 cups of raspberries to get this much silver in return. If Barney uses 15 cups for 75 grains, he gets only 60 grains in return. If he uses 25 cups for 120 grains, he gets only 110 grains in return. 20 cups for 100 silver grains maximizes his return in silver for his investment, just as, above, 20 cups maximized the labor that he got in exchange.

It is simpler to talk in terms of money but it can be misleading. It is worth laying a foundation in exchange first so that we can be confident and precise when we do use money for convenience.

Barney’s use of 20 cups for 100 silver grains says nothing about whether he makes a profit. In fact, under perfect competition, he does not make a profit, but we have to wait to see why.

Lessons from Barney’s Allocation of One Resource.

Opportunity Cost. Barney allocates raspberries (resources or input factors) cost effectively so as to get the greatest return from the marginal use of the resource. If Barney did not allocate resources in this way, then Barney would suffer an opportunity cost at each misuse of raspberries. If Barney put an extra spoonful of raspberries in a glaze when that spoonful would have brought a greater return in a tart, then Barney has lost some return from that spoonful of berries. Barney suffered an opportunity cost. So, another way to think of his actions is as minimizing opportunity cost. Barney acts cost effectively both when he minimizes opportunity cost and when he directly maximizes return; in a well-run firm it should all amount to the same thing.

Equalized Marginal Returns. When Barney has carried out his strategy fully, then the returns from each marginal use of every resource are equal. This is just another way of seeing the force of opportunity cost. If this were not true, then Barney would not be getting the greatest return from some marginal use of some resource, such as raspberries. Barney would shift spoonfuls of raspberries from one use to another use (muffins to pound cake) until it was true.

Sum of Costs. The sum of the labor that Barney puts into getting raspberries to put into his baked goods to exchange for labor from his customers equals the labor that Barney gets in exchange. The cost of the component that goes into a final good equals the price of the final good. This relation would be true not only for raspberries but for all components. This relation is true not because the cost of the component determines the final good but because of what Barney can get in exchange for the final good. This relation is true because the price of the final good determines that the sum of costs for the components equals the price of the final good.

Public Welfare. When Barney uses raspberries most cost effectively to get the greatest return for his bakery, he also uses raspberries so as to provide the greatest utility to his customers from raspberries. Barney uses resources most efficiently to yield the greatest total welfare among the general public. If customers did not get the greatest utility from Barney’s use of resources, they would go to another shop that did use resources so as to give them the greatest utility. The same is true of any other resource such as cream or eggs. When Barney uses resources most cost effectively so as to gain the greatest return for his firm, he also automatically uses resources most efficiently so as to provide the greatest utility (welfare) to people in general. This is true not only of Barney’s use of resources in his bakery but is also true in all cases, although I do not point it out for each case.

Two Terms. The return that Barney gets from each marginal spoonful of raspberries is the “marginal revenue product” from that spoonful. The extra (marginal) labor that Barney gets from his customers in return for each marginal spoonful of raspberries is the marginal revenue product from that spoonful, expressed in terms of labor. The term “marginal revenue product” is actually a technical term from mathematics, so I change it slightly to “marginal revenue productivity”, which has more intuitive sense. I have been stating return in terms of labor for this example so that we do not rely too much on money, but usually marginal revenue productivity is stated in terms of money. With money, Barney thinks about how much more money revenue he can get from one more spoonful of raspberries put to a particular use.

The idea of marginal revenue productivity applies not only to raspberries but to any resource, so Barney can think about how much more revenue he might get from the next (marginal) spoonful of cream, chocolate, or cheese in any particular use.

Marginal revenue productivity is almost always positive because, if it were negative, that means a firm lost revenue (money) with each additional bit of resource – and firms will not do that.

Because marginal revenue productivity is almost always positive, it is easier to think of it in terms of cost effectiveness. The marginal revenue productivity of any resource is the cost effectiveness of that resource. Because people respond to the term “cost effectiveness” better than to the term “marginal revenue productivity”, I use “cost effectiveness” more often; but I sometimes include “marginal revenue productivity” in parentheses to remind the reader of the more technical term.

Change at the Margin. We could also understand Barney’s strategy by looking at what makes the biggest difference at the margin. We can take a spoonful of raspberries out of any particular use, such as cakes, and put it into every other possible use, such as tarts and pies, to see what happens. Which returns change the most? We can put in another spoonful of raspberries to see which use (cakes or tarts) increases revenue (labor in exchange or silver grains in exchange) the most. We can see if revenue from some use actually declines. This technique of varying at the margin gives a sense of what is most cost effective, and why Barney uses the proportions that he does.

Economists often use this technique to understand the effects from several resources at once. They vary several resources at the same time, at the margin, to see which has the most effect on revenue. You should know of this technique for multiple resources in case you run into it in readings but the details are not needed here. In later examples, we will use this technique with several input factors at the margin to get a sense of what is most important, to get a sense of “what is really going on”.

Everything Together. As it is with raspberries, so it is with all other input factors too, including honey, sugar, flour, cake pans, ovens, baking powder, yeast, and the time (wages) of employees. Think of how to apportion honey between various baked goods so as to get the most in exchange from those goods – not necessarily so that they taste best to the baker. As it is with bakers, so it is with all firms and all their resources including carmakers, doctors, lawn care, bicycle shops, musicians, politicians, universities, etc.

Best Use of Multiple Resources. In jargon: Business firms use a bit from each of several resources together so as to maximize their return from all the resources. Firms use marginal (additional) revenue from a marginal (additional) application of each resource to guide their use for all the resources together. When firms maximize their return on several resources together they also maximize their total return. We can see this well enough in the use of two resources together in the same good. From two resources in one good, we can generalize to many resources in many goods.

In example: Sally runs a local diner. Sally makes jambalaya, shrimp Creole, goulash, stew, barley-and-beef soup, and other thick and hearty soup-like food, served with various breads. She makes about 20 varieties. She makes soups in large 20-gallon pots. Like Barney, Sally has to decide how to apportion ingredients between different uses.

Like Barney with his raspberries, Sally has to decide how much meat to put in the stew, beef and barley, lentils, or chili so as to get the most in exchange for a bowl of any of them. Sally does not put labor into raising beef but instead exchanges little pieces of silver for the beef, and she gets little pieces of silver in exchange for her various bowls of soup. Even so, it is the same problem, and she solves it the same way. Think about having 50 pounds of cut-up beef and apportioning it out to the various pots. I do not go through the details.

Sally has another problem: how much of each of various multiple input factors (ingredients) to put into each particular pot. How many potatoes, and how much meat, should go into the steak-and-potatoes soup? How many beans, and how much meat, should go into the chili? How much tomato, and how many carrots, and how many alphabet bits, should go into the vegetable soup? How does she best use multiple resources together in one soup? If we can solve this problem for two resources together at once for one kind of soup, then we can extend the idea to many resources and to many different final goods (soups).

Sally could follow some recipe but that recipe might not match Sally’s taste or the taste of her customers. Sally could follow her own taste, but her taste might not match the taste of her customers. Like Barney with raspberries, Sally has to learn what works best by trying out the ingredients to see what her customers respond to.

Sally figures out her problem of multiple resources much as Barney did with one ingredient. Suppose Sally makes a big pot of chili. At first, she adds a double handful each of meat and beans. These initial handfuls are the parts that go before the margin, about which marginality theory does not have to pay close attention here (but which could be handled by marginality theory if we needed to be exact and tedious).

After this big lump at the start, then Sally has to start working on the margin. Into the chili, she adds a cup of beans, and then a cup of meat, to see which has the best results. As long as beans keep working best, she adds more beans until they start having less effect. Then she adds beef chunks until they begin to have less effect. Eventually she figures out how much beef and beans to add in her chili so as to most please her customers and to get the most from them in return. She has used beef and beans together so as to be most cost effective.

Sally does not add too much because she does not add more than causes her to get at least as much in return. Sally does not add another cup of beef to the pot of chili if the beef cost 2 silver coins per cup but brings in only 1 more coin in trade. That would not be cost effective. The same is true for beans or any other ingredient.

When Sally knows how much of each ingredient to put in each pot, she has used her ingredients most cost effectively to maximize the return-in-exchange that she gets from her venture. She maximizes her return. She gets an equal return from each marginal use of every resource. She has used her opportunities fully and suffers no opportunity cost. This is the basis for maximizing any profit she might get as well. Even though the ingredients act together, and their effects cannot be easily separated, by using this method Sally can still be sure to get the most return for her inputs.

We can get a good sense that Sally has succeeded by seeing what makes the biggest difference at the margin. Sally can take out a cup of beans first to see what difference that makes on sales. If sales diminish more than the cost-price of the cup of beans, then she puts it back in. Sally can add another cup of beans. If sales diminish more than the cost-price of the cup of beans, then Sally takes it out. She can do the same with a cup of beef. She can even do the same with both beans and beef at the same time. Eventually she can be sure that she has put in exactly the right amount of both ingredients, no more and no less. Real cooks in real restaurants actually do all this. So do real cooks for families at home but they measure success not with silver in return but with how hearty the appetite of their small customers.

As with meat and beans, so with tomato sauce, chili, peppers, onions, garlic, bits of carrots, and anything else we might put into any pot. Eventually Sally has to learn how to balance ALL the ingredients for any particular kind of soup, and between all the various soups. The more ingredients there are, the longer it takes, and the more minor variation the customers can stand; but the general idea is no different than with two ingredients for one kind of food.

A Few Complications, Same Results. Real business firms have to take other considerations into account, but the technique is no different than when Barney apportions resources between goods or when Sally decides how much of each resource to use in any one particular good. I do not give details on how to solve these problems, but only list the problems to make readers comfortable.

Value Rather Than Physical Quantity. The biggest difference is in a shift from physical quantity to value-price-cost. Instead of thinking in terms of cups or spoonfuls, Ralph, Sally’s rival, thinks in terms of the value of ingredients. He has to think in terms of the value-price-cost of ingredients in relation to the value-price-cost of final baked goods. If money is used in his economy, he has to switch to think in terms of that money.

Sally already thinks of her ingredients in terms of small grains of silver rather than in terms of physical quantity. The cost of ingredients differs per unit of physical quantity, so that a cup of beans might cost one silver grain while a cup of meat might cost two silver grains. In this case, Sally has to figure how to get the best return not per cup but per grain of silver.

She can do this by adding the beans and meat not per cup but per grain. For example, when she thinks about adding a cup of meat, she really thinks about adding two silver grains worth of meat; if she thinks about adding a cup of beans she really thinks about adding one silver grain worth of beans. In this case, she is liable to add meat one-half cup at a time (one grain at a time) and to add beans one cup at a time (one grain at a time) for a more accurate comparison.

All firms have to figure out the return per unit of value. In real economies, they use money to assess value, such as the return per dollar.

Simultaneous Variety. Most firms make more than one good, or make more than one variation on one good. A business firm both has to use the correct combination of ingredients in any one good (Sally) and to apportion out its resources to its various goods (Barney). Even with one good there is often some variation. Dispensing legal advice can be a good. No law firm specializes only in divorce cases between Asian middle class couples with exactly three. The “product” of a law firm includes a diversity of cases and situations, even when the firm specializes. Moreover, the young lawyers (input factors) in every firm differ a bit in their abilities. Wise senior partners learn how to apportion out the young members to their strengths.

Sets. Ingredients tend to come in sets, so there is some constraint on how resources can be used and can be mixed. A car takes so much steel, a house takes so much wood, a cake takes so many eggs and flour. Even so, there is “wiggle room” in all but the most fixed recipes, and so the general idea is true even if there are some constraints.

Lumps. Some resources come in large fixed amounts, such a cruise ship or an intercontinental jet passenger plane. It would be hard to fine-tune the service by offering half-a-boat or a plane-and-a-third. Still, the techniques of Barney and Sally work better than alternative ways of trying to figure out what to do, and lead to the same results for the economy.

Influence between Types of Business. Barney and Sally use some ingredients in common, such as eggs, milk, and corn syrup. Barney’s use of corn syrup depends to some extent on Sally’s use of corn syrup, and vice versa. If Sally is more efficient at using a cup of corn syrup then she gets a greater return on corn syrup than Barney. She can use more of it, and she can pay more for it as well. In that case, some bakeries will go out of business. Resources will flow from bakeries to eateries. This is familiar from Adam Smith. The difference is that now we can see that the flow depends on the marginal return to the resource in each kind of business. I will not go through the details. Figuring this out exactly was one of the advances of neoclassical economics.

Diversity from Unity. Corn syrup is only one of many products from corn, including: corn on the cob, corn meal, canned corn, ingredients in animal food, corn flakes, artificial sweeteners, and even ethanol as a fuel in cars. Corn is allocated between these uses according to its marginal efficiency (cost effectiveness, marginal revenue productivity) in each of the various uses. This would be easier to see if one business firm took care of all the corn products at the same time, like Barney with his raspberries in his bakery. Instead, many firms each take one, or a few, aspects of corn products. Corn is allocated between these businesses by how each business uses its corn products most cost effectively to maximize its return. When each firm in each business uses its corn products most effectively, then all corn is most efficiently turned into all its various products. It is the same way with all resources in all businesses, and business firms, in the entire economy.

Capital. Business firms see all resources as if the resources were variable ingredients in one complicated soup that can be pored into one venture or that can be pumped from one venture to another: the soup is called “capital”. Training, education, gasoline, land, work, planning, sales campaigns, concrete, wood, pipes, wires, electricity, etc. are all ingredients in a capital soup that can be fed to farms, shopping malls, dental offices, law offices, dentists, lawyers, teachers, gin mills, computer factories, programmers, or whatever, according to opportunity.

Capital is all resources considered from the point of view of being able to lead to revenue and to potential profit; able to move within ventures according to cost effectiveness; or able to move between ventures according to cost effectiveness.

Capital includes not only physical goods such as corn, or services such as legal advice, but also includes reputation and credit. In the modern world, reputation and credit are probably the most important forms of capital.

To think of capital by itself, not in terms of any specific resource that makes it up, is to think of capital in the abstract. We think of capital in the abstract in terms of money value. Capital in the abstract can be a little mysterious but it helps if we keep in mind that it always refers back in the end to some kinds of specific input factors. Money does not build a shopping mall until it turns into bricks and hours of sweat.

Value-Price-Cost of an Input Factor (Resource) as Its Marginal Revenue Productivity (Cost Effectiveness).

In the previous chapter, we saw that marginal utilities governed trade, and thus that marginal utilities set exchange rates. Exchange rates define the value-price-cost of goods. Carl and Teresa traded corn and tomatoes until they agreed on four large baskets of corn for five small baskets of tomatoes. This ratio of corn and tomatoes became the trading rate for corn and tomatoes in general. The value-price-cost of four large baskets of corn is five small baskets of tomatoes; the value-price-cost of five small baskets of tomatoes is four large baskets of corn.

We used Carl and Teresa to represent average people, and so they represented the average marginal utility that develops when many people trade the same final goods, and when opportunity cost and transitivity come into play. Their case showed the average marginal utility that arises even when people have a range of tastes. The trading rate develops among a group on the basis of this average marginal utility.

In jargon: In the same way, cost effectiveness (marginal revenue productivity) governs the process of manufacture, and therefore sets the substitutability of input factors (resources) in a final good. The ratio of substitutability for resources is like the trading ratio for final goods. It indicates how much influence any particular resource has on the value-price-cost of a final good. The substitutability ratio determines the price-cost-value of input factors (resources). An average ratio develops among all kinds of business firms despite modest differences in particular conditions of production. This average substitution ratio depends on the average marginal productivity, or average cost effectiveness, for a resource among all kinds of businesses despite modest variations between them. Average cost effectiveness (average marginal revenue productivity) of any input factor for making final goods determines the price-cost-value of the input factor for the whole economy.

In example: For now, it is easier to work through physical quantities rather than through price-value-cost. Sally discovers that she is best off using beans to meat in the ratio of three pounds of beans to one pound of beef. At the margin, three cups of beans can substitute for one cup of meat, or one cup of meat can substitute for three cups of beans. This substitution ratio determines the value-cost-price of resources just as the exchange ratio determines the value-cost-price of final consumer goods. Any other substitution ratio will result in less interest by her customers, and will result in a chili that is less valuable, that has a lower price. The value of three pounds of beans is one pound of meat, and the value of one pound of meat is three pounds of beans.

Suppose that Sally’s use of beans and beef represents the average use in the economy among many different kinds of producers. Other users of beans and meat find that they can substitute them in about the same ratio for use in the final goods that they make. This ratio shows the cost effectiveness (marginal revenue productivity) in bringing revenue to various kinds of businesses. This ratio sets the cost-price-value of beans and beef throughout the economy.

Carl and Teresa did not use money. Barney used labor time as a kind of money to evaluate the return he got on raspberries. Sally used silver grains. It does not matter, but it is easier to use silver grains.

Other business firms have to think of other trade-offs (substitution) but the result is the same because opportunity cost and transitivity tie together the entire economy. Burger joints have to think about the trade off between meat, buns, and condiments. Vegetarian soup restaurants have to think about the trade off between beans, carrots, and alphabet bits. If any one place did better with beef or beans than any other, resources would flow, and recipes would be adjusted. Eventually the price of beef in terms of other ingredients would be the same for all restaurants, and the price of beans in terms of other ingredients would be the same for all restaurants. And so it is also for the trade-off between beans and cooking gas, beef and cooking gas, and etc. for all of businesses all through the economy. The balance in the market for any one particular resource (beans or beef) is a particular equilibrium that gets tied into a general equilibrium.

Values. Now, instead of using physical quantities, we can rephrase in terms of value-cost-price, using money, with less danger of being misled and with more accuracy. In this case, I change the substitution ratios a bit to make sure the reader sees this situation in its own terms. Suppose a cup of beef exchanges for 2 silver coins while a cup of beans trades for 1 silver coin. If Sally uses 1 cup of meat for every cup of beans, then she loses some potential value; she over-uses meat in comparison to beans given their prices. If Sally uses three cups of beans for every cup of meat, then she loses some potential value; she over-uses beans in comparison to beans given their prices. For Sally to use beans and meat most cost effectively given their prevailing prices (costs) she needs to use 2 cups of beans for every cup of meat. This use equalizes the marginal cost of beans and meat even though it does not equalize marginal quantities. The public price-cost-value is more important than the physical quantities. Here the public price-cost-value is stated in terms of silver coins but it could be stated in terms of any medium of exchange, including the labor that Barney used.

The price of ingredients should reflect their effectiveness at the margin in drawing customers to exchange for the final product. The price of ingredients reflects the effectiveness of physical quantities. At the margin, Sally discovers that 1 cup of meat makes as much difference as 2 cups of beans. The substitution ratio of beans for meat at the margin is 2 for one. Looking the other way, Sally discovers that it takes 2 cups of beans to makes as much difference at the margin as only 1 cup of meat. Sally has to use twice as many cups of beans as of meat or else she will not use beans and meat cost effectively. It takes twice as much quantity of beans to equal one quantity of meat. This is another way of saying that meat costs twice as much per physical quantity as beans, or that meat costs 2 silver coins per cup while beans cost 1 silver coin per cup.

Ingredients get their value-cost-price initially based on their physical substitution ratios at the margin, according to their effectiveness in making final goods that are traded to customers. Their value-cost-price reflects their substitution ratios. Once ingredients get their value-cost-price based on their physical substitution ratios, their value-cost-price serves as a shorthand telling a firm how to use the ingredients.

Non-Circle. Using silver grains to assess value-price-cost points out a small circle in logic. This small circle is not really a problem but I mention it so that readers do not worry about it. I change the ratios to focus attention on the logic. In using silver grains to assess how much beef to put into a pot, Sally already uses the value of beef in terms of silver – say that beef has a value of 4 silver grains per pound. If the value of beef were different, Sally would use a different amount of beef. If the value of beef were 5 grains per pound, she would use less. If she used less, the substitution ratio with beans would change. The substitution ratio of beef with beans determines the value of beef, and so the value of beef would change. Here is the circle: If the value of beef was different, then that difference would lead to another value of beef. From the other way around, if the value of beef were 3 grains per pound, Sally would use more beef in relation to beans. The ratio of beef to beans would change, and so the value of beef would change. So we use value to derive value, and that is a logical circle. It is not a circle if we realize that we actually used the cost effectiveness of beef in relation to beans a long time ago in the background to give beef the value of 4 silver grains to begin with. The original value of 4 silver grains depended on substitution ratios that we forgot to mention. Silver grains now only measure a value that we determined directly through exchange and cost effectiveness a long time ago in the background. Changes in value can happen. Changes in value start with old values as a reference. So they do not necessarily trap us in a logical circle. This is all part of the magic of big and small for firms.

