Prices and Information: A Simple Framework For Understanding Economics

TABLE OF CONTENTS Page 1 of 3
PRICES AND INFORMATION

A SIMPLE FRAMEWORK FOR UNDERSTANDING
ECONOMICS
by
W. Robert Reed and Max Schanzenbach
© 1996 W. Robert Reed and Max Schanzenbach
TABLE OF CONTENTS
PART I: Prices and Information
CHAPTER 1: Why You Should Read This Book

CHAPTER 2: What is the Purpose of an Economy?
CHAPTER 3: How Can You Measure Happiness?
CHAPTER 4: If You Don't Like It, Give 'Em Money
CHAPTER 5: The Incredible Information Contained in Prices: Part I
CHAPTER 6: The Incredible Information Contained in Prices: Part II
CHAPTER 7: The Incredible Information Contained in Prices: Part III
CHAPTER 8: Information and the Fundamental Problem in Economics
CHAPTER 9: The Rest of the (Output Price) Story
CHAPTER 10: The Information Contained in Input Prices
CHAPTER 11: A Ton of Copper Versus A Ton of Steel
CHAPTER 12: A Ton of Ph.D.'s Versus a Ton of High School Dropouts
PART II: A Simple Framework for Analyzing Public Policy
CHAPTER 13: The Big Picture

CHAPTER 14: The Amazing Story of Profits
CHAPTER 15: Profits and the Invisible Hand
CHAPTER 16: Price Controls and Other Disasters
CHAPTER 17: Does Recycling Waste Resources?
CHAPTER 18: Job Destruction and Economic Growth
CHAPTER 19: A Simple Framework for Analyzing Public Policy--Part I
CHAPTER 20: A Simple Framework for Analyzing Public Policy--Part II
CHAPTER 21: A Simple Framework for Analyzing Public Policy--Part III
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CHAPTER 22: Can We Afford to Let the Maritime Industry Sink?

CHAPTER 23: Job Training--Ticket to Prosperity?
CHAPTER 24: Making Ourselves Poorer by Trying to Make Ourselves Richer
CHAPTER 25: These Quotas Don't Amount to Peanuts
CHAPTER 26: Who Will Protect Workers and Consumers?
CHAPTER 27: OSHA--We're From the Government and We're Here to Help You
CHAPTER 28: Unintended Consequences of Consumer Safety Regulation?
CHAPTER 29: A Game Called Hot 'N Cold
PART III: Extensions of the Simple Framework
CHAPTER 30: Moving to Greener Pastures

CHAPTER 31: That Loud Sucking Sound
CHAPTER 32: But Where Will the Jobs Come From?
CHAPTER 33: Who Gains From Trade?
CHAPTER 34: How to Spite Our Collective Face by Cutting Off Our Collective Noses
CHAPTER 35: Are Trade Deficits Bad?
CHAPTER 36: Trade Wins, and Losses
CHAPTER 37: The Information Contained in Interest Rates
CHAPTER 38: Who Watches Out for Our Children's Children?
CHAPTER 39: The Great Timber Famine
CHAPTER 40: A Little Bit of Heaven on Earth
CHAPTER 41: All for One and One for All?
CHAPTER 42: What's the Catch?
PART IV: Market Imperfections and the Public Sector
CHAPTER 43: Market Imperfection I: Monopolies

CHAPTER 44: A Government Price Fix
CHAPTER 45: Regulating a Monopolist
CHAPTER 46: Market Imperfection II: Externalities
CHAPTER 47: Environmental Regulation
CHAPTER 48: Market Imperfection III: Public Goods
CHAPTER 49: Public Goods and Free Riders
CHAPTER 50: Voting on Public Goods: All in Favor, Say "Aye"
CHAPTER 51: Free Riders Versus Forced Riders
CHAPTER 52: Exploiting Fellow Citizens for Fun and Profit
CHAPTER 53: Why Economists Disagree
CHAPTER 54: Closing Thoughts
I WANT TO GO HOME
I'M READY FOR SOME PRACTICE
CHAPTER 1 Page 1 of 3
CHAPTER 1
Why You Should Read This Book
Have you ever wanted to comment, with clarity and assurance, on government programs,
education, the environment, and the appropriate level of national defense? Do you want
members of the opposite sex to swoon at your incredibly thoughtful manner of looking at
political, social, and economic issues? In short, do you want to be a hit at cocktail parties? If
these are your desires, then look no further than this book. Skip over all those dry textbooks
with their graphs and complicated mathematics. Scrap all those weighty tomes written by
famous politicians. We promise you a revolutionary way of looking at the world. We
promise to teach you the ECONOMIC WAY OF THINKING.
Now maybe this was starting to sound really good until we mentioned the word
"economics." After all, economics doesn't enjoy the best of reputations. In what other field
can two people be awarded Nobel Prizes for saying the opposite things? George Bernard
Shaw proclaimed, with characteristic wit, that "if you placed all the economists in the world
from end to end they wouldn't reach a conclusion." Economists are frequently the butt of
derisive jokes and clever putdowns. (Our personal favorite: "Economists are people who
didn't have the personality to be accountants.") Well, what can we say? Economics does
have a bad reputation, and economists haven't always helped.
And that's too bad. Because few would deny the importance of economics. Look at the front
page of your daily newspaper. Economic growth, federal spending, international trade,
unemployment, and environmental issues consistently fill up the column inches. On every
issue there is a cacophony of arguments that try and explain why one policy is good and
another is bad. The person who is able to understand economics is in a unique position to
sift through these arguments and objectively evaluate the merits of conflicting policy
positions.
But perhaps economics has always been a subject that put you to sleep. There is a general
perception that economics is about things like economic efficiency, benefit-cost analysis,
capital investment, and marginal tax rates. Don't be fooled. Economics is a much broader
subject than the dry statistics and complicated terms that those bland talking-heads on
television would lead you to believe. You see, economics is bigger than interest rates. Its
bigger than the money supply. Its bigger than the GDP (the gross domestic product). It's
even bigger than the federal deficit! As important as these are, they are not the main issues.
They are the potatoes, not the meat.
First and foremost, economics is about the quality of life experienced by ordinary people. It
is about having a society that produces things like multimedia personal computers,
blockbuster movies, hot dance clubs, and enough leisure time to be able to enjoy these
things. It is about having health care, education, and a warm bed to sleep in at night. It's
about having enough prosperity so that parents can provide the basic necessities for their
children, and still have enough left over for a family vacation. In short, it is about the ability
of the citizens of a nation to enjoy the highest quality of life that is humanly possible given
http://www.ou.edu/class/econ3003/book/area1c1.htm 9/21/2007
the technology and resources at their disposal. The person who understands economics
understands more than the latest news story on unemployment or corporate earnings. The
person who understands economics has insight into the process of wealth creation that
makes it possible for us to afford all those things that make our lives enjoyable and
satisfying.
It might surprise you to know that there is a simple formula, a single recipe if you will, for
understanding economics. We would be lying if we said that it didn't require some
exercising of the brain. But it's not rocket science. Free trade, the balanced budget
amendment, the spotted owl, child care, and military spending--believe it or not, all of these
seemingly different issues can be understood using one, straightforward framework. We like
to think of it as the unifying field theory of economics. Only there is no need for any higher
level mathematics, algebra, or even graphical analysis. That is what you will learn from this
book. By the time you finish reading this you will be a bona fide expert on all economic
topics imaginable. And it will not be because you are smart (though you might be), or
because you have done a lot of research (because you probably don't have time). It is
because you will have mastered an incredibly fruitful way of thinking.
You are probably thinking this is too good to be true. How can we promise to teach you a
simple system of economic thinking when so many people disagree about economics? This
leads us to a great insight about the nature of economics itself. While it is true that
economics is relatively easy to understand, it also relatively easy to screw up. Of course,
there are legitimate reasons why well-informed, reasonable people disagree about economic
policies. You will learn these reasons in this book. Nevertheless, it is our judgement that
most disagreements about economic policies have their source in incorrect economic
thinking.
Henry Hazlitt began his classic work on economics by writing "Economics is haunted by
more fallacies than any other study known to man."1 Those words were penned in the
1940s. They are just as true today. Economics does seem to attract a disproportionate
number of bad ideas. Fortunately, these bad ideas often stem from common errors that are
easily identified...and corrected. In this book we will not only discuss how to think correctly
about economics, we will also point out some fundamental mistakes that cause people to get
tripped up when they think about economic subjects.
One thing you should know before you read any further. There are times when this book will
infuriate you. You will become frustrated with our simplistic analysis and feel as if we have
ignored some obvious criticisms. Let us encourage you...hang in there! While our
framework ends up being a simple one, it does require a lot of separate pieces to make it
work. In particular, before we can address the major objections to the "free market"
approach to organizing economies, we need to fully understand what makes unregulated
markets so attractive. Only then will we be in a position to appreciate the relevant criticisms.
So please be patient with us. The last section of this book is specifically designed to address
the major criticisms of unregulated markets. It is our experience that most people find that
their objections get addressed in this section, if not earlier.
Why should you read this book? Because this book will teach you the economic way of
thinking. You will be amazed by how different the world looks once you learn to view it
through "economic glasses." By understanding the principles in this book, you will be able
to confront and deflate a vast array of economic fallacies. You will be able to point out the
economic blunders of your favorite, nightly newsperson. You will dazzle your friends and
associates with your insightful comments on current events. You will be a hit at cocktail
parties.
CONTINUE ON TO THE NEXT CHAPTER
TAKE ME BACK TO THE TABLE OF CONTENTS
HOLD ON! I'VE GOT A QUESTION!
TAKE ME HOME
Notes
1
Henry Hazlitt. Economics In One Lesson. New York: Crown Publishers, Inc., 1979, page 9.
CHAPTER 2
What is the Purpose of an Economy?
Most economics texts are very clear about what economies do. Strangely enough, they often
fail to identify the goal of that economic activity. Although we certainly want to discuss
what economies do, we believe the much more important question is, what is the purpose of
economic activity? In other words, in order for us to determine whether our economy is
doing a good job, we need to know what the economy is supposed to be doing.
What economies do is allocate resources, where by "resources" we mean all those things that
play a role in producing goods and services for consumption. This is the tie that binds all the
economies of the world. The economies of capitalistic Hong Kong or communist North
Korea both go about the business of directing resources between competing options.
Obviously, each society has a very different way to allocate resources (a different economic
system). Hong Kong generally relies on prices to allocate resources. In contrast, North
Korea generally relies on government planners to allocate resources. Whether by private
decisions or government mandates, the bottom line is that resources are allocated to specific
uses.
Whether an economy does a good job of allocating resources is another question. In fact, it
is the key question. How should an economy allocate resources? How many resources
should be directed towards home building, bread baking, food growing, movie making, and
clothes producing? How will we know when an economy is doing a good job or a bad job?
To answer these questions we need to know what an economy ought to do; what its goal
ought to be.
If you'd ask the average politician what the purpose of an economy is, you'd probably get
one of three responses. Response Number One: "The purpose of the economy is to create
jobs." This is a bad answer. To see why, ask yourself, why do people work? Here's a little
thought experiment to help you answer that question. Suppose that starting tomorrow,
everybody's wages, salary, and pay went to zero. Who would show up for work? Most
people work not because of the intrinsic joy they receive from working, but because they get
paid for it. (Economists have a word for jobs that people would do without pay. They call it
play.) People want jobs because those jobs give them money, and that money allows them to
go out and buy the things they want. People work so they can consume more. Thus, creating
jobs is a means to an end. It is not the end itself.
This leads us to Response Number Two: "The purpose of the economy is to increase
wages." This is an even worse answer than responding that an economy should create jobs.
Suppose that the government outlawed all private sector jobs and placed everybody in jobs
producing dumb stuff--things that nobody wanted. However, it compensated them by paying
all workers a wage of $1000 an hour (plus paid vacation and time and a half on holidays).
That's $40,000 a week! Would this be the kind of economy you'd want to live in? Think
about it. While it might be nice to look at your monthly pay check and see that you are
making approximately as much money as your favorite professional athlete, you'd have a
rude awakening when you went to the local WalMart. There would be nothing there but
dumb stuff to buy. Wages are also a means an end--the end of having nice things to buy--
and not the end itself.
Response Number Three states, "The purpose of an economy is to increase production." By

now you should be able to explain why increasing production is also the wrong purpose for
an economy. We care about production only because it is necessary for consumption. Think
of it in these terms: if we produced cars, stereos, and hamburgers, but didn't let anybody
consume them, society would be no better off. Likewise, if we produced left-handed smoke
shifters, square wheels, and Ringo Starr solo albums--i.e., goods that nobody wanted--
society would again be no better off. In fact, in both cases we would be worse off because
we expended valuable resources to make goods from which no one was able to derive
pleasure. It would be like slaving away in the kitchen all day making a pot roast and then
discovering your dinner guests were vegetarians. You just wasted a pot roast as well as your
time and energy.
We are now ready to state what we think most people, after some thought, would choose as
the overriding purpose of an economy. THE PURPOSE OF THE ECONOMY IS TO
ALLOCATE RESOURCES IN A WAY WHICH MAXIMIZES SOCIETY'S HAPPINESS.
This response probably makes the most sense to you, but we bet you haven't thought about it
this way before. The other goals of more jobs, or higher wages, or more production are
merely means to an end. The end is greater happiness for consumers.
If we have two economies with the same set of resources, and the citizens of one economy
are all miserable, and the citizens of the other economy are all deliriously happy, we can
state that the second economy must be doing a better job. Or if people are generally happy
now, but resources get reallocated so that people become even happier, then we say that the
second allocation is better than the first, and the economy has improved. If any lingering
doubts remain about the purpose of an economy, ask yourself this question: If economies
don't exist to make people happier, then what good are they?
There's another way of stating the purpose of an economy that will help to show us to how
to proceed: THE PURPOSE OF THE ECONOMY IS TO ALLOCATE RESOURCES TO
THEIR HIGHEST VALUED USE. If a resource does not go to its most highly valued use, it
is wasted and society is made "poorer." Imagine a society in which no one liked liver and
onions, but everyone liked burgers and fries. Suppose that initially resources like pots, pans,
cattle, and cooks were all directed towards making liver and opinions. Ugggh! What a loss!
Think of how much better off that society would be if these resources were reallocated
towards producing burgers and fries. While it is true that we would have fewer livers and
onions (a lower valued use), we would be more than compensated by additional burgers and
fries (a higher valued use). By giving up something we like less in order to gain something
we like more, we make ourselves happier, and we do this simply by reallocating resources.
Clearly, if resources are directed to their highest valued use--i.e., the use that produces the
most happiness--then society's happiness must be maximized given the resources available.
But how is one to know a resource's highest valued use? How can one determine whether
the members of a given society will be happier with more shirts and less pants, more public
subway systems and fewer private automobiles? How can we ever measure happiness?
These are difficult questions that will lead us to the heart of what economics is all about. But
before we proceed, let us recognize one thing. If we have no way of measuring happiness,
no way of deciding whether one allocation makes people better off than another, then we
have no system for guiding how society should proceed (not to mention that we'd also have
a very short book!). To put it bleakly, if we can find no acceptable way of measuring
happiness, then economics has nothing to say about how resources should be allocated. We
must agree on a standard for comparing different allocations of resources before we can
determine whether economies are successfully doing their jobs.
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CHAPTER 3
How Can You Measure Happiness?
Up to this point, we only have determined that we want our economy to direct resources to
their highest valued use for the purpose of maximizing society's happiness. But how can we
determine the "highest valued use" of a resource? Consider the problem facing an economic
planner in Cuba or the former Soviet Union. If a Soviet planner was trying to decide exactly
where to build a new apartment complex, he might take several things into consideration.
For example, he might do a study of housing conditions in various sections of Moscow.
Based on that study, he might come to the opinion that new housing should be located in the
most crowded part of the city or perhaps close to where a new factory is going to be built.
However the dilemma is not resolved when the location is decided. Next come questions
such as: What kind of housing? Should the planner build family units or singles? Luxury
apartments or just the basics? How big should the unit be? As you can see, this is a
tremendously difficult decision--and an important one. From our previous discussion we
decided that society is poorer if resources are not directed to their most valued use. If the
planner directs bulldozers, architects, concrete and other construction resources to a part of
Moscow where new housing is valued less than in another part of the city, he has done more
than just made a mistake. He has hurt society. There is less happiness than what was
possible. With all these difficult questions to answer, it is clear that the planner faces an
overwhelming task.
Imagine how much more difficult the problem becomes when all of the resources of a
country are considered. How many cars should the nation build? How many office buildings
should be constructed? Should the farmers produce more vegetables, or the ranchers more
beef? For the economic planner, there is simply no objective way to determine how best to
use the resources that are available.
Does an objective way to measure "highest valued use" even exist? Let us consider this
question in the context of an example. Let us suppose that a very wealthy, very eccentric old
man meets his demise. In his will the old man directs the executor of the estate to divide his
possessions among his relatives in the way that generates the most happiness. However, a
codicil in his will dictates that the estate cannot be sold. Additionally, his relatives may not
sell their inheritance. Whoever receives a particular allocation from this inheritance is
restricted from trading or otherwise exchanging that allocation for other goods. What
approach could the executor of the estate use to ensure that the maximum happiness was
generated?
Consider first the approach of the planner. The executor could attempt to learn the relatives'
preferences by undertaking a study. Based upon the results of his study, he would make a
judgement about which relative would receive the greatest happiness from any given item.
For example, in deciding who would benefit the most from having the old man's Mercedes,
the executor would investigate which relatives have cars, how many cars they have, how old
their cars are, etc. Suppose the results of his study showed that Uncle Morton already has
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three, very expensive luxury automobiles, while Cousin Ralph has no car and rides a bicycle
to work every day. Then the executor could safely conclude that Cousin Ralph would get
more happiness from the Mercedes than Uncle Morton. Or could he?
Maybe Cousin Ralph rides a bike to work each day because he enjoys the exercise. Or
maybe he is a card-carrying member of Save the Planet!, and believes automobiles spoil the
environment. In any case, if he received the Mercedes he would rarely use it. On the other
hand, maybe Uncle Morton already has three luxury automobiles because he derives intense
pleasure from luxury automobiles. Perhaps he has seven teenage sons who are always
borrowing his cars. Either way, a fourth automobile would give him great joy. With lots of
relatives and myriad goods, the informational requirements of his study would soon become
overwhelming.
Consider another approach. Perhaps the executor says to himself, "These people know what
they want. Rather than having me try to figure out their preferences, I'll just let them decide
among themselves how to allocate the goods." Here he runs into another problem. How can
the relatives compare their respective desires? Suppose the widow of the deceased says to
the daughter-in-law, "You say you value the Mercedes a little, but I value it a lot. Therefore,
I think I should get the car." What does "value a little" mean? What does "value a lot" mean?
So the executor goes back to the drawing board, knowing that he must figure out some way
of ranking preferences across relatives.
Then he gets a brainstorm. He decides to develop a questionnaire. Each relative would have
to answer questions like: "On a scale from 1 to 10, how much do you value the Mercedes
Benz?" "On a scale from 1 to 10, how much do you value the Louis XIV dining room table
set?" The relative giving the highest rating would receive the item. The problem here is that
it probably wouldn't take long for the relatives to realize that it pays to exaggerate on a
questionnaire like this. There is no cost to lying about one's valuation. Even if a relative only
believed a given item was worth a "7," he would always be better writing down a "10."
Consider a more sophisticated version of this questionnaire. Suppose the executor asks each
relative to assign a rank to each item. Given a thousand items in the estate, each relative
would rank order every item from their most preferred to their least preferred. While this
represents an improvement on the previous approach, it also some obvious flaws. For
example, what should the executor do when there are ties? Suppose an aunt, two nephews
and a niece all put down the 3-D, virtual reality, home computer gaming system as their top
choice? How does the executor decide which one gets it? And what does he do for the other
three relatives? Does he give them their second choice instead? Suppose their second choice
is somebody else's first choice?
Can you think of a better approach? It is our experience that, by now, most people come up
with an alternative procedure that (i) utilizes all the information that is relevant for deciding
the value of each item, (ii) allows the executor to compare preferences across individuals,
and (iii) encourages truthful revelation by the relatives. And that procedure is an auction.
The executor would allot each relative an equal number of tickets or coupons. Each relative
would be free to bid as much or as little as they wanted, with items going to the highest
bidder. In this way, each of the dearly departed's possessions would be allocated across the
respective relatives. Note the attractiveness of this approach. The heirs are encouraged to
think carefully about how much they value the goods, valuations can be compared across
individuals, and no relative has an incentive to exaggerate.
Suppose Heir Number One outbids everyone else by bidding ten coupons for the Mercedes,
with Heir Number Two being the next highest bidder at nine. The fact that Heir Number
One has to give up ten of his coupons to obtain the car means that he has to think carefully
about his valuation of the car. He has no incentive to bid more than it's really worth to him,
because winning the bid means he loses the opportunity to purchase other goods. Further,
because Heir Number One is willing to sacrifice more of other goods than Heir Number
Two, we can say with some confidence that Heir Number One anticipates getting more
happiness from the car. In other words, if the car goes to Heir Number One, we can be fairly
confident that the most happiness possible will be generated.
We call this method of allocation the "willingness to pay" approach. Let's replace coupons
now with dollars, rubles, pesos, etc., and let's CALL THE MAXIMUM AMOUNT OF
MONEY A PERSON WOULD BE WILLING TO BID FOR A GOOD THEIR
WILLINGNESS TO PAY FOR THAT GOOD. By allocating goods to those who are
willing to pay the most, we allow individuals to reveal just how badly they want something.
People who would receive only a little happiness from consuming a particular good would
not be willing to pay very much for that good. In contrast, those who would receive a lot of
happiness also would be willing to pay a lot. Thus willingness to pay provides one way to
measure happiness.
The Soviet planner's dilemma is solved! To decide where resources would provide the most
happiness, he just needs to discover how much money people would be willing to pay to
enjoy those resources. If people in one section of Moscow are willing to pay more for
housing than people in another section of Moscow, the planner's decision is now an easy
one. But is willingness to pay really the best way to allocate resources? In the next chapter
we consider this approach in greater detail.
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CHAPTER 4
If You Don't Like It, Give 'Em Money
So far we have suggested that WILLINGNESS TO PAY provides a way of measuring how
much happiness individuals receive from the allocation of resources. The obvious problem
with this approach is that income--the "coupons" underlying the bidding procedure--is
unequally distributed across society. In 1991, before taxes and transfers, the average income
of the poorest 20 percent of households in the United States was $7,272, compared to
$88,101 for the richest 20 percent.1 In some countries, the difference between the top and
bottom is even greater. Simply put, there are very poor people and there are very rich people
and this causes problems when we use the willingness to pay approach to determine
valuations.
If some of the old man's heirs from the previous chapter were provided with 1000 coupons,
while other heirs were provided with only 100, the "richer" heirs would be able to bid away
most of the estate for themselves. The poorer heirs would have a difficult time getting the
estate's goods even when they anticipated receiving more happiness from their consumption
than the rich heirs.
Let's take an even more direct example. Suppose an extremely wealthy man owns a fleet of
Rolls Royces. His butler, however, has no car and must use smelly, crowded public
transportation. The wealthy man decides that he wants a new Rolls Royce because he always
rather liked the ones with the mauve interior. The butler wants a car so badly that he would
be overjoyed if he could just have a Ford Pinto. But alas, he cannot afford even an awful car.
According to the willingness to pay procedure, who gets the car? It goes to the fabulously
wealthy man who already has a Rolls for every day of the week. The poor butler gets
nothing.
In this case, resources are directed to the wealthy man, but are they directed to the use that
produces the most happiness? The answer is probably not, though we cannot be certain. It is
possible that the butler hates driving and likes using public transportation, and it is possible
that the rich man receives intense pleasure from the mauve Rolls Royce. But we are willing
to concede that in this case using the willingness to pay procedure to divide up resources
probably did not maximize happiness. More generally, we are willing to acknowledge that a
billionaire probably values an extra dollar's worth of goods less than a poor person.
If this is an objection which you have with the willingness to pay approach--and we
emphasize that it is a perfectly reasonable objection--we have a solution. Simply GIVE
POOR PEOPLE MORE MONEY. If we distribute money more evenly, then we are back to
something like our previous example of auctioning off the dead man's estate to generate
maximum happiness--an approach that had much to recommend it.2
Now don't misunderstand us. We do not personally advocate equalizing incomes or

possessions as a policy prescription. The redistribution of income is a messy and difficult
procedure, even when everybody is in agreement that this is the thing to do. And it has
negative side-effects that many believe outweigh its benefits. However, we want to
emphasize that determining the highest valued use of a resource is a different issue than
determining the best initial distribution of incomes.3 If this problem with the willingness to
pay approach really bothers you, then let's reallocate incomes so that there's a fairer
distribution of "coupons" in society. With redistribution, we would still have a way of
measuring happiness. And without some way of measuring happiness, we'd be in the dark
about how to direct resources to increase society's happiness.
What about the alternatives? Aren't there some other ways of measuring happiness? We've
already seen that surveys and questionnaires have major flaws in their ability to measure
happiness. One possibility that we haven't considered yet is voting. Allocating resources by
majority vote has the attraction that everyone gets one vote. This solves the unequal
distribution of income problem. On the other hand, voting suffers from some pretty serious
problems of its own. For example, how are the voters supposed to know whether June Smith
of Mobile, Alabama or Ralph Diminico of New Haven, Connecticut will get the most
pleasure from a new Plymouth Voyager with air conditioning, front-wheel suspension, and
cruise control? We'll talk about voting later on in this book, and we'll see that there are some
instances in which voting can serve as a reasonable measure of societal happiness. But when
it comes to allocating most of the goods of society, voters are no better able to determine the
highest valued use of a good than was the estate executor in the last chapter.
Well...maybe we don't really need a measure of happiness. Aren't there other ways of
directing goods and services that don't require a measure of happiness? Indeed there are. For
example, one alternative is to ration goods so that everyone receives an equal share. That
eliminates the problem of trying to determine highest valued use. But why should a person
who prefers meat receive the same amount of sugar every year as someone with a sweet
tooth, who in turn receives too much meat and not enough sugar? And ration economies
generally aren't very successful in getting producers to produce enough goods for everyone
to have a reasonable share. In fact, history has demonstrated that economies which don't
concern themselves with the question of highest valued use tend not to do very well over the
long haul. There's a reason, you know, why we call it the former Soviet Union.
Clearly, willingness to pay isn't a perfect measure of happiness. Is it better than all the other
alternatives? Ultimately, that's a question you have to decide for yourself. If you think that
willingness to pay does not provide an adequate measure of the happiness that poor people
receive from goods and services, then our advice is to give poor people more money--but
preserve the approach. If you reject the willingness to pay approach, then you need to come
up with something better. What do YOU suggest? It is our judgement that no better measure
exists.
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Notes
1
Edgar K. Browning and Jacquelene M. Browning, Public Finance and the Price System. New York:
MacMillan Publishing Company, 1994, page 259.
2 Even if everyone has an equal amount of money, we still cannot be certain that resources go to their
highest valued use. We do not know if two people who hold the same amount of money value goods and
services the same. Is it not possible that $20,000 worth of goods and services provides less happiness to
you than it may to someone else? Maybe you are not materialistic at all, and you value a walk in the
fresh air as much as you value a new car. Right now a new car isn't even an option because you don't
have the $20,000 to purchase a new car. Somebody else who has $40,000 might receive intense pleasure
from having two cars (maybe that's why he worked so hard to earn his $40,000). Suppose we equalize
incomes by taking $20,000 from this other person and give it to you. You who do not value a car very
much can now purchase one. The guy who intensely valued two cars can now only buy one because we
took some of his money away. By redistributing this income, we have taken a car away from somebody
who valued it more and given it to somebody who valued it less. Society is made worse off, even though
money is equally distributed.
3 While the allocation of resources is a different issue than the distribution of income, the two issues are
related. For example, if incomes are taxed to provide money for poor people, both rich and poor will
have a smaller reward for work. This will likely have effects on the allocation of time between work and
other activities.
CHAPTER 5
The Incredible Information Contained in Prices: Part I
Up to this point we have spent most of our time arguing that willingness to pay represents
our best hope for guiding resources to their highest valued use. This might strike you as
somewhat strange since our only concrete example of this approach--a bidding or auction
market--would surely be a grossly impractical way to distribute the hundreds of millions of
goods and services that must be allocated every day in a large economy. However, there is
another way to distribute goods and services with which you are already very familiar. It
incorporates the best features of the willingness to pay approach with a minimum of
administrative maintenance. It is the organizing principle behind the allocation of resources
in free market/capitalistic economies. It is currently on display at your local supermarket,
laundromat, and music retailer. It is the price system. In this chapter we will begin to explain
the connection between the price system and the willingness to pay approach.
We defined willingness to pay as the most you would be willing to spend to obtain a good.
We also could have said that your willingness to pay for an item is the happiness, measured
in dollars, that you expect to receive from the item. This definition may sound a bit strange
to you, but it is really just a restatement of our previous definition, and you probably use it
every day.
Each time you purchase (or do not purchase) a good, you compare your willingness to pay to
its price. Say you eat a fine meal at the best restaurant in town. After eating broiled cod, crab
legs, a T-bone steak, stuffed mushrooms, and a Caesar's salad, you find yourself a tad full.
When the waiter brings around a tray of tempting desserts, you refuse. Though the French
chocolate silk pie looks quite delicious, you decide that your $4.75 can be better spent
elsewhere. NOTE: In this case, the price of the pie exceeds your willingness to pay. After
dinner, you join your friends at the mall and purchase a new pair of designer jeans for $31
because your old pair suddenly was feeling a little bit tight. (You suspect they were shrunk
in the dryer again.) NOTE: In this case, you decided that the $31 for the jeans could not be
better spent elsewhere. Your willingness to pay exceeded the price of the jeans. We take this
sentiment one step further by declaring that your willingness to pay for a good (the absolute
most you would spend on it) is the happiness, measured in dollars, that you expect to receive
from consuming it. At some price level, you would refuse to buy a pair of designer jeans.
This price level is your willingness to pay, or the amount of happiness you expect to receive
from your purchase.
Max, one of the authors, is no slave to fashion and would at most be willing to pay $30 for a
pair of designer jeans. When Max goes to The Gap and discovers that jeans are $31 per pair,
he decides that spending his money on other goods would be more pleasing, so he buys a
pair of cheap slacks at Target. Bob, the other author, loves being a snappy dresser. He would
be willing to pay up to $100 for the same jeans. At $31 a pair, he thinks that he is getting a
great deal. From our previous work with willingness to pay, we know that Bob expects to
receive more pleasure from the jeans than Max because he is willing to pay more. In fact,
Bob expects to receive $100 in pleasure from a pair of designer jeans, while Max expects to
receive only $30 in pleasure from them. Notice that even though Bob paid $31 for his jeans,
he receives $100 in happiness (his willingness to pay) from them. Armed with this
knowledge of willingness to pay, we can begin to draw an amazing insight.
Unfortunately, we cannot take credit for this amazing insight. It goes back at least as far as
Adam Smith. It is the fundamental insight of economics, the foundational building block of
the science of resource allocation. Here it is: PRICES CONTAIN INFORMATION ABOUT
WHERE RESOURCES WILL PRODUCE THE GREATEST AMOUNT OF HAPPINESS
IN SOCIETY. To understand this point is going to take a little bit of concentration on your
part, but stick with it because this insight is worth working for. Here we go.
Let's suppose we have five consumers. Being the creative people that we are, let's call them
Consumers A, B, C, D, and E, respectively. Let's also suppose that we have some "inside"
information on each consumer. Literally. We are going to imagine that we could look deep
into the heart and soul of each and know exactly how much that consumer would be willing
to pay for one more T-shirt. Not how much the consumer thinks he will have to pay it. Not
how much it's "worth" to them according to some nebulous standard of worth. When we say
"willing to pay" we mean the maximum amount of their own money they would really be
willing to give up in order to consume the good. If we think back to our auction example,
each consumer's willingness to pay value represents the maximum amount they would be
willing to bid in order to win that T-shirt in an auction. In other words, we are going to
imagine that we know how much happiness--as measured by willingness to pay--an extra T-
shirt would generate for each of our consumers.
Of course, in real life this information is known only by the consumer. Nobody can know
just how much somebody else is willing to pay for something. But we are going to pretend
we know this information in order to see something we otherwise would miss. The table
below reports each consumer's personal willingness to pay value for the T-shirt.
Willingness to Pay Values for the Five Consumers
Consumer A Consumer B Consumer C Consumer D Consumer E

$3.50 $11.75 $13.15 $5.60 $7.90
Suppose these five consumers each walked into a town where the going price of T-shirts
was $10. At a price of $10, only two consumers would choose to buy T-shirts (Consumers B
and C). Consumers B and C each anticipate receiving more than $10 of happiness from
owning the T-shirt. Purchasing the T-shirt clearly makes them better off. The other three
consumers would not choose to buy a T-shirt (Consumers A, D, and E). While they each
would receive some happiness from the T-shirt, the amount of happiness they anticipate
receiving is less than $10.
Let's stop for a moment to see if we really understand what's going on here. Answer the
following one-question, multiple-choice exam.
QUESTION: Assuming that his expectations are correct, how much happiness will
Consumer B gain from owning the T-shirt?
a. $10.00.
b. $1.75 ($11.75 minus the $10 purchase price).
c. $11.75.
d. None of the above.
e. All of the above.
f. (d) and (e).
The answer is not (a). While it is true that Consumer B paid $10 for the T-shirt, this only
tells us that he anticipated receiving at least $10 of happiness from the T-shirt. Consumer C
also paid $10 for the T-shirt. But his greater willingness to pay value indicates that he
anticipated receiving greater happiness from the T-shirt than Consumer B.
How about answer (b)? In purchasing the T-shirt, Consumer B gained something from
which he anticipated receiving $11.75 of happiness. In return, he gave up $10.00. Doesn't
that trade make him better off by $1.75? Yes it does. But that's not the question. The
question isn't how much better off Consumer B feels he is as a result of purchasing the T-
shirt. The question is, how much happiness will Consumer B receive from owning the T-
shirt. That's an important distinction. And one that is difficult to keep straight at times.
We will say this many times over in the course of this book: people get happiness from the
consumption of goods and services, not from money itself. Money is merely the means that
enables consumers to get goods and services. In evaluating the happiness that society
receives from consuming goods and services, it is important that we remember to keep our
eyes on the goods and services, and not the money. Forgetting this simple truth is the source
of a great many economic fallacies, as we shall see later on.
So what's the answer to our question? The answer is (c), $11.75. The consumer's willingness
to pay value tells us how much happiness he expects to receive from owning the particular
good or service. With this firmly in mind, we can continue with our discussion of the
"incredible information contained in prices."
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CHAPTER 6
The Incredible Information Contained in Prices: Part II
In this chapter we will demonstrate that THE MARKET PRICE OF A GOOD TELLS US
THE WILLINGNESS TO PAY VALUE OF THE MARGINAL CONSUMER. By "market
price" we mean the prevailing price of a good in a given city, town, or market. By "marginal
consumer" we mean the consumer who would end up with a good if one more unit of that
good were distributed to that market. In the context of our T-shirt example, if the price of T-
shirts in a given market is $10, that means that if one more T-shirt were shipped to that
market, the consumer who would end up with that T-shirt would have a willingness to pay
for T-shirts right around $10.
Recall from the previous chapter that at a price of $10, Consumers B and C would choose to
purchase the T-shirt, while Consumers A, D, and E would not. Let's assume that once a
consumer buys a good, their willingness to pay falls to zero. That is, once they have the
good, they wouldn't get any pleasure from having another unit of that good. (This is what we
call a simplifying assumption. It's not necessary to get our result, but it greatly simplifies the
analysis of the problem.) Now our table of willingness to pay values looks like this.
Willingness to Pay Values for the Five Consumers
Consumer A Consumer B Consumer C Consumer D Consumer E