Using silver grains makes it easier to see changes in value and to assess the effects of changes in value. Even so, we need to keep in mind that value-cost-price are always based on exchange ratios or substitution ratios, that is on real stuff, real utilities, and real revenues.

Next Steps. Now that we know how a particular firm uses resources, we have to see how firms and consumers fit together into a whole economy. We have to see how firms create the public price system, then respond to the public price system, and then recreate the public price system in their response to it. The first step is to see how firms decide how much to produce, in particular how firms decide how big to make a plant (bakery or soup restaurant), and at what capacity to run a plant (how “hard” to run the plant).

Background to Plant Size. A “plant” is the production unit of a firm. For a carmaker, a plant is a factory. For a law firm, a plant is an office. For a retail chain store, a plant is one particular storefront such as the neighborhood Kroger.

Operating in Perfect Competition. In perfect competition, the idea of a public price means that everybody pays the same price for a good no matter how much of the good that they buy. A person pays the same price for chocolate cakes no matter how many he-she buys. The output goods from one factory are the input factors (resources) for another factory. The idea of a public price also means that a firm pays the same for units of a resource (pounds of sugar) no matter how much the firm uses for production and how many units of its own output (chocolate cakes) come from the resource.

We all know about wholesale versus retail, and about volume discounts. These seeming aberrations are really not large problems. Marginality theory can easily account for them but it would take too much space to do that here.

In perfect competition, a firm sells all units of any good that it makes for the same price no matter how few or how many units it makes. No matter how many cakes Barney makes, he sells them all for the same price. If this were not so, then resources (input factors) would not all sell for the same price because what is a resource (input factor) to one firm is only the output (good) from another firm. A constant buying price and a constant selling price are two sides of the same coin.

How Many Units to Make. If the selling price is the same no matter how many units of a good a factory makes, and the cost of resources is the same no matter how much a factory uses, then the only thing that a factory can control is how many units of a good that the factory makes. The next few sections describe how a firm decides how many units of a good to make. Later sections tie this result into ideas about cost effectiveness and into implications for the economy.

Business people tend to think of the issues in this section in terms of average cost per good while economists tend to think in terms of cost per marginal good or in terms of marginal cost. The average method and the marginal method lead to the same results. It is harder to think in terms of the marginal method but more exact, and the reader will need to think in marginal terms if he-she ever goes on to take a course; so I talk in marginal terms where I can.

Marginal Cost and Marginal Revenue. The extra cost per each extra good made is the marginal cost per marginal good, or just “the marginal cost”. The cost of making one more cake or one more bowl of soup is the marginal cost. The revenue from any additional (marginal) unit made and sold is “the marginal revenue”. Because the price is the same no matter how many goods are made and sold, the marginal revenue is just the price of the good. The marginal revenue from the hundredth loaf of bread is the same as the marginal revenue from the tenth loaf of bread – just the public price of a loaf of bread – because that is the price of bread under perfect competition. Marginal revenue is constant.

Varying Costs. If the price per unit did not vary and the cost per unit did not vary either, then there would not be much for me to talk about. No matter how many units a factory made, the results would be the same. As it turns out, the cost per unit does vary. There are four kinds of costs to consider. As it turns out, the first three are much less important than the fourth, but they have to be described because people know about them and want to consider them.

(1) Start Up Costs. Before a restaurant, factory, or office can begin operation, it has to set up. Start up requires resources too. Before Sally can begin her diner, she has to build a storefront, decorate the place, buy cups and saucers and spoons, buy stoves and heaters, buy large soup pots, and hire employees. These are “fixed costs”. Sally has to pay these costs no matter how much she sells or how little she sells.

(2) Necessary Regular Costs. Sally also has to pay some costs regularly every month. If she does not buy her building outright, she has to rent one. She has to pay monthly electricity, gas, and water. She is likely to have monthly plumbing and similar repair bills. She has to maintain a skeleton crew no matter how little or how much she sells.

Necessary regular costs include the salary to the owner-manager of a business as the manager. They do NOT include any profit of any kind. They specifically exclude the normal profit that many business people expect on any investment, about 5% to 15%. We have to see where profit might come from; we cannot mysteriously assume profit from the beginning.

The start up costs and the necessary regular costs together are sometimes called “fixed costs” or “fixed capital”.

(3) Monthly Costs. Usually fixed costs, including start up costs, are arranged so that they do not have to be paid off all-at-once at the beginning of a business venture but are spread out over a long period of time through monthly payments. Suppose that a restaurant usually has to go into debt for $100,000 to start out. The restaurant would arrange to make monthly payments of $5000 to cover the fixed costs, including start up costs such as equipment and necessary monthly costs such as rent and insurance. For simplicity, we can consider the monthly payments of start up costs and necessary regular costs as the monthly costs.

Monthly costs represent the fixed costs.

(4) Variable Costs. This is the most important cost. Variable costs vary with the amount of production. As Sally increases production, she has to replace what she uses up in production, and eventually she has to buy more. She has to buy more meat, vegetables, and other soup ingredients. She has to hire more employees. She has to bring in repair people more often. She might have to hire an accountant and a lawyer.

Together, fixed costs and variable costs determine how big Sally’s operation will be. They set the operating capacity of any plant in any venture, including factories, restaurants, offices, and store fronts. At first, fixed costs are more important, but then variable costs dominate. Eventually variable costs set the number of units made, the operating capacity of the plant.

Some costs are on the borderline between categories, such as if Sally is buying her diner with monthly payments rather than renting it. Borderline cases do not alter the main argument, so I do not consider them.

Rising Marginal Cost: Sally’s Diner Again 1: No Profit.

This section explains the size of Sally’s operation without any consideration of profit. The next section considers profit.

No matter how many bowls of soup Sally sells, the public price system fixes the maximum price per bowl that Sally can charge; say 5 grains of silver. Marginal revenue is the price per bowl, so marginal revenue is constant.

Marginal cost seems to start low because fixed costs dominate at first. Suppose monthly fixed costs are 100 silver grains and that production is 1 bowl of soup. The first bowl of soup is also the latest, or marginal, bowl of soup. The cost for the first bowl of soup is the entire 100 silver grains, so the cost per marginal bowl is also 100 gains. Suppose production goes up to 2 bowls of soup. The cost per bowl is now 50 grains, and the marginal bowl is the second bowl, so it cost 50 grains less per bowl to produce the second bowl than the first bowl. Marginal cost has fallen from 100 grains to 50 grains! This sound good but it is only an illusion. Sally’s marginal cost dropped to 50 grains but her marginal revenue (selling price) is still only 5 grains. If Sally sells only 2 bowls of soup, she will go bankrupt, so we cannot take this situation seriously. Marginal cost continues to fall until rising variable cost dominates fixed cost. For Sally to make any profit at all, marginal cost due to fixed cost has to fall below marginal revenue (selling price) of 5 grains per bowl. That happens at about 20 bowls of soup. Say that Sally makes and sells a minimum of 100 bowls of soup, so that marginal cost due to fixed costs is only a small fraction of the total cost of producing 100 bowls of soup, about 1 grain per bowl. If Sally sells much more than 100 bowls of soup, then marginal cost due to fixed costs can be ignored. Now we can concentrate on the effects of rising variable cost.

Eventually marginal cost rises because rising variable cost dominates fixed cost. Eventually the cost of ordering supplies, paying existing employees, hiring new employees, making a lot of soup, making a lot of soup sometimes in a hurry, taking deliveries, and hiring accountants all begins to be more important than fixed costs spread out among all bowls of soup, and these costs begin to rise. Variable costs begin to determine the cost-per-bowl.

Suppose we have reached the point where variable costs are important but have not yet started to rise much. Assume that fixed costs make a small contribution in the background so we can just take fixed costs for granted and ignore them.

As long as marginal cost is below marginal revenue (selling price), Sally should increase production by making more bowls of soup. So, when Sally makes 100 bowls of soup, the cost due to ingredients, labor, napkins and other variable costs is 1 silver grain per bowl. 1 grain per bowl is well below the selling price (marginal revenue) so Sally is making money and should continue to increase production.

Sally increases production to 200 bowls. Now marginal cost increases and Sally feels its effect. The cost per bowl goes up from 1 grain per bowl to 2 grains per bowl. Marginal cost, the cost of making another bowl, is now 2 grains per bowl. If the cost of making another (marginal) bowl of soup is 2 grains of silver but the price is 5 grains, then Sally still makes a profit of 3 grains per added (marginal) bowl. So she should make more.

Sally increases production from 200 bowls to 300 bowls. Marginal cost rises from bowl 200 up through bowl 300. The cost per bowl (marginal cost) goes up to 3 grains per bowl at bowl number 300. Do not worry about average cost or total cost. The marginal cost is now 3 grains per bowl. Yet marginal revenue is still 5 grains per bowl, so Sally should still keep making more bowls.

Sally increases production from 300 bowls to 400 bowls. Marginal cost rises from bowl 300 up through bowl 400. The marginal cost goes up to 4 grains per bowl at bowl number 400. Again, do not worry about total cost or average cost. Even though marginal cost has now risen to 4 grains per bowl, marginal revenue is still 5 grains per bowl, so Sally should still keep making more bowls.

Sally increases production from 400 bowls to 500 bowls. Marginal cost rises from bowl 400 up through bowl 500. The marginal cost goes up to 5 grains per bowl at bowl number 500. At this point Sally makes no more profit from more bowls of soup. If Sally made less than 500 bowls, her costs per bowl would be below marginal revenue (selling price) and so she would miss out on some potential profit she could have made. If Sally makes more than 500 bowls, her costs per additional bowl (marginal bowl) will be above marginal revenue and so she will lose money. She should make about 500 bowls.

This process of increasing production keeps going until marginal cost rises to equal marginal revenue. When marginal cost rises to reach marginal revenue, Sally should stop producing any more bowls of soup. That point sets the optimal capacity of Sally’s diner. The same is true of all plants for all kinds of business for the whole economy.

As long as marginal cost (cost per bowl of soup) is below marginal revenue (price per bowl of soup), Sally makes a potential profit on each bowl of soup. As long as marginal cost is less than price, Sally makes a potential profit. When marginal cost equals price (marginal revenue), Sally can no longer make a potential profit, and should stop. If cost ever exceeds price, then Sally would make a loss, and so Sally should scale back production.

In real life, plants can rarely hold production steady at the point where marginal cost exactly equals marginal revenue. Some days Sally sells 450 bowls while other days she sells 550 bowls. Some days broken dishes make variable costs (marginal costs) higher while some days good tips make marginal revenue higher. But real firms know about what level they do best at. Real restaurants know about how many customers it takes to make a really good day, and know that they actually make less if they have too few or too many customers.

This account leaves out of consideration the exact role of fixed costs except as something in the background, and it leaves out the full interplay between fixed costs, variable costs, and marginal cost. Sally has to cover fixed costs as part of her marginal costs. She does that when she covers marginal cost. I cannot give any more detail without going into too much detail.

Sally’s Diner Again 2: Profit Considered.

Pick up where Sally has just increased production from 100 bowls to 200 bowls. The marginal cost for the first 100 bowls was 1 grain per bowl.

It would be great for Sally if the cost of the second 100 bowls (from 100 to 200) had no influence on the first 100 bowls, but it does. The rise in cost of the second 100 bowls (from 100 to 200) changes the cost of the first 100 bowls so that now all bowls have the same effective marginal cost. The marginal cost of all 200 bowls, from 1 bowl to 200 bowls, is now 2 grains per bowl. This outcome is a bit mysterious but it comes from the same roots as the fact that marginal utility sets the exchange rate for goods as in the previous chapter. To explain it further would require a really long version.

This “contagion” of the cost of the marginal bowl to all the bowls that go before does not matter though, as long as Sally’s costs per bowl are still below marginal revenue, or price per bowl. Even though the cost per bowl is now 2 grains for all bowls, as long as marginal cost is below marginal revenue, Sally still makes a profit, and she should continue to increase production. As long as the marginal cost is 2 grains of silver and the price that Sally can charge is 5 grains of silver, Sally makes a potential profit, and she should make as many bowls as she can.

Sally increases production again. As she increases production, marginal cost rises again, forcing up the effective cost for every bowl that is produced. Effective marginal cost has now risen to 3 grains of silver per bowl. Cost per bowl has now risen to 3 grains per bowl for all bowls, even the bowls that Sally made before this increase in production. Sally still makes a potential profit, and so should still continue to produce more.

As Sally increases production, eventually marginal cost rises to 5 grains of silver per bowl. Then, effective cost equals marginal revenue for all the bowls that Sally makes, including all the ones that went before. When marginal cost equals marginal revenue, effective cost per bowl equals revenue. Now Sally cannot make any profit, potential profit or real profit. Sally cannot make any profit on the most recent bowls, and she cannot make any profit on the previously cheaper bowls that went before. Any potential profit has disappeared entirely. Sally makes no profit, although she does break even. She runs a healthy business and earns a good salary as the manager of that business.

Reaching the Goal. At this point, Sally has now found the optimum capacity for her plant (restaurant) and she has found the optimum size for similar firms in the same business. Other diners are likely to be about the same size, and this is what we find in real life. In the same way all fast food restaurants are about the same size even if they are of different ownership like McDonald’s, Wendy’s and Burger King; most department stores are of similar size such as Penny’s, Sears, Dillard’s, and even Macy’s; and most supermarkets are nearly the same size such as Wal-Mart, Kroger, and Safeway.

Some firms in the soup diner business have only one plant (restaurant) while some have more than one. The combination of all the soup restaurants for all the firms in the soup diner business makes up the production for the whole business. The combination of all the production for all the plants, for all the firms, for all the businesses, in the whole economy makes up production for the whole economy. The production for the whole economy determines how much salary all workers together get. The salary of all the workers together needs to be enough so that they can buy the total production. The production of the whole economy determines how much revenue the firms get so that they can buy all the raw materials to make the goods.

No Profit. This is a happy outcome but it leaves out profit. That is what happens in perfect competition. Even so, people find this result a bit odd at first. So, to be sure, we need to look again to see if Sally could have done anything to make a profit.

Sally had been doing well by increasing production, yet now finds herself unable to make any profit. She increases production again to see if that helps. When she increases production again, she finds that the marginal cost has risen to 6 silver grains per bowl. Marginal revenue is still only 5 silver grains per bowl. Now Sally is even losing money! The restaurant is crowded, the workers get in each other’s way, people get the wrong food and do not pay, food is wasted, some people file lawsuits, and deliveries are not received on time. So many things go wrong that seemed to go right when the diner was running at a lower capacity for these facilities.

So Sally scales back production. She tries to drop back to a marginal cost of 4 silver grains per bowl so that she can make a profit of 1 gain per bowl, or a 20% rate of profit. That is a good rate of profit. Too bad for Sally, here the Invisible Hand reaches in. Steven, her competitor, had been in the same situation as Sally, operating at a marginal cost of 5 grains per bowl and making no profit. He tries to scale back too, and he tries to lower his price to capture as much of the market as he can. Steven does not lower his price to 4 silver grains per bowl, to marginal cost, because he sees that, if he did, 4 grains would become the new market price, and he would not make any profit there either. He would be in the same situation as before. So Steven holds cost at 4 grains per bowl but he charges 4.5 grains per bowl. At first this works. All the customers go to Steven. Steven makes a profit.

But it cannot work for long. Serena, the owner of anther soup diner, gets the same idea. She scales back to a cost of 4 grains per bowl but charges 4.4 grains per bowl. Then she gets all the market from Steven. Then Sebastian does the same thing to Serena, lowering the price to 4.3 grains per bowl. This goes on until all firms are driven to a production level with a marginal cost of 4 grains per bowl, and to a public price of 4 grains per bowl, and there is no profit at all again.

In that case, all the firms might as well have accepted the original situation with a production level that yielded a marginal cost of 5 grains per bowl and a public price (marginal revenue) of 5 grains per bowl. That is the most stable situation, and that is what the market moves to.

When firms were trying to make a profit, they did it by scaling back production below the level where production would have been on a free market. This result is typical of imperfect competition, where production is reduced to below what would have prevailed on a free market so as to take advantage of the gap between marginal cost and selling price (marginal revenue). When firms can get away with this tactic, it leads not only to reduced output levels but also to perceived shortages and a misuse of resources.

Now we go the other way, up from 4 grains per bowl. Suppose the price reaches a temporary new stable point at 4 grains per bowl, so that marginal cost equals marginal revenue at 4 grains per bowl. To hold marginal cost at that low level, the quality of product had to deteriorate. Cheaper price necessarily requires a switch to cheaper ingredients – this is part of imputation. The customers are not satisfied by cheaper product even at a cheaper price. By offering increases in quality, better service, and other amenities, some diners are able to increase production costs to 4.5 grains per bowl but can charge 5 grains per bowl. They capture a portion of the market through a different tactic in a different direction. Soon all diners follow suit in that way too. Then some diners offer a better quality of product that costs them 4.6 grains per bowl, and the customers go to them. Then some diners invest 4.7 grains for an even better product, and customers go to them, and so on. The market edges up-and-up again until marginal cost is 5 grains per bowl and the marginal revenue is 5 grains per bowl.

Eventually the market stabilizes at this marginal cost and this marginal revenue, 5 grains, where it all began. Nobody makes a profit, but good managers make good salaries, the bills get paid, all the workers get an appropriate decent salary, and customers get a decent bowl of chili or chowder for a decent price. Nobody can lower the price or raise the cost. Firms can only decide on the size and capacity or their plants.

Key Ideas. The key ideas are:

(1) At first, fixed costs dominate. Marginal cost starts below marginal revenue (market price). As long as marginal cost is below marginal revenue, the firm can potentially make profit, and so the firm should increase production.

(2) Then variable costs dominate. Marginal cost rises while marginal revenue remains the same. Still, as long as marginal cost is below marginal revenue, the firm can potentially make a profit, and so the firm should increase production.

(3) Eventually marginal cost rises to meet marginal revenue. If the firm increases production beyond this level, marginal cost would exceed marginal revenue, and the firm would lose money. Here the firm can no longer potentially make any profit, and so the firm should stop increasing production. This is the normal operating capacity.

(4) Although the firm seemed as if it were going to make some profit, when it reaches the point of potential maximum profit, all profit disappears. The rising marginal costs ate into the potential profit that seemed to go before.

(5) This point is stable. Firms cannot long maintain conditions away from this point.

(6) Only if potential profit disappears in this way can imputation strictly hold. I go into this topic in later sections of this chapter.

(7) Business firms set the conditions to which they respond. In responding, they recreate the conditions to which they respond. This is part of the magic of big and small, and it is how the public price system works.

(8) Even though ultimately firms do not make a profit, they pursue potential profit. We can still understand what they do by looking at how they pursue the potential, even if they get little of the real. We can still understand Joe’s Garage by Joe’s hope of making a lot of money even if Joe does not make any real profit but only makes enough to pay himself a decent salary according to his cost effectiveness.

Range of Plant Sizes. Firms can delay the rise in cost per good (increasing marginal cost) by expanding the size of the office, factory, or storefront; by dividing internally into sub-units such as personnel and maintenance; by creating hierarchies; and by delegating authority.

These tactics work only up to a point. A clinic of forty doctors can avoid some of the bottlenecks in a clinic of two doctors. It can more exactly use various kinds of secretarial help, and can use server computers instead of multiple micros for all the employees. But a clinic of forty doctors has its own problems that lead to high costs per patient; and even in the large clinic the cost per patient has to go up eventually. The same is true of a bakery or of a factory to make cars. Even a GM plant or Toyota plant has a maximum best size.