$3.50 0 0 $5.60 $7.90
Suppose we were to distribute one more T-shirt. What would be the willingness to pay value
of the person who would receive it? Clearly, the answer to that question depends on who
gets the additional T-shirt. If Consumer A was given the T-shirt, then the answer to the
question would be $3.50. Alternatively, if Consumer E received the T-shirt, then the
willingness to pay value of the person who receives the extra T-shirt would be $7.90. To get
us over this hurdle we will make the assumption that a market guided by the price system
will tend to direct goods to those who value them most. In a little bit we will explain this.
For right now you have to take it on faith.
Of the three consumers who would not buy T-shirts at the price of $10 (A, D, and E), clearly
Consumer E would derive the greatest happiness from having one. Assuming the market
would direct this additional T-shirt to the one who valued it most, Consumer E would end up
with it. Consumer E is then the "marginal consumer." Using the information from the table,
we see that the willingness to pay value of the marginal consumer is thus $7.90.
Hold on here! Didn't we just get done saying that the price of a good tells us the willingness
to pay of the marginal consumer? We did. But isn't the price of the good $10, while the
willingness to pay value of the marginal consumer is only $7.90? That's true, but we aren't
done yet.
Let's add five more consumers to our market and repeat the analysis from above. These new
consumers have the willingness to pay values reported in the table below.
Willingness to Pay Values for the Ten Consumers-Before
A B C D E F G H I J
$3.50 $11.75 $13.15 $5.60 $7.90 $12.80 $8.90 $10.50 $11.10 $12.25
At a price of $10 per T-shirt, how many T-shirts get bought and who buys them? There are
now six consumers who decide to buy T-shirts (B, C, F, H, I, and J) and four who decide not
to buy a T-shirt (A, D, E, and G). After the six buy T-shirts, and assuming that they have no
interest in another T-shirt, we get the following table of willingness to pay values.
Willingness to Pay Values for the Ten Consumers-After
A B C D E F G H I J
$3.50 0 0 $5.60 $7.90 0 $8.90 0 0 0
What would be the willingness to pay value of the marginal consumer if we were to
distribute an extra (seventh) T-shirt? Once again we assume that the extra T-shirt will go to
the consumer who values it most (we really will explain this later). Since Consumer G
values it more than A, D, and E, he becomes the marginal consumer to whom the market
directs the extra T-shirt. Thus, with ten consumers in our society and a T-shirt price of $10,
we can say that the marginal consumer has a willingness to pay value of $8.90.
Now we know that $8.90 is still not $10, but consider what just happened as the number of
consumers in the market increased. When there were 5 consumers, the willingness to pay
value of the marginal consumer was $7.90. When there were 10 consumers in the market,
the marginal consumer's willingness to pay value was $8.90. What do you think would
happen if there were 50 consumers in the market? 500 consumers? 500,000? Don't you see
as there are more and more consumers in the market, there is a greater likelihood that one of
those consumers will have a willingness to pay value a little less--but very close--to the
market price of the good. Thus, the marginal consumer's willingness to pay value
approaches the market price as the size of the market increases.
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CHAPTER 7
The Incredible Information Contained in Prices: Part III
Up to now, we just assumed that the market had a way of directing an extra unit of the good
to the person whose willingness to pay was less than--but closest to--the market price of the
good. We're now ready to explain this. Let's imagine ourselves observing the buying and
selling of T-shirts in a large city. Suppose that a million T-shirts get sent to this city in a
given year. Suppose further that the consumers in this city are free to purchase as many or as
few T-shirts as they want, and that the retailers in this city are free to set any price they
want. Finally, suppose the going price for T-shirts in this city is around $10.
What would happen if a million-and-one T-shirts were sent to this city rather than a million?
Obviously, there would be somebody--one person--who would end up with a T-shirt if a
million and one were sent, who would have not gotten a T-shirt if only a million had been
sent. This is the marginal consumer. What do we know about this person's willingness to
pay for a T-shirt?
The marginal consumer is not somebody whose willingness to pay is more than $10.
Somebody who is willing to pay more than $10 for a T-shirt would buy one whether a
million or a million-and-one were sent to that city. For example, if a consumer anticipated
getting $25 of happiness from a T-shirt and its price was only $10, one would expect this
consumer to be sure to go to the store and purchase a T-shirt. And he would do that even if
only a million T-shirts were sent. But that means he can't be the "marginal consumer"
because the marginal consumer doesn't buy a T-shirt if only a million get shipped to the city.
The same logic holds for anybody with a willingness to pay for a T-shirt that is more than
$10. Therefore we conclude that our marginal consumer does not have a willingness to pay
larger than $10.
This is the situation that was represented in the previous chapters by the "Willingness to
Pay--After" tables. Recall that after every consumer that wanted to buy a T-shirt at a price of
$10 did so--and before we distributed an extra T shirt--only those consumers with
willingness to pay values less than $10 were in the market. Thus the marginal consumer
couldn't be somebody who had a willingness to pay greater than $10.
A similar logic leads us to the conclusion that the marginal consumer doesn't have a
willingness to pay much less than $10. After all, an increase in the supply of T-shirts by one
unit will exert only a minimally downward pressure on the price of T-shirts. As a result, the
market price of T shirts will still be very close to $10. But if a consumer anticipated
receiving much less than $10 of happiness from the T-shirt, he wouldn't be willing to shell
out the $10 needed to buy it. Since we know the marginal consumer does end up purchasing
a T-shirt, this must mean that his willingness to pay can't be much less than $10.
The careful reader will have noticed that the market mechanism which directs the good to
the consumer with the highest willingness to pay is precisely the price system. When an
extra unit of the good is sent to the market, the price drops just enough to induce one more
person to buy the good. That is, the price drops just low enough until the consumer with the
highest willingness to pay value finds it attractive to buy the good. When that happens, the
price decrease stops, and all the other consumers find themselves still unwilling to buy the
good. This is our basis for assuming that the market has a way of directing an extra unit of
the good to the person whose willingness to pay is less than--but closest to--the market price
of the good. If the market is reasonably large, this willingness to pay value is likely to be
very close to the market price of $10.
Now it's time to put all of this together. If the marginal consumer is not somebody whose
willingness to pay for a T-shirt is more than $10, and he is not somebody whose willingness
to pay is much less than $10, then we are left with only one possibility: The person who
ends up with the million-and-oneth T-shirt is somebody whose willingness to pay value for a
T-shirt is right around $10. That is, if an extra T-shirt were sent to this city, it would go to
somebody who would receive about $10 of happiness from the extra T-shirt.
Anybody here got a problem with this story?! We can think of some. For example, in real
life, T-shirts aren't sold for exactly the same price in every store. They might be $9.97 at
WalMart, $8.97 at Target, and $12.47 at Sears. Furthermore, not everybody who values a T-
shirt at more than $10 is going to run down to the store this second and buy one at that price.
Perhaps you can think of some other objections to our story. That's okay. We're willing to
loosen up our story a little bit, because we know that in real life things aren't always so nice
and clean as they are in theory.
Rather than saying that the marginal consumer can't have a willingness to pay more than
$10, let's just say that the marginal consumer is probably somebody whose willingness to
pay isn't much larger than $10. In real life it might be $11, or $12. But most likely not $20.
Likewise, the marginal consumer is never likely to be somebody with a willingness to pay
much less than $10. People with willingness to pay values of $5 just aren't going to be
willing to dish out $10 for a T-shirt. So, as we translate our theory to the real world,
recognizing that it's something of an approximation, we still end up with the same
conclusion. THE PERSON WHO ENDS UP WITH THE MILLION-AND-ONETH T-
SHIRT IS SOMEBODY WHOSE WILLINGNESS TO PAY VALUE FOR A T-SHIRT IS
RIGHT AROUND $10, NOT A LOT MORE, NOT A LOT LESS.
At this point you might be tempted to be a little unimpressed by this amazing insight.
However, recall that willingness to pay is a measure of happiness. So when we say that the
marginal consumer has a willingness to pay right around the market price, what we are
really saying is this: The price of a good tells us the approximate amount of happiness--
measured in dollars--that society would receive from having one more unit of that good.
If the market price of T-shirts is around $10, then if one more T-shirt gets sent to that
market, it will go to a consumer who will receive approximately $10 of happiness from that
T-shirt. Of course, we have no idea who that person is. We do not know what they look like.
We don't know where they live. We don't even know why they want the T-shirt, if they plan
to wear it under a sweater by Ralph Lauren or if they plan to tie-dye it. But we do know this:
if the market price of T-shirts is $10, and if one more T-shirt were shipped to that market,
somebody is going to be made better off by about $10.
This is incredible information! It shouldn't be too difficult to see that this is the key to
helping society know where to direct resources. For example, if the price of T-shirts is $10
and the price of Spam is $4 a can, we know that society will receive more happiness from an
extra T-shirt than from a can of Spam. (You probably suspected this all along!) The beauty
of the price system is that it provides an objective way to compare the happiness generated
by two unlike goods. Still unimpressed? Then read the next chapter.
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CHAPTER 8
Information and the Fundamental Problem in Economics
It is commonly stated in economics textbooks that the fundamental problem in economics is
scarcity. We beg to differ. The fact that resources are finite, or scarce, isn't a problem--it's
just a fact of life. When allocating resources, choices must be made among competing
options. Economics can no more solve the problem of scarcity than it can invent a perpetual
motion machine. Rather, THE FUNDAMENTAL PROBLEM IN ECONOMICS IS A
LACK OF KNOWLEDGE. Not just any kind of knowledge, but the knowledge of where
resources have their highest valued use. This is the primary obstacle that keeps an economy
from achieving its purpose of maximizing social wealth. This is the fundamental problem
that economics, and economies, must attempt to solve.
Another way of looking at this knowledge problem is to note that people are heterogeneous,
that is, they have different preferences. To see the connection between this and the
knowledge problem, suppose all people were alike. They liked the same foods, fashions,
music, cars, etc. Then the economic planner wouldn't have to look any further than himself
to know what people wanted. All he would have to do is ask himself what would give him
the most happiness. In answering the question for himself, he would be answering it for all
of society, since his preferences were representative of everybody else's.
Of course, people are not all alike. For example, it is incomprehensible to us why some
people don't like economics. We love economics, and we're reasonable people. So how it
can be that there are people out there who don't like this stuff? Go figure! People have
different likes and dislikes--a fact that becomes painfully obvious to most of us at Christmas
time. Indeed, anybody who has had to shop for a Christmas present for a distant relative is
fully aware of how difficult it is to buy what others want. Imagine going Christmas shopping
for the entire economy! Millions of people whom you've never met. Should you give
Rodney Smith of Peoria, Illinois Def Leppard's new CD? Gee, what if he already has it?
What if he doesn't like Deff Leppard? (Is that possible?) Maybe he only likes classical
music. Maybe he doesn't have a CD player!
Different preferences are merely a nuisance at Christmas. They are a fundamental problem
when allocating society's resources across millions of consumers. A person who doesn't
think that lack of knowledge about people's preferences is a serious problem is a person who
thinks that people have essentially the same preferences. On the other hand, if people do
have significantly different preferences, then the information produced by the price system
is incredibly important. Thus, the appreciation one has for the information produced in
prices is directly proportional to how different one thinks people are.
Let's return to the Soviet planner of Chapter 3 who was trying to decide where and what
kind of apartment complex to build. He could do a fine job of allocating resources if
everyone was like him. The contractor would just have to decide what he wanted, and then
order the same thing for everyone else. Of course, if the economic planners' preferences are
different from his consumers' preferences, and the consumers have differing preferences
amongst themselves, then the planner faces an impossible task. Should he order an extra
apartment complex to be built in Moscow or St. Petersburg? Should he build family units or
singles? Luxury apartments or efficiencies? He can only make these decisions correctly (i.e.
in a way that maximizes happiness) if he knows how much each consumer in his market
values housing. Some of his consumers might prefer more automobiles or trips abroad
instead of luxury apartments. If they get luxury apartments instead of their heart's desire of a
trip to Disneyland, society is made worse off.
In contrast, let's consider how a private building contractor answers these questions in a free
market or capitalistic society. It seems safe to assume that the private contractor doesn't
spend much time thinking about directing resources to their highest valued use. He does,
however, care about the prices of the goods and services which he sells. When examining
where to build a new apartment complex, his first consideration is the price of housing. If
the market price for apartments is $300 per month in Tulsa, Oklahoma, but $500 per month
in Kansas City, Missouri, the contractor will decide to build new apartments in Kansas City
(assuming that costs are the same in each city). And this is precisely what we would want
the contractor to do if we wanted him to maximize happiness! Consumers in Kansas City
would get around $500 a month in extra happiness from having a new apartment in their
city, while consumers in Tulsa would derive only about $300 per month in happiness.1
How can we say this without first doing a study on where an apartment complex is most
"needed?" And how can we compare the happiness of consumers in Tulsa and consumers in
Kansas City? We can, if we adopt the willingness to pay approach to measuring happiness--
and recognize the incredible information contained in prices. Thus, an apartment complex in
Kansas City, Missouri would generate a greater increase in society's happiness than one in
Tulsa, Oklahoma. The planner's dilemma is solved--almost.
OPTIONAL SECTION FOR ECONOMISTS: It has been our experience that when students with prior
econom ics training are f irst exposed to the ideas in this book , their im m ediate reaction is " W here did these g uy s g et
this stuf f f rom ? ! " W e want to dem onstrate that there is nothing in this book that is " new. " T he ideas in the preceding
chapters--and in the chapters to com e--are al l im pl ied by standard m icroeconom ic theory .
F or exam pl e, consider a standard dem and and suppl y g raph. G eneral l y , the dem and curv e is interpreted
" horiz ontal l y . " T hat is, hol ding price constant, the dem and curv e reports the m axim um q uantity of the g ood that
consum ers in the m ark et woul d purchase at that price. H owev er, one can al so interpret the dem and curv e
" v ertical l y . " S pecif ical l y , hol ding q uantity constant, the dem and curv e reports the m axim um am ount of m oney that
the m arg inal consum er woul d be wil l ing to pay f or a unit of the g ood if exactl y that q uantity were suppl ied to the
m ark et. In other words, the wil l ing ness to pay v al ue of the m arg inal consum er f or ev ery g iv en l ev el of q uantity is
indicated by the heig ht of the dem and curv e. 2
T he g raph abov e represents the T -shirt exam pl e we hav e been discussing f or the past three chapters. A t a price of
$ 1 0 . 0 0 , the eq uil ibrium q uantity of T -shirts sol d in the m ark et is Q0 = 1 , 0 0 0 , 0 0 0 . A l l of the consum ers who hav e
wil l ing ness to pay v al ues g reater than $ 1 0 . 0 0 are represented on the horiz ontal axis as l y ing to the l ef t of q uantity
Q0. In contrast, those consum ers with wil l ing ness to pay v al ues l ess than $ 1 0 . 0 0 are represented as l y ing to the
rig ht of q uantity Q0. If one m ore T -shirt is suppl ied to the m ark et, the price drops neg l ig ibl y --f rom $ 1 0 . 0 0 to $ 9 . 9 9 --
and the consum er who ends up with this T -shirt is one who has a wil l ing ness to pay v al ue between $ 1 0 . 0 0 and
$ 9 . 9 9 , or " rig ht around $ 1 0 . "
H ow about our statem ent that wil l ing ness to pay m easures happiness? E conom ists do not g eneral l y use the term
" happiness. " Instead, they use a word cal l ed " util ity . " H owev er, if y ou ask y our econom ics instructor what she
m eans by " util ity , " m ost of ten the response y ou' l l hear is " happiness, " or " pl easure. "
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Notes
1
Of course, the relative costs to building in each of these cities also plays into the contractor's decision
and is just as important economically, but we leave the exploration of this topic for a later chapter.
2 That the height of the demand curve represents the amount of money the consumer is willing to pay in
order to get one more unit of the good is easily derived from standard microeconomic theory. For an
easy-to-understand, graphical derivation, see Figure 3-4 on page 74 in Edgar K. Browning and
Jacquelene M. Browning, Microeconomic Theory and Applications, Second Edition, Boston: Little,
Brown and Company, 1986.
CHAPTER 9
The Rest of the (Output) Story
The previous chapters have established that the price of a good tells us the willingness to
pay of the marginal consumer. Since willingness to pay is a measure of anticipated
happiness, and since the marginal consumer is the one who would purchase an additional
unit of the good if it were supplied, we can restate our finding as follows: The market price
of a good tells us the approximate gain in happiness--measured in dollars--that society
expects to receive from the consumption of one more unit of that product. So far so good.
There is however, more to this story, and as they say, the plot thickens.
It is straightforward to demonstrate that the market price of a good also tells us the
approximate expected loss in society's happiness--measured in dollars--from consuming one
less unit of that product. We encourage you to go back to Chapters 5 through 7 and repeat
the analysis for T-shirts with a market price of $10. This time however, ask yourself what
would happen if 999,999 T-shirts were sent to the city rather than 1,000,000. Obviously,
there would be somebody--one person--who would end up with a T-shirt if a million were
sent, who would not get one if only 999,999 are sent. What do we know about this person?
The person who ends up not getting a T-shirt when only 999,999 are sent is somebody
whose willingness to pay value for a T-shirt is right around $10 (not a lot more, not a lot
less--how do we know this?). Since that is how much pleasure he would have gotten from
the T-shirt, not getting a T-shirt means that he's out about $10 in happiness. That is, having
one less T-shirt lowers society happiness by about $10. (From here on out, we drop the drop
the distinction between "expected happiness" and "happiness." While consumers will
sometimes be disappointed--or pleasantly surprised--by the amount of happiness they
receive from the consumption of a good, we would expect their expectations to be
reasonably accurate on average.)
Perhaps by now you've noticed something that bothers you about our story. While it's true
that somebody is out a T-shirt if one less gets sent, don't they still have their ten dollars?
Can't they spend those ten dollars on something else? Then how can we say that society has
just lost $10 in happiness? DANGER...DANGER...ECONOMIC FALLACY IN THE
MAKING! While the objection appears reasonable on the face of it, it leads to economic
error. The fallacy arises when "we take our eyes off the ball." In this context, the "ball" is
the happiness gained from consumption. When we focus our attention on dollars, we are
bound to get into an error. While we all push, shove, kick, and scratch to get them, dollars
themselves don't give pleasure. They're just little, green pieces of paper, incapable of
producing any happiness on their own. It is the goods and services that dollars buy that yield
happiness.
Suppose a tough punk walks up to a consumer who just bought a T-shirt for $10. Suppose
this consumer's willingness to pay for a T-shirt was right around $10. Now suppose that
punk rips the T-shirt off this consumer and completely shreds it to pieces so that it is now
good for nothing. But then--consumed by guilt--the punk reaches into his pocket and gives
the consumer a $10 bill to compensate him (we're supposing he's a tough, sensitive punk).
Let's do a social accounting of this transaction.
The consumer views himself as being largely unaffected by this chain of events. While it is
true that the consumer lost something that he valued at around $10 (the T-shirt), he also
received $10 in compensation. Thus, from the individual consumer's perspective, the
transaction is a wash. However, it is not a wash from society's perspective. The undeniable
fact is that there is now one less T-shirt available for enjoyment. This T-shirt would have
brought about $10 in happiness. Hence, the absence of this T-shirt now means that society
has lost $10 in happiness.
How do we reconcile the individual's ambivalence against society's loss? When the
consumer takes his $10 in compensation and buys something else with it, that's one less
good that some other guy gets to consume. We can do all kinds of things to try and disguise
this fact. We can put out more green pieces of paper (dollars) to try and hide the loss. We
can shuffle goods between different consumers to try and compensate the victim. But there's
no changing the reality that there is now one less T-shirt in the world. This T-shirt would
have produced about $10 in pleasure. Thus having one less T-shirt has cost society $10 in
happiness.
The recognition that the price of a good tells both the gain in society's happiness of having
one more unit of the good and the loss in happiness of having one less unit of the good
allows us to see some astounding things. For example, suppose a Nissan car dealer has show
lots in both Dallas, Texas and Albuquerque, New Mexico. Suppose further that a Sentra,
four-door sedan with the basic amenities sells for around $11,000 in Dallas, but fetches
$16,000 in Albuquerque. Lastly, just to make it interesting, suppose this car dealership is
owned by Mother Theresa, and her sole purpose in life is to increase society's happiness.
Would she make society better off by taking one of her Sentras in Dallas and sending it to
her lot in Albuquerque, or by transferring a Sentra from Albuquerque to Dallas?
The Answer is...moving one of her Sentras from Dallas to Albuquerque. The explanation is
simple. Sentras are selling for a higher price in Albuquerque. Price provides a measure of
happiness. If Sentras are selling for around $11,000 in Dallas, then there is a loss of $11,000
in happiness from having one less Sentra in the Dallas area. However, if the same car is
selling for $16,000 in Albuquerque, there is a gain of $16,000 in happiness from having one
more Sentra in the Albuquerque area. Thus, transferring a Sentra from Dallas to
Albuquerque increases society's happiness by $5000.
Isn't that amazing? We didn't have to know anything about the car markets in the two
respective areas. We didn't have to do any research on why the price of a care is higher in
Albuquerque. All we need to know is the price of the car in the two cities. Once we have
that nailed down, we used our knowledge of the information contained in prices to draw our
conclusion: Society's happiness would be increased by transferring a car from the low price
city to the high price city. With that knowledge, Mother Theresa can proceed accordingly.
But there's something else you should have noticed. Suppose the car dealership wasn't
owned by Mother Theresa? Suppose it was owned by Ebenezer Scrooge, a money-grubbing,
filthy rich, dirty capitalist whose sole purpose in life is to make himself the richest man in
the world. How would Ebenezer Scrooge have behaved had he been the owner of the car
dealership? Do you see that he also would have transferred a car from Dallas to
Albuquerque? That is, he would have done the very thing that the economy would have
wanted him to do to help it achieve its goal of allocating resources to their highest valued
use. Ebenezer Scrooge would have acted just like Mother Theresa. Very interesting. As we'll
see several chapters from now, this is more than just a mere coincidence.
Up to this point, the story we have told concerns the information contained in the prices of
output goods and services. Output goods and services are consumables that yield direct
pleasure. In contrast, input goods and services are factors used in the production of output
goods and services. They aren't consumed directly by consumers and they don't yield
pleasure by themselves. Output goods and services are things like hot dogs, roller coaster
rides, Ford Tauruses, and personal home computers. Input goods and services are things like
delivery trucks, electronic circuit boards, steam-powered generators, accountants, and
downtown office buildings. Properly understood, all goods can be classified as either output
or input goods. In fact, some things, like labor, can be both an "input" (work) or an
"output" (leisure). Whether a good or service is an output or an input simply depends on
how it is used.
To recap then, we have demonstrated that prices contain information that is absolutely
crucial for deciding where resources have their highest valued use. In particular, THE
PRICE OF AN OUTPUT GOOD IDENTIFIES THE GAIN IN HAPPINESS--MEASURED
IN DOLLARS--THAT SOCIETY RECEIVES FROM CONSUMING ONE MORE UNIT
OF THAT GOOD. ALTERNATELY, THE PRICE OF AN OUTPUT GOOD IDENTIFIES
THE LOSS IN HAPPINESS--MEASURED IN DOLLARS--THAT SOCIETY SUFFERS
FROM CONSUMING ONE LESS UNIT OF THAT GOOD.
But what about the prices of input goods. There's some good news and some bad news. The
good news is that the information contained in input prices is very similar to that contained
in output prices. Specifically, the prices of input goods identify the gain in happiness that
society receives from employing one more unit of the input good. Alternatively, they
identify the loss in happiness from employing one less unit of the input good. The bad news
is that the demonstration of this truth is considerably more complicated. But don't worry, it's
not anything that you can't handle. Even so, we'll save it for the next chapter.
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CHAPTER 10
The Information Contained in Input Prices
Consider the problem facing Reginald Buford, an aspiring kumquat farmer. From 6 in the
morning to 2 in the afternoon Reginald delivers mail for the U.S. Postal Service in Lodi,
California. Reginald is an ambitious kind of guy, and he hears there's money to be made
growing kumquats. He figures he could grow a 1000 bushels of kumquats a year on an acre
of land working afternoons and evenings after delivering his mail. From reading the Wall
Street Journal that he delivers to one of the houses on his route, Reginald learns that
kumquats are selling for about $43/bushel. How much would he be willing to pay to rent an
acre of land for a year?
Let's assume that all it takes to grow kumquats is an acre of land and Mr. Buford's good
labor--nothing else. At $43/bushel and 1000 bushels a year, Reginald calculates he can make
$43,000 a year. Since the only inputs to producing kumquats are land and labor, and the
labor is "free," you might be tempted to say Reginald Buford would be willing to pay up to
$43,000 to rent an acre of land on which to grow kumquats. But since you're smarter than
the average reader, you realize that it isn't quite this simple. While Reginald's labor does not
cost him anything, it's not as though he doesn't have anything better to do with his time. If he
wasn't raising kumquats, Reginald would be sipping margaritas on the deck of his backyard,
above-ground pool, working on his tan and keeping an appreciative eye on his next door
neighbor, Bambi Vavoom (but that's another story).
In fact, Reginald's labor does cost him something. It costs him the happiness he would
receive from what he would be doing if he wasn't raising kumquats. As a result, Reginald
figures that he needs to make at least $20,000 a year in income from his kumquat venture.
Anything less than that wouldn't be enough to compensate him for the time he is giving up.
As a result, Reginald Buford is willing to pay up to $23,000 a year for his acre of land.
($43,000 in revenue from kumquats minus $20,000 for Reginald's lost leisure time yields a
$23,000 willingness to pay valuation of the land. In other words, if the land costs $23,000 to
rent, the $43,000 of revenue will just cover rent and the dollar value of Reginald's lost
leisure time.)
What would happen if Reginald paid more than $23,000 a year for the land? Suppose he
paid $30,000? Then, at the end of the year--after he grew and sold his 1000 bushels of
kumquats--he would gross $43,000 in income. From this he would have to pay $30,000 in
costs for his acre of land, leaving Reginald with just $13,000 in net income. Now $13,000
might sound like plenty of money to you, but it's not enough for Reginald Buford of Lodi,
California. He would have to make at least $20,000 to get him to give up his current lifestyle
and go into kumquat farming. That is why he wouldn't be willing to pay $30,000 a year for
the land. Indeed, that is why he wouldn't be willing to pay anything more than $23,000 a
year for his acre of land.
The world is full of Reginald Bufords. Some want to go into kumquat farming. Others want
to raise oranges, peaches, squash, and kiwi fruit. Others want to expand their current scales
of production. For example, just a mile down the road from Mr. Buford is Sally Raisin, of
the California Raisins. Sally currently owns a 100 acres of farmland on which she grows
grapes. She is thinking of renting an additional acre in order to increase her grape
production. Let's assume that all it takes to grow grapes is an acre of land and Sally's good
labor--nothing else (remember, this is not a textbook on how to farm!). Further, let's say that
the market price of grapes is $38/bushel, and that Sally Raisin could grow 1000 bushels of
grapes on an acre of land in a year. How much would Mrs. Raisin be willing to pay for this
land?
Once again, we have to consider the value of her time. Having an extra acre of land means
more work for Sally Raisin, and less time at home with her husband and kids. As a result,
Sally figures she'd have to make at least $15,000 a year in take-home income to compensate
her for the extra hours she'd be spending away from her family. Subtracting this from the
$38,000 in sales revenue that she would make from the extra 1000 bushels of grapes she
would grow, Sally Raisin calculates that she also would willing to pay up to $23,000 a year
for the acre of land.
Of course, the fact that Reginald Buford and Sally Raisin both are willing to pay the same
amount for an acre of land is a coincidence. Other farmers, and aspiring farmers, will have
different willingness to pay values: $13,000 an acre; $29,000 an acre; $18,000; etc. In fact,
there are thousands of farmers out there, each with their own particular willingness to pay
value. In this respect, input goods are just like the output goods we discussed earlier.
Now suppose we had some way of producing an additional acre of farmland in northern
California's Napa Valley--say, by reclaiming land that had previously been wiped out in a
mud slide, or brush fire, or earthquake (take your pick). Suppose further that the market
rental price of an acre of farmland in the Napa Valley was $23,000. Some farmer is going to
end up with an acre of land that he wouldn't have had if this extra acre of land had not
become available. This is the marginal farmer. What do we know about the willingness to
pay value of the marginal farmer?
Is the marginal farmers' willingness to pay value going to be a lot larger than $23,000? By
no means. Why not? A farmer who valued an acre of land a lot more than $23,000 would be
sure to get an acre of land whether or not an extra acre was supplied to the market (does this
sound familiar?). Is the marginal farmer's willingness to pay value going to be a lot less than
$23,000? Of course not. Even with an extra acre of land, the market price of land in the
Napa Valley will still be about $23,000. That means the marginal farmer will have to shell
out around $23,000 in cold, hard cash to get this acre for a year. He certainly would not be
willing to do this if he had a willingness to pay value that was much less than $23,000. Thus,
the farmer who ends up with the extra acre of land must have a willingness to pay value for
land right around $23,000-- not a lot more, not a lot less. Just as in the case of output goods,
the marginal purchaser of the land has a willingness to pay value right around the price.
What has happened to society's happiness now that an extra acre of land has become
available? The correct answer is...we can't say! We can't say at this point because--note--the
farmer who uses the land does not get any direct pleasure from it. The farmland is an input.
It is being used to produce other things that provide happiness, but it doesn't provide
happiness on its own. Thus, we can't just assume that the farmer's willingness to pay
provides a measure of happiness. This will turn out to be the case, but we have to prove it
first.
To trace out the effect on society's happiness, we have to follow through all the
consequences of employing the farmland that impact society's happiness--remembering that
society only gets pleasure from output goods. Let's return to our aspiring kumquat farmer,
Reginald Buford. Suppose as a result of having an extra acre of land in the Napa Valley, Mr.
Buford is the marginal farmer who ends up having an acre of land which he would not have
had otherwise. On this acre of land, Mr. Buford grows 1000 bushels of kumquats, and
kumquats sell for about $43 a bushel How much happiness has Mr. Buford produced by
growing kumquats? $43,000. Kumquats are an output good. If the price of kumquats is
$43/bushel, we know from our previous analysis that an extra bushel of kumquats would
yield about $43 in happiness. An extra 1000 bushels would yield about $43,000 in
happiness. Thus, having an extra acre of land has caused society to have $43,000 in
happiness from eating kumquats that it would not have had otherwise.
But there is a downside to all this happiness. In order to produce these kumquats, Reginald
Buford had to give up those leisurely times of sipping margaritas, working on his tan, and
admiring the handsome Bambi Vavoom. This loss in leisure means that Reginald missed out
on $20,000 in happiness over the course of a year. A social accounting shows that society
gained $43,000 from the kumquats (an output good), but lost $20,000 from Reginald's
leisure time (also an output good). As a result, employing the extra acre of land resulted in a
net gain to society's happiness of $23,000. Not coincidentally, $23,000 also happened to be
Reginald Buford's willingness to pay for the land...and the price. This demonstrates our
claim: THE PRICE OF AN INPUT GOOD IDENTIFIES THE GAIN IN HAPPINESS--
MEASURED IN DOLLARS--THAT SOCIETY RECEIVES FROM EMPLOYING ONE
MORE UNIT OF THE INPUT GOOD.
By now you should have no problem telling the story in reverse, about the loss in society's
happiness from having one less unit of the input good. That is, you should be able to easily
demonstrate that THE PRICE OF AN INPUT GOOD ALSO IDENTIFIES THE LOSS IN
HAPPINESS--MEASURED IN DOLLARS--THAT SOCIETY RECEIVES FROM
EMPLOYING ONE LESS UNIT OF THE INPUT GOOD.
This is important stuff. If we know that the rental price of land is $23,000 an acre for a year,
and if some reason society were to lose the use of this land, society would suffer a loss in
happiness of approximately $23,000. We can say this without even knowing what that land
was going to be used for. Maybe Reginald Buford would have used it to farm kumquats.
Maybe Sally Raisin would have grown grapes on it. Maybe some developer would have
built luxury condominiums on it. Perhaps the land will be used for a new factory. It doesn't
matter what is done with the land. All the information that we need to know is right there in
the price. And while we've told this input story about an acre of farmland, it should be clear
that the story is valid for any of the innumerable different types of inputs that are used to
produce output goods: a ton of steel, a truck, a gallon of water, a shovel, an office personal
computer, a kilowatt of electricity, a 5000 square foot warehouse.
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CHAPTER 11
A Ton of Copper Versus a Ton of Steel
We are now ready to apply our knowledge about the information contained in input prices.
Let's take Mother Theresa out of the car business and put her in charge of production at a
large industrial plant. Once again, we're going to assume that Mother Theresa's one abiding
passion is to increase society's happiness, and forget about the capitalistic dogs that run
American industry. The plant that she runs produces pens. To be more specific, it produces
those little metal clips that can be used to attach pens to the shirt pockets of their owners.
Let's give this company a name, say Pen, Inc. Right now the production accountants for Pen,
Inc. are trying to decide whether to use copper or steel in producing those little metal clips.
The price of copper is $1000 a ton. The price of steel is $750 a ton. It looks like a no-brainer
to the accountants: use the cheaper input and keep costs down.
But the CEO at Pen, Inc. isn't interested in keeping costs down. She wants to choose the
input that will result in the greatest happiness for society. Market surveys have showed
convincingly that consumers don't care whether the clips are made out of copper or steel.
Either works equally well. Thus, the choice of copper or steel has no impact on the
happiness of Pen, Inc.'s customers.
Who, then, will it affect? Think carefully now. If Pen, Inc. uses a ton of steel to produce the
metal clips for their pens, that means there will be one less ton of steel available for other
uses. One less of ton of steel to produce skyscrapers, Tonka Toys, Ford Rangers, steel-belted
radial tires, steel cleats for soccer shoes, etc. How much happiness will be lost because there
is now one less ton of steel available for these uses? How can we possibly answer this
question? All we know about steel is its price. The market price of steel is $750 a ton. The
beauty of it is, that's all we have to know.
If the market price of steel is $750 a ton, then we know that society will lose approximately
$750 in happiness if that steel is withdrawn from the market to make metal clips for pens.
We can't say for sure what that steel would have been used for if it wasn't used to make
clips. To be truthful, we don't have a clue. However, we do know this. Somebody
somewhere is going to not consume certain goods and services that they would have been
able to enjoy if Pen, Inc. hadn't used up all that steel in making their metal clips. Probably a
lot of somebody's somewhere are going to be doing with less. We don't know who they are.
Those other goods and services will never be made, and so nobody knows who would have
ended up with them. But here's what we do know: the price of steel tells us that having one
less ton of steel means society loses the $750 of happiness that steel would have contributed.
And the price of copper tells us that having one less ton of copper means society loses $1000
in happiness.
If Pen, Inc. has already decided to produce the metal clips and the only question is copper
versus steel, then SOCIETY WANTS THE FIRM TO USE THE INPUT THAT WILL
RESULT IN THE SMALLEST LOSS OF HAPPINESS ELSEWHERE IN THE
ECONOMY. But THIS MEANS USING THE INPUT WITH THE LOWEST PRICE. And
so, Mother Theresa makes her choice. Without a thought about the bottom line--concerned
only about the happiness of the masses--she calls the Purchasing Department and tells them
to place an order for a ton of steel. She sits back in her director's chair, filled with quiet
satisfaction from the knowledge that because of her choice, the world is going to be a
(slightly) happier place. The only thing disturbing her reverie is a memo on her desk from
the firm's accountants. It recommends the very course of action she chose herself. Isn't that
strange?
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CHAPTER 12
A Ton of Ph.D.'s Versus a Ton of High School Dropouts
Armed with the knowledge that the price of inputs contains incredible information, we can
now consider a choice between two labor inputs. Suppose that an electronics firm has an
opening for an entry level janitor. While the job does require the employee to have a good
work attitude, it doesn't require formal skills. Two applicants show up for the position. One
is a high school dropout. The other is a Ph.D. in electrical engineering. Each of the
candidates has made it clear that he will take the job only if he is paid his market wage. The
market wage for high school dropouts is about $15,000 a year. The market wage for Ph.D.'s
in electrical engineering is about $70,000 a year. Which applicant should the firm hire?
Once again, when we say "should" we aren't interested in what may or may not be good for
the firm. We are interested in the overriding goal of maximizing society's happiness.
Of course, the firm should hire the high school dropout. You don't see a lot of Ph.D.'s in
electrical engineering sweeping floors, and we personally think that is a good thing. Why?
Because Ph.D.'s in electrical engineering are extremely valuable elsewhere in the economy.
They can design new computer chips that allow home computers to play games that have
more brilliant special effects. They can be used to build stereo systems that have more
realistic sound quality. They can design circuit boards that allow better transmission and
reception of telephone calls. In short, it seems like an absolute waste to put somebody with
all this valuable training to use sweeping floors.
While we hate to say it like this, Ph.D.'s in electrical engineering are more valuable than
high school dropouts. (If it's any consolation, we also have to acknowledge that they are
more valuable than Ph.D.'s in economics.) The trick here is to know what we mean when we
say "valuable." Ph.D.'s in electrical engineering--by virtue of their training--are in a position
to produce more happiness for consumers than high school dropouts. They may not be nicer.
You might not want to travel cross country on your Harley with one. But in terms of what
they can do for the happiness of consumers, Ph.D's in electrical engineering are more
valuable.
In our particular case, if the firm hires a high school dropout, that dropout won't be available
to do other things. Consumers elsewhere in the economy will be missing out on some goods
and services--such as washed cars, mowed lawns, and grocery bags packed--that they would
have received if this high school dropout had not been removed from the labor market to
produce clean floors for this firm. The fact that this worker expected to make around
$15,000 a year doing something else means that the loss to consumers of not having him do
those other things will be about $15,000. And that's too bad.
However, it's not nearly as bad as what would happen if the firm had hired the Ph.D. in
electrical engineering. His market wage of $70,000 a year tells us that because there is one
less electrical engineering Ph.D. out there in the world producing whatever he might have
produced had he taken an electrical engineering job, consumers will be out about $70,000 in
happiness. Let's save that Ph.D. for something more happiness-producing for consumers
than a clean floor!
Up to this point, our analysis has considered what happens when a firm chooses to employ a
new resource. However, the same tools can be applied when a firm chooses to let go of an
old resource. Suppose our electronics firm already employs a Ph.D. in electrical engineering,
but it doesn't use him to clean floors. It employs him in its product development department.
Recently, a new software package became available that greatly simplifies the work that the
Ph.D. was doing at this firm.1 In fact, this software now makes the job so simple that, after a
short training session, any high-school dropout could perform this work as well as this Ph.D.
Question: Do we want the firm to replace its Ph.D. with a high school dropout?
The answer is a resounding YES. The Ph.D.'s market wage of $70,000 a year tells us that
after he is laid off, he will contribute about $70,000 of happiness to society in another use.2
In contrast, when the high school dropout is hired on, his market wage of $15,000 tells us
that society is deprived of $15,000 of happiness someplace else. After one weighs out the
respective gains and losses, the net effect is an increase in society's happiness of $55,000!
The fact that the price of an input tells us information about the happiness the input produces
is really pretty reasonable once you start to think about it: Ph.D.'s in electrical engineering
make more money than high school dropouts because consumers are willing to pay more for
the things that Ph.D.'s produce--compared to the things that high school dropouts produce.
To look at this issue from another angle, suppose an input had no gainful employments. That
is, suppose nobody could figure how to produce anything useful with this input. In that case,
we would expect the price of that input to be zero. Ultimately, it is the amount of happiness
that an extra unit of an input is expected to produce that supports the price of that input.
Copper and steel, Ph.D.s and high school dropouts. They seem so different. Yet the common
bond between them is that they are all inputs in the production of goods and services. In this
very important respect they are alike. As a result, the information contained in the relative
prices of copper and steel is the same information that is contained in the relative prices of
Ph.D.s and high school dropouts. Their prices tell us the comparative value of those
resources to society. They provide a crucial piece of information for helping society to
allocate resources to their highest valued use.
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Notes
1
To keep the problem uncomplicated, we assume that while the software simplifies the work of the
Ph.D. at this firm, it doesn't affect his productivity at other firms. Thus, the market wage of the Ph.D.
stays at $70,000.
2You may question how we can be so certain that the Ph.D. will be readily reemployed. We will
address this issue in Chapter 32.
CHAPTER 13
The Big Picture
It's about time that we start to put some of these pieces together. To do that, we have to
focus on the BIG PICTURE. The big picture is reproduced below, reduced in size so that we
can still fit it on the page.
At the top of the picture we have our millions of consumers. Each of our consumers is
characterized by a unique set of preferences known only to himself. Some like red cars,
some like white; some like to spend their vacations roughing it in the wilderness, others like
to sip gin and tonics slowly through a straw while playing the slot machines in Las Vegas;
some like pizza pies with anchovies, some don't.
At the bottom of the picture we have our millions of resources, where a resource is defined
as anything that has the potential to produce happiness. Coal, plumbing, spring water, and
steel are merely resources that are waiting to be turned into something useful, like
electricity, housing, bottled water, and automobiles. All resources are like that---sitting out
there somewhere, capable of producing pleasure for consumers, only needing someone to
direct and organize them into something fit for consumption. There are literally billions--no,
trillions--of ways to allocate these resources across the millions of consumers hungry for
pleasure. It is the economy's job to manage these resources so that the happiness of society
is maximized. What a gargantuan task! What a superhuman endeavor! Who possibly can be
entrusted with such an awesome responsibility?
Let's reconsider some of the possibilities. There really aren't very many. One possibility is
that we have an economic dictator. It makes little difference whether the dictator is a single
individual ("Hi, my name is Joe...Joe Stalin" ) or a national economic planning board, say
the Committee to Review Every Existing Possibility for Insuring Exceptional Satisfaction
(CREEPIES). Either way, the problem remains the same. How will the economic dictator
know where to direct resources so as to maximize society's happiness? Of course, we visited
this problem in Chapter 3 when we considered the Soviet planner's dilemma about allocating
resources to housing and how best to distribute the deceased rich man's estate. Short of
operating a national auction that would allow the millions of society's consumers to place
bids, it's difficult to imagine how the dictator(s) would know what items consumers wanted
and how many of them to make. In addition, there is the sticky problem of what to do if the
dictator doesn't prove up to the task. ("Hey, Joe, I think you're losing touch with the
proletariat, have you thought about stepping down and giving someone else a go at
it?...Siberia, no I've never been there, why do you ask?")
Another possibility that seems to be quite popular today is that we let democracy do it--that
is, let the people vote. Direct or indirect elections to determine the allocation of resources is
an intriguing idea. The one person, one vote convention seems a particularly fair way to
allow people to express their views about how society's resources should be allocated.
Indeed, in many so called "capitalistic" economies, much or most of the economy is directed
by this mechanism. For example, in the United States, approximately 40 cents of every
dollar spent in the economy is spent by some level of government: local, state, or federal.
These levels of government are led by representatives who are directly elected by voters
(a.k.a consumers). Thus, voters already control--indirectly--the allocation of over forty
percent of the U.S.'s resources. If democracy seems like a good way to decide how many
soldiers to train and how many nuclear missiles to build, why not use it to decide what kinds
of cars we should drive and what brands of breakfast cereal we should eat? While this would
make for some very interesting political campaigns ("If elected, I promise you that I will put
more raisins in every box of Toasted Raisin Bran Crunchies"), there are some serious
drawbacks to this way of allocating resources. For one thing, the last time we checked,
politicians enjoyed approval ratings just below used car salesmen and not much higher than
convicted drug felons. We may not want to place even greater control of our resources in the
hands of politicians. Further, the astute reader might ask, how does the one person-one vote
rule relate to a consumer's willingness to pay? The answer is: not well. This is an important
topic and one that we will return to later on in the book.
For now we want to focus our attention on a third possibility. In an economy organized by
the market, the agents that carry out the awesome task of allocating resources across
consumers are none other than those everyday, humdrum organizations we call FIRMS. For
our purposes, we think of firms as nothing more than resource owners. They range in size
from General Motors, which has sales upwards of $130 billion a year; to a roadside produce
stand which has sales of $500 and operates for just a week. Some firms are singly owned,
others have hundreds of thousands of shareholders. No matter. In fact, the laborer who
"owns" his or her time and skills can also be thought of as a "firm." Firms all share the
common characteristic that as resource owners, they make the decisions that result in the
allocation of resources across the economy's consumers.
Maybe this isn't exactly comforting. After all, what guarantee do we have that firms will
carry out their task in a socially responsible fashion? Somehow, the thought that men like
John D. Rockefeller, J. P. Morgan, Donald Trump, and Bill Gates should be entrusted with
the job of deciding the happiness of millions of consumers is--shall we say--a little
disconcerting. Before you get too discouraged, however, let's first think of how we would
like our firms to behave in an ideal world. Then we'll compare our idealized firms to those
that exist in the real world.
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CHAPTER 14
The Amazing Story of Profits
Earlier (in Chapter 7) we saw how the price system could be used to signal where a new
building would produce the greatest social happiness. If 2000 square foot homes are selling
for $160,000 in suburban Detroit and $120,000 in Ann Arbor, Michigan, then greater
happiness would be produced if a new home were built in Detroit rather than Ann Arbor.
Note, however, that we have never said whether or not a new home should be built; we have
only stated where the new home generates the most happiness. Deciding if society should
build a new home is somewhat more complex.
Building a new home diverts a lot of valuable resources from other happiness-producing
activities. The cement that will be poured to lay the new home's foundation could have been
used to build swimming pools in suburban Atlanta. The carpet used to line the floors of the
new home could have been used for a new apartment complex in Duluth, Minnesota. The
wiring and electrical materials that will be employed in the walls of the new home could
have been used for building electrical components in the dashboards of new Chevy pickups.
How can we know that the private contractor (the firm) will make the right decisions in
taking these resources away from these other activities and diverting them towards the
production of a new home?
Let's first think of how we would want firms to behave in an ideal world. If we could fill out
a job description for our firms, we would put down "maximize society's happiness." This is
admittedly a little vague, so we'll try to be more specific. Since firms are resource owners,
we'd like them to DIRECT RESOURCES FROM LOW-VALUED USES TOWARD
HIGH-VALUED USES.
Just our luck! The firms in the real world don't give any thought to doing what is best for
society. In a free market economy, firms are interested in only one thing...PROFITS.
Making more money, maximizing their incomes, that is what interests firms. But is profit
lust a good thing? Shouldn't people come before profits? Before answering these questions,
let's examine this thing called profits. While we promised that we would not resort to fancy
formulas and high-level mathematics, here's one equation that will prove absolutely crucial
for appreciating what firms do.
PROFITS = REVENUES - COSTS
Profits are the difference between revenues and costs. Now think. How are a firm's revenues
determined?
REVENUES = (Output Price) X (Number of Output Units Sold)
Or, more simply, a firm's revenue is its total dollar income. What information is contained in
a firm's revenues? We already know the information contained in the price of output goods.
The price of an output good tells us the gain in happiness that society receives from having
one more unit of the output good. If we multiply this by the number of output units sold, we
see that REVENUES PROVIDE A MEASURE OF HOW MUCH TOTAL HAPPINESS
THE FIRM CREATES FOR SOCIETY THROUGH ITS PRODUCTION OF GOODS
AND SERVICES.1
To complete the story, compare revenues with the cost side of the firm's accounting sheet.
COSTS = How much the firm paid for the resources to make its output
In our example of Reginald Buford the kumquat farmer, total costs equalled the price of the
land ($23,000), plus Reginald's own cost for his labor, ($20,000), for a total cost of $43,000.
Of course, this was a simplistic example. A more realistic description of costs would include
kilowatts of electricity, hours of secretarial assistance, tons of cement, and many other types
of inputs.
Consider the information contained in a firm's COSTS. We know from our previous hard
work that the price of an input good tells us the loss in happiness that society suffers from
having one less unit of the input good. When a firm chooses to employ a given input, say a
ton of cement, it deprives the rest of the economy of the use of that input. For example, if
the price of cement is $600 per ton, we know that consumers will be foregoing
approximately $600 in happiness because that cement will no longer be available to produce
alternative goods such as swimming pools and shuffleboard courts. If 150 tons of cement are
required to build ten new homes, then the firm's cement costs will be $90,000 ($600 X 150).
The economic interpretation of those costs is that building those two homes has resulted in
$90,000 less happiness elsewhere in the economy because that cement is no longer available
to produce other things. Applying this logic to all the firm's costs, we see that COSTS
PROVIDE A MEASURE OF THE TOTAL LOSS IN HAPPINESS THE FIRM CAUSES
FOR SOCIETY BY WITHDRAWING RESOURCES FROM OTHER USES.2
And now, for the pièce de résistance...(drum roll, please). Look what happens when we put
revenues and costs together to obtain profits. If revenues tell us the gain in happiness from
the goods and services supplied by the firm, and costs tell us the loss in happiness caused by
using up resources to produce those goods and services, then PROFITS PROVIDE A
MEASURE OF SOCIETY'S NET GAIN IN HAPPINESS GENERATED BY THE FIRM
AS IT TRANSFERS RESOURCES FROM OTHER USES TO THE PRODUCTION OF
ITS OWN GOODS AND SERVICES. Incredibly, profits provide the ultimate measure of
whether a given firm is making society better or worse off.
Meditate for a moment on the human drama that is represented by the following home
builder's income statement.
Amount Description
REVENUES: $1,000,000 Sold 10 homes
Itemized costs: Cement: $90,000;

Labor: $320,000; Wood: $270,000;
COSTS: $900,000 Plumbing: $60,000; Sheet rock:
$10,000; Carpeting: $90,000;
Miscellaneous: $60,000.
PROFITS: $100,000
Most people would just look at this income statement and see a bunch of numbers and not
realize the amazing story that it represents. But we know better. These numbers represent a
chapter in the saga of humanity's never ceasing struggle to carve out a better life from an
inhospitable world. It is the story of a firm that made the world a happier place. By
redirecting resources such as cement, labor, wood, etc. away from LOWER VALUED
USES, and using them instead for the HIGHER VALUED USE of building homes, this--
dare we say, heroic?--firm produced an increase in society's happiness of $100,000. Once
we understand what's going on, reading firms' income statements becomes a moving,
emotional experience. It almost makes us want to run out and become accountants (if only
we had the personality for it!).
OPTIONAL SECTION FOR ECONOMISTS: R e a d e r s f a m i l i a r w i t h e l e m e n t a r y e c o n o m i c t h e o r y w i l l

r e c o g n iz e th a t w h a t w e a r e c a llin g " t h e n e t g a in s in h a p p in e s s fr o m a r e s o u r c e tr a n s fe r " is n o th in g m o r e th a n w h a t
is c o m m o n ly id e n t ifie d a s th e " w e lf a r e g a in s fr o m t r a d e " in s ta n d a r d e c o n o m ic s t e x tb o o k s .
T h e s u p p ly c u r v e r e p r e s e n t s t h e h o r iz o n t a l s u m m a t io n o f e a c h f ir m 's m a r g in a l c o s t c u r v e s . A s s u c h , t h e h e ig h t o f
th e s u p p ly c u r v e a t a n y g iv e n q u a n tity r e p r e s e n ts th e m a r g in a l c o s t o f p r o d u c in g t h a t p a r tic u la r u n it . A s d is c u s s e d
p r e v io u s ly , t h e h e ig h t o f t h e d e m a n d c u r v e r e p r e s e n ts th e w illin g n e s s t o p a y o f th e m a r g in a l c o n s u m e r fo r th a t
p a r tic u la r u n it. T h u s , th e d is ta n c e b e t w e e n th e d e m a n d a n d s u p p ly c u r v e r e p r e s e n t s t h e d iff e r e n c e b e t w e e n t h e
m a r g in a l c o n s u m e r 's w i llin g n e s s t o p a y a n d t h e m a r g in a l c o s t s o f p r o d u c t io n f o r t h a t p a r t ic u la r u n it o f t h e g o o d .
W h e n s u m m e d o v e r a ll th e u n it s o f th e g o o d p r o d u c e d in th e m a r k e t, o n e o b ta in s t h e a r e a in t h e g r a p h b e lo w ,
w h ic h s h o u ld b e f a m ilia r a s t h e " w e lf a r e g a in " a s s o c ia te d w it h th e m a r k e t, o th e r w is e id e n t ifie d a s t h e s u m o f
" c o n s u m e r s ' a n d p r o d u c e r s ' s u r p lu s . "
T h e c la im in th is c h a p t e r is t h a t a f ir m 's p r o f it s m e a s u re th e n e t g a in s in h a p p in e s s f r o m a g iv e n re s o u rc e tra n s fe r.
T h e k e y a s s u m p t io n n e e d e d to ju s tif y t h is c la im is th a t t h e w illin g n e s s to p a y o f th e m a r g in a l c o n s u m e rs a s s o c ia t e d
w it h th e f ir m 's o u t p u t m u s t b e e q u a l t o th e p r ic e o f th e g o o d . H o w e v e r, a s lo n g a s th e f ir m c o m p r is e s a s m a ll
c o m p o n e n t o f th e m a rk e t , th e n it is a " p r ic e ta k e r , " w h ic h m e a n s th a t th e d e m a n d c u rv e fa c in g th e fir m is h o r iz o n t a l
a t th e m a r k e t p r ic e . T h is is th e s itu a tio n r e p r e s e n te d in th e g r a p h b e lo w .
T h e s h a d e d a re a - - th a t is , t h e a r e a b e t w e e n t h e f ir m 's d e m a n d c u rv e , r e p r e s e n t in g th e w illin g n e s s to p a y o f its

c o n s u m e rs , a n d t h e f ir m 's m a r g in a l c o s t c u r v e - - id e n tif ie s th e f ir m 's p r o fit s fr o m p r o d u c t io n . I t a ls o id e n tif ie s th e
w e lfa r e g a in s r e c e iv e d b y s o c ie t y fr o m th e m a r g in a l f ir m 's p ro d u c tio n . O n c e o n e r e c o g n iz e s th a t e v e ry u n it o f
p r o d u c tio n r e p r e s e n ts a "re s o u r c e tr a n s f e r ," th e n it s h o u ld b e s e e n th a t th e c la im o f th is c h a p te r is a s tr a ig h t fo rw a rd
d e d u c t io n o f c o n v e n tio n a l w e lf a r e t h e o r y .
S tu d e n t s s o m e t im e s r a is e th e o b je c t io n t h a t s in c e a ll fir m s a r e s u p p o s e d to e a r n z e r o e c o n o m ic p r o f its in lo n g r u n
e q u ilib r iu m , t h is m u s t im p ly t h a t f ir m s a d d n o t h in g t o s o c ie t y 's h a p p in e s s . T h e r e a r e t w o s o u r c e s o f c o n f u s io n
r e p r e s e n t e d b y th is o b je c t io n . F ir s t, fir m s c a n e a r n e c o n o m ic p r o f its in th e s h o r t r u n . I n fa c t , th e " lo n g r u n , " a s it is
u s e d in e c o n o m ic s , r e p r e s e n ts a th e o r e t ic a l id e a l t h a t is n e v e r r e a liz e d . S e c o n d , th e r e is a n im p o r ta n t d is tin c t io n
b e t w e e n m a r g i n a l a n d t o t a l . P r o f i t s m e a s u r e t h e m a r g i n a l c o n t r i b u t i o n o f t h e f i r m t o s o c i e t y ' s h a p p i n e s s . Marginal
c o nt rib u t io n m e a n s t h a t w e h o l d t h e p r o d u c t i o n o f o t h e r f i r m s c o n s t a n t . A s s u m i n g t h e c l a s s i c a l m i c r o e c o n o m i c
d e f in it io n o f lo n g r u n e q u ilib r iu m , t h e n a n y p a r t ic u la r f ir m in lo n g r u n e q u ilib r iu m c o n t r ib u t e s z e r o g a in t o s o c ie t y 's
h a p p in e s s a t th e m a r g in . T h is is d iffe r e n t fr o m s a y in g t h a t th e t o ta l o u t p u t p r o d u c e d b y a ll fir m s in a n in d u s tr y a d d s
n o t h in g t o s o c ie t y 's h a p p in e s s .
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Notes
1
This interpretation of the information contained in the firm's total revenues does assume that the
firm's output represents a relatively small portion of the entire quantity of goods supplied to the market.
That is, we are assuming that the firm does not have significant market power in influencing the price of
the output good. Chapter 43 considers the implications for our analysis when a firm possesses market
power.
2 This interpretation assumes that the firm does not have market power in input markets. That is, we
assume that the firm is not able to influence the price of input goods by altering the quantity of inputs it
employs
CHAPTER 15
Profits and the Invisible Hand
The simple equation Profits = Revenues - Costs represents the unifying field theory of
economics. If this strikes you as pathetically simplistic, we're sympathetic (maybe that's why
they call economics a soft science). Nevertheless, this simple equation represents a
remarkably powerful framework for analyzing all economic activities. After all,
ECONOMICS IS ALL ABOUT RESOURCE TRANSFERS, taking resources away from
one possible use and redirecting them towards something else. Health care, job training,
child care, workplace safety, environmental cleanup--properly understood, these things are
nothing more than resource transfers. If we direct more resources to child care, we have less
resources for other things. If we want to provide better health care to more people, we
cannot help but deprive consumers of other goods and services that would have produced
happiness. The key question is--always is--which use of a resource provides the greatest
happiness?
To better visualize how profits help us to answer this question, let's return to the BIG
PICTURE.
For example,
building a house means taking resources away from some consumers and directing these
resources to others. When we say that the building contractor "takes away" resources from
consumers, we don't mean that he drives through town in his half-ton pickup truck with his
gang of carpenters snatching cement, sheet rock, and carpeting out of the hands of
unsuspecting consumers. It is all done in a very pleasant and neighborly sort of way, with
the contractor exchanging green pieces of paper for the right to employ these resources. But
don't let those pleasantries prevent you from seeing what is really going on. Resources are
being taken from one activity and put to use in another. To determine whether this resource
transfer makes society better off, we need to compare the loss in happiness that arises from
not having those resources available for alternative uses, with the gain in happiness received
from the activity those resources have been redirected to.
Under the right circumstances--we'll talk more about this later--profits provide a measure of
the net gains in happiness from resource transfers, with revenues measuring the gains and
costs the losses. If profits are positive, the firm has generated an increase in society's
happiness. If profits are negative, the production activities of the firm have served to
decrease society's happiness.
IN A FREE-MARKET ECONOMY, PROFIT-MAXIMIZING FIRMS ARE AN

UNWITTING ACCOMPLICE IN THE GREAT SOCIETAL TASK OF MAXIMIZING
HAPPINESS. This is a powerful insight. Take the greediest, most selfish, money-grubbing,
heartless capitalist you can imagine. In his never-ending lust to maximize his own profits, a
startling thing occurs. The greedy capitalist becomes indistinguishable from the zealous
altruist who works untiringly for the improvement of the masses. It is as if the capitalist
woke up each morning and asked himself, "How can I improve the lot of my fellow citizens
today?" Ebenezer Scrooge becomes Mother Theresa, or at least her economic equivalent.
In fact, one could say that it is as if an INVISIBLE HAND guided the firm unknowingly to
do what was good for society. Invisible hand indeed. Just so you don't labor under the
misconception that any of this is particularly new, consider the words of Adam Smith, taken
from his book The Wealth of Nations, first published in 1776:
"As every individual, therefore, endeavors as much as he can...to

direct that industry that its produce may be of the greatest value;
every individual necessarily labours to render the annual revenue of
the society as great as he can. He generally, indeed, neither intends
to promote the public interest, nor knows how much he is promoting
it....he intends only his own gain, and he is in this, as in many other
cases, led by an invisible hand [italics added] to promote an end
which was no part of his intention."1
ONE IMPLICATION OF THIS IS THAT WE SHOULD BE SUSPICIOUS OF POLICIES

THAT PROPOSE RESOURCE TRANSFERS WHICH PROFIT-MAXIMIZING FIRMS
ARE NOT WILLING TO UNDERTAKE. If more child care would really improve society's
happiness, we should expect profit-maximizing firms to be able to make good money
operating day care centers. If providing more health care really is a good thing, for-profit
hospitals will rise up to meet the need. Likewise, if redirecting resources to produce better
trained workers would make society better off, then we should see firms opening up "worker
education" centers, training workers for a profit. And we should cast a wary glance at
politicians who talk about the need for government job-training programs to help America
"grow stronger" in the world economy.
Does this mean that every activity that loses money decreases society's happiness? And any
activity that makes money increases society's happiness? No, it does not. Recall that at this
point in our analysis we are operating in a world without market imperfections. As we shall
see, the presence of market imperfections will cause profits to distort the impact of resource
transfers on society's happiness. Our point here is merely that one should be "suspicious" of
calls for society to undertake resource transfers which profit-maximizing firms are unwilling
to undertake. That is, we should ask ourselves: if this activity is so good for society, how
come profit-maximizing firms aren't doing it?
Maybe you're skeptical that our "unifying field theory" is complete enough to analyze the
complicated issues we promised to discuss in the first chapter. Good. We plan to spend a lot
of time addressing these and other issues in greater detail. In the meantime, keep your
skepticism.
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Notes
1Adam Smith, An Inquiry Into the Nature and Causes of the Wealth of Nations, Indianapolis: Liberty
Classics, 1976, page 456.
CHAPTER 16
Price Controls and Other Disasters
"STORM DRIVES LUMBER PRICES TO RECORD HIGHS.