At any given time, there is usually a range of good plant sizes, all with about the same efficiency, varying a bit in their particular specialties. An office run by one dentist who specializes in orthodontics (braces) can co-exist with a clinic of eight dentists with various specialties; a factory making 1000 computers can compete with a factory making 10,000 computers.

Some Comments.

In one business, the combination of outputs of all the plants of all the firms, each operating at its own best capacity, makes up the total output for the industry as a whole. This is the same output for the market when it is in partial equilibrium. The total output for all the dentists in the U.S. makes up all the capacity for dental work in the U.S. The total output of all corn farms in the U.S. makes up the total corn output in the U.S. This is the output when consumers and producers can agree on a price and quantity, as in the imaginary auction.

The combinations of outputs of all the types of businesses for all markets makes up the total output (total supply) for the economy as a whole.

Each type of business is in partial equilibrium in its market, and all the interlinked markets together are in general equilibrium. In general equilibrium, the salaries of all the workers together are enough to buy all the products of all the firms in all the businesses. All the firms in all the businesses make enough from selling their products to buy all the resources that they need and to pay their workers enough so that workers can collectively buy all product.

If firms could cooperate to thwart the normal self-regulation of the market, then they could make a real profit rather than a potential profit. If the firms in the case of Sally’s diner could conspire to maintain production where marginal cost was 4 grains of silver per bowl but the public price was still 5 grains per bowl, then they could all make a profit. In perfect competition, they cannot do this. In imperfect competition, some firms can do this.

Very large factories play a role in imperfect competition, particularly in modern economies after World War I. In those cases, the costs of production are below the selling price on the market, and the firm does make a profit. That topic is best taken up in the Chapter Six on profit and imperfect competition.

Coming Together at Equilibrium. The imaginary auction can help us to see some of the ideas of the previous sections.

Recall how the auction works: At a low price per unit of good, consumers wish many units but firms are willing to supply only a few. At one coin per loaf, Barney and the other bakers might be willing to sell half-a-dozen loaves each per day for a total of 200 loaves per day while the consumers would want a total of 5000 loaves per day. At a high cost per unit of good, consumers wish only a few units but firms want to sell many. At 20 coins per loaf, Barney and all the other bakers would supply 200 loaves each per day for a total of 10,000 loaves per day while all the consumers together could afford only a total of only 100 loaves per day. At some price in between, the total number of loaves that all consumers together wish exactly equals the total number of loaves that all firms together supply. At some price in between, the market balances, or “clears”. At 8 coins per loaf, Barney and the other bakers will supply 20 loaves each per day for a total of 1000 loaves per day, and the consumers together want a total of 1000 loaves per day. The market is in “partial equilibrium”.

In partial equilibrium, the price-cost-value of bread per loaf is the same for all consumers; it is a public price. This is the same result as when exchange ratio (value-price-cost) is the same for everybody in a public price system in a barter model from the previous chapter. Partial equilibrium helps make the public price system, and the public price system helps make partial equilibrium by guiding the actions of consumers and business firms.

In perfect competition, in partial equilibrium, the contribution from each plant from each business firms coincides with the optimal capacity for that plant. When the consumers and producers have come to agreement at the imaginary auction, the contribution from each plant is just that amount where marginal cost equals marginal revenue (the public price of the good), and where all profit disappears. This much coincidence can seem a bit amazing at first, but it is a true implication of all this logic. This is how resources get used efficiently.

If partial equilibrium did not coincide with optimum plant capacity, then marginal cost would have to deviate from marginal revenue. If partial equilibrium did not coincide with optimal plant capacity, then cost would have to differ from price. In that case, imputation could not be true. It could not be true that the value of the final good determines the cost-price-value of the resources that make it up. Because imputation is so important in the price system, we need to see that, in perfect competition, partial equilibrium coincides with optimal plant capacity.

When all this is true for partial equilibrium in each particular market for all goods and resources, it is true for the links between all markets and for the economy as a whole. It is true for general equilibrium.

In the previous chapter on exchange, both traders gained in the same way, so there was not much difference in roles and there were no points of view. Here, bakers sell bread to consumers while consumers buy bread from bakers, so there are points of view. To consumers, the buying cost is the same for all consumers and from all bakers; no matter how much any consumer buys. To bakers, the selling price is the same for all bakers to all consumers; no matter how much any baker sells. This is also an effect of the magic of big and small.

We need to look at another level too. Just as bakers sell bread to consumers, so also bakers buy corn syrup from suppliers. Besides bakers, a lot of other firms and people use corn syrup and buy corn syrup from suppliers as well, such as homemakers, and makers of ice cream, soda, most breakfast cereal, and animal feed. The same idea of partial equilibrium applies in the market for corn syrup. At a low price of 1 coin per gallon, the suppliers will provide only 100 gallons to the user of corn syrup while the users of corn syrup want 40,000 gallons. At a high price of 20 coins per gallon, the sellers will provide 100,000 gallons but the users want only 1000 gallons. At an intermediate price of 10 coins per gallon, the total amount provided by all suppliers just equals the total amount desired by all users – 40,000 gallons.

From the point of view of the firms and people that want corn syrup, there is one public cost for all corn syrup for everybody regardless of what they use it for, and no matter how much any user buys. From the point of view of the suppliers, there is one public price at which they sell to anybody that wants corn syrup, no matter how much any particular suppliers provides and no matter how much any particular user buys.

The same is true “up and down as well”. Corn syrup makers have to buy raw corn. Corn farmers have to buy seed, fertilizer, bug spray, and land. Bakers sell to consumers but they also sell to retail grocery stores and to institutions such as schools. What is a good from one point of view is a resource from another point of view. The same is true “sideways”. Corn farmers buy bread and they even buy corn syrup for various needs. Realtors buy bread and buy lots of other products from bakers and from farmers; and so on. The demand (by consumers and firms) for all goods connects to the supply for all goods. Eventually all markets connect in a single system of public prices. Each particular markets has its own partial equilibrium. All the markets together form a general equilibrium. All markets together clear when a set of prices can be found, one for each market, with all the prices linked together.

The real economy actually approaches this ideal closely enough to be amazing.

Everything Together. Under perfect competition, for each market in partial equilibrium, this is also true:

(1) The amount desired by all consumers coincides with the average marginal utility to consumers of the good, the average marginal utility that creates the stable exchange ratio for that good.

(2) The amount of each input factor used by any producer coincides with the marginal revenue productivity of each input factor. The total amount used of each input factor leads to its average marginal revenue productivity, the average marginal revenue productivity that creates the stable substitution ratio, and the stable exchange ratio, for that input factor.

(3) What is true in partial equilibrium for each separate market is true of general equilibrium for all markets.

Under perfect competition, partial equilibrium, average marginal utility, average marginal revenue productivity, exchange ratios, substitution ratios, and general equilibrium, all coincide and all reinforce each other. This result is a strong version of marginality theory. This strong version does not have to hold for the arguments in the rest of the book but it is useful to keep this strong version in mind.

Looking Backwards and Forwards. Recall from Chapter Two on Adam Smith and Classical economics that “total supply” is everything that firms make while “total demand” is everything that consumers want. The proper neoclassical term for total supply is “aggregate supply” while the proper neoclassical term for total demand is “aggregate demand”. In perfect competition, aggregate supply equals aggregate demand at general equilibrium when a set of prices (the public price system) leads all markets to clear at once, within each market and across all markets.

General equilibrium usually occurs when three things happen at once:

(1) The rate of interest leads savings to equal investment.

(2) Aggregate demand equals aggregate supply.

(3) Full practical capacity for the economy, including full employment and the greatest practical welfare attainable.

Profit tends to zero. Interest is a kind of profit, so we expect the rate of interest to dwindle to zero. In that case, interest could not serve to keep investment equal to savings. Interest could still play that role if banks pursued interest on loans, and bank customers pursued interest on savings, even if, in the end, interest vanished – just as firms pursue profit even though in the end profit vanishes. This alternative is needed for perfect competition but it is not needed in the real world where interest does persist. For now, we can still think that conditions two and three hold without worrying too much about condition one.

In the next few chapters we will see where profit and interest come from, and we will see that a lot of profit and interest depend on not being near perfect competition. Under imperfect competition, can the rate of interest still serve as an intermediary between savings and investment, and can it still serve as the pillar that holds up, and holds together, these conditions? Can we rely on the dynamic ideal to move us toward greatest welfare even if we are not there right now all the time? The answer is “yes, mostly”. But it is complicated and we have to consider situations in which the economy might not be at full capacity, savings might not equal interest, and aggregate demand might not equal aggregate supply.

Some Results for the Price System.

Cost Effectiveness. The beneficial results happen because business firms use resources cost effectively while consumers maximize utility. A kind of average cost effectiveness for any resource, among all business firms, determines the price that the firms will pay for that resource. A kind of average cost effectiveness for any resource, among all business firms, determines the price-cost-value of that resource. An average cost effectiveness for any resource determines how much of the resource is used totally among all business firms.

Magic of Big and Small. Together, all firms set the price-cost-value of any resource according to the average cost effectiveness for the resource among all the firms. Together all firms set the price-cost-value of all resources. This is the magic of the small.

Once all firms together have set the cost-price for any resource, any firm faces that cost-price as a given to which it has to adjust. The firm adjusts its strategy for seeking the greatest potential profit according to the prices-costs for all resources that it faces on the market. The firm adjusts its level of production so as to seek the potentially greatest profit.

No one firm can influence the cost-price of any resource, no matter how much it demands of the resource, or how much it supplies of the resource to other firms that demand the resource. No one supplier of corn syrup can influence the cost-price of corn syrup no matter how much corn syrup it can supply.

No one firm can influence the total quantity of a finished good (bread) or of any resource (corn syrup) bought-and-sold at market equilibrium, no matter how much the firm can supply. Barney cannot change the total number of loaves of bread in the bread market no matter how much he supplies.

That a firm cannot influence either price or supply is the magic of the big. Firms face the big market as if it were something outside of themselves, something given, to which they have to adjust.

Even though no one firm can influence price or supply, all firms together, and in cooperation with demand, set the total supply and price – the conditions to which firms respond. In responding to the conditions that they created, firms recreate the conditions to which they respond. This relation can seem circular but really it is not. This is the magic of the big and small together under perfect competition.

Of course, sometimes price and quantity change. That is a dynamic adjustment that we will look at in later chapters.

Caution about the Price System. The price system results from the simultaneous operation of the magic of the big and small in many markets. The price system can seem a little magical too. Sometimes economists write in a holistic way as if the price system were something in-and-of-itself, apart from the actions of particular business firms. Usually they write this way to stress the usefulness of the price system and to warn about interfering. Those are good points but we should not forget that the price system arises out of the actions of consumers and business firms. We cannot think of “the price system” or “the economy” as something that exists on its own apart. That is how we lose sight of flaws and problems, or how we justify modern mercantilism. Nor can we think of the price system as a magic guide to economic action without also realizing that consumers and firms make the guide before they use it. The price system is not the economy, nor is it a convenient substitute for strategic action. We have to think in terms of the actions of consumers and business firms in many steps through many chains.

Cost Effectiveness at the Margin, and Price. Barney uses 20 cups of raspberries per day in baking. It is not the first 15 cups that determine the price of raspberries but the last few spoonfuls at the margin that Barney distributes among various uses. It is cost effectiveness at the margin that determines price for all the units that are used, even those units that went before the margin.

The problem is that it can seem as if cost effectiveness at the margin is zero.

When Barney finally reaches the limits (margins) of cost effectiveness, the loss from expending the resource equals the gain from his customers that Barney gets from selling (trading) his baked goodies. In money terms, if raspberries cost 2 silver coins per cup: the last cup of raspberries that Barney distributes among various baked goods, a spoonful at a time, brings in only 2 silver coins’ worth of labor in exchange from his customers. The value-price-cost of what Barney expends on the last cup of raspberries brings in not much, really. So where is the cost effectiveness that serves as the basis for price? If we push this to the tiny limits, we see that one spoonful of raspberries brings in not much at all. This is like the paradox of the two traders who exchange goods of equal value but both gain. Where does the gain come from? If all resources are used so that they bring in about the same at the margin, and all resources bring in only a little tiny bit at the margin, how can we assign a price to the resources? This might seem an odd and finicky point, but people get confused about it.

The solution lies in varying things a bit at the margin to see what difference they make. We can see this solution in the last cup of raspberries. If Barney had NOT used this last cup, then Barney would have missed out on 2 silver coins’ worth of value-price-cost. If Barney had used another cup, he would have gained almost another 2 silver coins worth of return – but not quite the full 2 coins’ worth. The last cup that is fully worth using gains Barney 2 silver coins; and that is what it is worth, its price-cost-value. That final price determines the price for all units up to the marginal unit, for all 20 cups, not just the last.

To find the price, we vary the balance by a typical unit at the margin, and see what difference that variation makes in the exchange. That variation is the typical exchange rate for that typical unit. If a cup of raspberries typically makes a difference of 2 silver coins, then that is the price-cost-value of one cup of raspberries. If one cup of cream typically made a difference at the margin of 1 silver coin, then that would be the price-cost-value of one cup of cream.

Economists refined the technique of making variations at the margin to see effects. The point is not to understand the technique but to see that cost effectiveness at the margin sets the price for all resources, for all alternative uses of resources, for all business firms, for all businesses.

In later chapters, we will need to use this technique to understand how particular occupations get their wages, and how different occupations get their share of the total wealth of the economy.

Some Implications.

Do Not Interfere. With no flaws or problems in the public price system, any interference destroys the balance of cost effectiveness. The public price system leads to the most efficient use of resources. Thus any interference, except to cleanly correct flaws or problems, leads away from cost effectiveness and leads to less efficiency. It leads to poor use of resources and to less total capacity for the economy.

Adding Up, Imputation, and Time. Although, in the long run, the demand for a final good sets the price of the resources that make up the final good, this is not the way that most people see the relation, and it is not the way the relation works in the short run. Most people think that the price of a final good has to “cover” the cost of the resources that make it up, and that the price of a final good is the sum of the costs of its input factors plus some modest mark-up for profit.

In the short run, the common way of seeing is true. The price of jet fuel went up from about 85 cents per gallon in 2002 to about $4 per gallon in 2006 due to the Iraq war. Airlines had to raise their ticket fees or they would have stopped. The same was true for other businesses that used petroleum products. A similar increase went on in 2012.

In the long run, this common way of seeing the relation is not true. Instead, imputation is true. The long run relation shows us the importance of both demand and natural abundance in setting the price of final goods and of input factors. In the long run, people adjust their use of airlines, or cars, or plastics, or heating oil, or whatever. The price of a ticket depends not just on the new scarcity of jet fuel but also on how much people want to fly and on how much they are wiling to sacrifice to keep on flying. If enough people decide not to fly, then jet fuel will become relatively more abundant, and its price will decline.

Risk, Time, and Reward. This section switches topics to risk. The idea of risk closes out the static ideal. A venture is risky when the result cannot be known for sure but when we can apply good odds to the various possible outcomes. A venture is uncertain when we can only make a guess; we cannot even apply good odds. This chapter explains risk while the next explains uncertainty.

For example, the insurance business depends on accurately assessing risk. We can give good odds on the probability of how many men age 50 will live to reach age 75, or how many airplanes out of 10,000 will crash. We cannot know which particular man will die, or which particular plane will crash, but we can know the rate overall. That is enough to give good odds, and enough to carry out normal business. In contrast, politics in the Middle East is uncertain. In 2008, and again in 2012, we had no clear idea of how stable oil production from the Middle East would be. We could not be sure of what gasoline prices would be although we could be fairly sure they would rise. This is not as much information as we might like on which to run our business firm, but we have to try anyway.

Surprisingly, risk has little overall effect as long as firms can calculate odds and can arrange their strategies accordingly over a long enough time frame. Risk has almost no effect on business firm strategies, marginal revenue productivity (cost effectiveness), switching resources, the price system, the magic of big and small, perfect competition, or imputation. Risk makes calculating cost effectiveness more difficult but does not change calculations in principle.

No return is ever certain when risk enters. There is no “sure thing”. It is always possible to fail. Even when 99 out of 100 succeed, 1 will fail. We need to accept this fact when we think about what it means to invest and where to invest, especially with state funds. We need to look not just at the occasional great success but also at the failures, and, most importantly, at the long-term average yield.

Generally, the lower the risk and the shorter the time span for a venture, the lower is the potential profit on the venture. The greater the risk and the longer the time span, the greater is the potential profit. The potential return on building small, cheap apartments quickly is less than the potential return on building large, solid housing slowly. The more quickly a piece of land is developed for a sure return, as for a small mall, the less the return. The longer it takes to develop the land, as for a downtown upscale shopping center, the greater the eventual return.

People tend to think that the greater risk and the longer time span cause the greater potential return, but this is backwards. People are willing to endure the greater risk and the longer time span because of the potential reward. People search for sunken treasure or for diamonds because, if they find them, the reward is great. People will not endure a great risk and a long time span when the potential reward is small. Nobody spends a great deal of time and effort developing a punk polka band. Strategic action causes the relationship between risk, time, and reward; the relationship does not determine strategic action.

It is easier to understand if we hold up some silly counter-examples. Putting more time into a project does not thereby make the outcome more valuable. Think of obsessive gardeners and auto hobbyists. Their tomatoes and their wax are not the more valuable than anybody else’s just because they take three times as long. Putting more risk into a project does not thereby make the outcome more valuable. If Johnny climbs a steep cliff and fights off a bear to pick roses for his girlfriend, that might impress his girlfriend, but it does not make his roses any more valuable than the roses that Old Aunt Myrtle grew in the flowerbeds around her little home.

Suppose there were some ventures that had a very low risk, took only a short time, and had a great yield. At first, a few gold mines were available where the gold could be picked up right out of the dirt. These ventures would be taken up so often, and exploited so quickly, that they would soon disappear. The easy gold is soon found, and then people have to take the risk, and the time, and the cost, to dig for deeper gold. On the other hand, suppose there were some very risky ventures, that they took a long time, and they had a very low potential yield. Who would undertake these ventures? This is the case with growing cotton in the United States now.

Short term, low risk, high yield ventures disappear quickly. We overlook long term, high risk, low yield ventures. Normal ventures are in between. We sort out normal ventures in between according the relation between risk, time, and return mentioned. The greater the potential yield, the more business people are willing to wait a long time and to take a greater risk. The less the potential yield, the less business people are wiling to wait and the less risk they are willing to take. The relation between time, risk, and yield results from the rational strategies of business people, not due to any magic in time or risk. Time alone does not cause higher yield. Greater risk alone does not cause higher yield. Thinking that they do is to make the same mistake as to think that the sum of costs determines the value of the final good, to think that costs are an objective reality apart from the wishes of consumers.

Business people sometimes think profit is a reward for waiting, a reward for risk, or a reward for roundabout production. Business people often think increased capital brings increased potential profit because more capital often involves more risk, more time, or more roundabout ways. All this is plausible on the surface, but, at a deeper level, it is untrue and backwards. Profit is related to time, risk, and amount of capital but not in the sense that those cause profit. For the true relation, we have to look in the next few chapters.

We have to keep inevitable loss in mind when enthusiasts for privatization advise we could “make a killing” in some scheme, or that we could always do better by putting state assets into the stock market. They say we could always get a better return on the Social Security fund if we invested it in the stock market instead of in federal bonds. That might be true in some cases, but only if we are also willing to accept the risk and the real failures in other cases that go along with the risk. We have to be willing to accept that a portion of the fund gets wiped out from time to time. In the end, when we average the gains and the losses, the result is the same as leaving the fund in federal bonds. I invite people to look up long term statistics.

Answers to the Four Questions. The previous chapter began with sets of questions that economists pose to help us understand the economy. Now we can respond to the first four sets. All the answers have this in common: the economy achieves what it does automatically through

(A) the interaction of many independent consumers each rationally acting to seek his-her own greatest utility, B) the interaction of many business firms each acting to seek its own potentially greatest profit (even if profit dwindles to zero), and (C) the interaction between consumers and firms.