Seattle (Reuter)--Hurricane Andrew has spiked cash lumber prices
to record levels and sent futures soaring as investors speculate on
the billions of dollars that will be spent to repair some 85,000 homes
in Florida and Louisiana...Florida's attorney general has begun
investigating recent retail price increases for plywood, alleging that
the companies were no better than looters."
We've all seen newspaper stories like the real-life story quoted above. Earthquakes, floods,
tornadoes, hurricanes leave a path of billions of dollars of property damage in their wake.
Families are left homeless. Food, clothing, and shelter are suddenly in short supply. And
how does the free-market economy react to all this pain and suffering? It generally responds
by causing the prices of these necessities to go through the roof, assuming the roof is still
there. Funny way to increase society's happiness! After all, when was the last time you went
to the store, saw a higher price, and were happier as a result? Indeed, we suspect that most
people share the sentiments of Florida's attorney general, who accused the lumber
companies of being "no better than looters." Such a statement is usually followed by a
recommendation that it should be illegal for businesses to raise their prices beyond a certain
point. This is called a price control. But let's think about this. Would we really be better off
if the government prohibited lumber companies from raising the price of plywood following
a natural disaster like Hurricane Andrew?
Suppose that prior to Hurricane Andrew, the price of plywood was fairly uniform over the
continental United States. Say plywood initially cost $300 per thousand board feet in North
Carolina and Florida. Now Hurricane Andrew devastates Florida, causing the price of
plywood to rise to $400 in that state (assume the price remains at $300 in North Carolina).
What happens next?
The owners of plywood in states like North Carolina realize that they can make a buck by
shipping their lumber stocks to Florida. Assuming that the shipping costs of a thousand
board feet are less than $100, these owners can make a quick profit by raiding their
warehouses and putting their available plywood on the first train going south. This is
good...and bad. It's good because the people in Florida now have more wood to rebuild their
devastated cities and homes. It's bad because the people in North Carolina now have less
wood for building tree houses and redecorating their family rooms. Who can say whether the
gains of the consumers in Florida outweigh the losses of the consumers in North Carolina?
The answer is: anyone who understands the Unifying Field Theory of Economics
(Profits=Revenues-Costs).
Shipping a thousand board feet of plywood out of North Carolina means that consumers
there will miss out on about $300 in happiness which they would have received from that
wood. But sending another thousand board feet to Florida causes an increase in happiness of
$400 there. Taking plywood resources out of the hands of North Carolina consumers and
putting it into the hands of Florida consumers has created a net increase in society's
happiness. This increase in happiness has occurred only because of the high price of
plywood in Florida. It wouldn't have happened if government regulators had refused to
allow the price of lumber to rise as a result of the natural disaster.
In fact, HIGH PRICES ARE A DISTRESS CALL THAT GOES OUT TO THE REST OF
THE ECONOMY. "Mayday, Mayday...Please send food, clothing, and the resources to
rebuild homes...Over and out...P.S. Hurry Up!" This SOS call is picked up by thousands of
"rescue organizations" across the economy that respond with a great outpouring of relief to
the disaster victims. These "rescue organizations" have names like the Georgia-Pacific
Lumber Company, the Kroger Corporation food company, the Sears and Roebuck clothing
company, etc. Shipments of food, clothing, and plywood all start arriving in great quantities.
Oh sure, maybe the intentions of these "rescue organizations" isn't what it ought to be in an
ideal world. Maybe they should be more concerned about the pain and suffering of the
disaster victims and less concerned about their own interests. But that's not an argument
against the price system. On the contrary! It's a tremendous argument in favor of the price
system. Even though the owners of these resources may not have a whit of sympathy for the
poor consumers afflicted by this disaster, they're doing everything they can to help them in
their hour of need.1
The key to seeing all of this is to recognize that PRICES CONTAIN INFORMATION. The
fact that the price of lumber is higher in Florida means that an extra 1000 board feet of
lumber is more valued there than elsewhere. Price controls keep this information from
getting out. In fact, one can think of price controls as a form of censorship. They keep the
SOS call from being sent. And without this vital information, the free-market economy
cannot transfer resources where they are most needed.2
That's all fine and good you say, but don't higher prices hurt people as well? Well, higher
prices surely impose a burden on everybody. But note that the real problem here isn't the
higher prices. The real problem here is that Hurricane Andrew (or whatever disaster we're
dealing with) has wiped out the resources available to consumers. There's not enough food,
clothing, and shelter to accommodate the past consumption behavior of consumers--this is
the source of the real burden from the natural disaster, not the higher prices. Higher prices
aren't causing there to be less food, clothing, and shelter. They are merely reflecting the fact
that there's less of these things to go around. Price controls can't alter this stark reality.
In fact, artificially lowering prices makes things worse. Since the real problem here is the
lack of necessities, the only way to make things better is to somehow get more of these
things in the hands of consumers. High prices attract these goods from other parts of the
country. Perhaps we can draw some consolation from the fact that the high prices which
follow natural disasters are temporary. Thanks in large part to the tremendous desire of for-
profit organizations to capitalize on this disaster, a flood of valuable resources will soon be
sent to the devastated communities. As food and clothing quickly fill the shelves of stores
throughout the area, prices will come tumbling down. Thus, the spike of high prices
following a natural disaster contains the seed of its own demise. It unleashes forces that will
soon cause prices to return to their pre-disaster levels.
You may be thinking, "That's great, but don't higher prices disproportionately hurt the poor?
After all, they're the ones least able to pay. Shouldn't we help them if they can't afford
necessities?" We certainly agree with this sentiment, but consider the following. Price
controls do not just lower prices for poor people. They lower prices for rich people as well.
If we are really concerned about putting more food and clothing in the hands of poor people,
there is no guarantee that price controls will do the job. At the lower prices, rich people will
want to buy more of these goods than they would otherwise. If they do, there will be less of
them available for poor people. How's this for a perverse result: ARTIFICIALLY
LOWERING PRICES TO HELP POOR PEOPLE MAY IN FACT
DISPROPORTIONATELY HURT POOR PEOPLE.
All of this leads us to the following conclusion. If you don't like the allocations that arise
under the price system, don't kill the messenger. The price system isn't the problem. On the
contrary, since the price system directs resources to a devastated area, it is the solution. The
real problem is one we touched on when we first discussed the willingness to pay approach:
poor people don't have enough money to adequately express their desire for goods and
services. So give poor people more money. Price controls can't be counted on to help the
poor because there's no guarantee that more goods and services will actually go to them. At
least when we give poor people more money, there is no doubt they are going to be able to
get more of the things they really need. And we can take comfort in the knowledge that we
haven't compounded the original, natural disaster with the man-made disaster of price
controls.
OPTIONAL SECTION FOR ECONOMISTS: T h e a r g u m e n t i n t h i s c h a p t e r is t h a t a p r ic e c o n tr o l- -

s p e c if ic a lly , a p r ic e c e ilin g - - lo w e r s s o c ie t y 's h a p p in e s s . S t u d e n t s f a m ilia r w it h t h e u s e o f d e m a n d a n d s u p p ly g r a p h s
to m e a s u r e w e lfa r e g a in s w ill r e c o g n iz e th is a r g u m e n t in th e g r a p h b e lo w . T h is g r a p h d e p ic t s th e im p o s it io n o f a
p r i c e c e i l i n g o f P c. T h e b i n d i n g p r i c e c o n t r o l r e d u c e s t h e e q u i l i b r i u m q u a n t i t y s u p p l i e d t o Q c. T h e s h a d e d a re a
r e p r e s e n t s o n e s o u r c e o f w e lfa r e lo s s e s a s s o c ia te d w ith t h e lo s t o u tp u t c a u s e d b y th e p r ic e c o n t r o l.
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Notes
1
Food for thought: Is it possible that these self-seeking, for-profit organizations do more to help the
disaster victims than all the charitable efforts of the non-profit, humanitarian organizations?
2 In addition to causing too little of the good to be supplied, price controls also cause shortages. These
shortages generate another source of lost happiness for society, because the lumber that does get
supplied will not necessarily go to those who value it most. For example, suppose a price ceiling of $300
per thousand board feet is imposed on the lumber market and a shortage arises. This shortage means that
not everybody who is willing to pay $300 for a thousand board feet will be able to buy it. Let Consumer
A be someone who is willing to pay $450 for lumber, and Consumer B somebody who is willing to pay
only $350. Assuming that there is not enough lumber for both of these consumers, it is possible that
Consumer B is able to find a supplier who will sell him lumber, while Consumer A does not. If that
happened, the lumber would not go to the person who values it most. In other words, we could increase
society's happiness by taking the lumber away from Consumer B and giving it to Consumer A.
CHAPTER 17
Does Recycling Waste Resources?
"SCHOOLS COLLECT TRASH BUT NO CASH. Universities

across the country are going into the red to be green. Each month,
228 tons of paper are collected and recycled from the U. of
California, Los Angeles campus. But UCLA recycling director E.J.
Kirby said the money earned from recycling is not enough to pay for
the expense of the recycling program. 'Our goal is not to make
money,' Kirby said. 'We are trying to reduce the amount of trash that
is taken to landfills, regardless of the cost.'"1
This is an exciting story. Recycling finally seems to have moved into the mainstream of
American society. Everywhere you go--in offices, in schools, in all kinds of public places--it
is almost impossible to avoid seeing a recycling container for cans and paper products.
Many communities require their residents to separate their trash into paper, plastic, and
glass. Some even go further, mandating that glass refuse be separated into brown, green, and
clear glass. People proudly boast that they take the time to recycle. And what parent hasn't
felt a touch of pride at seeing one of their children fish a tossed can out of the garbage pail
and then say, "Daddy, we can't throw these cans away with the other trash. We need to
recycle this to help save our planet." Everywhere, dedicated men and women, sparked by
idealism and a desire to leave this world a little better than how they found it, work to save
our precious resources. And yet...
Our first indication that all is not right comes with the recognition that recycling is often a
money-losing proposition. IT EARNS NEGATIVE PROFITS. Somewhere in that statement
is a story about how recycling affects society's happiness. Let's consider the two components
of the profit equation. First is revenues. Despite the hoopla about the precious resources
being saved, in reality recycled products generally sell at a relatively low price. Consider the
following statement by the recycling coordinator of New York University (quoted later in
the same article), "The revenue from recycling doesn't offset any of the costs of recycling,
because right now the market price for materials is at an all-time low." Hmmm. Prices are
low. What does that tell us? It can only mean one thing. Society is not getting much
happiness from the recycled goods it produces as a result of all this effort.
Okay. But think of all the resources we're saving. We are saving resources, aren't we? This
statement is a half truth. We are saving some resources. But in the course of doing that,
we're also using up other resources. It takes resources to save resources. It takes labor to
collect and sort the telephone books, newspapers, Pepsi cans, plastic milk cartons, and
brown glass, green glass, and clear glass that are recycled. Labor is a resource. It takes
machines to transform discarded newspapers into a pulpy mush that can be reprocessed into
usable paper products. Machines are a resource. It take energy to operate those machines.
Energy is a resource. Each of these resources has alternative uses. They could be used to
produce happiness elsewhere in the economy. When we tie up these resources in order to
make recycled products, we deny consumers in our economy the other goods and services
that they could have received from these resources.
Seen from the perspective of our unifying field theory, recycling is just another resource
transfer. There are gains and losses. The trick is to compare the size of the gains against the
size of the losses. But that is exactly what profits do for us. If recycling loses money, it
means that the resources used to generate recycled goods would produce more happiness if
they were used for something else. In other words, recycling takes resources away from
higher valued uses and directs them to lower valued uses. Is it possible to state this a little
more clearly? How about the following statement: RECYCLING CAUSES THE
DESTRUCTION OF RESOURCES THAT ARE MORE VALUABLE THAN THE
RESOURCES RECYCLING SAVES.
If the resources that were being saved were really valuable, one would expect recycled
products to sell for more. For example, suppose trees were becoming scarce. Then the price
of trees, and hence the price of paper, would be high. Faced with high prices for paper
products, consumers would be willing to spend a lot of money for substitute, recycled paper
products. But paper isn't expensive, it's cheap. (In fact the reason there is so much waste
paper is precisely because paper is cheap. If it were expensive, people wouldn't "waste" it.)
And because paper is cheap, consumers aren't willing to pay very much for recycled paper
products. That is, consumers don't value additional paper products--recycled or otherwise--
precisely because trees are not scarce. Trees are abundant. As a result, trees are not a
particularly valuable resource, at least when compared to other, less plentiful resources.
Thus recycling paper to save trees doesn't make a lot of sense, unless you get a kick out of
cluttering up your garage with newspapers to haul down to the recycling site.
How about the landfill argument: "Recycling is good because it keeps trash from piling up
in landfills." This argument is based on the premise that landfill space is scarce. Let's
see...how would we know whether landfill space is scarce? That would make the price of
landfill high. (If we're starting to sound a little repetitive, all we can say is that's the beauty
of our "unifying field theory" of economics. The same argument works for everything.) If
the price of landfill was high, then businesses, universities, cities and towns would all have
to pay a lot of money for the right to deposit their trash on somebody's land. In that case
nobody would have to force them to recycle. They would do it voluntarily because it was in
their own financial interest to do so.
And that really is the point of this discussion on recycling. We're not saying that recycling is
inherently bad. All we're saying is that if recycling were good--that is, if it would increase
society's happiness--then self-interested firms and consumers would choose to recycle
voluntarily. Not because it was good for Mother Earth, but because it was in their own
interests to do so. In fact, for commodities such as aluminum and steel, recycling has been
the norm for a long time, without any encouragement from government. In these cases,
recycling is good for society. But oftentimes universities, communities, and private firms
recycle because they think they're helping society, even though they're losing money doing
it. When this happens, we conclude that recycling wastes more valuable resources than it
saves, and ends up lowering society's happiness.
OPTIONAL SECTION FOR ECONOMISTS: The graph below illustrates the welfare loss associated with
an ex cise subsidy . The subsidy causes the m ark et supply curv e to shift down , resultin g in an in crease in eq uilibrium
q uan tity from Q 0 to Q 1. The shaded area in the graph represen ts the correspon din g welfare loss for the m ark et.
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Notes
1
U. The National College Magazine, Fall 1992.
CHAPTER 18
Job Destruction and Economic Growth
"PROFITS FIRST AND PEOPLE LAST. Too many companies

have their priorities all mixed up. Their motto is, 'Profit first, people
last.' They just want to make an extra penny without worrying about
the damage to the people they are stepping all over....In my opinion,
there should be more laws concerning plant closing and the
responsibilities of plants to their employees. They shouldn't be able
to just move away and close down, leaving their faithful employees
empty-handed."1
Suppose a company finds that at the end of a given year of production its revenues are $21
million, but its costs are $25 million. It has made negative profits. Maybe we feel bad for the
owners who lost all this money (probably not). However, we shouldn't lose sight of the
important story here. The important story concerns what has happened to society's
happiness. This firm has taken resources that would have produced $25 million of happiness
elsewhere in the economy, and misdirected them to the production of goods and services
that generated only $21 million in happiness. Negative profits are the economy's way of
telling the company to be sure and not make that mistake again ("Nothing personal, but
we're going to have to penalize you $4 million for making this world a little less happy.
Please don't do that again.") Suppose this company stubbornly continues to rack up losses.
From the perspective of maximizing society's happiness, what do we want to see happen?
Let's be blunt. We've got to stop this company before it hurts any more people. ("Alright you
guys, put your hands up in the air and give up those resources...and no funny stuff!"). In a
free-market, capitalistic economy, this is accomplished by having the firm go bankrupt. And
this is good, because we want the firm to shut down and quit producing. Actually, that's an
awful way of saying it. What we really want the company to do is shut down and start
releasing. Having firms go belly up is just the economy's way of getting resources released.
IN ORDER TO MAXIMIZE SOCIETY'S HAPPINESS, WE MUST FREE UP
RESOURCES WHICH ARE IN LOWER VALUED USES AND ALLOW THEM TO GO
TO HIGHER VALUED USES.
This is such an obvious point, and yet failure to see it leads to one of the most common of
economic fallacies. Consider the case of plant closings. Generally, plant closings are
covered in the news media in much the same way as earthquakes, floods, tornadoes, and
other horrible disasters. We don't mean to belittle the pain and suffering that communities
and workers go through every time a major employer closes down. But let's consider this
carefully. The plant is closing down because costs exceed revenue. If the plant is earning
low revenues, then the firm must be producing something that consumers don't value very
much. On the other hand, the high costs mean that other firms are anxious to get their hands
on these inputs (after all, if no other firms were willing to buy those inputs, then why are
they so expensive?). And the reason other firms are anxious to get their hands on them is
because these inputs can be used to produce goods and services that consumers are willing
to pay high prices for. Thus, plant closings are a desirable thing. They are good. They are
good because they result in an increase in society's happiness. The last thing we want to do
is create impediments that will discourage plants from closing down.
In fact, if consumer groups and labor unions were really serious about wanting to improve
public welfare, they wouldn't picket firms that were closing plants. On the contrary. They
would demonstrate in front of firms that were trying to stay open despite all indications that
they weren't going to turn profitable. They would carry placards which said things like "LET
OUR RESOURCES GO" and shout slogans like "REVENUES LOW, COSTS ARE HIGH,
GUESS ITS TIME TO SAY GOODBYE." In fact, if the media were really doing their jobs,
they would cover the human tragedy of firms that were continuing to stay open despite
losing money ("Hi, this is Dan Rather and we are going live to the XYZ Corporation where
executives continue to hold valuable inputs hostage"..."And now to Connie Chung, who will
tell us of one American family's continuing struggle to survive without the other goods and
services these resources could have produced.")
Consider the hypothetical example of a movie company that made only really bad movies.
Let's call this company Adud, Unlimited. Let's suppose that Adud negotiates with Dustin
Hoffman to make three new movies: "Ishtar II," "Ishtar III," and "Ishtar IV: This Time It's
Personal." Movie fans will remember that the first Ishtar, in which Hoffman starred, was
widely regarded as one of the worst movies of all time. It lost tens of millions of dollars.
Few would dispute that Ishtar significantly decreased the happiness of moviegoers.
Nevertheless, armed with three new scripts, Adud plunges forward--and downward. Three
movies--and thousands of blistering movie reviews--later, Adud goes out of business. Prop
men, cameramen, make-up artists, and Dustin Hoffman are all thrown out of work.
We bet you'll agree that movie companies that only make movies no one wants to see--like
Adud--should close their doors and release their resources. After all, Dustin Hoffman has
alternative uses, such as Rain Man. An actor of his prodigious talents should not be stuck in
dumb movies, and neither should the other people who work for the company. When people
lose jobs in unprofitable industries, they are released to work for industries which produce
more highly valued goods and services. They proceed to their alternative uses, and thank
heavens they do.
If you're still feeling uncomfortable with the idea that the destruction of jobs in unprofitable
industries can be good for the economy, think about this. In 1900, there were 11,680,000
workers employed in agriculture (approximately 40 percent of the entire labor force). In
1993, there were only 3,074,000 workers employed in agriculture (less than 3 percent of the
labor force). What caused this massive exodus from agriculture? Increases in agricultural
productivity caused huge increases in agricultural output. This, in turn, dramatically lowered
prices and made farming unprofitable. Most of the people who left farms did so because
they could no longer make a living at it.
It was the release of these valuable resources (labor) which allowed the manufacturing
sector to grow and stimulated America's transition to an industrial economy.2 Now think of
what would have happened if we had imposed "plant closing laws" (pardon the pun) in
1900? What if the government had tried to stem this exodus out of agriculture by passing
"bankruptcy forgiveness laws" that encouraged bankrupt farmers to continue tilling their
fields? Very simply, America would not have grown. While it was painful for the farmers at
the time, these economic forces worked to shift resources out of a lower valued use
(agriculture) into a higher valued use (manufacturing). As a result of this massive resource
transfer, the living standards of the American worker rose dramatically. While we admit it
goes contrary to conventional wisdom, it is an indisputable fact that job destruction plays a
vital role in economic growth.
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Notes
1
Solidarity, June 1994.
2 We recognize that unemployment and labor market transitions can be emotional subjects. Perhaps you
think that we are a little too sure that workers will find new jobs. If these issues bother you, we
understand. We will address them in greater detail later on.
CHAPTER 19
A Simple Framework for Analyzing Public Policies--Part I
Having walked up to the water, it's now time for us to take a big drink. In this and the next
two chapters, we develop a simple framework for analyzing public policies. How can one,
single framework be so useful for analyzing so many different topics? Most every public
policy that we can think of involves resource transfers. But resource transfers is what our
Grand Unifying Theory of Economics is all about. So buckle up and get ready for an
intellectual ride that will turn you into an economic analyst extraordinaire and the absolute
hit of any cocktail party. In the previous chapters you learned the pieces of the puzzle. The
last three chapters previewed the value of our simple framework by putting those pieces
together in a way that allowed us to gain some unconventional insights. Now we tidy things
up a bit and present the whole system as an easy, do-it-yourself policy kit.
A large assortment of public policies can be summarized as either SUBSIDY or TAX