(1) What gets made? What gets made depends on what people want, with some consideration for the abundance of resources in nature. If people want more beef and less corn, that is what they get; with the balance depending also on how much land is suitable to each. If people want cars instead of bicycles, that is what they get; keeping in mind that cars are harder to build and maintain than bicycles.

(2) How does it all get made? Are resources used efficiently? It all gets made through business firms pursuing profit. It all gets made through business firms using resources at maximum efficiency to make just what people want made. It is not possible to use resources more efficiently in any other way than through business firms using resources according to the public price system.

One aspect of the efficient use of resources is that resources are fully used. Under perfect competition, at public prices, there is no shortage of any good and there is no surplus of any good. All the goods that are provided at the market price can be sold at the market price. Anybody that is willing to pay the market price for any particular good can buy as much as he-she wishes. Shortages or surpluses are usually a sign that something has gone wrong, such as imperfect competition taking over a market.

A particular result is that there is no unemployment, or, in other words, there is always full employment. The prevailing wages should be enough for a person to live decently on, and should be enough for most parents to raise their families on. Anybody who is willing to work for prevailing wages should be able to find a job. Any employer willing to pay the prevailing wages should be able to find as many employees as he-she needs. Unemployment and poor employment are signs that something went wrong.

(3) Who gets what? Why do workers, managers, capitalists, and capital itself get such-and-such a share of the total wealth? What determines the distribution of total wealth and the comparative wealth of social classes?

A better first reply is to ask another question: “What gets what”? How much does iron get in comparison to corn? What is the price-cost of iron in comparison to the price-cost of corn? Iron costs as much as it takes to call forth the amount of iron that is needed to meet the wants of the consumers, and compared to the need for all other resources. Iron costs as much as warranted by its cost effectiveness (marginal revenue productivity). Iron gets as much as it gets because that is how much it deserves according to its cost effectiveness. The price-cost-value of iron is its cost effectiveness. The same is true of corn, petroleum, and any other resource. In a normal economy, iron would get as much, iron would cost as much, as was just needed to replace the stock of iron for all normal uses of iron. This would happen automatically through the action of consumers and business firms in making the public price system. If any input factor received less than its cost effectiveness, suppliers would not supply it. Eventually due to the lower quantity, price-cost-value would rise, and then suppliers would begin production again. If any input factor got more than its cost effectiveness, suppliers would flood the market until the price dropped to match cost effectiveness.

People are an input factor like any input factor: workers, managers, owners, and professionals. People are paid according to their cost effectiveness, according to their ability to contribute to the satisfaction of demand throughout the economy – neither more nor less. People get what they deserve according to their cost effectiveness (marginal revenue productivity). People are not paid according to any intrinsic worth as humans or according to their social group, ethnic group, age, or religion. People are not all paid equally because they do not all do the same job and they do not all contribute equal cost effectiveness. Even so, in a modern, complex, wealthy economy, the prevailing rates of return (wages) to various occupations should be enough for everybody to lead a decent life. Prevailing wages should be enough for most parents to raise their family on.

Real life does not match up to this ideal. People are overpaid or underpaid when the economy is not near perfect competition. We will look at this situation in later chapters.

(4) How does the economy grow? How fast? How much? The full answer depends on looking at profit and the dynamic ideal in the next chapter. In brief, the economy grows automatically by implementing the innovations that people want, to the extent that people want. Then it stops. The economy also changes when people change their taste, often in response to innovations such as cell phones and computer pads. There is no need to stimulate growth or to direct growth. Trying to do so distorts and damages the economy.

The rest of the question sets from Chapter Four are picked up in later chapters: (5) profit, (6) socio-economic classes, (7) greatest welfare, (8) stability and reliability, and (9) effects that are out of the public price system such as pollution.

Scarcity Again. Together, the answers to these questions reinforce points made in Chapters Two, Three, and Four:

(1) Except under conditions of general growth, to make more of one good is necessarily to make less of other goods (unless the first good supports the other goods or unless the other goods are necessary to make the first good). To seek one good is necessarily to seek less of other goods. To grow more corn is necessarily to grow less barley and oats. To make more SUVs is necessarily to make fewer small trucks and passenger sedans. We cannot have as much as we wish of all goods. We cannot make the economy grow as large as we wish so we can have as much as we wish of all goods. We have to choose what and how much. We choose when we pursue our interests in the free market.

(2) Only if the economy grows naturally through the implementation of innovation can pursuing more of one good not reduce the availability of other goods. Even then, it only works for the goods that the innovation affects. An innovation in LCD screen technology might bring more computer tablets but it probably would not have much effect on barley production.

(3) Any forced shifting of resources necessarily distorts and shrinks the economy. If we force resources away from cars toward making airplanes, we necessarily distort the economy and shrink the economy. We necessarily have less wealth than if we left the market alone. If we force resources toward farming by helping farmers, we necessarily move resources away from other activities, shrink and distort the economy, and have less total wealth than if we left the market alone. If we subsidize house buying, we necessarily take resources away from other industries, and so we make the whole economy smaller.

(4) We can only successfully shift resources if we respond to an obvious flaw, and only if our interference does not cause more harm than help. We can only help the poor if their poverty results from an obvious flaw, and to the extent that their poverty results from an obvious flaw; and even then only if our help does more good than harm. The same is true with business firms or the military.

Not Necessarily Smithian Wealth. The idea that the economy gives the people what they want really does mean that the economy gives the people what they want. If the people prefer soap operas to Shakespeare, cheap tin flash buckets to sensible cars, gas-guzzlers to hybrids, cocaine to bibles, porn to sutras, services such as palm readers to real material goods such as cars, speculating in real estate to hard work making HD TVs, or current consumption to savings, then that is what the people get. The people do not necessarily get the kind of wealth that serves as the basis for a powerful nation. The people do not have to become morally upright or spiritually strong because they have a free economy.

In a real, complex, advanced, already-wealthy economy such as the United States, we should get enough of all kinds of wealth through the automatic operation of the economy to satisfy the needs of the people directly and to satisfy the needs of the people indirectly as the basis for a powerful nation. We get both MTV and the know-how to build tanks. But there is no guarantee. We have to take this on faith. It is part of the leap that is required by the free market.

Whether we are willing to take this leap depends on the world situation. When the world is fairly peaceful, then we trust ourselves, our neighbors, and other nations. When we think we have formidable enemies, we want to make sure the economy provides the factories and the other material wealth that serves as the basis for power. Then the state intervenes, and we have another version of mercantilism.

If we feel the need to force the economy to provide the kind of wealth that can serve as the basis for power, we have to realize that we distort the economy directly through state intervention, and we distort our lives indirectly by giving the state an excuse to intervene in all aspects of our lives.

The Price System and the Definition of Economics. Chapters Four and Five seem to reinforce the common idea that economics is only about whatever good has a money price on the market, and is not about what does not have a market price, such as time spent with the family or effort put into church. These chapters seem to reinforce the idea that humans are naturally strategic about some things but naturally not strategic about other things. This is not so. All these chapters do is explain how goods that have a price actually get a price. They do not say anything about goods that do not have an obvious money price on the market. Sometimes it is strategic to leave a good out of the public price system. Because of how mates want to get along after marriage, usually it is not strategic to buy a spouse; but buying a spouse has worked; and many people around the world have to pay a dowry or bride wealth. Some goods have a tacit [shadow] price even if those goods do not have an obvious market price. The tacit price of time spent with the family is income lost from the business, and some people do think like this even if they do not want to admit it. Before we decide that some aspects of human life are not strategic because they do not have an obvious market price, we have to decide why some goods do have a market price and why some goods do not even though people strategically pursue non-market-non-money-priced goods. I think nearly all goods have some kind of price, at least in terms of what we forego to seek them (opportunity cost) and I think that people really do act strategically about nearly all aspects of life including love, children, and religion. Economics applies more broadly than the public price system. Still, the public price system is the most important application of economics in modern life, so I focus on that. These questions belong to economic anthropology, so I cannot consider them here.

Static Ideal. This chapter completes the static ideal, and the reader should realize that it is an ideal. No economy lives up to this paradise. The reader should already sense many ways in which the real deviates from the ideal even before I describe the most important deviations in the next few chapters. Yet real economies actually come close enough to this ideal so that we need to seriously respect the ideal. It works. It works well enough so that we can see flaws and problems as deviations from this ideal. The static ideal works well enough so that we do not want to interfere unless we see a clear need, are sure that we will not cause more harm than good, and sure that we will not set a bad example.

06 Profit

This chapter explains the three major sources of profit: innovation, uncertainty, and imperfect competition. It uses ideas about profit as a way to move from the static ideal to the dynamic ideal and to describe the bad effects of imperfect competition. Because both good dynamism and bad flaws produce profit, it is hard to tell when we are in a good dynamic situation or in a bad flawed situation. This chapter talks sometimes about costs as if they were fixed. It does not intend to ignore imputation but only takes this stance for convenience.

The static ideal is “determinate” because most questions can be answered and most situations have definite outcomes. This is not true when dynamic relations and imperfect competition appear. They make the real economy “indeterminate”. Sometimes we do not know exactly what will happen. Some questions arise for which there are no clear answers, and in some situations we do not know what to do. This is not the fault of economists but is inherent in the situation. I make guesses when I can.

Business firms come in various sizes and types ranging from one person working alone in a shop to a giant corporation with its own bureaucracy and a hundred lobbyists. The various types and sizes do affect sources of profit but this chapter cannot go into that relation.

06 Profit; Synopsis.

Profit is occasional or sustained. Most firms expect to make sustained profit. Occasional profit comes from (1) innovation and (2) uncertainty. Innovation includes both new gadgets like smart phones and new ideas such as the assembly line, double-entry bookkeeping, a new cartoon style, and a new movie character like Iron Man. Everything real in this world is a little uncertain. Sometimes it rains and sometimes not. Sometimes a movie hits unexpectedly and sometimes what looks like a sure hit flops. Innovation and uncertainty usually do not distort the economy too much or in bad ways.

Sustained profit comes from (3) unfair competition. Unfair competition need not be dastardly. It only means that a firm does not have to “take” prices but can, to some extent, “make” prices. It can set prices above production costs. Firms achieve this power in three ways. (3A) One, or a few, firms can be so large that they make most of a kind of good, as Boeing makes most of the commercial airplanes in the United States and Microsoft makes most of the software. (3B) The state can give a firm power to set production and prices as with defense products and home cable TV. Firms seek this kind of power through influencing government officials. (3C) Firms can cut up a large market into small chunks, and become the monopolist of one small chunk. Usually firms do this by fostering brand loyalty, as with frozen dinners, cars, computers, smart phones, cosmetics, kinds of music, motels, clothes, schools, etc. Any market with enough of one of these kinds of control is called “structured” rather than “free” or “unstructured”.

Firms use fear of uncertainty to structure a market. Rather than always check out new brands, consumers will pay more for a particular brand of toothpaste, car, or laptop computer, because they have used it before, and it is “tried and true”. We pay for familiarity with a higher price and less choice.

Firms that cannot structure their markets make no profit in the long run and so die at the hands of firms that can. Banks expect all firms to make a sustained profit, even firms that cannot find a way to control a market. Thus banks inadvertently help kill small firms. Nearly all goods in the United States are made by firms in structured markets, usually type 3C. Family diners have been almost completely replaced by chain franchises.

A structured market does not work as Smith described for ideal capitalism. It does not deliver the most benefit to the most people, use resources most efficiently, and support one price for all. Structured markets distort the economy in bad ways. I do not know how badly and in what ways the American economy is distorted. Accumulated profit increases distortion and bad effects. Firms cannot spend accumulated profit in the normal way that consumers spend salaries. Firms cannot reinvest accumulated profits naturally in their own market so they look for other ways to invest. Their investment usually increases structuring and bad effects. In America recently, firms invested accumulated profits in real estate by investing in other firms that gave bad loans. Firms also invest in politicians. Accumulated profits helped fuel the housing crisis. Accumulated profits probably also accentuate the boom and bust cycle, but how is not clear.

Figuring Profit and Seeking Most Profit. Profit is revenue above costs. What matters is not the amount of profit alone but the amount compared to the value of the capital that generated the profit, and the amount of profit in this venture compared to what profit might be gotten in other ventures. Profit is figured by comparing the amount of return to the value of (amount of) “invested capital”. If a firm invests $1,000,000 in a venture and gets a return above costs of $80,000 then it has made 8% percent profit. If a firm invests $2,000,000 and gets a return of $80,000 then it has made a 4% profit.

Firms have to take time into consideration, so profit is figured on an amount invested “spread out” over time periods. Suppose a firm invests $1,000,000 in increments of $200,000 per year for 5 years. The venture yields $212,000 the first year or $12,000 above cost for the first year. The firm made a profit of 6% for that year. When compound interest over time is considered, these calculations get complicated. None of that is done here. Do not worry about the details of time.

Whether a profit is “good” depends not just on the rate itself for this venture but also on the rate for this venture compared to alternative ventures. If a firm made 7% in a pizza venture but could have made 10% in an electronics venture with the same investment, then the firm should have invested in electronics, and the firm effectively made a loss of 3% on this venture. It suffered an opportunity cost of 3%. This idea comes up often.

Types of Profit. It helps to group profit into three types. These three types of profit are not the same as the three sources of profit, although they are related. Two of the types have their own distinct sources while the other type comes from a mixture of sources. The third type causes much of the confusion.

(1) Earned Profit from Innovation and Uncertainty. Business firms use new ideas and the normal fluctuations of life to earn a profit. This kind of profit is the basis for the good dynamic ideal. It is called “earned” profit because it comes from adding to the sum total of utility for the economy as a whole and because it is not based on taking unfair advantage of a situation. The implementation of innovation increases productivity and leads to growth, so profit from innovation promotes productivity and growth.

(2) Unearned Profit from Imperfect Competition. Some business firms can take advantage of oddities in production or of oddities in the market to earn a profit. This kind of profit is “unearned”; it does not come from an increase in the total utility to the economy as a whole but comes from taking advantage of a situation. It does not necessarily come from taking unfair advantage, but it can come from unfair advantage. It usually comes from a market and/or “structures” the market (see below). It often leads to unfairness. It always leads to distortions.

Rent income (profit) is a kind of profit from imperfect competition, likely the most important kind because worldwide it probably leads to the greatest total profit. I do not go into rent much here because the neoclassical standard account of rent is cumbersome and not intuitive, if accurate. The remarks here about imperfect competition apply to rent. For more details, please see my website.

(3) Normal Profit and Interest. This is the difficult category. All business firms routinely expect to make a certain minimum profit based on their total investment. The expected normal profit varies from about 5% for small business firms to as much as 20% for some large corporations. If a family restaurant is worth about one million dollars, the owners expect to make about $100,000 profit (10%) for the year. This profit is in addition to any salaries the owners might receive as managers of the restaurant.

Likewise, banks expect to make a certain minimum return on all loans, usually no less than 5%, even during recession. Normal interest is related to normal profit and to the other types of profit, but it is not clear how interest is related to profit. The average rate of expected normal interest differs a little from the average rate of expected normal profit but the two are related, so I will not go to much trouble to distinguish them for now. We can treat normal profit, and thus cause (2), as the primary source of normal interest.

We cannot be sure about the relation of interest to profit because we cannot be sure about the origin of all normal profit. If all normal profit were based on the natural increase in productivity then we would expect the average rate of normal profit and interest to be close to the average rate of growth due to increase in productivity, about 2.5% per year. The average rate of expected profit and interest usually is higher than that, so expected normal profit and interest must have other sources. Taking advantage of the normal fluctuations of life (uncertainty) might increase the average rate slightly but not enough to reach the observed sustained rate of about 5%. So somehow unearned profit from imperfect competition by some business firms (cause 2) adds significantly to the expected rate of normal profit for all business firms (cause 3), even for firms that do not gain from imperfect competition; and somehow unearned profit from imperfect competition (cause 2) contributes to the expected rate of normal interest (cause 3). As far as I know, nobody knows exactly how all this happens.

We need to know because, if the normal rate of expected profit exceeds the rate of natural growth due to increase in productivity, then the economy is distorted. The economy does not reach full efficiency and full welfare. Problems arise such as unemployment and poor employment. In fact, this is the case in all real economies.

It is tempting to think the amount of distortion equals the difference between the usual expected rates of normal profit (10%) minus the rate of natural growth due to increased productivity (2.5%) (10% minus 2.5% = 7.5%). This amount matches the rate of persistent unemployment, and so likely this guess is not too far off. But we cannot even say this much for sure.

Marxists make much of these problems about profit and interest but their ideas are too different from the framework used in this book to go into here. Neoclassical economists tend to take the idea of normal profit for granted, and to analyze profit only to the extent of trying to figure out how much profit might be expected in particular cases. They do not think much about the origin of profit and interest, and about relations between various contributing types of profit. Essentially, mainstream economists developed a method that allows them to ignore questions about origins of profit and interest, overall effects of uncertainty and imperfect competition, and implications for flaws and problems. We have to dig a little deeper than that here.

Growth and Productivity. Growth is a lasting increase in average utility, in average benefit. When the average person feels better off for a long enough time, then the economy has grown.

Some growth comes from an increase in material goods. Just as utility differs from money and material goods, so growth is not limited to money or material goods. Any enduring increase in average utility is growth. A good idea can make us all better off, and so a good idea is growth too. All this can be growth: a work of art such as a good TV show; a new scientific idea; a new relation between groups of people who had been suspicious; the better use of a natural resource such as solar power; better institutions such as respect for the rule of law and for the duties of office; and a better understanding of human relations such as came with the study of history and political science.

Most people think of growth in terms of an increase in average material wealth or an increase in average income. We can think of growth this way as long as we keep in mind that real growth might not be limited in this way. Non-material increase in benefit is growth too. Material goods and money make convenient measures of growth.

Because real growth should last, if we want to think of growth in material terms, we need to focus on enduring material goods or long-term increases in income for everybody. We should think of new roads, better forests, safety for animals, the discovery of electricity or atomic energy, new beautiful buildings, and new forces in art such as rock and roll. We can ignore “bubbles” such as the housing boom that began in the 1970s and peaked in middle 2000s.

We could not have growth if we had only the same resources and could only do the same things with those resources that we always have done. For growth, we need more resources such as oil or we need to use better our current resources. Since new resources are not very important now, I focus on using what we already have better. Growth requires that we be more efficient in our use of present resources. This does not only mean conservation. It can mean a better use of electronics in ideas that everybody likes, such as the switch from portable disc players to portable MP3 players. Real growth in material wealth requires an increase in productivity.

Real growth has intrinsic limits. Pushing a trend beyond the intrinsic limits is not real growth but is a kind of misleading anti-growth that takes away from the benefits of the prior real growth. Increases in productivity have their limits. Pushing productivity beyond its intrinsic limits is anti-productivity that takes away from the benefits of prior real productivity. This idea of intrinsic limits is part of the idea of diminishing returns on which marginality theory rests. It is not possible to have one without the other. A few skyscrapers can be glorious but a lot of skyscrapers ruin it for all of them. Mass transit is better than never-ending traffic jams with everybody each burning gas in his-her private air-conditioned box.

In capitalism, change occurs through business firms responding to consumer desire when firms pursue profit. In pursuing profit, firms often have to implement greater productivity. So growth should occur through business firms being increasingly productive in responding to consumer desires. Together with the idea that increased productivity has intrinsic limits, these ideas lead us to the first source of profit: innovation.

Good natural growth automatically takes productivity to its correct limit and then stops. Bad induced expansion creates investment where there should be none or forces the implementation of productivity beyond its proper limit. Induced expansion is the enemy of natural growth because it sours people on all growth. I like natural growth and very much dislike induced expansion.

The implementation of innovation through free action by individuals and business firms should lead to the maximum practical benefit (utility or welfare) but it does not always lead to the most imaginable. There is another kind of growth that can lead to more wealth. This kind of growth is not relevant to the body of this chapter but it is relevant to policy questions in Chapter Nine, so I describe it in an appendix to this chapter.

(1) Innovation. Innovation includes technical change, changes in organization, and changes in taste. It is easy to see that computer chips changed our lives. We do not always appreciate that these innovations did too: bureaucracy; the assembly line; double-entry bookkeeping; modern offices; and segmented business firms such as General Motors with Chevy, Pontiac, Buick, and Cadillac lines. It is easiest to talk about technical innovation, so most examples are of technical innovation but the ideas apply to all kinds of innovation.

A change in taste might not increase the total amount of wealth - in fact it can decrease the total amount of material wealth as when people prefer services such as lawyers to hard material goods such as a new car. But a change in taste does serve the total amount of utility, and business firms do have to respond to a change in taste as with the switch to mountain bikes or the switch away from SUVs. With a change of taste, the economy does not grow in the usual sense of growth in material goods. If changes in the economy due to changes in taste are carried out by free individuals and business firms, then changes in taste should lead to an increase in utility (welfare) even if they do not lead to an increase in material wealth. If we prefer lawyers to cars, then more lawyers increase the total sum of utility (welfare). I do not know of total utility goes up when one “boy band” falls out of favor and another rises or if hip hop replaces R&B. I do not dwell on taste because we can understand changes in well enough if we understand changes in technology or organization.

Not all innovation is good, and most innovation has both good and bad aspects, as for example bureaucracy. Genetic research is a two-edged sword. With it, we will both cure disease and experiment on bottle babies.

I focus on the good aspects of innovation because I assume people usually adopt innovation because it increases their utility; they judge its good aspects to outweigh its bad aspects. People do not adopt innovations that do not increase their utility – a valid use of circular subjective reasoning. People adopted cell phones because they judged them to be better than worse. Sometimes people do have innovation forced on them, and sometimes innovation is a net good for some people but a net bad for others. I do not like cell phones and texting but have had to make my peace with them. I love music, but I would gladly ban speakers in cars if that edict would get rid of rolling boom boxes.

Implementing Innovation. In Chapter Two on Classical economics, we saw intuitively how innovations are implemented. Restating that story in terms of strict marginality theory is not useful as long as you get the basic ideas. It is enough to state the major themes here and to go through some details in later sections.

-An innovation increases the normal cost effectiveness of some resource.

-An innovation reduces the cost of at least some input factor.

-In contrast to the static ideal where the sum of the costs of input factors equals the price of the final good, with an innovation, the sum of the costs of input factors is temporarily lower than the price of the good on the market.

-For a while, firms can make a profit from the difference between reduced cost and standard price.

-Eventually due to increasing implementation, and to competition from other firms entering the market, cost increases.

-At the same time, the price for goods made through the innovation decreases.

-The combination of rising cost of inputs with reducing cost of output (price of the final good) causes profit to disappear again.

-At that point the innovation has been completely absorbed into the economy.

As a result of an innovation, consumers can use a good more than they might otherwise, or people can use the good in the same amount but can also use some other goods more. When TVs got cheaper, people bought more TVs or they replaced their old TV and bought better stereo equipment too. A firm can use a resource more than previously to make more goods than it would have, or it can reduce the price of goods, or it can make other goods more cheaply. As plastics got cheaper, firms used more plastic, they reduced the price of some things made of plastic such as furniture, and they could make quality wooden furniture because they no longer needed wood for such things as floors and bathroom cabinets.

Albert runs a factory that makes all kinds of small-wheeled vehicles for an entire region: bicycles, motorcycles, tricycles, wagons, etc. Like any adept firm, Albert uses rubber to make tires most cost effectively. Albert makes tires of the proper quality and the proper thickness. He gives the customers what he has to give them but he cannot give them more.

Albert’s rubber supplier has developed a new rubber that is stronger and more durable. The new rubber costs slightly more per ounce (it does not matter how much) but with it Albert can make some tires thinner and can make some treads deeper. The tires run better and last longer.

It does not pay to use the new rubber in all applications and on all vehicles. Albert would not use the new rubber for handlebar grips or for mud flaps. It does not pay to use the new rubber for the tires of tricycles or most wagons. It does pay to use the new rubber on the tires of most bicycles and most motorcycles.

It does not pay” here means that it is not cost effective, that the marginal revenue productivity is negative, or that the cost per marginal unit is greater than the revenue per tricycle or wagon. “It does pay” here means that it is cost effective, that the marginal revenue productivity is positive, or that the cost per marginal unit is less than the revenue per bicycle or motorcycle.

It would be cost effective” here means that Albert makes a profit when he uses the new rubber on the tires of some bicycles and motorcycles. The cost of the new rubber is less than the price of the bicycles or motorcycles, especially if Albert can raise the price slightly by appealing to the better performance and greater durability of the new tires. Whenever marginal revenue exceeds marginal cost, then a firm makes a profit.

Productivity and Growth Reminder. As firms implement innovation, the economy becomes more productive. People get more goods from the same amount of resources, or the same goods for fewer resources, or entirely new goods, or some combination. The total utility in the economy goes up.

At any time, more than one innovation is working its way through the economy. We now have advances in computers and in bio-technology at the same time. The increase in productivity for the economy as a whole is an average of the increase due to all innovations being implemented.

The natural growth rate is the same as the rate of increase in productivity, which is the same as the rate of implementation of all innovation in general.

When economies first switch to capitalism, they grow quickly because they have many innovations to implement, innovations in organization (rule of law) as much as in technology (electrical power). The most dramatic recent example is the Chinese switch to state capitalism. As capitalist economies mature, they grow more slowly. The United States has been a mature capitalist economy at least since World War II. In the decades since then, productivity has grown at an average of about 2.5%. People have seen an average increase in welfare (utility), as indicated by income, by about 2.5% per year. We have been getting steadily better off. Of course, some people do not feel the improvement because they are poor while a lot of other people do not feel it because they are caught up in a game of comparative competition.

Profit and Interest. While an innovation works its way through the economy, firms make a profit, such as Albert the wagon maker above. As an innovation works its way through the economy, the usual price war between firms happens. Capital flows into the business. The price decreases and some costs go up. Eventually firms make no more profit through the innovation even though everybody is permanently better off.

While firms were implementing an innovation, any profit they made might give rise to interest as well. To take advantage of innovation, firms would be willing to borrow money. The rate that they would be willing to pay would pretty nearly equal the rate of profit they might expect. In near-perfect competition, the general rate of interest due to the implementation of an innovation would about equal the rate of profit from the average of all innovations, or about equal the rate of increase in productivity, or about equal the rate of natural growth.

Whenever the general rate of profit or of interest does not equal the rate of natural growth then something else is going on. Most business firms expect to make a profit of about 5% to 15%. The background rate of interest is around 5% to 10%. The general expectation of profit, and the background rate of interest, both exceed the rate of natural growth (2.5%), so something else is going on too.

A Long Time. We tend to think of innovations as gadgets we see on TV, or as the latest pop culture craze, and so we think they work their way through the economy pretty quickly. The standard time for a patent is 17 years, and we tend to think that most innovations have worked their magic by that time. In fact, many innovations take much longer to work their way through the system and have much deeper effects than we realize. One primary innovation can spawn a host of consequent innovations. An innovation in one type of business directly changes other types of business and spawns consequent innovations in other places too. The modern form of alternating current for the delivery of electricity was developed around 1900 but it still profoundly changes our lives in new ways every year. It allowed for mass communication such as radio, the movies, and TV. Biotechnology will literally change lives for hundreds of years to come. On a lighter note, the bikini was invented in the early 1950s, and its descendants still affect our lives today. The same is true of rock and roll.

(2) Uncertainty. Uncertainty is the second major factor contributing to profit and interest. The previous chapter defined “risk” in terms of an outcome for which we can calculate the probability (the “odds”), such as the chance of rain today; and it defined “uncertainty” in terms of an outcome about which we cannot calculate the probability but can only make a decent guess, such as whether Johnny has an aptitude for music. Outcomes about which we cannot even make a decent guess, such as a major tsunami, can affect the economy but cannot figure into any analysis, so I do not discuss them.

Uncertainty is like playing “whack-a-mole”. We know that the head will come up somewhere. We even have a good idea about how many heads will come up over a five-minute period. But we do not know exactly where the head will come up, and that is what counts in our score. Uncertainty is like trying to predict the location of the next particular bubble that comes up in a pot of gently boiling water, or trying to predict the next direction of a particular dust mote that is floating through the air.

Uncertainty provides both opportunity for gain and danger of loss. If the orange crop is poor this year, the price of oranges will go up (see the movie “Trading Places”). Anybody that buys shares in a juice company is likely to make money. If a war breaks out, the people that supply materials are likely to make money, such as Daddy Warbucks from Little Orphan Annie or the Bechtel Corporation of ex-Vice President Dick Cheney. If the government inflates the currency to pay for the war, then the price of gold will go up. People who foresee a rise in the price of gold can make a good profit from that rise. People who bought Google stock when it first went public made a lot of money. People who bought Apple stock when the first iPod came out made a lot of money. Of course, if the orange crop is really bad, or really good, then orange farmers are likely to lose money. If the war goes badly, then the bonds of the new government are not worth much. If a new shopping center catches the public eye, it makes money. But if a planned off-ramp from a nearby highway does not go in, then the shopping center loses money instead.

An important part of business activity is guessing about uncertainty and trying to take advantage of it. Business people that are good at this have “good business sense”. They are good at “whack-a-mole”. They are business Jedi or business Sith. They can make a lot of money. If they work in a firm, they can make a lot of money for the firm. When business people say they are “assuming a risk” or “taking a risk”, economists would say that really they are “assuming an uncertainty” or “taking an uncertainty”.

Just because uncertainty cannot be calculated precisely, it is hard to say how much money astute that “uncertainty takers” should earn. Business people that use uncertainty to make profit get the rewards or punishments of their skill automatically. If their guesses make money, then they are paid. If their guesses lose money, then they are punished. We don’t have to devise a formula for how much they should earn because the market figures that automatically.

Sometimes it can seem as if the reward is out of all proportion to the skill, and that luck plays a huge role. Original investors in Google or Microsoft did well as much out of luck as out of skill. This is true. Even so, it is necessary. It is not possible to make the economy certain, and some people have to deal with the uncertainty. If some people did not deal with the uncertainty, then the economy would halt and we would all suffer. The reward that some people get from dealing with uncertainty is how the public pays those people to deal with our uncertainty for us.

Sometimes people that deal with uncertainty also make income from imperfect competition, as when they control a large firm. Then it is almost impossible to distinguish how much of their income comes from good business sense and how much comes from taking advantage of a situation. I think most of the very large salaries that we read about for corporate executives (CEO) are from imperfect competition rather than from their skill in dealing with uncertainty but I cannot argue the point here.

People that deal with uncertainty manage uncertainty. They control it, tame it, weaken it, and make it less scary. They put it to work. They do other people a service when they make money for themselves, just as bakers do other people a service when they bake bread. “Uncertainty takers” help limit the unavoidable weirdness of the world, and so make the world more manageable for the rest of us. People that buy wetlands because they think wetlands might someday make money from duck hunters do everybody a big conservation service. People that are willing to take on uncertainty cause good events that otherwise would never happen such as the development of cable TV and high-speed internet services.

People that deal with uncertainty are an important force in helping us to cope with natural changes, especially natural problems and disasters. Even in the static ideal, people cope with natural changes because they respond to risk, to different availability of resources, and to different costs. In contrast, people that deal with uncertainty respond more aggressively and decisively. They rebuild after floods, tornadoes, and hurricanes. They do medical research. They do leading-edge science and engineering.

Acting on uncertainty is the major way that innovation is implemented. In the beginning stages, innovations are uncertain, and are subject to considerable loss. When personal computers first came out in the early 1980s, the best brand on the market probably was the Commodore - now unheard of. When video games moved from handheld devices to the PC, the move was tremendously uncertain and actually lost some money.

An inevitable part of uncertainty is some loss somewhere sometimes. It cannot be all gain. When some investors gain, some lose. This gives the familiar “risk” element to capitalism. People mistakenly think that all investments in pension funds, bonds, or stocks can be made entirely secure but they cannot. If investments could all be made secure, we would not have capitalism.

As with risk, there is a relation between uncertainty and return: the greater the gain the greater the uncertainty. If people wish a high level of security then they have to accept a modest return; if they wish a higher return then they have to accept failure and pain at least sometimes, even with pension funds.

Most people fear uncertainty. People do many things to protect themselves and their families from uncertainty, including calling upon the state. We have the police, Food and Drug Administration (FDA), Consumer Reports, American Medical Association, labor unions, business associations, and legions of lawyers, all to protect us from uncertainty. Uncertainty can induce imperfect competition directly, as when a big insurance company can handle hurricanes while a small insurance company cannot; or imperfect competition can develop as a response to reduce uncertainty, as when we turn to big corporations such as Wendy’s to make sure our dinner will not poison us. It is hard to stress enough how much people fear uncertainty, and how much firms and people will do to lessen uncertainty. The study of responses to lessen uncertainty is a large and fascinating topic within economics. We need to keep this in mind when we look at labor and wages in the next chapter.

A person who routinely deals with uncertainty so as to gain from uncertainty is an “entrepreneur”. Entrepreneurs are the human means by which we all implement innovations and manage uncertainty.

We tend to romanticize entrepreneurs; we tend to see entrepreneurs as “captains of industry” or as Captain Kirk on the Enterprise. We should appreciate all the good that entrepreneurs do but we should not to take them all as heroes. Some entrepreneurs are good guys but many of them are more like the Jack Black character (Carl Denham) in the movie “King Kong” than like any of the obvious good guys.

Managers are not entrepreneurs, and the types of people get different rewards. Entrepreneurs get profit while managers get a salary. A manager often deals with risk, and a manager takes care of affairs, but a manager does not often deal with uncertainty, and a manager does not share in profits from uncertainty. A manager makes a salary based on his-her cost effectiveness (marginal revenue productivity) in taking care of affairs and in dealing with risk; a manager does not make a return based on profit. Especially a manager does not make a return based on profit from uncertainty. Only an entrepreneur makes profit from dealing with uncertainty. Often business people blend both characters somewhat in their jobs, and business people like to think of themselves as entrepreneurs if any part of their job calls for guesswork and decisions; business people are prone to self-romanticizing too; but really most business people are more managers than entrepreneurs.

Profit and Interest So Far. To understand the effects of uncertainty on the economy, we need to know if the total sum of profits from uncertainty in the entire economy about equals the total sum of losses, or if gains are more, or if losses are more. Just because uncertainty is uncertain, we cannot be sure either way. Even so, in any large arena such as modern capitalism, it is likely that the profits and losses about equal. Any excess of profits over losses likely comes from the role uncertainty plays in implementing innovation, and so those profits are best attributed to innovation. With that warning, it is fair to say that, if overall profits and losses from uncertainty do not equal, then likely considerable distortion occurs in the economy. But it is hard to say much about the distortion. Even if profits and losses are about equal, they do not just cancel each other out and distortion does not disappear. To see the distortion even when profit and loss from uncertainty are about equal, we need to look at profit and interest.

In the early 1900s, economists debated if the static barter ideal would have interest. Static barter likely would not give rise to the kind of pervasive interest that we know, in which the value of all goods can be assessed according to how much interest they yield, and in which interest has to be taken into account in nearly all transactions.

Interest does arise in a real economy with innovation, uncertainty, and imperfect competition. The problems are: (1) How much of the interest rate arises from each source? (2) What are the effects of interest from each source? In particular, which sources of profit and interest distort the economy? There are no clear answers.

Innovation creates profit and some interest but innovation does not cause distortion because innovation also increases productivity, and any interest that arises from implementing innovation can be paid out of profits from the increase in productivity. No resources from other parts of the economy have to be used to pay back the interest on loans taken out to implement innovation. If a wagon maker borrows money to use new sources of rubber, he-she can pay back the interest from the profit on the new wagons.

Leave innovation out of the picture and suppose the economy is static except for uncertainty. In this case, even if profits equal losses, interest will arise because people might be able to make a profit from some uncertain event, and so they are willing to borrow money and to pay interest in the hope that they might make a profit. If they actually do make a profit, they can pay back the interest out of the profit. If they do not make a profit, either they do not pay back the interest on the loan, or they pay back out of resources taken from other parts of the economy. The potential for gain from uncertainty moves resources around the economy even if the total gains and losses cancel out. The potential for gain from uncertainty creates interest even if there is no underlying increase in productivity as with innovation.

Even if losses exceed profits, interest will arise due to uncertainty. If people think they can make some gain in some venture despite losses elsewhere, they are willing to borrow money and pay interest to try. In the 1800s in America, people gave up steady jobs by the droves, and their families went into debt, so the people could go seek gold in California, the Dakotas, and Alaska.

When entrepreneurs make a profit from uncertainty, they look for ways to invest the profit. Unlike as with innovation, the profit from uncertainty usually cannot be invested back into the original market but has to be invested somewhere else. Investing somewhere else distorts the economy. When a currency speculator “makes a killing” in Greek drachmas, he-she has to invest the profit in some other market. The somewhere else gets an infusion of resources that unbalances the effects of cost efficiency and market equilibrium. Unfortunately, too often adept speculators use their profits to induce imperfect competition in other markets so as to make continued profits there. Profit from uncertainty can be invested back into the original market if the intent is to make the original market imperfect. For example, a person makes a killing in Greek drachmas and then uses the profits to buy Greek politicians so as to continue to make profit in Greek currency. In the computer and IT industries, I believe some firms have used their profits to structure their market, even through “buying” politicians, but I cannot be more specific without risking a lawsuit.

We do not know how much interest arises from uncertainty, and how much the interest due to uncertainty contributes to the background rates of expected profit and interest. We do not know how much the pursuit of profit from uncertainty, or the interest that arises from uncertainty, or the profit that arises from uncertainty, distorts the economy, and how.

The Dynamic Ideal. Now we have the full dynamic ideal. Adding innovation and uncertainty to the static ideal allows for change and allows for the economy to constantly get better. It allows the static ideal to respond to natural change and to problems, to self-regulate. We have identified the agent of progress and change as the entrepreneur, and identified profit as the logical payment for willingness to take on uncertainty. These changes seem small but they mark a different and much better kind of system. This is really what Adam Smith had in mind, and what many hopeful business people and economists have in mind. It is a good ideal.

We have to be clear. The static ideal always lies behind the dynamic ideal; the dynamic ideal cannot be understood without the static ideal for reference. A healthy dynamic ideal should always tend to move toward the static ideal as when the implementation of innovation eventually comes to saturation, and firms no longer make a profit from the innovation. We understand the dynamic ideal primarily in terms of how it is different from the static ideal rather than as an entirely different thing in its own right.

Along with innovation and uncertainty come problems with profit and interest, in where to put the profit, and in where to remove the losses. We can mistakenly think there are no flaws or problems, or that dynamic actions can cope with all flaws and problems easily. This mistake is typical of people that romanticize capitalism and romanticize entrepreneurs, or of idealistic proponents of the free market. We cannot just trust entrepreneurs to manage the world for everybody’s better welfare. People are strategic all the time in every type of economy, including economies without free markets and free action, but that does not necessarily lead to the benefits of the static ideal and dynamic ideal. We have to take the flaws and problems seriously; we have to have the proper institutions within which the activity of entrepreneurs really does add to the general good, such as the free market, respect for law, and the desire to take care of nature; and we have to make decisions sometimes in problem cases about how to preserve the benefits of the dynamic ideal.

Imperfect Competition Prelude: Free Trade and Not Free Trade. Imperfect competition is the third source of profit and interest. Imperfect competition is called “imperfect” because it interferes in Smithian free unstructured fair markets. We need to recall what happens when we interfere in any free market.

Under near-perfect competition, a public price system prevails. The price of a good reflects its average marginal utility. The price is set when the amount supplied matches the amount demanded. Demand is determined by subjective average marginal utility. Supply is determined by average substitution ratios (average marginal productivity).