policies. Let's first consider the effect of a government subsidy program. A subsidy is simply
a government payment for production. For whatever reason, governments love to subsidize
agricultural products. Honey, milk, wheat, cheese, wool, wine, tobacco--these are just a few
of the products that governments pay billions of dollars each year to encourage farmers to
produce more than they would on their own. (This then causes such huge increases in
production that government then has to pay billions of dollars more each year to encourage
farmers to not grow so much, but that's another story). To be concrete, let's consider the
effect of a government program to subsidize the production of watermelons.
Suppose Ima Hogg is a pig farmer who happens to have a good patch of unused land behind
her house. Early in the spring, Ima gave some thought to raising watermelons in that patch.
She figured she could raise 1,000 watermelons a year back there. At a market price of $5 a
watermelon, she'd earn revenues of $5,000. Unfortunately, Ima figured that it would cost her
$5,500 to grow those watermelons. After mulling it over for some time, Ima decided against
going into the watermelon business. That would have been the end of it, except for a chance
encounter.
One day while Ima was down at the seed store, she happened to bump into the local
agricultural extension agent. He told Ima about a new government program to help
watermelon farmers defray their costs. For every watermelon she raised, the government
would now pay her $2. That lowers the costs of growing 1,000 watermelons by $2,000. This
was wonderful news! Ima quickly figured that with the government subsidy, her watermelon
business would now be profitable. Being a woman of action, she got right on it. By the end
of the summer, Ima had some of the best looking watermelons in the valley. Thanks to her
hard work and the government subsidy program, Ima made a profit of $1,500 on her
watermelon business. And society enjoyed 1,000 watermelons that otherwise would not
have been available.
Here is a great American success story. The farmer's happy (she made money), the extension
agent's happy (he was able to help a friend), watermelon consumers are happy ("Sure been a
lot of good watermelons this year."), and the government's happy (the new program seems to
be working--more watermelons are being produced). With so many happy people, how
could such a program not be good?
Let's analyze this subsidy program with the help of the PROFIT TABLE below.
Before Subsidy After Subsidy
REVENUES: $5,000 $5,000
COSTS: $5,500 $5,500 - $2,000 = $3,500
PROFITS: -$500 +$1,500
Before the watermelon subsidy program, raising watermelons was going to result in a loss of
$500. After the program, Ima found she could make a profit of $1,500. Since Ima is making
a profit now, and profits are good for society, doesn't the watermelon subsidy program
increase society's happiness? DANGER...DANGER...ECONOMIC FALLACY IN THE
MAKING!
The fallacy arises because Ima's profits were generated by government intervention (the
subsidy), not by consumers buying her goods. Our previous statement that profits measure
society's happiness assumed that revenues and costs reported the correct information about
the gains and losses in happiness from producing watermelons. In the Before Subsidy
column, Ima's costs are the same as society's costs--$5,500. In the After Subsidy column,
Ima's costs are now less than society's costs--$3,500 compared with $5,500. As a result of
the subsidy, Ima is no longer forced to consider all of the happiness that the inputs could
have produced in some other activity.1 The costs she sees on her balance sheet are, from
society's perspective, horrible lies. Through no fault of her own, Ima is destroying
happiness.
Another way to approach this problem is to ask yourself, what are the only two numbers in
the table which represent the gains and losses to society from transferring resources to
watermelon production? The answer is: $5,000 and $5,500. In reality, this resource transfer
has given consumers $5,000 in additional pleasure from consuming Ima's watermelons.
However, other consumers have lost about $5,500 in happiness because Ima withdrew
fertilizer, tools, water, etc. from other pleasure-generating activities. So the net effect is a
$500 loss in society's happiness. The fact that the government now has kicked in $2,000
doesn't change this reality. It just disguises the real gains and losses from this resource
transfer. In this sense, subsidies (and taxes as we shall see), can be thought of as
INFORMATION POLLUTION. The bottom line is that the government subsidy "tricked"
our firm (Ima Hogg) into transferring resources from a higher valued use to a lower valued
one, making society poorer in the process.
But haven't we forgotten something here? Didn't Ima get a check for $2,000? Didn't that
make her $2,000 better off? Once again, we make mistakes when we take our eye off the
ball, and the ball is always the real gains and losses in consumption that result from any
resource transfer. The government handed Ima a check for $2,000, but the government had
to take that $2000 from other taxpayers in order to give it to Ima. The government's gift to
Ima of $2000 was completely offset by the loss of $2000 suffered by taxpayers who were
forced to contribute to the Ima Hogg Watermelon Relief Fund. This is nothing more than a
WEALTH TRANSFER. Wealth transfers are always a wash for society.2 While you may
think that wealth transfers are unfair or unwise, from the perspective of our simple
framework, they make no difference in the overall happiness of society.
OPTIONAL SECTION FOR ECONOMISTS: T h e g r a p h b e l o w s h o w s a s i m p l i f i e d r e p r e s e n t a t i o n o f t h e

w e lf a r e lo s s e s r e p r e s e n t e d in t h e P r o f it T a b le . T h e s u b s id y lo w e r s I m a H o g g 's m a r g in a l c o s t s b y $ 2 p e r
w a te r m e lo n . N o w t h a t h e r c o s t s h a v e b e e n s u b s id iz e d , s h e fin d s it p r o fit a b le to p r o d u c e 1 0 0 0 w a te r m e lo n s .
H o w e v e r , in t h e a b s e n c e o f t h e s u b s id y , m a r g in a l c o s ts w e r e a b o v e p r ic e , w h ic h is e q u a l to c o n s u m e r s ' w illin g n e s s
to p a y .3 T h a t is , th e o p p o r t u n it y c o s ts o f th e r e s o u r c e s u s e d to p r o d u c e t h e w a te r m e lo n s w a s g r e a te r th a n th e
w illin g n e s s t o p a y o f th e c o n s u m e r s r e c e iv in g th e w a te r m e lo n s . T h e s h a d e d a r e a r e p r e s e n ts t h e $ 5 0 0 lo s s in
w e lf a r e a s s o c ia t e d w it h I m a H o g g 's p r o d u c t io n o f 1 0 0 0 w a t e r m e lo n s ( n o t e t h a t w e h a v e m a d e t h e s im p lif y in g
a s s u m p tio n th a t t h e fix e d c o s ts o f p r o d u c tio n a r e z e r o ) .
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Notes
1
Note that we could just as easily have added the subsidy to the farmer's Revenues. This would have
given us exactly the same result.
2 Barring administrative costs to transferring wealth and possible incentive distortions.
3
The observant reader will note that we have ignored the feedback effect of the subsidy on the market
price. That is, the subsidy shifts out the market supply curve, lowering the equilibrium price of
watermelons. Including this feedback effect would complicate the analysis without changing any of our
conclusions. Accordingly, we disregard this effect so as to avoid unduly complicating our analysis.
CHAPTER 20
A Simple Framework for Analyzing Public Policies--Part II
As it turns out, Ima Hogg has a sister, Ura, who is already a successful watermelon farmer.1
We want to address the following question, "If a farmer is already making a profit, would a
subsidy still lower society's happiness?" Let's take a closer look at Ura's business affairs to
get an answer to this question.
Before After
REVENUES: $5,000 $5,000
COSTS: $4,000 $4,000 - $2,000 = $2,000
PROFITS: +$1,000 +$3,000
Before the watermelon subsidy program went into effect, Ura Hogg was making a nice little
profit on her watermelon operation. Like Ima, she had a patch of land behind her house on
which she too could grow a 1,000 watermelons. At a market price of $5 per watermelon, this
gave her $5,000 in revenues. But Ura is a better shopper than Ima. By buying her materials
from low-cost suppliers, Ura finds that she could grow 1,000 watermelons for a total cost of
only $4,000. As a result of her hard work and smart business sense, Ura earns $1,000 in
profits before receiving any subsidies.
Now consider the effect of the watermelon subsidy program. As the table clearly shows,
with an extra $2 per watermelon in subsidies, Ura's profits increase to $3,000. What has
happened to social happiness? Absolutely nothing. The subsidy hasn't affected social
happiness in this case because the subsidy hasn't altered Ura's management of society's
resources. Before the subsidy, Ura transferred $4,000 of resources from other activities to
the production of 1,000 watermelons. After the subsidy, Ura still transfers $4,000 of
resources from other activities to the production of 1,000 watermelons. Resources are
allocated the same way before and after the subsidy. SINCE THERE IS NO CHANGE IN
THE ALLOCATION OF RESOURCES, THERE IS NO CHANGE IN SOCIETY'S
HAPPINESS.
How about the fact that Ura Hogg now makes more money? Again, the transfer of $2,000 in
subsidies to Ura Hogg is exactly counterbalanced by the transfer of $2,000 away from other
taxpayers who had to foot the bill for this program. It represents a pure wealth transfer that
results in no change in society's total happiness.
You should now see that when it comes to subsidies, there are two kinds of watermelons in
the world. There are those watermelons that would have been produced before the subsidy,
and still get produced after the subsidy (like Ura Hogg's watermelons). And there are those
watermelons that would not have been produced before the subsidy, but now get produced
because of the subsidy (like Ima Hogg's watermelons). Only the production of the latter kind
of watermelons causes a change in society's happiness.
Thus, in analyzing the effect of a particular public policy on society's happiness, we follow
the following three-step procedure.
Step 1. We begin by determining how the policy will change the allocation of society's
resources. In particular, we ask whether the policy will increase or decrease the quantity of
the good directly impacted by the public policy. For example, subsidies lower costs, so
production increases. In contrast, taxes increase costs and hence decrease production.
Step 2. Once we determine whether more or less of the good will be produced, we focus on
a specific resource transfer that is changed by the public policy. For example, in the case of
watermelon subsidies, we look only at those watermelons that would not been produced
before the subsidy, but get produced after the subsidy. Further, we don't look at all the
affected watermelons. We just choose a representative case. We focus on a typical resource
transfer that is altered by the policy.
Step 3. We then construct numbers using the PROFIT TABLE to illustrate how society's
happiness is impacted in this particular case.
Having shown it for the representative case, we're finished. For while the numbers might be
different for other resource transfers impacted by the policy, the conclusion will always be
the same. Thus, our simplistic Profit Table will lead us to the correct conclusion every time.
("Look out cocktail parties, here we come!") The next chapter shows how to use this simple,
three-step framework for analyzing public policies involving taxes.
OPTIONAL SECTION FOR ECONOMISTS: Perhaps one can obtain a better idea of this three step
procedu re by referring to the fig u re bel ow . T he first step consists of determ ining w hether m ore or l ess of the g ood
w il l be produ ced. I n the case of a su bsidy , the su ppl y cu rv e shifts ou t so that q u antity increases from Q 0 to Q 1.
T he second step consists of choosing a representativ e resou rce transfer affected by the pol icy . N ote that the u nits
betw een Q 0 and Q 1 are the onl y resou rce transfers affected by the pu bl ic pol icy . T hey are the u nits that w ou l dn' t
hav e been produ ced before the su bsidy , bu t g et produ ced after the su bsidy . T hu s, w e focu s on one of the u nits
betw een Q 0 and Q 1, cal l it Q *
T he l ast step consists of representing the resou rce transfer Q * in the Profit T abl e. N ote that before the su bsidy , the
su ppl y cu rv e l ay abov e the dem and cu rv e at the indicated q u antity . W e transl ate this into ou r Profit T abl e by
show ing R ev enu es as being l ess than C osts. A fter the su bsidy , the su ppl y cu rv e l ies bel ow the dem and cu rv e at
Q * . T his is refl ected in the Profit T abl e by show ing that R ev enu es are now g reater than the ( su bsidiz ed) C osts.
T he Profit T abl e thu s represents a resou rce transfer w hich l ow ers society ' s happiness. B efore the su bsidy , this
resou rce transfer w as u nprofitabl e, and thu s a profit-m ax im iz ing firm w ou l d nev er u ndertak e it. A fter the su bsidy ,
this resou rce transfer becom es profitabl e, so that the firm is " trick ed" into doing som ething w hich l ow ers society ' s
happiness. T his captu res the essence of the w el fare l oss associated w ith the su bsidy .
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Notes
1 We should note that the names Ima Hogg and Ura Hogg are not the product of our overactive
imaginations. Ima Hogg was the only daughter of James Stephen Hogg (1851-1906), a Texas politician
who served as governor of that state from 1891-1895. With respect to the names Ima Hogg and Ura
Hogg, the Texas historian Kenneth Hendrickson writes, "It has often been suggested that the Hoggs's
behavior in naming their only daughter Ima was peculiar; however, their intent was anything but
strange. The child was named after the heroine of a novel, The Fate of Marvin, written by Hogg's
beloved older brother Tom in 1873. Truly peculiar, even bizarre, is the myth that the Hoggs had a
second daughter whom they named Ura. Even though no such person ever existed, there are still many
people in Texas who insist that she did" (Hendrickson, The Chief Executives of Texas, College Station,
Texas: Texas A&M University Press, 1995, page 130).
CHAPTER 21
The Simple Framework for Analyzing Public Policies--Part III
Many states and localities derive a special source of financing from Hotel and Motel taxes.
These taxes are largely responsible for the shock most tourists experience at check out time.
"I thought you quoted me a price of $50 a night?" "That is correct, Madam." "But I only
stayed here two nights." "That is correct, Madam." "And your telling me that I owe you
$149?" "That is correct, Madam." "But that's outrageous!" "That is correct, Madam." We
know tourists are hurt by this tax, but remember...we care only about the big picture. We
care only about the tax's overall effect on society's happiness.
The first question we want to ask ourselves is what effect will Hotel and Motel taxes have
on the allocation of society's resources? Will more or less resources be devoted to the
provision of hotel and motel accommodations after the tax? It certainly seems reasonable
that these taxes will make tourists and other travelers less willing to stay in hotels and
motels. That means that there will be less demand for hotels and motels. And that means that
profit-maximizing firms will build fewer hotels and motels, or maybe they will build hotels
and motels with fewer rooms. The bottom line is that fewer resources will be transferred
from other activities to provide accommodations for travelers. The table below illustrates the
effect of this tax on a representative resource transfer affected by this tax policy.
Before Tax After Tax
REVENUES: $100 $100
COSTS: $75 $75 + $49 = $124
PROFITS: +$25 -$24
Before the adoption of the Hotel and Motel tax, a hotel would have found it profitable to
provide two nights' lodging to a traveler. At $50 a night, these resources would have
generated around $50 times 2, or $100 in social happiness. And that would have been great.
Because the hotel figured that it only cost $75 to provide a room for two nights to a guest.
Resources--say sheets, maid service, electricity, etc.--that could have generated $75 in
pleasure in doing something else are withdrawn from those activities and directed towards
the provision of hotel services. Here they generate $100 in happiness, resulting in a net gain
of $25. Since the profit-maximizing firm can make a buck at this activity, this resource
transfer goes through and society is made better off.
But look what happens after the tax. The hotel no longer finds this transaction profitable. As
a result, it either goes out of business or sells off some of its facilities. And that is a shame.
A resource transfer which would have increased social happiness by $25 now does not take
place. Resources are withdrawn from a higher valued activity (hotel lodging) to a lower
valued activity (who knows what). Again, from the perspective of social happiness, the only
two numbers that matter in the table are the Revenues and Costs that the hotel would have
experienced before the tax was imposed. These are the numbers that reveal the gains and
losses, respectively, of transferring additional resources to hotel guest services. In this case,
the economy has been "tricked" into not providing additional accommodations, even though
providing them would have made society better off.
The fact that taxes can make people worse off probably isn't a new insight for you. But
there's an additional reason to dislike taxes here that you might not have appreciated before
(just in case you needed one more reason). Suppose the government raises $10 million in tax
revenues from a variety of specific taxes on goods and services. What is the total cost to
taxpayers? Most people would say $10 million, the amount of the tax revenues. Since you
are smarter than the average reader, you know that this isn't the full story. On top of the
actual tax revenues taken away from taxpayers, there is the additional cost due to the lost
happiness from misallocated resources. Economists call this the WELFARE COST OF
TAXATION. It is the lost happiness that results when taxes take resources out of higher-
valued uses and divert them to lower-valued uses--just like in our hotel/motel example.1
Does this mean that all taxes are bad? A full answer would require us to compare the value
of government services society receives from its tax burden with the value of private
consumption given up through taxation. We will examine this topic in more detail when we
talk about government finances later in this book. For right now it's worth noting that if
society wants to raise a given amount of revenues for a particular purpose, taxes should be
set so that the disruption in the allocation of society's resources is minimized.
If a government decided to raise all of its revenues through a Hotel and Motel Tax, the size
of this tax would be huge, and there would be dramatic changes in the way society allocated
resources. (For example, most travelers would probably choose to pack a tent in their
suitcases or just stay home.) But if a government spread the tax burden across all of the
goods and services in the economy, there would be relatively little change in the way
resources are allocated. Think about it. If all prices only go up by a penny, consumers will
probably not alter their consumption patterns by much. This would minimize the likelihood
that taxes would distort the allocation of resources by "tricking" the economy to place
resources in lower-valued activities. This is why economists generally advise that taxes be
broad-based (like a sales or income tax), rather than narrowly focused on a few goods (like a
Hotel/Motel tax).
Now that we have developed the theory of the PROFIT TABLE to analyze government
subsidy and tax policies, the next step is to learn how to apply this framework to news
stories that are commonly encountered in the media. That is the goal of the next few
chapters.
OPTIONAL SECTION FOR ECONOMISTS: T h e g r a p h b e l o w i l l u s t r a t e s t h e w e l f a r e l o s s r e p r e s e n t e d i n
t h e P r o f it T a b le . T h e t a x in c r e a s e s t h e h o t e l c h a in 's m a r g in a l c o s t s , m a k in g s o m e o f its u n it s u n p ro f ita b le . A s a

r e s u lt , th e c h a in s e lls o ff s o m e o f its p r o p e r t ie s , r e d u c in g its n u m b e r o f r o o m s fr o m Q 0 t o Q 1. Q * i s a re p re s e n ta tiv e
r o o m w h ic h w o u ld h a v e b e e n p r o fit a b le f o r th e c h a in to le t b e fo r e t h e t a x . T h a t is , t h e a s s o c ia te d R e v e n u e s fro m
le t tin g th e r o o m a r e g r e a te r t h a n t h e C o s ts ( M R is g r e a te r th a n M C a t Q * ) . H o w e v e r, a fte r th e ta x , R e v e n u e s a re
le s s t h a n C o s ts ( M R is le s s th a n M C + t a x a t Q * ) . T h e d is t a n c e b e tw e e n t h e M R a n d M C c u rv e a t Q * re p re s e n ts th e
w e lfa r e lo s s c a u s e d b y Q * n o lo n g e r b e in g " p r o d u c e d " b y t h e h o t e l c h a in .
TABLE OF CONTENTS
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Notes
1
In our example, the firm bears all of the tax burden. However, the situation is not altered if the
consumer bears some or all of the tax burden. In this case, you would subtract the tax from the Revenues
column to represent that the marginal consumer now would consume more hotel accommodations only
if the price were lowered to $51 (i.e., willing to pay of $100 - $49 = $51).
CHAPTER 22
Can We Afford to Let the Maritime Industry Sink?
"HAULING DOWN OLD GLORY. The Clinton Administration's

decision last year to end maritime operating subsidies has forced
America's two largest commercial shipping companies, American
President Lines and Sea-Land, to consider going foreign-flag with
foreign crews. I believe that Clinton's policy represents a major
threat to the American laborer, our economy and the role of the
United States in an expanding global market."1
The American shipping industry is sinking. Fast. Hit hard by environmental mandates and
foreign competition, the industry has shrunk rapidly in recent years as older ships have been
retired. American shipping firms have chosen not to build replacements for their aging
fleets. Instead, they are choosing to run their business on foreign ships, run by foreign crews.
The bottom line is not only the loss of one of the country's most important industries, but the
loss of American jobs. Can we really afford to stand by and watch this economic disaster
and do nothing? Subsidizing the maritime industry is an investment in the U.S. economy
that will pay off in more jobs, higher wages, and an economical way for American business
to ship its goods. To not financially support this industry would be a short-sighted, penny-
wise/pound-foolish policy. We can't afford not to help the maritime industry!
What do you think? (We have to confess that we become suspicious the moment someone
tells us that we can't afford not to spend money!) Hopefully you should be able to see past
most of the candy-coated fallacies in the previous paragraph. Our task in this chapter,
however, is to translate this news story into the framework of our Profit Table. This is an
exercise which we will repeat throughout this book.
To do this, we need to know how subsidies to the maritime industry would work. Since we
don't know anything more about this issue than what we have read in the excerpt above, we
will have to use our imagination. One way the government could choose to help the
maritime industry would be to subsidize the cost of new shipbuilding. While the editorial
writer did not suggest a specific policy, we note that a subsidy for new shipbuilding is
consistent with his concern that the size of the American fleet is shrinking. Let's consider a
hypothetical decision by one of the shipping companies--say, American President Lines
(APL)--to build another ship, before and after the government subsidy for new shipbuilding.
Remember, we want to construct a scenario that will focus our attention on how this subsidy
would alter the allocation of resources in the society.
Recalling our three-step procedure for evaluating this policy, we first ask whether this
subsidy will cause more or fewer ships to be built. Having determined that the subsidy will
cause more ships to be built, the second step consists of concentrating our attention on a
"representative ship." Not just any ship. Rather, a ship that wouldn't have been built before
the subsidy, but gets built after the subsidy. In terms of our Profit Table, this means that the
"representative ship" should show a negative profit in "Before Subsidy" column, and a
positive profit in the "After Subsidy" column. The third step consists of entering numbers
for Revenue, Cost, and the subsidy that are consistent with these outcomes. One possible
Profit Table is given below.
Before Tax After Tax
REVENUES: $17M $17M
COSTS: $25M $25M - $10M = $15M
PROFITS: -$8M +$2M
The numbers in the table show that APL would never choose to build a new ship without a
subsidy from the government. APL predicts that an additional cargo ship would increase
revenues by $17 million. However, the costs of building such a vessel would be $25 million.
Thus, the profit-seekers at APL--without a thought to the well-being of American women
and children, particularly children--just say no to another ship.
Look how different this proposal appears after the government decides to come to the
rescue. If the government targets $10 million to APL to help pay for the new ship--either
through a direct subsidy or a special tax exemption, which is essentially the same thing--this
ship now becomes profitable. Rather than losing $8 million, APL finds that it can make $2
million. So APL goes ahead and builds the ship. Let's call it the U.S.S. Subsidy. Men and
women have been put to work. Profits have been made. Shareholders have been enriched.
All because a spanking new ship now sails the oceans blue, a testimony to the far-sighted
partnership of government and industry. (All this is starting to make us sea-sick!)
Of course, we're only looking at half of the story here. This ship didn't come out of nowhere.
It was built by the employment of resources that had alternative uses. From the perspective
of society's happiness, there are only two numbers in the table that matter--$17 million and
$25 million. There is no denying that the additional cargo ship made society better off by
$17 million. But society lost something when the resources to make that ship--the laborers,
the steel, the land on which the ship was built--were taken away from other activities.
Society lost $25 million in happiness. Thus, the profit-seekers at APL--without a thought to
the well-being of American women and children, particularly children--did precisely the
right thing for society's happiness when they first chose not to build a new ship. Society
would have preferred the alternative uses of those resources. The subsidy, however,
provided an incentive for APL to misallocate these resources to ship building, and society's
happiness decreased.
Now let's consider some objections to this analysis. How about the objection that this is too
simplistic. All these numbers are made up! We confess--this is true. We haven't done any
research on this issue. We have no idea how much a new ship would actually cost. We have
no idea how much revenues a new ship might actually generate. In fact, just so there's no
doubt about this--we'll just come right out and say that we are completely ignorant about the
shipping industry. Before we read this editorial, we thought the Merchant Marines were a
new service of the armed forces established to provide crowd control for storeowners during
end-of-the-year closeout sales. How embarrassing!
However, the beauty of our simple framework is that we don't have to know anything about
the maritime industry. All we have to know is that the subsidy is going to cause more ships
to be built. Who can deny this? Increasing production is the whole point of a subsidy.
Furthermore, we know that these ships were not profitable without the subsidy, or they
would have been built. The particular numbers that we choose aren't important. After all,
we're not saying that the subsidy will cause a social loss of exactly $8 million. To be honest,
we don't know how much of a social loss will actually result. Our made-up numbers merely
illustrate that (i) a ship will be built after the subsidy that wouldn't have been built before
(that is, the subsidy will cause a different allocation of resources), and (ii) the transfer of
resources represented by the building of this ship will take resources from higher valued
uses and direct to them to a lower valued use. That is, the hypothetical numbers in our table
illustrate the essence of the problem--subsidies to the maritime industry will decrease
society's happiness.
Low revenues signal that there is only a small social benefit from additional shipping
services. Note that it really doesn't make a difference why the social benefit of extra
shipping services is small. In this particular instance, the reason society is not made much
happier from additional shipping services is because foreign firms are already providing a
lot of those shipping services for American consumers. As a result, the extra benefit from
extra shipping services is small. But, again, we don't have to know. All we have to know is
that society will receive relatively little benefit from having additional resources transferred
to the shipping industry.
OPTIONAL SECTION FOR ECONOMISTS: T h e g r a p h b e l o w i l l u s t r a t e s t h e w e l f a r e l o s s c a u s e d b y t h e