Free trade happens naturally when individuals are comfortable that their property is secure, feel they can dispose of property as they see fit, can pursue their own interests, and when flaws do not seriously distort the situation. Free trade happens naturally when business firms can pursue greatest profit. Free trade does not just refer to international trade but also refers to trade inside the country. Under free trade, the relation between price and quantity develops naturally. It leads to the greatest supply and to the greatest practical welfare of consumers at the lowest practical price. It uses resources efficiently. Interfering with free trade distorts the relation between price and quantity. Usually interference reduces supply, raises price, and reduces benefit. We should interfere with free trade only to right an obvious wrong.

If we change one part of this balance, we necessarily change the other part. If we change price, then we change quantity; and if we change quantity, then we change price. From the point of view of consumers and demand, generally: (1) Reducing quantity raises the average marginal utility for consumers and thereby raises price for the goods that are still for sale. (2) Raising price increases cost for consumers, reduces average marginal utility, and thereby reduces the quantity demanded. From the point of view of firms and supply, generally: (1) Reducing quantity allows firms to produce at less than cost, so firms make a profit. (2) Raising price allows for the same outcome. Firms might wish to produce more at the increased price but that is not allowed in this imaginary scenario, so firms do make a profit. Firms in an imperfect market generally are able to restrict quantity so they can raise price above costs, and thereby make a profit. The opposite happens on both sides if we increase quantity or reduce price but that is rare enough so there is no need to go through the steps. (It can become relevant in case the state forcibly reduces price, in which case a black market usually develops.)

From Chapter Four, recall the results of moving resources from one market (business) to another in a free market, not done automatically through free consumer demand. Moving resources into one business also necessarily removes resources from other businesses. It raises prices and reduces the output in other markets, reduces the total output of the economy, and reduces the total utility (benefit or welfare) that everybody gets from the economy. Forcibly moving resources shrinks the economy. Changing investment moves resources to some businesses from others. Changing interest so as to change investment also moves resources to some businesses from others. Giving tax breaks or incentives forcibly moves resources from some markets into others. Even if any of this is done in the name of growth or creating jobs, the net result is to shrink the economy, reduce total utility, and reduce the total number of jobs.

Interference in free trade can help particular subgroups even if it hurts the public, so subgroups try to interfere when it might benefit them. Usually they need help from the state to interfere, as when the state favors a subgroup through a tariff, restrictions on imports, or tax breaks.

Firm View and Market View. We can see most imperfect competition as a variation on monopoly, which I describe as the first case of imperfect competition in sections below. Before that, we have to review markets from the points of view both of the small firm and the large market. We have been looking at markets as if the magic of big and small were already at work, and we have been looking from the point of view of a particular small firm. We need to look at the market before the magic of big and small takes effect, and we need to do this from the point of view of the market.

In the static ideal under perfect competition, after the magic of big and small, the following holds true for a firm:

(1) No matter how much the firm sells, the price of the product on the market is the same.

(2) No matter how much a firm buys of any resource, the cost is the same.

(3) In pursuit of profit, the firm uses all resources so that all resources are equally cost effective.

(4) At that point, all profit disappears.

(5) The sum of values-costs-prices of input factors (resources, ingredients, or components) equals the value-cost-price of the final good.

(6) No matter how much of a good that consumers buy, the price to them is the same for all units of the good.

(7) If the quantity is reduced then the price goes up.

(8) If the price goes up then the quantity is reduced.

Now look at a market before the magic of big and small, the market for bicycles. Suppose the market usually has 100 firms. We will start with 0 firms, and add firms in groups of 10 at a time. If the market were in equilibrium under the static ideal in perfect competition, 1 million bicycles would be made and sold (10,000 bicycles per firm), and the price would be $100 per bicycle.

All the markets for resources (input factors) are near perfect competition, so that bicycle firms still pay the same in costs per bicycle no matter how many bicycles they make. Assume that the cost per bicycle remains the same throughout this example. If the bicycle market were perfect, the cost of making a bicycle would equal the price of a bicycle, so a bicycle in a perfect market would also have a price to the consumer of $100. Cost eats up any potential profit. In contrast, in an imperfect market, the price of a bicycle can be higher than the cost to make the bicycle, which is where the profit comes from.

With only the first 10 firms in the market, only 100,000 bicycles get made and sold. With so few bicycles, the marginal utility of the 100,000th bicycle is much higher than it would be if the full 1,000,000 bicycles were made. Price depends on marginal utility, so consumers will pay a much higher price per bicycle, as much as $2000 per bicycle. The shortage creates a higher price but it does not create higher costs to make the bicycle. At a cost of $100 apiece, but with a price of $2000 per bike, the first 10 firms in the market make a profit of $1900 per bicycle on a total of 100,000 bikes. The reader can see why more firms would want to enter the market.

When the next 10 firms enter the market, for a total of 20 firms making a total of 200,000 bikes, the price per bike has to fall because there are more bikes and thus the marginal utility of the last bike has declined. The decline in marginal utility at 200,000 bikes affects the price of ALL the bikes, even the first 100,000 bikes, so that ALL 200,000 bikes now sell according to the average marginal utility of the 200,000th bike. Say that the price now falls to $1600 per bike for all bikes. Even so, the cost of making a bike remains the same at $100 per bicycle, and bike firms make $1500 profit per bicycle. Things still look good for bicycle firms.

Now the next 10 firms enter the market, for a total of 30 firms making a total of 300,000 bikes. The price falls according to the average marginal utility of the 300,000th bicycle, to about $1100 per bike. The cost per bike is still constant, so that a firm still makes $1000 profit per bike.

Now the next 10 firms enter the market, for a total of 40 firms making a total of 400,000 bikes. The price falls according to the average marginal utility of the 400,000th bicycle, to about $700 per bike. The cost per bike is still constant, so that a firm still makes $600 profit per bike.

Now the next 10 firms enter the market, for a total of 50 firms making a total of 500,000 bikes. The price falls according to the average marginal utility of the 500,000th bicycle, to about $500 per bike. The cost per bike is still constant, so that a firm still makes $400 profit per bike.

We continue until we have all 100 firms producing a total of 1,000,000 bicycles. At that point, the market will be the same as in perfect competition. The price of ALL bikes is set by the average marginal utility of the 1,000,000th bicycle at $100 per bike. The cost is still $100 per bike, so that there is no profit at all.

The first few tens of firms in the market would like to keep out the rest of the firms. If the first 30 firms in the market kept out the 70 firms that eventually enter the market, the first 30 firms could make a profit of $1000 per bike. Not as many bikes would be made as in perfect competition, consumers would pay a lot more per bicycle, and society would not receive as much total utility; but the 30 privileged firms would make real profit rather than just chase an elusive promise of profit. In the ideal world of perfect competition, the first 30 firms could not keep out the last 70. In the real world, sometimes they can.

I cannot make it clear without a lot more cumbersome arithmetic, but there is a relation between profit per bike, the number of bikes made, and total profit; and total profit usually peaks somewhere at a production level of more than a few units yet less than the full production of perfect competition. Total profit starts out modestly at low production levels, increases with increasing production up to a point, and then declines again well before reaching the quantity that would have been made under perfect competition. There is a quantity of production in an imperfect market that yields maximum total profits. This quantity is well below what would have been produced under imperfect competition.

The first 10 firms make 100,000 bikes, with a profit of $1900 per bike, for a total profit of $190,000,000. With 30 firms, there are 300,000 bikes with a profit of $1000 each, for a total profit of $300,000,000. Of course, with all 100 firms in the market, there is 0 total profit. The total profit does not peak at the beginning of production with few units, or at the end of production with as many units as we would find under perfect competition, but somewhere in the middle. In this example it comes at around 300,000 bikes. I could provide a precise level of production where peak profit occurs by juggling the figures but there is no real use in going through that kind of game as long as the reader can see the trend. Firms can make real profit, not just potential profit, by limiting production, causing a rise in price above costs.

If total profit peaks somewhere around 30 firms, that is even more incentive for the first 30 firms to keep out the remaining 70.

In this example, I exaggerated the number of firms so as to approach ideal perfect competition. Few real world markets have this number of firms, perhaps only agriculture. More commonly, a real market might have 10 firms in total. If a real market had only 10 firms, we can think of each step above as taken by 1 firm at a time. Then, the first 3 firms would wish to control the market, exclude the last 7 firms, and limit production between 300,000 to 600,000 bicycles so as to reap the greatest profit while still being able to exclude the other 7 firms. Even if the first 3 firms cannot fully exclude the last 7 firms, they can still control the market so that consumers buy their bicycles at higher-than-perfect prices. These numbers are, in fact, pretty close to imperfect competition in the real world.

(3) Imperfect Competition. Imperfect competition occurs when one firm or a few firms control a market, so they can seek the greatest amount of real profit (not just potential profit), usually by limiting production. Usually the firms that control the market can exclude other firms. Imperfect competition leads to higher prices, less total goods in the economy, less total welfare (utility) for everybody, less use of resources, and/or less efficient use of resources. Imperfect competition uses resources inefficiently because resources do not produce the greatest practical total utility.

A market under perfect competition is called “unstructured” because the only structure in the market develops spontaneously out of the interaction of firms and consumers. The market might have considerable order but no particular actors can impose the order. Markets under imperfect competition are “structured” because some firms in the market can impose order on the market. The type of structuring depends on the type of imperfect competition.

Market Fairness. Perfect competition, even with innovation and uncertainty, is fair to business firms. Imperfect competition and unfairness are connected but it is not true that imperfect competition arises from unfairness, imperfect competition requires unfairness, or unfairness is found only under imperfect competition. One does not just cause the other. Even in perfect competition, people and business firms try to compete unfairly, and can even succeed briefly; but the conditions of the perfect market force them back to fairness. Imperfect competition can arise for reasons that have nothing to do with unfairness, usually through bigness that comes from technology, through bigness as a response to uncertainty, or brand loyalty as a response to uncertainty. Executives of firms in imperfect competition are not more ruthless or more conniving than executives of firms in perfect competition. All firms strategically pursue profit, and any imperfection arises out of that rational strategy. We just have to accept that sometimes rational pursuit of self-interest does not lead to a nice Smithian fair and perfect outcome, and can even lead to overall harm. Once established, imperfect firms often do act more unfairly than perfect firms because they can get away with it. They have money and power, they can bully other firms, and they can buy political favors. When firms in perfect markets temporarily make a lot of profit, they often abuse their power in the same unfair ways.

Imperfect competition does become unfair when it often involves restrictions, collusions, and direct interference with other firms. Then it can look like gang warfare, or to the lasting tension of gang pseudo-peace.

(3A) Monopoly. “Monopoly” comes from the Greek, meaning “one seller”. In it, one firm controls an entire market. That firm seeks the level of production at which it makes the most profit and at which it can exclude all other firms. In the case above, if one firm could make about 300,000 bikes, and could keep out all other firms, it would be a monopolist.

Sometimes a monopolist has to increase production slightly above what would yield peak profits so as to be able to exclude other firms. If a monopolist made 600,000 bikes per year it would not make as much total profit as at 300,000 bikes per year but it might be able to satisfy consumers enough so that no small firm could successfully invade the market to compete.

True monopolies with only one firm are rare. In the past, they have come about mostly because the government granted a license to produce a good or to control a market, and because the state used force to exclude other firms as a service to the monopolist. States have granted monopolies for salt production, mining, liquor, fur pelts, minting money, and shipping. States do this because they know that a monopoly can make a profit from which the state can take a tax, or take its “cut” of the profit. In contrast, many small firms in the same market would make little or no profit, and would be harder to tax. Sometimes the tax revenue comes not through an official tax but in the form of “donations” to a political party. States also support monopolies so that they can control a key good, such as salt, and thereby influence the economy and the people.

Sometimes monopolies arise for technical reasons out of “economies of scale”. Bigness is more efficient than smallness, at least up to the point where bigness interferes with itself or has other problems. A farm of 400 acres is more efficient than a farm of 40 acres because the larger farm can use machines that the small farm cannot, it can use larger machines of the same type, and it can install improvements such as irrigation and methods to deliver chemicals. The larger farm can usually be harvested more efficiently than the smaller farm. Yet a farm of 4000 acres is probably not more efficient than a farm of 400 acres, and it has administrative problems of its own. There is an optimum “plant” size for most businesses, and most plants approach the optimum plant size as new plants replace old plants. The average farm size in the United States has grown to over 400 acres since World War I after machines prevailed in farming, and, in some places such as the Dakotas, average farm size exceeds 1000 acres; but average farm size has not grown to 4000 acres yet.

When the optimum size for one plant approaches the production for a total market, then the one firm that owns the plant can control a market no other firms can reasonably start competitive plants. The Boeing Company can efficiently produce nearly all the commercial jetliners needed in the United States, and so it has a near monopoly. That is not the fault of Boeing, and Boeing is not necessarily unfair or bad; it is just a result of how large a facility is needed to make modern jet planes. The availability of large amounts of electricity from hydroelectric dams revolutionized the production of aluminum After World War II, forced plants to locate not far from major dams, and vastly increased optimum plant size. The Aluminum Company of America (ALCOA) jumped in with very large plants near major dams in the U.S., and nearly monopolized aluminum production.

Some production-or-distribution situations call for one system under the control of one central authority. Additional providers would only result in useless duplication and a waste of resources. The classic examples are utilities such as water, electric power, natural gas, roadways, and telephones. Similar situations are air routes and bus routes between major hubs. Another variation in the modern world is computer operating systems, such as the ubiquitous “Windows” from Microsoft. It makes little sense to force software manufacturers to adapt their products to several different operating systems, and to make users learn several different operating systems. That is almost like having several different rules of automobile driving in effect at the same time. It makes more sense to standardize the rules of driving and to standardize computer operating systems. The standardization opens the door to monopoly.

When the optimum plant size is large enough to support a monopoly, or when a single system is called for, then trying to force perfect competition with many small firms and plants, by forcibly breaking up the monopoly, can cause more harm than leaving the monopoly in place. Breaking up a monopoly is a form of state intrusion to correct a flaw, but it is a form that can cause more harm than good. Before the 1970s, American Telephone and Telegraph (AT&T or “Ma Bell”) ran the American telephone system, largely for the benefit of the public, and did a good job. The break up of “Ma Bell” was probably a mistake, and probably resulted in higher rates and worse service. Now, the original monopoly is slowly re-constituting as the regional parts acquire one another. The regional monopolies do not always offer good service at low rates. The best way to deal with monopoly is not always easy to see. I defer offering more comments on what to do until the end of this chapter when we have seen other types of imperfect competition.

Effects. Monopoly has the same effect as all imperfect competition in reducing total production, increasing price, reducing total welfare, leading to inefficient use of resources, and distorting the economy. Monopoly creates real profit. We should find out where the profit goes to, and how it affects the economy; but this is not clear. Because true monopoly is rare, these comments really apply more to oligopoly, when a few firms control a market (see below). I make them here because economics uses monopoly as the model of all imperfect competition, and I want to get across the idea that the problems come with all imperfect competition. For technical reasons, monopoly profit, and sometimes all profit from imperfect competition, is called “rent”. It would be too confusing to do that here, so I avoid it, but be prepared in case you see it in another book.

Because monopolists make a profit and can pay interest, banks get the idea that all firms should make a similar profit and should pay a rate of interest similar to what the monopolist can pay.

Banks do not give loans to firms that are not likely to make enough profit and are not able to pay enough in interest. Firms that should not be able to make a profit or to pay interest because they are in perfect markets, such as the local family-owned restaurant, or the family farm, now expect to make a profit and to pay interest. A normal rate of profit prevails, and a normal rate of interest prevails.

Small firms in more perfect markets do a lot of things to try to make a profit and pay the interest on their loans, into which efforts I cannot go much here. I think the most common strategy is to use the family as “slave” labor. The family puts a lot of time and effort into the business but does not get paid an official salary or gets paid much less than their cost effectiveness. Under-paying labor allows the family business to make a profit “on paper”. If labor were paid correctly, then the family business would only break even most of the time. In effect, the family gives its wages to the bank so the bank can charge the same rate of interest as the monopolist can pay. The efforts of small business firms actually result in further uncertainty and further opportunities for monopoly take-over (see below), that is, in more distortion.

It is very hard to tell apart the profit and interest that arise from monopoly versus the profit and interest that arise out innovation and out of uncertainty.

Monopolists do not need to advertise because they do not compete with anybody and do not have to fear competition. Monopolists cannot invest their profits “back into the business” as would firms in a perfect market because monopolists do not wish to increase production. They already have what they need in their markets.

So monopolists (all controlling firms) look for opportunities to invest in other markets. They try to take over other markets, to convert unstructured markets into structured markets. This is what happens when a chain store or chain motel moves in on local “mom and pop” operations or on local small department stores. When Microsoft had finally consolidated its hold on the market for computer operating systems with the success of Windows 98, it moved aggressively into other software markets such as for word processing and spreadsheets. It effectively eliminated such pioneers and long-time competitors as Quattro Pro and Word Perfect. It tried to compete with eBay, but eBay itself is a near monopoly and so was able to keep out Microsoft for now. Because the firms in perfect markets are trying hard to make a profit and to pay interest when they should not be able to do either, they are more vulnerable to take-over than otherwise. Mom and pop grocery stores and motels were vulnerable to elimination because they had to advertise or to cut rates. Small colleges almost disappeared from America because they had to compete with universities to pump out degrees, and they could not make a profit through doing research as did the universities.

Markets into which monopolies invest have an over-abundance of capital. Firms in those markets are able to bid away resources from other markets. When Wal-Mart moves into a small city, it raises all real estate prices, prices on rental units, and prices on some kinds of entertainment like bowling, above what they would be otherwise. These rises might sit well with the industries that benefit but they do not sit well with the consumers that have to pay the higher prices, and with other industries that might suffer such as bowling allies that have to pay the increased rents on local properties.

Monopolies invest in politics. There is no point in saying more about this without going into more detail than is possible here.

Monopolies can also invest their profits in innovation. Sometimes they can help the economy to grow. Whether they actually have this effect depends on how well they understand innovation, how quickly they act to invest, how much they invest, and how they invest; the details are too much for here. Generally, they help no more than firms in perfect markets. Microsoft did not invent the GUI (graphic user interface) on which Windows is based. Nike pioneered modern running shoes in a garage.

Monopolies might be able to help in case the economy slides into depression. From their profits, monopolies have reserves that can be applied to maintaining demand for some goods. Monopolies tend to have more steady revenues and profits even in recessions than do firms in more perfect markets just because they produce less than they should and thus demand for their goods remains strong and steady. Even in recessions, people need to heat their houses and buy gasoline for their cars. By having reserve from their profits, and by having almost a guaranteed market except in all but the worst depressions, monopolies can help keep parts of the economy going, and that helps keep other parts of the economy going. It is not clear how strong this effect is. It depends on what benefits the monopolist. In the near-depression of 2007 and afterwards, large financial institutions such as banks sat on huge reserves of cash but were notorious for NOT making loans to small business and NOT helping the recovery.

It is not clear if some markets cannot balance (find particular equilibrium) because of monopoly profits and because of pervasive interest; but probably some cannot. I think many cannot. I think the presence of some large producers in forestry products keep the world forestry industry from finding a healthy balance, but to make the case would take us too far off course. The same imbalance might come to be in the future as some large firms move into all aspects of farming, food production, and food delivery. It is not clear if the economy as a whole cannot balance (be in general equilibrium); but probably it cannot. I am fairly sure it cannot. The benefits of the ideal static balance no longer hold but we are not sure how far off we are and what that means. The benefits of the dynamic ideal no longer hold but we are not sure how far off we are and what that means.

The three mutual conditions for a beneficial balance are:

(1) The rate of interest causes savings to equal investment.

(2) Total demand equals total supply.

(3) The economy is at full capacity.

Monopolies and imperfect competition mean that these conditions cannot hold, but we cannot be sure how the economy deviates, what interactions deviation sets up between the conditions, what the overall result is, and whether the end result is an alternative system like the static ideal or the dynamic ideal. As far as I know, economists just cannot be sure, although they do offer many complex models.

Monopolies are like the landlords that Malthus described. We are not sure if their profits (rents) are in the system or out of it. We are not sure if the normal spending of their profits unbalances the system or balances the system. We are not sure if the spending of their profits can help the system when it is in trouble. We are not sure what role they play in the business cycle, or what role they might be able to play in the business cycle. What actually happens varies from case to case. See remarks in later chapters on money and on macroeconomics.