s u b s id y . T h e s u b s id y lo w e r s th e m a r g in a l c o s t s o f b u ild in g n e w s h ip s f o r A P L . A s a r e s u lt , A P L e m p lo y s m o r e o f
s o c i e t y ' s r e s o u r c e s i n s h i p b u i l d i n g , a n d t h e i r p r o d u c t i o n o f n e w s h i p s i n c r e a s e s f r o m Q 0 t o Q 1. Q * i s a
r e p r e s e n t a t iv e s h ip t h a t w o u ld n o t h a v e b e e n b u ilt b e fo r e th e s u b s id y , b u t w h ic h A P L d e c id e s t o b u ild a ft e r t h e
s u b s id y . T h a t is , p r io r to t h e s u b s id y , th e R e v e n u e s fr o m b u ild in g a s h ip w e r e le s s th a n th e C o s t s ( M R is le s s th a n
M C a t Q * ) . H o w e v e r , a f t e r t h e t a x , R e v e n u e s a r e g r e a t e r t h a n C o s t s ( M R i s g r e a t e r t h a n M C -s u b s i d y a t Q * ) . T h e
d is ta n c e b e t w e e n th e M R a n d M C c u r v e a t Q * r e p r e s e n ts t h e w e lfa r e lo s s c a u s e d b y A P L b u ild in g t h e s h ip Q * .
N O T E : T h e r e a d e r m ig h t b e c o n fu s e d b
y th e d iff e r e n c e b e t w e e n th is fig u r e a n d th e o n e u s e d to re p re s e n t th e
w e lfa r e lo s s e s c a u s e d b y s u b s id iz in g Im a H o g g , th e w a te rm e lo n fa r m e r . In Im a H o g g 's c a s e , th e P r o f it T a b le
r e p r e s e n t e d th e p r o d u c t io n o f 1 0 0 0 w a te r m e lo n s . S o th e w e lf a r e lo s s r e p r e s e n te d th e s u m o f th e d iffe r e n c e
b e tw e e n M R a n d M C fo r e a c h o f th e 1
0 0 0 u n its , r e s u lt in g in th e in d ic a te d a r e a . H o w e v e r , in th is s h ip b u ild in g
e x a m p le , th e P r o fit T a b le r e p r e s e n ts th e p ro d u c tio n o f o n ly o n e u n it, Q * . T h u s th e w e lf a r e lo s s in th is c a s e is t h e
d if fe r e n c e b e tw e e n M R a n d M C o n ly a t Q *.
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Notes
1
Newsweek, August 29, 1994.
CHAPTER 23
Job Training: Ticket to Prosperity?
"DISPLACED WORKERS GET AID. Huntington, W. Va. (AP)--

The U.S. Labor Department has approved $6 million in grants to
help retrain 1,300 workers in four states who have lost their jobs to
foreign competition, government action, or technological change...
[Labor Secretary Robert Reich said,] 'With the continuing changes
taking place in our economy, we must be sure affected workers have
the opportunities they need to remain productive. That means
necessary training, retraining, and support services.'"1
To listen to most politicians, job training is a win-win proposition. We take workers who
have lost their jobs. We give them new skills and productive training. With the extra training
they receive, not only do they produce more goods and services for society, but they also
earn higher wages. Higher wages means more tax revenues, and with the stream of increased
tax revenues, society gets a return on its original investment that pays off for many years to
come. "We can't afford not to help workers invest in job training." (Sound familiar?)
Let's take this case one step at a time. First, we analyze the worker's decision to invest in job
training before and after the government makes available job training grants. Once again, we
have to use our imaginations to represent the effects of this program. How exactly might this
program work? To keep it simple, let's assume the government gives each worker a job
training voucher. This voucher is essentially a check, written by the government, that can
only be used for purchasing work-oriented education. In this simple example, the worker is
free to choose the kind of education he or she wishes. The only effect of the government
grant is that it helps to pay for whatever training workers believe would best help them.
Job training grants will surely cause more workers to choose to get trained. That is, there
will be workers who would not have chosen job training before the government announced
this program, but who now will choose to get trained with the help of the government grant.
We want to choose numbers for our table that represent this scenario. For our representative
case, let's consider the situation of Rosie Riveter, who loses her job in a small, West
Virginia manufacturing plant that closed down due to technological change. We explain the
situation in terms of her personal profit table.
ROSIE'S PERSONAL PROFIT TABLE FOR JOB TRAINING
Before Training Grant After Training Grant
REVENUES: $10,000 $10,000
COSTS: $14,000 $14,000 - $5,000 = $9,000
PROFITS: -$4,000 +$1,000
We can think of Rosie as a firm. In fact, Rosie is a resource owner. She is CEO, Chairman
of the Board, and sole stockholder of "Rosie's Labor Services." Now that Rosie has been
displaced (released) from her old job, she has a hard decision to make. She could take her
current skills, somewhat antiquated though they are, and take a job that pays $5 an hour. Or
she could get some training that would allow her to upgrade her job skills. This would
enable her to have a job that paid $6 per hour. Rosie calculates that earning a $1 an hour
more would allow her to make about $10,000 more over the course of her expected working
life. This increase in her earning power is represented by "Revenues-Before" in the table
above.
Before continuing, let's reflect on the information contained in this increase in Rosie's
wages. In particular, can you explain how this job training will produce additional happiness
for society? Why should consumers care that Rosie has better training? They care because
Rosie's better training will allow her to produce more goods and services that consumers
want. The higher wages she receives is a reflection of the happiness consumers get from
those additional goods and services. This follows directly from the fact that the price of
labor, like the price of any input, tells us the additional happiness society gets from one
more unit of that input. If job training causes Rosie's market wage to increase by $10,000,
the additional goods and services which she produces generate approximately $10,000 more
in happiness than she could have produced without that job training.
Now let's turn to the "Costs" side of the ledger. To get her job training, Rosie would have to
enroll in classes offered by a local vocational-technical school. This school employs a
number of resources in order to make job training classes available to students. For example,
it occupies some old storefront property in a low-rent mall in which to hold classes. It
employs a staff of instructors to teach the job training classes. And there are books, audio-
visual supplies, secretaries, photocopiers, and other resources that this school has brought
together in order to provide job training classes. In order to pay for all these resources, the
vocational-technical school charges a tuition of $6,000. Further, there is another set of costs
that need to be included. Rosie will have to go to school for two years during weekday
evenings in order to attend classes. She will also need time on weekends to study for her
classes. She calculates that the costs to her giving up this time is about $8,000. Thus, the
total costs of obtaining job training for Rosie is $14,000.
Before the government grant, Rosie decides that the training is just not worth it. But after the
government institutes the grant program, Rosie finds it pays for her to be retrained. Using
the same analysis as before, we find that the job training program has lowered society's
happiness. It has directed resources (Rosie's time, the job trainer, classroom space) that
would have produced $14,000 of pleasure doing something else, to an activity (job training)
that only produces $10,000 of pleasure for society. Society's happiness is decreased by
$4,000.2
This is true despite the fact that everybody directly involved in the job training activity is
delighted with the government grant program. Rosie is delighted because she is made better
off by the program. The vocational-technical school is pleased because the program makes it
possible for its students to take classes. The job training instructor is satisfied because the
school now has money to pay him to teach classes. And the government program
administrator is elated because workers are getting trained and earning higher wages after
they leave school (Newspaper headline: "LABOR SECRETARY DECLARES PROGRAM
A SUCCESS. 'IT WORKS,' HE SAYS."). What these participants are not considering in
their praise of the program is the happiness that consumers are missing because resources
were taken away from higher valued uses.
Now let's consider some objections to this analysis. Are we saying that job training is bad?
Of course not. Job training can be great. It makes workers more productive. With greater
productivity, workers can produce more--and better--goods and services that consumers
want. The problem is that job training is no different from any other resource transfer. You
want the economy to produce more job training? Then resources must be transferred away
from something else. The corollary to the famous statement that there is no such thing as a
free lunch, is that there is no such thing as free job training (or free anything else for that
matter).
Suppose we had a government program to train everybody to earn their doctorate degree.
Would that be a desirable policy? Some Ph.D.'s are clearly good for the economy. But
everybody having a Ph.D.? ("Hey, Honey, I'm going to the doctor's." "Don't be smart with
me, Frank. Are you going to the doctor who pumps gas down at the corner service station or
are you going next door to see that cute little, redheaded Ph.D. again?") Having everybody
earn their doctorate would be an incredible waste of society's resources. But then, how many
Ph.D.'s is the right amount? Now that's a tough question. It requires a lot of information
about the value of that education and the value of the resources needed to educate those
workers. That is precisely the kind of information that markets produce. Self-interested
individuals will make the right choices for society so long as the information contained in
their personal profit tables isn't distorted by excessive subsidies and taxes.
How about the objection that job training is an investment for society, since higher wages
mean more tax revenues later on? DANGER...DANGER...ECONOMIC FALLACY IN
THE MAKING. Can you catch it? The economic fallacy once again arises because we've
taken our eyes off the ball. The purpose of the economy is not to maximize the amount of
tax revenues we can collect from consumers (we just wish someone would tell our
politicians that!). Income taxes represent WEALTH TRANSFERS from taxpayers to the
recipients of government-supplied goods and services. Every dollar transferred from Rosie's
future paycheck is one dollar more of goods and services for someone else, and one dollar
less for her. From the perspective of society's happiness, they cancel out.3 Thus, taxes
certainly shouldn't be counted as a source of social gain, and a justification for job training.4
Alright already. Maybe the reason we want to give Rosie a job training grant is because we
feel sorry for her. She's poor, doesn't have much training, and we would like her to be better
off. No problem. We've got a solution for that. Give her money. Just don't require her to
spend it on something that will lower society's happiness.
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Notes
1
Daily Oklahoman, March 14, 1995.
2
Notice that we optimistically assume that the government training program actually works. If the
government program fails to provide Rosie with better skills, then society would lose the entire $14,000
training fee, with no return on its investment.
3
We emphasize that our simple analysis assumes that (i) no resources are taken away from other uses
in order to collect and distribute government tax revenues, and (ii) that there are no distortions in the
allocation of society's resources other than the increase in resources directed to job training. Of course, if
either of these assumptions is invalid, the case against government subsidies for job training is even
stronger.
4
How about the argument that Rosie does find the job training profitable, but she doesn't have the
money to pay for it? The correct response here is to note that Rosie could always borrow the money.
However, the costs of borrowing (i.e, interest) must also be included on the Cost line of the Profit Table.
As we shall see later on in the book, the interest on borrowed funds represents the lost happiness of
borrowers who have agreed to forgo current consumption. As such, it represents a cost to society as real
as the lost happiness from diverting any other resource away from alternative activities. If Rosie finds
that job training is unprofitable once she takes into account borrowing costs, then society's happiness
would be lowered if she proceeded to upgrade her job skills.
CHAPTER 24
Minimum Wages and Unions: Making Ourselves Poorer by
Trying to Make Ourselves Richer
"WAGE HIKE WOULD MEAN $18 WEEKLY. New York (AP)--

Raising the minimum wage by 90 cents an hour would buy an extra
bag of groceries or two tickets to the movies for the estimated 4.2
million Americans who toil for the lowest allowable hourly
pay...Unions say raising the minimum wage would benefit even those
who make more because it raises the floor on wages. 'Everyone
benefits from it,' said Lenore Miller, president of the Hotel
Employees and Restaurant Employees International Union."1
A major function of unions, perhaps the major function of unions, is to see that a given firm
pays its employees more than their market wage. Governments perform the same role when
they impose minimum wages. In this chapter we demonstrate how our Profit Table can be
used to evaluate union and government efforts to coerce firms to pay higher wages.
Many people who earn the minimum wage work in the fast food business. Accordingly, let's
consider the case of a fast food restaurant trying to decide whether to employ a machine or a
person for a particular job task. To avoid any legal problems, let's call our imaginary firm
McBurger King. McBurger King is thinking of expanding its business by staying open later.
One consequence of being open later is that there will be more trays to wash. McBurger
King could hire a local teenager to wash those trays. Or it could employ a mechanical
dishwasher. The human dishwasher has a market wage of $9,000 a year, while the
mechanical dishwasher rents for $10,000 a year. The fast food restaurant expects to generate
about $12,000 in Revenue by staying open later. (To simplify our analysis, we assume that
the services of either a human or mechanical dishwasher are identical, and that this is the
only extra cost of staying open later.) We can represent McBurger King's choice between a
human dishwasher and a mechanical dishwasher in the Profit Tables below.
Table for Employing a Teenager 5 Table for Employing a

Machine
REVENUE: $12,000 5 REVENUE: $12,000
COST: $9,000 COST: $10,000
PROFITS: $3,000 PROFITS: $2,000
Clearly, McBurger King will hire a person to wash dishes rather than rent a machine. And
this is exactly what we want. If the restaurant employs the human dishwasher, that is one
less person on the job market, one person who will not be producing $9,000 of happiness in
an alternative use. If the restaurant employs a mechanical dishwasher, then there is one less
machine available to generate $10,000 of happiness in its alternative use.
Now say the government decides to impose a minimum wage, raising the worker's wages to
$10,400. The firm's profit tables now look like this:
Table for Employing a Teenager 5 Table for Employing a

Machine
REVENUE: $12,000 5 REVENUE: $12,000
COST: $10,400 COST: $10,000
PROFITS: $1,600 PROFITS: $2,000
After the minimum wage, McBurger King still decides to expand its hours, but now it
employs a machine to wash trays instead of a human. And that is a shame. Why? Because
the higher price of the machine tells us that the machine would produce more happiness
elsewhere in the economy than the teenager. It is the more valuable input. As a result,
society would prefer that McBurger King leave that resource alone, and instead employ the
less valuable input. Hiring the machine to wash trays instead of the teenager is like hiring a
Ph.D. in electrical engineering to sweep floors rather a high school dropout (remember that
one?).
Not only will the artificially high wages caused by unions or minimum wages induce firms
to hire the wrong inputs, it will also affect the quantity of goods available for consumption.
For example, by changing a few numbers in the table (try changing Revenue to $9,500), you
can see that the minimum wage may actually stop McBurger King from staying open later
and offering more of its product to the public. And that is (another) shame. The fact that
transferring resources to later hours was profitable before the minimum wage tells us that
society wanted the restaurant to stay open later.
Lastly, on top of all these other problems, note that we are left with some unemployed
workers. If the best use of a worker can only produce $9,000 of Revenue per year, while his
mandated wage is $10,400 per year, you can probably guess that this worker will find
himself unemployed for quite some time. And that is a (third) shame.
Aren't there any winners from minimum wages? Yes there are. While some workers will
lose their jobs, others will be able to keep their jobs at the higher (minimum) wage. The
workers who keep their jobs are clearly better off. In fact, the benefits from union wage
raising or government minimum wages are clearly evident to those who benefit. It's not hard
for them to see that the efforts of their union officials or elected politicians have directly
helped them. As a result they can be expected to support those leaders who advocate raising
wages artificially.
On the other hand, the workers who lose their jobs, or who find it difficult to get employed,
may not see that their misfortune is due to distortionary wage policies. They are more likely
to blame the greediness of insensitive, self-seeking employers. They are not likely to see the
irony that the efforts of the very people who are trying to "help" them are precisely what is
keeping them from finding a job. Accordingly, union officials and elected politicians may
find relatively little political resistance to plans for artificially raising workers' wages.
The bottom line is that artificially setting wages above their market level is going to cause
distortions in the allocation of resources in society. By affecting the way that firms employ
inputs and produce outputs, artificially high wages result in lower overall happiness for
society. Still unconvinced? Alright, then, we give up. Let's raise the minimum wage. But
let's not be cheap about it. If raising the wage from $4.25 per hour to $5.00 an hour is a good
idea, then raising it to $5.50 or $6.00 an hour is even a better idea. Even at $6.00 an hour, a
worker who puts in a 40 hour work week and works 50 weeks a year will earn only $12,000.
Hardly enough money to raise a family. So let's make the minimum wage $10 an hour. No,
$50 an hour...$100 an hour!
Why doesn't anybody advocate a minimum wage of $100 an hour? Because everyone knows
that the end result would be an economy with a couple of $100-an-hour workers, surrounded
by a great ocean of unemployed. But if raising the minimum wage from $4.25 to $100 an
hour is a bad idea, why then is it a good idea when it only gets raised to $5.00 an hour? As
always, the secret in economics is to keep one's eye on the ball. As a nation, we make
ourselves wealthy by allocating resources to their highest valued use. This is the only real
way to raise our "national wage."
In a free market/capitalistic economy, the individual efforts of society's members to make

themselves richer serves to enrich all of society. This is the essence of Adam Smith's
"invisible hand" insight. But there is a public sector analog to the "invisible hand." We like
to call it the "invisible foot." By attempting to use laws or coercion to artificially make
ourselves richer, the individual efforts of society's members can backfire, producing
precisely the opposite effect from that which was intended. That is, the very efforts intended
to provide prosperity can cause the economy to stumble, to trip up, just as if it was being
impeded by a great "invisible foot:" making ourselves poorer by trying to make ourselves
richer.
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Notes
1
Daily Oklahoman, February 4, 1995.
CHAPTER 25
These Quotas Don't Amount to Peanuts
"PEANUT GROWERS QUICK TO DEFEND QUOTA SYSTEM.

Caddo County [Oklahoma] has the nation's largest quota allotment
for a single county, according to the Agricultural Stabilization and
Conservation Service, which administers the program. Caddo
County's peanut allotment this year was 80.14 million pounds. But
the efficiency of the quota system is questioned by [a]
study...commissioned by the...Western Peanut Growers Association
and Panhandle Peanut Growers Association. [Jack] Coppedge
[president of the Oklahoma Peanut Growers Association] said the
two peanut grower groups involved in the study are composed mainly
of farmers outside the quota system. 'They've got some quota...They
want a lot more. They want to disrupt the program so they can get
some (quota).'"1
Up to this point in our analysis, we have examined the impact of price ceilings, subsidies,
and taxes on society's happiness. But a lot of government interventions belong to two
additional categories: QUOTAS and MANDATES. Quotas are government-imposed
restrictions on the amount of output a firm can produce. Mandates are government rules
which require firms to produce more of something--like workplace safety. Quotas and
mandates are easily incorporated into our Profit Table once we see their connection to taxes
and subsidies respectively.
Consider peanut quotas. What is the primary impact of peanut quotas on the allocation of
society's resources? You don't have to be a rocket scientist (or peanut farmer, for that matter)
to realize that the primary impact of a peanut quota is to divert resources out of the peanut
industry into other activities. There will be fewer peanuts grown under a quota system.
Fewer peanuts means fewer peanut farmers, less farmland, fewer automated peanut-picking
machines, etc., that will be directed to the peanut industry. We want to use our Profit Table
to illustrate how a resource transfer that would have been profitable before the peanut quota
now becomes unprofitable.
Why is it now unprofitable to harvest peanuts beyond the quota? What happens to the peanut
farmer if he goes beyond his quota? Actually, we have no idea. We confess that we are
woefully ignorant of the peanut industry, just as we were woefully ignorant of the shipping
industry. On the other hand, reason suggests that there are only a few possibilities. The most
obvious possibility is that the peanut farmer would have to pay a hefty fine if caught.
Alternatively, he could lose his quota allotment entirely and have to find alternative
employment. (Maybe he could join the merchant marines.) Another possibility is that he is
thrown in jail. (If he tries to escape, he could be shot. Headline news story: "QUOTAS
RESULT IN DEATH OF GOOBER FARMER.")
For our purposes, it really doesn't matter which of these possibilities is the right one. The
main point is that there is a PENALTY for exceeding the quota, and that this penalty is large
enough to discourage some farmers from growing additional peanuts. Consider the
following representation of the farmer's decision to grow another 1000 pounds of peanuts.
Before Penalty After Penalty
REVENUES: $700 $700
COSTS: $450 $450 + $5000 = $5450
PROFITS: +$250 -$4750
At 70 cents a pound, this farmer calculates that he could earn $700 in revenues by growing
1000 more pounds of peanuts. The costs to growing these additional peanuts are $450 (in
extra land, labor, fertilizer, etc.), so the farmer decides to grow the peanuts.
Enter the Department of Agriculture. Since these peanuts would put the farmer over his
peanut quota, he now needs to consider the full economic transaction. While he'll make $250
in profit, he will also incur a $5000 penalty for violating the United States' government
policy on peanut production. Note that this penalty enters our Profit Table in precisely the
same way as a tax. It represents the monetary value of the hurt that the farmer will
experience once the feds catch him.
Once the farmer considers this penalty, those extra peanuts lose their luster. The farmer
chooses not to grow additional peanuts. An economic transaction that would have increased
society's happiness by $250 has been discouraged. Resources are transferred to lesser valued
activities instead of the higher valued use of peanut production. Society is made a little
poorer. And that is a shame.2
Of course, this numerical example illustrates the loss associated with not producing an
additional thousand pounds of peanuts. How large is the total loss associated with the quota?
It is close to impossible to be able to answer this question. Among other things, one would
have to know how many peanuts would have been grown in the absence of the quota. That
is, one would have to look into their crystal ball and see a world that doesn't exist--a world
without peanut quotas. Even though we can't be certain how large the total loss will be, we
can be certain of one thing. Production restrictions--quotas--reduce society's happiness by
causing too few resources to flow to an industry where the government has intervened. Our
next task is to examine the impact of government mandates that cause too many resources to
be devoted to a particular good.
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Notes
1
The Daily Oklahoman, November 30, 1994.
2
Quotas seem like an especially nonsensical policy, so you might be wondering why government
would implement a quota policy. If government can get farmers to decrease their supply of peanuts, the
price of peanuts will rise. At higher prices, farmers can earn greater income--at least those farmers lucky
enough to have quota allotments. So a quota allows government to increase the incomes of one favored
group (peanut farmers with quota allotments) at the expense of consumers and other farmers.
CHAPTER 26
Who Will Protect Workers and Consumers?
"UNITY DECLARATION OF UAW, IAM, & USWA. Left solely to