(3B) Oligopoly. “Oligopoly” also comes from Greek, and means “several sellers”. It refers to a market that is controlled not by one seller but by a small group. This situation is much more common than real monopoly, as, for example, K-Mart, Wal-Mart, and now Target often split the retail market between them rather than that one alone controls. According to widely accepted guidelines, a market is under oligopolistic control when it has six or fewer major firms, when one firm controls at least 40% of the market, or when four or fewer firms control at least 50% of the market. A “cartel” is a kind of oligopoly, usually an openly declared association, often for the control of a natural resource in an international market. The Organization of Petroleum Exporting Countries (OPEC) is a cartel that tries to control the supply and price of oil in the world for the declared benefit of its member nations. An “oligopolist” is a firm in a market characterized by oligopoly.

Bigness (economies of scale) can help create and sustain oligopolies, as with car factories or with firms that make farm equipment. Usually the bigness is not so efficient that one firm can totally drive out rivals but enough so that a few firms together can exclude rivals.

Oligopolies control a large part of modern life. General Mills, Post, and Kellogg’s control nearly all the breakfast cereal in the United States. Only three major credit cards dominate that market: American Express, MasterCard, and Visa (although they are administered by a host of banks and other institutions). Before the entry of international firms into the American market, three carmakers almost totally controlled: Chrysler, Ford, and General Motors. Coke and Pepsi control nearly all the market for soft drinks.

Sometimes bigness alone is enough so that a few firms can control a market. Sometimes firms consolidate control of a market after they get large, and are able to exclude competitors after they get large; it seems that this is what Coke and Pepsi were able to do, and what Microsoft did.

Usually oligopolistic firms have to cooperate in some way. They have to stop the price war that drives perfect markets. They have to agree to limit production at a level where price remains well above cost. Ideally for them, they would like to limit production to the point of maximum profit. They also have to limit production so that they can exclude other firms or control other firms. Sometimes they have to allow more production than would yield maximum profits so that they can exclude other firms. Maximum profit would be ideal for them, but without some exclusion there might be no profit at all.

Cooperation can be a big problem. Cooperation used to be done openly as with the railroad cartels and steel cartels of the 1800s, but now it has to be done tacitly because it is against the law. Firms have developed many ways to start and to maintain tacit cooperation but this book cannot go into them. As with the study of uncertainty, the study of cooperation is a large and fascinating sub-field within economics. Oligopolists and government regulators often fight an intriguing, never-ending battle of hide-and-seek, like “spy versus spy”.

Most oligopolies do not like to admit they are oligopolies but instead try to pretend they are fair competitors by allowing a host of very small firms to remain in the market as camouflage. This is part of tacit self-protection and part of fending off the regulators. Within the credit card market, several small cards still hang on such as Discover and Diner’s Club. At any given time, the domestic airline market is dominated by a few airlines such as Northwest and Delta but many small carriers fly alongside them. Gypsy cabs run alongside the approved firms in most major cities. Coke and Pepsi allow store brands from Kroger and Wal-Mart, and allow small specialty brands such as IBC and Knudsen’s.

Oligopolies have all the same effects on the economy as do monopolies. In fact, the effects are due more to oligopolies than to monopolies.

(3C) Differentiated Sellers. “Differentiated sellers” is another type of imperfect competition. This type is probably the most common form of imperfect competition in the daily experience of most consumers. This type has other names such as “monopolistic competition” or “oligopolistic competition” that reflect that this type is similar to oligopoly or monopoly but not exactly like them.

Basically, firms cut up a big market into many small “niche” markets. Each firm is a monopolist or is an oligopolist within its own smaller niche market. Within that smaller but surer space, it avoids competition with other firms, and can reap near-monopoly benefits. Firms cut up the market by distinguishing themselves in some way in the eyes of consumers, and they keep the market cut up primarily through brand loyalty. They foster brand loyalty through advertising. Each niche is like a monopolized market but the whole market is like an oligopolized market, hence confusion about the name.

Examples explain best. When I grew up on the West Coast, teenage boys used to argue vigorously over Ford versus Chevy. They never seemed that different to me. Until recently, the major active ingredient in nearly all over-the-counter (OTC) headache medicines was acetaminophen; all acetaminophen is exactly alike; yet nearly all OTC medicines claim that their product is faster and more effective than competitors. People are loyal to a particular brand such as Tylenol for reasons that have nothing to do with the chemistry of pain but that have a lot to do with the chemistry of human nature. There is almost no practical difference between any brands of toothpaste yet people tend to be amazingly loyal to their brand. Any parent that has tried to talk a child out of a favorite breakfast cereal into the cheap nearly-identical store brand knows how fanatical brand loyalty can be, and knows how much of a price difference it can generate.

Nearly all cosmetics have the same key ingredients (read the labels) yet some women (sorry for the sexism) would rather hide in a convent than appear in public without having first applied their favorite brand. The cosmetic industry makes many billions a year in profit. Lawyers, dentists, and colleges advertise on TV as a way to differentiate and to attract customers. Loyalty to an alma mater is legendary, as financial officers from Oregon, Harvard, Michigan, Ohio, Ohio State, Auburn, Alabama, and Notre Dame know. When cigarette ads were still allowed on TV, Kent advertised that its smokers “would rather fight than switch”, and showed people smoking Kent with black eyes to prove their loyalty. Everybody has his-her favorite rock band, hip-hop band, or pop singer. Brand loyalty, rather than talent, is the basis for most profit in the music business, even the classical music business.

Differentiating a product is probably the most widespread tactic that firms and workers use to fight against uncertainty. When a firm has an identity and has brand loyalty, then its market share is much more secure, and its profits are much more certain. Workers seek jobs with tenure. Consumers buy familiar products so that they know what they are getting. Keep this fact in mind for the next chapter on labor and wages.

Advertising. Perhaps the most interesting aspect of differentiation as distinct from other kinds of imperfect competition is the relation between differentiation and advertising, and how that relation can lock firms into a “runaway game”. Differentiated firms advertise heavily. They make profit, and they use their profit to advertise. They are the major supporters of ads. Without them, we would live in a different kind of world, one with far fewer ads.

I am not a good judge of the effects of advertising because I like advertising. I enjoy the year-end TV roundups of “world’s best ads”. I would rather that differentiated firms spend their profits on advertising than to invade other markets or to invade politics. I like the creativity of modern ads; am glad we have at least one way to support some creative people through the market rather than through state subsidies; and do not think ads have a mysterious power to control people, at least over the long run. So I do not mind too much that differentiated firms use their profits this way. This use of profits is a loss to public welfare, and a waste of resources, but one that we have to live with because the alternative could be worse. On the other hand, advertising often lies, and smart people disagree with me on all the points above, so we have to be careful too. At the least we have to be on guard against lies.

Once advertising gets established in a business, then a firm has no choice but to advertise at the same level as other firms. Differentiated firms compete primarily through advertising rather than through price or through product quality, and they escalate the level of advertising to as much as possible. They use all available profits for advertising. After they reach that level, they cannot back off.

Any firm that cannot sustain the standard level of advertising cannot break into the market and cannot stay in the market. This is the chief modern way that imperfect firms block entry into the market, and block the competitive price war that would allow new firms to enter and to drive down prices. Any beer company that cannot compete with Budweiser and Miller cannot hope to even enter the beer market. Even Sam Adams has had to advertise after it first succeeded as a specialty niche brewer.

The cost of advertising can be the major cost of production. Coke and Pepsi spend about half their total production budgets on advertising. Cosmetic manufacturers and OTC drug makers spend comparable amounts. Carmakers spend at least 10% of costs on advertising, often much more on a new line. If Ford did not advertise its pickup trucks, it would soon lose out entirely to GMC, Dodge, and Toyota – so much for macho decisions being made on the basis of pure manly practicality.

Biologists call this kind of situation a “runaway game”. Once in the game, a player has to devote resources to the game rather than to other kinds of competition or to other kinds of development, and a player cannot leave the game without total failure regardless of his-her merits in other regards. This kind of game results in peacock feathers or in gigantic impractical antlers on deer. It is comparative competition. The most familiar version of this game is “keeping up with the Joneses”. Keep this in mind for the next chapter on labor as well.

Advertising explains the fact that differentiated firms appear to compete even when they are not really as competitive as firms in perfect markets. It explains the fact that a modern imperfect firm tries to sell as much as possible when it seems as if imperfect competition should be all about limiting production. Differentiated firms compete for market share. They do not expand the total amount of product that is sold by all firms in the market together by lowering prices for the product in general. Coke and Pepsi do not lower prices. They do not provide consumers with a lot more soda for a lower price. Instead, they maintain price, which maintains limits on production for the total market; but they compete with each other to sell a greater share out of that limited market. The same was true of carmakers until firms from overseas upset the insulation.

(3D) Franchises. Franchises are only an extension of oligopoly and differentiation but they are probably the most important extension in the modern world and so deserve a few words on their own.

A franchise is a local storefront for a larger parent corporation, such as one local Burger King or one local Dominoes Pizza. A local franchise owner pays the parent corporation for the rights to use the name recognition, and thereby for a way to attract customers. The parent corporation enforces standards on the local franchise and the parent provides the local franchise with much of its operating inputs such as soda mixes and meat for hamburgers. The parent corporation might, or might not, get a share of the local profits. Usually it gets a big share.

A “buffer” intervenes between a danger and something that we wish to protect; a buffer lessens the danger to what we wish to protect. Bogs, bayous, and other wetlands serve as a buffer between flooding rivers and the dry lands further in. Sand islands buffer between ocean storms and the dry lands further inland. One parent often buffers between children and the other parent.

Franchises buffer their parent corporations from uncertainty so that the parent corporation usually benefits from uncertainty but rarely suffers from uncertainty. The franchises take on the uncertainty for the parent corporation. Franchises are willing to do this because they, in turn, are able to push the uncertainty off on independent local firms.

If a local franchise goes out of business due to uncertainty, the parent almost never goes out of business and rarely suffers much of a loss. One local Burger King might die but the chain lives on forever. Yet whenever a local franchise makes a profit, the parent corporation makes money from selling approved supplies and perhaps out of profit sharing. Local franchises tolerate this relation because the name recognition gives them a competitive advantage over local mom and pop stores. The local Red Lobster often does a steadier business than the local Mary’s Seafood Shack, regardless of prices and quality of food. Why this might be true has to do with how consumers respond to uncertainty, most readers have a good intuitive sense of why, and the details are tedious, so I do not go into it here.

The end result on mom and pop local stores is that they suffer even more from uncertainty than before the proliferation of franchises, and are even more likely to go out of business. Once a franchise moves in, mom and pop stores have to get much of their clientele from poor people, unreliable people, or other customers that cause problems, and they often have to give credit. When supermarkets such as Kroger, Piggly Wiggly, and Safeway moved into neighborhoods in the 1950s, they forced mom and pop groceries to shift into the convenience market and to give credit, both of which moves lead to considerable uncertainty and loss. When franchises, such as 7-11, then moved into the convenience market, they all but wiped out the mom and pop.

Once a local business person sees that franchises are more certain than free independent ownership, he-she then prefers going into a franchise rather than opening his-her own small business firm. Once introduced, franchises start a self-propelling process that drives out mom and pop. We lose free perfect competition and we are left shopping only at storefronts for major imperfect corporations.

Is this fair? Is this good? American politicians fuss about helping small business firms but they do not attack the franchises that drive out small business firms and that are owned by powerful imperfect corporations. This result is not ideal but I doubt there is much we can do about it that would not be worse than the trend itself.

This is one kind of directionality in the economy (see Chapter One). Many little decisions lead to a pattern that goes in a certain way and that is hard to reverse. The directed pattern leads to differences not only in the kinds of goods that we have but to differences in the basic form of our economy and to our basic way of life.

(3E) Rent. In near-perfect competition, the buyer can substitute one good for another, and the amount of the good responds pretty well to the demand and the price. If consumers want twice as many apples, then the price of apples about doubles and the supply about doubles. Farmers switch land from peaches to apples. If the price of apples doubles, then consumers can always switch to oranges and peaches. The same is true in reverse in case consumers want less.

In contrast, under imperfect competition, consumers cannot easily substitute another good for the one they want, and the supply does not respond well to demand or price. The supply is limited, and the supply is usually is much less than what consumers ideally would like. An imperfect market is not “Smithian”. There are only so many apartments in the core of a city near where most people work. You cannot have too many people live in one apartment. You cannot add more apartments, not even with more high-rise buildings. You cannot build houses, or live on the streets, in tents, or trees. You have to bid against other consumers for the limited apartments that are available. The owners of apartments are able to charge more for the apartments than it originally cost to acquire the land and build the structure, and they are able to do this for a long time. The situation with rent is like with bicycles except the owners of apartments do not have to contrive to limit the number of apartments, it just happens because space is naturally limited.

Some unusual incomes are best considered as kinds of rent. At any given time, by nature, there are only a few star athletes or movie actors. You cannot easily find more of the highest quality, although you can easily find more of second rate or third rate quality. You cannot substitute for stars of the highest quality. Consumers really want the highest quality, and are willing to pay more to see star athletes and movie actors. So stars are able to demand a high salary (rent) for their services.

A lot of income is generated by rent worldwide. As water, land, air, food, and some people get more limited and crowded in the future, rent is likely to become more important, likely to generate more unearned income, and to be a bigger source of distortion to an ideal Smithian economy. The general theory of rent is fairly clear but there are competing variations, and these variations can be important to understanding economic points of view and future situations. Please see my website for more details about rent.

Zero Sum Game: Scary Feeling. Imperfect markets, especially differentiated markets, have a different feel than near-perfect markets. They are scarier and tenser.

Because of the magic of big and small, in a near-perfect market, one firm more or less does not make any difference to the total quantity produced or to the price of the good. A gain by one firm does not require a loss by other firms. All firms are pretty much in the same condition. Although they compete, they do not feel the competition as cutthroat. Your rival firms are your rivals, not your enemies. In fact, the owners of firms in near-perfect markets often feel a kind of friendliness from being in the same trade. Farming is a near-perfect market, and small farmers are held up as the ideal in family life and as good neighbors.

In contrast, in an imperfect market, where exclusion is a part of life, each firm makes a big difference. A gain by one firm almost inevitably means a loss of customers and profit by other firms. Established firms feel that, if a new firm makes a foothold in the market, an old firm has to die out. In the cola market, if a new large firm succeeded, it would seriously cut into the business of Coke or Pepsi. The giants tolerate small firms on the fringe, especially small, differentiated firms such as Knudsen’s or IBC; but large firms would not tolerate a firm making a try to become a giant. Even in a city neighborhood where the restaurant market is differentiated and limited, a new Chinese restaurant means that an old Chinese restaurant is likely to fail, and, along with it, a family.

Near-perfect markets reflect the situation of free trade in which traders mutually benefit from trade. Imperfect markets are like a “zero sum” game in which any one player gains only when at least one other player loses, such as poker or Monopoly. In contrast to exchange where both traders benefit and feel good, zero sum games are tense, and players act accordingly. Players are more likely to compete not by doing better themselves but by hurting their opponents. They are often hostile and suspicious, or they band into subgroups so as to capture the game for their subgroup. They tend to act like gangs. Political campaigns are zero sum games because only one person can win, and all other candidates have to lose. Lately, American political campaigns have become notorious for their obnoxious negative ad campaigns rather than for giving us a real choice between qualitatively different candidates.

We will see in Chapter Seven on labor that the labor market is structured, differentiated, and ranked, and that it excludes some people from jobs. It is less like a near-perfect market than like a zero sum game where the results of losing can be severe and can last for generations.

What To Do. The first thing we have to do is accept the logic of the situation. The same logic that showed us the benefits of capitalism and the public price system now clearly shows us that the system has inevitable flaws, and that the flaws cause real problems. If we deny the flaws and problems, or we glibly say the dynamic ideal can take care of the flaws and problems without any need for deep thinking and personal responsibility, that is the same as denying the logic that showed us the benefits of capitalism and the public price system. We cannot throw out the bathwater without also throwing out the baby. We need to see if we can make the bathwater cleaner. We might have to accept a baby that is not perfectly clean, along with some dirty bathwater.

In the mid-1800s, the Republican Party, under President Lincoln, helped create a system of railroads in the U.S. by granting generous rights in land to large financiers. The grants were unfair and might have been illegal. Yet the railroads vastly increased the markets for all goods, in particular goods from farms and forests, and spurred the American economy into an international force. At the same time, the railroads came to dominate the freight business. They became a near monopoly under ruthless financiers such as Jay Gould. The railroads charged huge fees and made huge profits. Those fortunes still support powerful families today. Abuse by railroads, steel makers, oil firms, and others led to the anti-trust (anti-imperfect competition) laws of the late 1800s under Teddy Roosevelt. Those laws persist now but railroad empires do not. Eventually railroads were undone not by so much by state prosecutors as by another technical innovation: cheap cars and cheap trucks.

Imperfect competition succeeds by not allowing consumers much of a choice. If the state gives the right to make salt to only one firm, and people need salt, then people have to go to that firm. Large imperfect firms can exclude other firms. The strategy of differentiated firms depends on making people believe they must have that particular brand of toothpaste, face cream, car, or whatever, and thereby leading people not to choose any alternative.

In an undeveloped economy such as the American West of the 1800s, limiting choice works. As economies develop, limiting choice does not work as well, and some imperfect competition breaks down. In America now, we have enough choices so that imperfect competition is not as scary as railroads were to farmers in the 1800s. Innovation gives us substitutes. It helps to widen alternatives and thus to break down the power of imperfect competition. Even if we do not have a choice between different brands of the same good, we have a choice of similar goods that are good enough. These similar goods are called “substitute goods”. We really do have a choice between kinds of salt or kinds of headache tablet. If we do not like salt, we can use “Mrs. Dash” or some other condiment. If we do not like acetaminophen (Tylenol), we can use ibuprofen (Advil). If we do not like one kind of car, we can buy another kind. If we do not like cars at all, we can take the bus, ride a bicycle, take a taxi, ride a motorcycle, or walk. If we do not like licensed physicians from the American Medical Association, then we can seek an alternative such as faith healing or herbs, or we can go on the Internet to diagnose ourselves. The greater the scope of markets, the more there are viable substitutes. In the 1970s, with only three carmakers, all of them domestic, Americans did not have much choice, price was not low, cars were not good, and gas consumption was high. When making cars became a worldwide enterprise in the 1980s, people had a choice between a dozen major brands, the market was much more nearly perfect, the quality improved, the price dropped for cars of reasonable quality, and even fuel efficiency got better. With the rise of large corporations and their franchises, we still have to fear imperfect competition, but things have gotten better too.

When people first find out about imperfect competition, often their impulse is to “kill the beast”: use the power of the state to counter the power of imperfect firms. Break up the monopolies. Force a market into perfect competition. If we cannot break them up then force monopolies to produce more and to thereby lower the price. If we cannot do that, then tax away their unearned profits and use the tax revenue for the public good. In effect, run all monopolies as public utilities such as electricity. This response is perfectly natural, especially if a small near-perfect firm suffers by competition with a large imperfect firm, or if a consumer seeking a good software system feels how imperfect competition erodes the benefits of the free market. But this approach is very hard to carry out in practice and this approach is not the best response in the long run.

The Libertarian-Austrian response is the opposite: do nothing. Suffer over the short run, and let the free market provide innovations, choices, and substitutes over the long run. Imperfect competition is bad, but anything the state does to help is worse. The state often causes imperfect competition by interfering with the free market in the first place, as with the railroads. Interference is more likely to induce more imperfect competition and to help big firms rather than to help perfect competition and to help small firms. So stop all interference in the free market. If we were somehow absolutely sure the market never would help enough, not even over the long term, not even through innovation, then we might have to endure state interference; but the market will help enough, and so we should trust it. The history of innovations, choices, and substitutes bears all this out. The Libertarian-Austrian response is typical of people that romanticize the free market, mistakenly think the dynamic ideal can take care of any problems, overlook real problems and flaws in their lust for entrepreneurs and the dynamic ideal, or provide ideologies to rationalize the power of large business firms. Even though this response is ideologically tinged and it is not perfect, this response still is better than “kill the beast”.

I think the best response is pretty much what we do now. Legally our response seems to lean heavily on state interference but in practice our response is more like the Libertarians. We have laws in place against imperfect competition but we rarely use them directly to attack firms. (I do not explain the laws, how they developed, how they have been used in the past, or how they are used now.) Instead of using the laws often to go directly after clearly imperfect firms such as Microsoft or Wal-Mart, we use the laws as a threat to control the firms so that the firms do not cause too much damage, allow innovation to undermine the bad effects of the imperfect firms, and allow substitution to undermine the bad effects. Sometimes the state does have to prosecute obvious cases or bad cases. Sometimes the state has to go after cases of unfair competition where a large imperfect firm clearly has abused its power to hurt small firms through dumping goods, unfair price wars, or price fixing, or where a rich firm has bought political influence. I do not give examples here but some are in the suggested readings. Of course, having the laws in place means that politicians abuse the laws to help clients such as big firms, but, in this case, not having the laws at all would be worse.

Kodak pretty much invented the electronic (digital) camera about 1975. It did not implement the innovation for decades, probably because it correctly understood that the innovation would completely undermine the film business that Kodak dominated. But in the end, Kodak’s patents expired and digital cameras did come to dominate photography, without any state intervention. Because Kodak was late into that game, it nearly lost the photography market to rivals such as Canon and Nikon – poetic justice. Kodak declared in 2004 that it was switching over massively to digital and has begun to make some good cameras. The world lost a couple decades in which it might have benefited from crude digital photography, and Kodak gained some unearned profits until it was almost undermined by its own tardiness. We could have used the state to force the earlier development of digital cameras but then we would have had to live with state control. We lost some, and we gained some, by not inviting the state. I think we gained more than we lost even if we did really lose some.

I do not give up entirely to imperfect competitors and I favor some state action, even in cases where the state does nothing now. I would break up Microsoft into at least three distinct firms: operating system (Windows); Internet browser (Internet Explorer); and other related software such as Word, PowerPoint, and Excel. I would break up any other firm along similar lines, perhaps separating Adobe into distinct firms. I would not let any firm that markets Linux develop other software to go along intrinsically with it. I strongly favor “truth in advertising” and “truth in lending laws”. Maybe fortunately, though, I do not set policy or enforce policy.

Unfortunately the state does not follow all the Libertarian advice: do not interfere in the free market to begin with, and stop current interference as much as possible. The state interferes supposedly to help all business in general, such as by giving tax breaks to corporations and to wealthy people, and, by doing so, actually promotes big firms and imperfect competition more than it helps small firms and perfect competition.

07 Labor and Class

The subject of this chapter is important in economics and to me personally. The chapter covers the economic bases but it does so from my point of view. I say things about class conflict that some readers will not like.

07 Labor and Class; Synopsis.

Labor is a resource like any other, like steel or wheat. Ideally, all workers of a similar kind get paid according to how much another worker of their kind helps the business firm make profit (revenue). All journeymen mechanics get paid according to how much benefit another new mechanic brings the firm. The same is true of all new lawyers.

An ideal economy would have full employment for all people who were willing to work and who had reasonable training. The lifetime earnings for any job would be fairly similar for all kinds of work. There would still be some differences in lifetime earnings for some kinds of jobs, but not as much as we have now. Dentists would still make more than dental assistants but the difference would not be nearly as much as now. There would be no unemployment or poor employment.

Workers cannot tolerate uncertainty of job, wages, and benefits. Business firms need a reliable work force. To counter uncertainty, workers tacitly agree among themselves, firms tacitly agree among themselves, and workers tacitly agree with firms, to structure the labor market so that jobs and wages are secure.

Workers and would-be workers pay prices for the certainty. First, the market does not directly set wages. The firm gets greater control over wages. Employees and employers have to fight over wages. Second, there are fewer total jobs. Some people with skills who are willing to work truly cannot find jobs. Now there is real unemployment. Third, there are really better and really worse jobs. Some jobs get pay out-of-proportion to the amount of training, such as professionals and managers. Some jobs have low wages and no benefits. Now there is real poor employment. The unemployed and poorly employed face greater hardship and uncertainty than they did before the tacit agreement to structure the labor market to gain security. In effect, the unemployed and poorly employed people pay the price so that workers who do have jobs have good jobs.

The normal level of unemployment now is about 8%. It is not 4%. The problem of unemployment and poor employment aggravates other problems of a distorted economy, and booms and busts. In a bust, the unemployment rate can rise to 12%. People call for state action. Good state action can be helpful but too often it is bad state action which helps in the short run but only makes things worse in the long run, such as tax breaks to business firms, supposedly to create jobs.

The unemployment and poor employment is not curable by any training program, jobs programs through tax breaks to employers, or education. This does not mean that training and education are not worthwhile; it just means we cannot expect them to cure this problem.

Inevitable unemployment and poor employment cause many social problems. I do not list them in this synopsis. The attendant social problems are not curable as long as we do not face the root problem of systemic unemployment and poor employment, and deal with it directly rather than indirectly through some scheme.

When we deal with the problem of unemployment and poor employment, we have to not create another worse problem of dependency on government. Dependency occurs at the personal level through welfare and at the level of business firms through corporate welfare that is supposed to create jobs. It is very hard to cure one problem without aggravating the other. We have not done a good job in America. We have to do better.

07 Labor and Class; Bigger Synopsis. This bigger synopsis follows the development given in the main text.

Labor is an input factor like any other input factor (resource). Labor should be paid according to its cost effectiveness (marginal revenue productivity).

Workers cannot tolerate uncertainty. Business firms need a reliable work force. To counter uncertainty, workers tacitly agree among themselves, firms tacitly agree among themselves, and workers tacitly agree with firms, to structure the labor market as a ranked differentiated market.

Workers and firms create categories of jobs in a rough hierarchy. Jobs are ranked according to stability, wages, benefits or no benefits, amount of benefits, comfort, safety, and prestige. People are sorted into jobs through institutions such as schools, the police, and churches. The sorting of jobs works with the class system.

Because the labor market is imperfect, labor is not all used fully; some inevitable unemployment arises. The bottom rung in the labor market is the empty rung of unemployment. The next rung up is poor jobs with low wages and no benefits. Structuring the labor market to give security for most workers means inevitable unemployment and poor employment for some other workers.

Some particular features of labor as a resource make sure that unemployment is inevitable and that unemployment strongly affects the economy. See the text.

This unemployment really is inevitable. We cannot eliminate unemployment by being harsher to the poor, with any program to stimulate growth, jobs program, tax program, education, trade-off between unemployment and inflation, or any economic tweaking. Unemployment goes down during boom times we mistakenly believe that we can make it vanish, but we cannot. Even if we made all the unemployed people and the poor people vanish, the system would generate more of them. Unemployment is a reality, and we have to learn to live with it.

Unemployment reinforces racism, sexism, ageism, class conflict, driving toward fascism, bad schools, and other ills. To avoid these serious problems, we really do have to do something about unemployment.

We cannot cure unemployment and poverty by private charity, and so we have to go through the state. We are morally obliged to devise decent welfare, health care, retirement, and education.

These programs cannot inadvertently reinforce other social evils in some ways, such as welfare dependency. The programs cannot inadvertently expand by encouraging people not to work but instead to get on the programs.

We also have to accept the hard fact that we can only carry them out to the extent that we can afford. We might not be able to carry out welfare so that all people live middle class lives. We have to focus on giving children as equal a chance as possible.

The structured labor market is like a zero sum game in which the gains (jobs) of one person come only with the losses (poverty) of another person. People in zero sum games fear and suspect each other. People in zero sum games form subgroups to capture a portion of the game (market) for their subgroup so as to make sure that they do not lose. A subgroup can advance not just by promoting itself but also by hurting competing subgroups. Social classes advance not only by helping themselves but also by hurting other social classes.

People fear unemployment because it has horrible impacts on the future of their children. Their fear is justified. The people that fear unemployment the most are those that live closest to it but still have jobs: the working class and the middle class that are not professionals. Not only do people fear unemployment, they also fear the unemployed and the poor.

To preserve the future of their children, working people and middle class people act to “keep down” the unemployed and the poor. They oppose social programs that help the poor, such as welfare, especially because the programs come at a cost to themselves. They support laws that differentially hurt the poor, such as laws against drugs, gambling, abortion, prostitution, and homosexuality; and they support harsh penalties for petty crime and for victimless crime.

The only way to alleviate the problems is to support the poor yet to not alienate other classes and to not cause more fear in other classes. We have to take the fear out of being poor without taking away the incentive to work and without creating other problems. That is what good programs are for.

I do not advocate a return to failed programs such as public housing and food stamps.

We probably do not need to spend much more than we already spend. We cannot lift all poor people to the level of the middle class.

We need to make clear our commitment that nobody suffers inhumanely and that all children will have a decent chance.

How much we can afford programs to alleviate poverty, fear, and class conflict depends on: (1) the urgency of problems, (2) the general level of wealth, (3) comparative wealth as seen through the eyes of comparative competition, and (4) how much recipients abuse the programs. This chapter does not go into details.

We can try to make sure that no one particular ethnic group, gender, age, regional, or religious group always makes up the bulk of the poor, such as Blacks or single mothers. We need to make it equally possible for all groups to share in poverty. To do that, we need to make it equally possible for the children of all groups to be able to climb out of poverty. Only if people feel that their children are able to escape poverty are people willing not to oppress the poor. This is the key reason behind any of my suggestions.

We cannot give all poor children the equivalent of a middle class education. Education is not a cure for the problems and flaws of unemployment and poor employment. We should not expect education to lead to jobs for everybody, good jobs for everybody, or to end unemployment and poverty. We can make sure that all willing poor children that get a degree are absolutely qualified to the standards of that degree, so that there are no excuses for failure or for discrimination. We can give every willing child a minimum decent education.

We can maintain jobs programs not out of mistaken hope that they will provide jobs for everybody but as a way to rotate people out of poverty.

Some modest programs, such as Head Start and free school lunches, were cost effective and were morally good, and so should be reinstated or invigorated.

If we do not act, then class conflict will get worse as the United States becomes part of the single world economy. Politicians will take advantage of class conflict to promote reactionary power. Even if we do not care about the poor directly, still for our own interests we should help the poor so as to minimize the danger of reactionary fascism and the danger to ourselves. This danger is real and should not be under estimated.

Wages Introduction. Particular occupations get paid the same way that all input factors get paid: by their cost effectiveness. There can be no other basis for wages. This idea is the basic foundation for all further understanding.

Wages includes not only an hourly wage but also benefits of all kinds such as medical insurance, retirement, sick leave, vacations, bonuses, etc.

The category of “workers” includes not just people who receive an hourly wage but also people that receive a commission, managers, professional people paid by contract, and professionals who have their own business but the kind of business is quite secure. As part of wages, we can include fees to dentists, doctors, lawyers, teachers, plumbers, professors, accountants, etc. Their fees are the wages that we pay them for the utility that they render us in performing a service for us. We adjust how much we are willing to pay, or how often we seek them, according to the marginal utility that we get from another visit. Only true entrepreneurs that earn nearly all their compensation from deciding about uncertainty are not workers with wages.

Workers supply labor to business firms as if the workers were small firms supplying any input factor. Just as Carl gives corn to get something in return, workers give labor to get something in return. Labor has an exchange ratio, its wages. Workers give labor until the marginal cost of giving labor about equals the marginal gain from wages. The average marginal cost to workers in a particular occupation, and the average marginal gain to employers of workers in a particular occupation, set the general exchange ratio for labor of particular kinds of occupations such as plumbers, computer designers, and doctors. We can also think in terms of the imaginary auction in which providers of labor (workers) offer labor to buyers of labor at various ratios until the workers and the business firms can agree on the correct exchange ratio. At partial equilibrium (the agreement point of the auction), the average marginal utility of wages to workers coincides with the average marginal revenue productivity of labor to employers, the exchange ratio (wages) is set, and the exchange ratio reinforces the conditions that set it.

Firms look at labor as an input factor. I give their viewpoint below. We will use the viewpoint of firms throughout this chapter as the easiest way to understand wages and labor.

Interlude: Wrong Ideas. First we have to get over some wrong ideas:

(1) “A person is paid more to compensate for the greater time and effort that he-she puts into education, the expenses of a staff, or the costs of operation such as an office and insurance.” This idea of wages-for-trouble is an example of an objective explanation of cost, and it undoes imputation. Instead, we pay people who render more valuable services. We pay for the greater effectiveness of their services. In order to render more valuable services, these people have to pay for their education, staff, and other higher costs out of the extra they can charge us for the extra utility they can give us. These people get more education in anticipation of being able to provide more utility and so being able to receive higher wages. These people can afford more education, staff, and insurance because they deliver more utility, and so we are willing to pay them more for the more utility. If their greater expenses exceed the utility that we get from them, we don’t pay. Whenever they do raise fees by using costs as an excuse, we go less often until the utility we receive does match their higher fees. When my dentist raised his fees for cleaning my teeth, I went less often. If investment in education guaranteed a good job, then we would not have as many anthropology PhDs working in banks.

In the short run, it is true that higher costs of education can lead to higher wages just as higher costs of sugar can lead to a higher price for lemonade. In the long run, wages, prices, and the cost of the components (education or sugar) that go into any higher level input factor (labor) or final good (lemonade) adjust to the revenue or to the utility that is delivered.

(2) “People get paid more primarily because they have more talent. Doctors, lawyers, college professors, plumbers, electricians, etc. get paid more because they are smarter than everybody else.” This is also an objective theory of cost that undermines imputation. It is partly true, but mostly it is the other way around: smarter people seek professions that confer greater utility to consumers and therefore receive higher wages. Innate differences in ability are not all that important except for some unusual professions such as brain surgeon or great blues artist. More people could become lawyers, doctors, executives, or electricians than we have now. High wages in those professions come out of imperfect markets and out of limiting access more than out of any greater ability. Ability does matter, but not that much. When many smart people do enter those professions, then wages fall, as a lot of young lawyers are finding out.

Both these ideas are part of a false mythology that helps people maintain an imperfect labor market.

Back to Wages Main. If a firm had to pay employees more than their cost effectiveness, the firm would go out of business. If a firm could pay employees less than cost effectiveness, the firm would make a profit for a while. Soon other firms would enter the business and raise wages to bid away employees so that they could make some profit too, even if less profit. The price war would continue until, in the end, the level of wages would rise (or fall) to cost effectiveness, all firms have to pay according to cost effectiveness, and no firm makes a profit out of misusing labor. Plumbers, police, lawyers, doctors, and programmers all should get paid according to cost effectiveness.

To see how particular occupations get their particular level of wages, look at differences on marginal revenue productivity (cost effectiveness) “at the margin”. Adding one journeyman plumber adds or removes a certain amount of revenue for the firm. Removing one journey plumber adds or removes a certain amount of revenue from the firm. All journeyman plumbers are paid according to that difference. All journeyman plumbers are paid per day according to how much difference one more, or one less, typical journeyman plumber makes per day to the typical plumbing firm. All journeyman plumbers get paid according to the average marginal revenue productivity of journeyman plumbers. If one more, or one less, journeyman plumber meant a difference in revenue to the firm of $200 per day, then all journeyman plumbers get paid $200 per day. If one more, or one less, young associate lawyer makes a difference to the law firm of $300 per day, then all young associate lawyers get paid $300 per day. If one more, or one less, counter clerk at a fast food restaurant makes a difference of $5 per hour ($40 per day), then all counter clerks get paid $5 per hour.

If an imperfect labor market reduces the number of journeyman plumbers, or forces a rise in their wages, plumbing companies do what any firm does when a resource is in limited supply at a higher price: the plumbing firm hires fewer journeyman plumbers until the increasing cost effectiveness (marginal revenue productivity) of journeyman plumbers rises to meet their new cost. This is true when consumers hire laborers directly, as when they pay doctor’s fees. When doctors are more expensive, we use them less until their new cost effectiveness (marginal utility in this case) matches their higher fees.

If the state forces an employer to pay more than cost effectiveness, then the employers does what all firms do when faced with a higher price for any input factor: the firm cuts down on the input factor until the cost effectiveness (marginal revenue productivity) of the input factor rises to meet the cost. If the state forced the price of steel to go up from $100 per ton to $200 per ton, carmakers and washing machine makers would cut down on steel. Otherwise, the firm would go broke. If a law firm has to pay new lawyers $400 per day, then the firm cuts back on new lawyers until each one is worth $400 per day.

People use the argument above to justify not having a minimum wage law, but the argument is not used correctly for that purpose because the argument applies primarily to perfect competition while the minimum wage law operates in an imperfect labor market. For minimum wage laws, please see Part Ten of the companion big book.

The argument did not consider if wages are enough to live on, to live decently on, or to raise a family. In a modern economy, the wages for most jobs are enough to do all that, but the wages for a significant fraction of the jobs are not enough to live decently or to raise a family on. The rest of the chapter explains the situation more.

The argument did consider why an average law firm employs 8 junior lawyers at $500 per day while the average plumbing firms uses 12 journeyman plumbers at $300 per day. The argument did not say why an average law firms does not instead employ 12 junior lawyers at $400 per day, and the average plumbing firm instead employ 6 journeyman plumbers at $400 per day. These “what if” questions have to do with general equilibrium, and the sorting of all resources into all markets, at the same time. These questions do not undermine the ideas offered here, and would strengthen the results if we had time to work through it all.

Kinds of Unemployment. Some unemployment, called “frictional”, would happen even in a perfect labor market because people need time to look for a new job, need time to retrain, and sometimes have to move. Estimates differ, but frictional unemployment is probably no more than 2% of the work force. Frictional unemployment is not much in question in this chapter.

Some people do not have a job because they do not want to work. As long as they do not seek a job, they do not count in the statistics, and do not count here. Some people do not work because they are legitimately disabled. They also do not count here. Some people do not work because they would rather be on a state program such as welfare. If they get on a program because they fraudulently get certified as disabled then they do not count here except as examples of abuse. If they get on a program other than disability, and pretend to seek work, but do not really seek work, then they do count here; but it is not clear how they count. They contribute a bit to the percent of people who genuinely want work but cannot find any (see below). They do not contribute enough to invalidate the argument of this chapter.

Besides frictional unemployment, another about 6% to 8% of persistent unemployment comes from people not being able to find work even though they want work. This inevitable unwanted unemployment is the main subject of this chapter. This inevitable unemployment comes both from structuring the labor market (imperfect competition among workers) and from imperfect competition among business firms, and so is called “structural” unemployment. Out of 8% to 10% total unemployment, about 6% to 8% is structural. The best Conservative economist after 1950, Milton Friedman, acknowledged this source of unwanted unemployment, called it the “natural rate of unemployment”, and argued that the federal government should do something.

In a modern technologically-heavy economy, an increasing number of people are just not smart enough (are too stupid) to be able to find work, even with some education. In an ideal economy with perfect competition, many not-smart people would be able to find work, but that is not so in a real economy with an imperfect labor market. I do not know how much not-smart people make up of the 6% to 8% unemployment rate; I guess less than 1%. Most not-smart people end up in bad jobs rather than in no job. The real problem is that the future. Not-smart people have little hope of getting anything other than a bad job. I do not know how much worse this problem will get. Within about 20 years, I think it will get bad enough so we have to act.

A rate of 6% to 8% unwanted employment might not seem like much (unless the reader has been unemployed for a long time and knows from experience) but it is enough to cause serious trouble because there is no way for most people in the modern world to make a living other than with a job. President George H.W. Bush (Bush Senior) lost his own job when the official rate climbed to about 8% in 1991.

The United States has a total unemployment rate of 5% to 10% if we add frictional and structural. Sometimes the rate is higher because we are in the bust phase of the business cycle, or lower because we are in the boom phase; but the baseline rate always is somewhere in this range; and even in the boom phase, structural unemployment never goes entirely away. In the depression (o