their own devices, profit-driven multi-national corporations...can
neither be trusted nor expected to look out for the well-being of their
workers or the welfare of the societies in which they operate.
Without the countervailing power that only organized workers can
achieve, the economic freedom...that we have come to enjoy [is] in
serious peril."1
Thank goodness for unions! If it weren't for unions, work would be a living heck for most
workers. Why if the unions hadn't fought for a shorter work week, surely workers today
would all be forced to work 50, 60, or more hours a week. If unions hadn't fought for safer
working conditions, surely industrial accidents would be a leading cause of death for
working age men and women. And if unions hadn't been willing to go toe-to-toe with greedy
employers, firms would never have been willing to offer shorter work weeks, pension plans,
health insurance, and other fringe benefits. And while we're at it, let's give a hearty round of
applause to the U.S. government which each year mandates thousands of laws on everything
from job hazards to family leave. Surely, without all these diligent efforts by unions and
government to protect workers and consumers from the avaricious clutches of businessmen,
life would be, in the words of Thomas Hobbes, "nasty, brutish, and short." Surely?!
As you have probably guessed, we beg to differ! But just how do markets take care of the
interests of workers and consumers? As anyone knows who has ever approached their boss
about a raise, it's not as though employers always seem driven by a desire to protect, nurture,
and otherwise cherish their employees. "Sorry to see you go, and don't let the door hit you
on the way out" was the printable portion of the response that one of the author's bosses
gave him when he once asked for a raise. Remarkably, the simple framework that we
developed in the previous chapters can be applied to the issue of worker and consumer
protection.
Likely, you feel a little hesitant about discussing an issue such as worker and consumer
protection in economic terms. After all, when we discuss protection issues, especially safety,
we are discussing human life, and how can we ever put a price on something like that? Well,
we aren't really putting a price on a particular human life, but rather on risk to human life in
general. Almost every action involves some sort of risk. One could be smacked by a
rollerblader while walking in the park, one could die in an airplane crash, and one could slip
and fall in the bathtub. But walks in the park, airplane rides, and bathing are good things.
People get pleasure from them, yet they all involve a risk. That risk can be reduced, but it
can never be eliminated. Thus, the question we are concerned with is: how much risk to life
and limb is the right amount?
If you are still uncomfortable with discussing risk in economic terms, ask yourself this
question: would you ever stand for a speed limit of 25 miles per hour on the interstate?
Almost everyone would find such a slow speed intolerable. Yet when you say the limit
should be raised to between 55 and 75 miles per hour (which is where most people want it),
you are implicitly saying that for the sake of convenience and speed, you are willing to
increase the risk of an accident--to actually let more people die. While speed limits are quite
different from government mandates about worker or consumer safety, they still involve an
acceptance of increased risk to human life and limb--and solely for the sake of a fast and
convenient system of transportation! So could it be that a particular government mandate
could make us worse off, even though it makes us safer?
Let's begin with an illustration. Suppose a government study determined that a certain
stamping machine, used in the steel industry, was unacceptably dangerous. Accordingly, the
Occupational Safety and Health Administration (OSHA) issues an administrative decree
requiring all firms who utilize this machine to switch to a more expensive, albeit safer,
machine. Would this increase society's happiness? On the one hand, there would be fewer
workplace injuries and fatalities. These are clear benefits that even hard-hearted,
uncompassionate economists would be forced to acknowledge. On the other hand, the
resources needed to satisfy this law would have to pulled away from other activities. Would
the benefits be worth it? Suppose the OSHA-approved equipment cost the firm $1 billion
dollars a year. Do you think it would be a good idea? How about if it cost $100 million? $1
million?
These are tough questions. Answering them requires balancing out the lost happiness that
society suffers when it takes the resources used in supplying safer machines from other
activities, against the gain in happiness that society will receive from having fewer injuries
and fatalities. Who is in a position to balance out these gains and losses? From out of
nowhere comes the most improbable hero of all--that money-grubbing, self-seeking,
uncaring, capitalistic institution: the profit-maximizing firm.
The costs of supplying safer machines represent the dollar value of the happiness society
would have received had the resources used to produce the machine been put to other uses.
But what is the dollar gain of the benefits? If the firm supplies a safer workplace, that might
make workers better off, but how does it help the firm? (Remember, we are assuming that
firms don't care one whit about the well-being of their workers.) When it comes to output
goods, the benefits of supplying additional goods and services are represented by their
respective prices--which in turn reflects how much individuals are willing to pay for
additional units of those goods and services. Could there be a similar process at work when
it comes to workplace safety? Indeed, there is.
While workers don't pay for workplace safety directly, they can pay for it indirectly in their
willingness to trade off wages and other financial benefits for nonwage benefits like safety.
Let's suppose that each of 5 workers who have to use this stamping machine would get $40
of happiness per week from the additional safety (given 52 weeks a year, that amounts to
$2,080 a year per worker, or $10,400 a year for the five workers). As a result, they would be
willing to accept a dollar less per hour in wages if somehow they could convince the owner
to substitute the new, safer machine for the old, dangerous one. Thus, a firm that employed
the safer machine could save $10,400 a year in wages. As long as that greedy, profit-
maximizing firm could purchase that new machine for less than $10,400 a year, it would do
so.
But suppose the cost of the new machine was more than $10,400 a year. Then the firm
wouldn't find it profitable to replace the old, dangerous machine; and workers would suffer a
higher rate of injury. Exactly. That is precisely the outcome we want. If workers don't value
the resources employed in the new machine at more than its costs, then we are really saying
that workers wouldn't get as much happiness from these resources as other consumers would
receive from them. In that case, the happiness-maximizing strategy for society should be to
allocate these resources to their higher-valued alternatives.
Now we suspect that deep in your heart, you--dear reader--are harboring a number of
reservations about our conclusions that firms can be trusted to do what's best for their
workers. Let's see if we can anticipate what some of them might be. Let's begin with the
argument, "This is crazy, you never see workers taking wage cuts to have safer working
conditions." Response Number One: Why not?
If workers really did value safer working conditions, then why wouldn't they be willing to
take a pay cut in order to have a reduced probability of sustaining an injury on the job?
Would you accept a dollar an hour pay cut to reduce the probability of being killed next year
from 100% to 50%? From 50% to 10%? If you are like most people, the answer to these
questions would be, "Of course I'll take a wage cut!" Fifty percent and 10% are upsettingly
high probabilities when one is discussing death.
But how about this: would you be willing to take a dollar an hour pay cut to reduce your
probability of sustaining a life-threatening accident from 0.01% to 0.001% (that is, to reduce
your chance of having a fatal accident from 1 in 10,000 to 1 in 100,000)? To put this in
perspective, a 1 in 10,000 chance means that the average worker could expect to work
10,000 years before having a fatal accident. A 1 in 100,000 chance lengthens this period of
time to 100,000 years. Now we ask the question again, would you be willing to take a dollar
an hour pay cut to reduce your probability of sustaining a life-threatening accident from
0.01% to 0.001%?
If you are like most people, you probably would answer no to this last question. Those
probabilities are so small that most of us would be willing to risk the higher 1 in 10,000
chance of having a serious accident and keep the dollar per hour in higher wages. In fact,
given current, workplace fatality rates for the U.S. economy, most safety improvements fit
into this last category.2 Therefore, we suggest that one doesn't see many workers giving up
wages to have greater job safety because most improvements make the workplace only
negligibly safer. Most workers are not willing to make substantial sacrifices in wages in
order to obtain marginal improvements in safety.
Response Number Two: If this story isn't true, why do we see firms characterized by
dangerous working conditions paying higher wages? Consider work on oil derricks, which is
notoriously dangerous. Injuries, both minor and serious, are common occurrences. Yet,
workers are willing to work those dangerous jobs because firms pay a premium for that kind
of work. Why do firms pay a premium for dangerous work? Because if workers had to
choose between safe jobs and dangerous jobs, and both jobs paid the same wage, the choice
would be what economists call a NO BRAINER. Without higher wages, workers would not
be willing to do dangerous work. Even with higher wages, many workers choose not to take
dangerous jobs. They would rather have safer jobs with lower pay. Said differently, these
workers are willing to give up wages in order to get safer working conditions. But that's
what we said all along!
The trump argument is always, "Oh yeah! Well that might be fine in theory, but that's not
how it works in the real world." Response Number Three: Let's take a look at the real world.
The figure below shows death rates for workers on the job during the period 1930 to 1990.
Just how important has OSHA and workplace regulation been in reducing the number of
employment fatalities?
Source: W. K. Viscusi, J. Vernon, and J. Harrington, Jr., E conom ics of R egul ation and A ntitrust, L ex ington, M A :
D .C . Heath and C om p any , 1 9 9 2 , p age 7 1 4 .
One doesn't need to have a Ph.D. in statistics to figure out that OSHA has had no observable
impact in reducing deaths on the job. Amazingly, this figure shows that workplace deaths
have been steadily decreasing since 1930. Why? By now you've probably figured out our
explanation for this phenomenon. Profit-maximizing firms found they could increase their
profits by providing safer workplaces for their employees.
But..But..maybe it was the unions after all. They were around in the 1930's. Maybe
workplace fatalities have decreased since then because unions were fighting for workers'
rights. We can't dismiss this possibility. But here's the amazing thing. It isn't just that
workplaces are safer now then they used to be. Everything is safer. Cars are safer.
Appliances are safer. Homes are safer. Look at the figure below.
Source: W. K. Viscusi, J. Vernon, and J. Harrington, Jr., E conom ics of R egul ation and A ntitrust, L ex ington, M A :
D .C . Heath and C om p any , 1 9 9 2 , p age 6 0 6 .
Now what could possibly account for the trend in decreased fatalities associated with homes
and motor vehicles? Clearly unions had nothing to do with this. In contrast, we can tell
exactly the same, profit-maximizing story about why firms would want to provide safer
consumer products. If consumers value safety, they will pay more for safer products
(anybody ever hear of Volvo automobiles?). If firms find that the greater revenues from
safer products are more than the costs of producing the increased safety, they will take the
initiative to produce those goods.
Safer consumer products. Safer workplaces. It's the same story. When the gain in happiness
that society receives from increased safety is greater than the loss in happiness that comes
from diverting resources from other uses in order to produce that safety, profit-maximizing
firms will work to protect workers and consumers. And safety is not the only good which
workers trade wages to buy. Longer vacations, family leave, health insurance, fewer
working hours, and other non-wage benefits can also be "purchased" by workers through
lower wages. If these benefits are in society's interest, it won't take a crippling industrial
strike--or an act of Congress--to force firms to provide them.
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Notes
1
Solidarity, September 1995.
2
As a point of comparison, the annual rate of workplace fatalities for the U.S. labor force is about 1 in
10,000.
CHAPTER 27
OSHA--We're From the Government and We're Here to Help
You
OSHA is a U.S. federal agency which relies almost entirely on mandates to influence firm
behavior. The bottom line for the firms is that they end up employing more resources for the
purpose of worker safety than they would voluntarily choose. Now lest you think otherwise,
we are not members of the PRO-INJURY AND MAIMING SOCIETY. We don't get a
special kind of joy every time we hear of an industrial accident. However, consider the
following cost estimates of various OSHA worker safety mandates:
Regulation Year Estimated Lives Estimated Cost per Life

Regulation Year Saved per Year Saved (1984 dollars)
(1) (2) (3) (4)
Ethylene 1984 2.8 $25.6 million

oxide
1978 6.9 $37.6 million
Acrylonitrile
1976 31.0 $61.8 million
Coke ovens
1986 74.7 $89.3 million
Asbestos
1978 11.7 $92.5 million
Arsenic
Source: John F. Morrall III, "A Review of the Record," Regulation, 1986, p. 30.
Columns (1) and (2) report the specific area in which OSHA intervened and the year the
mandate was passed. Columns (3) and (4) report the number of lives estimated to be saved
by the regulation and the estimated cost per life saved. Thus, OSHA's 1986 asbestos
standards are estimated to have saved 74.7 lives per year, at an annual cost of approximately
$6.7 billion (= 74.7 times $89.3 million).
We're not saying that saving 74.7 lives is bad. We think it's great. It's just that $6.7 billion
could have produced an awful lot of happiness elsewhere in the economy. For example, just
think how many lives that $6.7 billion could have saved if these resources had been
transferred to the health industry instead of spent on asbestos removal. $6.7 billion could
buy an awful lot of open heart surgeries, not to mention high blood pressure pills,
mammogram examinations, drug research, and testing for an AIDS cure. It could also pay
for an awful lot of additional police to patrol the streets in high crime neighborhoods.1
Let us show how our simple framework can be used to analyze OSHA mandates. Consider
the example we discussed in the previous chapter. Suppose OSHA issued an administrative
decree requiring the XYZ Corporation to utilize a safer, but more expensive, stamping
machine. Suppose each of the 5 workers who had to use this machine valued the additional
safety at $40 per week times 52 weeks per year (equals $2,080 a year per worker, or $10,400
a year for the five workers). Thus, XYZ Corp. could save $10,400 a year in labor costs by
employing the safer machine. However, the yearly rental cost of the safer machine is
$20,000. Under these circumstances the firm would not have employed this machine before
the OSHA mandate.
Now we're going to do something really weird. Recall from our previous discussion of
peanut quotas that firms who violated government restrictions were subject to a PENALTY.
We used this concept to show how a firm could be induced to not produce something that is
otherwise profitable for them. We now introduce the concept of the PENALTY
AVOIDANCE BENEFIT (PAB) to show how a firm can be induced to produce something
(safety) that is unprofitable for them.
If the firm violates the OSHA mandate, something bad happens. What exactly will happen?
Surprisingly, this time we really do know the answer to that question: OSHA imposes an
administrative fine (penalty). In this instance, suppose that the firm would incur a $15,000
fine if they did not replace the old stamping machine with the newer, OSHA-mandated
model. By switching to the newer machine, the XYZ Corporation avoids having to pay this
tax penalty. The opportunity to avoid this penalty provides the financial incentive for the
firm to obey the OSHA mandate. As a result, we can treat this penalty avoidance benefit
(PAB) the same as a subsidy. (Recall that we previously treated the penalty from violating a
quota the same as a tax).
Why is a PAB like a subsidy? Suppose your boss tells you he'll pay you $50 to show up for
work next Saturday. As you lie in bed half asleep on Saturday morning, you consider that
there is a $50 benefit for getting out of bed and going to work. Compare that to the case
where your boss tells you he's going to reduce your bonus by $50 if you don't show up for
work on Saturday. The benefit of getting out of bed and going to work is still $50. In the
first case, your boss "subsidizes" your pay to get you to work. In the second, case he
threatens you with a penalty if you don't go to work. In each case, working gives you $50
more in your pocket than not working.
It's the same thing for the XYZ Corporation. If it follows OSHA's mandate to employ the
new machine, it ends up $15,000 more in its "pockets." We can now represent the XYZ
Corporation's decision to buy the new machine before and after the OSHA mandate as
follows.
Before Mandate After Mandate
REVENUES: $10,400 $10,400
COSTS: $20,000 $20,000 - $15,000 = $5,000
PROFITS: -$9,600 +$5,400
Prior to OSHA's mandate, the XYZ Corporation would have never chosen to make the
workplace safer by using the new stamping machine. And that was the right thing for them
to do. The gain that the workers would have experienced from having the safer machine was
only $10,400. But it would have come at the expense of $20,000 in lost happiness elsewhere
in the economy. The resources that would have been used to construct the new machine
would have had to be taken away from other consumers. Those other consumers would have
gotten greater pleasure from those resources than the workers at the XYZ Corporation. Thus,
by not employing the new stamping machine, the XYZ Corporation allows these resources
to be released to go to a higher valued use.
The OSHA mandate changes all this. It causes a reallocation of resources away from other
consumers to the workers of the firm. And that change in the allocation of resources lowers
society's happiness by $9,600 (the difference between the gain of $10,400 in happiness by
the workers of the XYZ Corporation, and the loss of $20,000 in happiness by other
consumers). Of course there are other firms besides the XYZ Corporation who are impacted
by OSHA's mandates. As a result, we will never know the total amount of the social loss
created by these mandates. But we do know that too many resources will be allocated to the
production of safer workplaces. This is the great value of our SIMPLE FRAMEWORK. It
allows us both (i) to demonstrate that society's happiness will be lowered by these mandates,
and (ii) to illustrate just what it is that causes this loss. All in the context of a simple table,
and we need not be experts in the industry being regulated.
TABLE OF CONTENTS
HOME
Notes
1
Note also that asbestos is a fire retardant, so its purpose is to prevent death and injury. Thus, while
lives are saved by removing asbestos, lives may be lost by its removal.
CHAPTER 28
Unintended Consequences of Consumer Safety Regulation
"LAUNDRY RULES DRESS WORKERS LIKE DOCTORS. New

federal regulations are requiring commercial laundry workers to
dress like surgeons when dealing with certain clothing, and promise
to cost many employers thousands of dollars annually....Bob
Guthrie, manager of Nichols Hills Cleaners, has discontinued
business with his few medical accounts....He said the expense of the
hepatitis shots as well as the gowns, gloves and face shields was too
much."1
The previous chapter showed how government MANDATES can lower society's happiness
by forcing firms to take resources that are higher valued elsewhere, in order to produce
something that is lower valued--such as safety. In doing so, we accepted the notion that at
least the government was successful in getting the market to produce additional safety. Now
we want to demonstrate that the government may not be successful in getting additional
safety produced, even when it mandates this outcome. The reason for this has to do with the
UNINTENDED CONSEQUENCES of market interventions.
The Profit Table below represents the Revenues and Costs associated with a commercial
laundry firm, before and after new regulations protecting the safety of laundry workers are
mandated by OSHA. Specifically, the table reports how much money Bob Guthrie's Nichols
Hills Cleaners made from his business with medical accounts.
Before After Regulation

Regulation
REVENUES: $10,000 $10,000
COSTS: $8,000 $8,000 + $6,000 - $1,000 = 13,000
PROFITS: + $2,000 - $3,000
Before the new rules, Bob Guthrie made a profit of $2,000 from this business. After the new
rules, two things happened. First, Mr. Guthrie had to spend a total of $6,000 to come into
compliance with the new regulations. Second, he was able to lower his wage costs by a
$1,000. This latter result didn't happen immediately of course. But Mr. Guthrie found that
workers appreciated working in a safer environment. This meant that his employees were
less willing to quit and take jobs elsewhere, and that he didn't have to give as many raises to
hold on to his good workers.
Unfortunately, the savings in labor costs were not enough to outweigh the costs of
compliance. Bob Guthrie found that the total costs of his medical laundry business had
increased from $8,000 to $13,000, resulting in negative profits. As a result--and as the
article states--he discontinued his medical cleaning business. We know from our previous
analysis that the effect of this mandate is to decrease society's happiness by diverting
resources out of the medical cleaning business. But that's not what we want to focus on now.
Instead, we want to investigate the overall impact of this mandate on the level of public
health in society.
The combination of higher costs and fewer laundries willing to take medical cleaning
business means that hospitals will have to pay higher prices to have their laundry washed.
To compensate for these higher costs, hospitals will have to cut back on some of their
medical services or charge higher prices to their patients. What do people usually do when
the price of something goes up? They consume less of it. Economists are so sure of this last
statement that this conclusion is awarded the prestigious title of being a law of human
behavior. It is called the LAW OF DEMAND. When the price of gasoline goes up, people
consume less gasoline. When the price of stringbeans go up, people consume fewer
stringbeans. And when the price of health care goes up, people consume less health care.
To see this clearly, let's take an extreme example. Suppose the government piles on so many
new safety regulations that the average cost of treating each patient rises to $1,000,000. Who
would (or could) purchase health care at this price? Virtually no one. In this case, mandating
excessive safety regulations clearly lowers the public's overall health. A bit unrealistic, you
say. Sure. But it does highlight the problem: IF THE DECLINE IN PUBLIC HEALTH
RESULTING FROM FEWER PEOPLE PURCHASING MEDICAL CARE OUTWEIGHS
THE INCREASE IN PUBLIC HEALTH RESULTING FROM THE SAFETY
MANDATES, THEN GOVERNMENT REGULATION DAMAGES PUBLIC HEALTH.
And it would not be the only time that regulations to improve public health have had
unintended consequences.
Consider the following real-life example. Until recently, the government has had strict
regulations mandating the adoption of child-resistant safety caps on products such as aspirin,
prescription drugs, etc. Now what to do you think the net impact on public safety has been
as a result of this regulation? Consider the following conclusion by a highly regarded
economist who has carefully studied this subject:
"The overall implication of this analysis is that there have been 3500
additional poisonings annually of children under five that resulted
from the decreased safety precautions after the advent of safety
caps."2
How can this be? It's not that difficult to figure out. As anybody knows who has ever
struggled with a so-called "child-resistant" safety cap, they aren't very easy for adults to
open either. How do some people choose to respond to this? Let's return to the law of
demand. In essence, it is now more "costly" to open up a medicine bottle. When an action
becomes more costly, people do it less frequently. One way to open up medicine bottles less
frequently is to leave them open. That is, people don't put the tops back on. So children find
more open medicine bottles to get into. The perverse result is that child-resistant safety caps
have--on balance--made it easier, not harder, for children to get access to poisonous
substances.
An isolated incident you say? Consider the effect of regulations governing the introduction
of new drugs. The federal Food and Drug Administration places severe requirements on the
ability of pharmaceutical firms to market new drugs. It takes an average of approximately
three years and millions of dollars for a new drug to receive approval by the FDA.3 While
the intensive testing required by the FDA no doubt reduces the number of harmful drugs
available to consumers, it also has another effect. It reduces the number of beneficial drugs
available to consumers. Many economists believe that the net effect of the FDA's tough
approval process has been to harm more consumers than it has helped. This is how one
advocate put it:
"...in 1981...the FDA published a press release confessing to mass

murder. That was not, of course, the way in which the release was
worded; it was simply an announcement that the FDA had approved
the use of timolol, a Beta-blocker, to prevent recurrences of heart
attacks. At the time timolol was approved, Beta-blockers had been
widely used outside the U.S. for over ten years. It was estimated that
the use of timolol would save from seven thousand to ten thousand
lives a year in the U.S. So the FDA, by forbidding the use of Beta-
blockers before 1981, was responsible for something close to a
hundred thousand unnecessary deaths."4
FDA regulations raise the cost of introducing new drugs. Not just ineffective or dangerous
drugs, but good drugs as well.5 As a result, less drugs make it to market. But that's not the
end of the story. Less drugs on the market can only mean one thing. Higher drug prices.
When drug prices are higher, consumers will take fewer of them, which means that
consumers will miss out on the health benefits of drugs that they would have taken in the
absence of the FDA regulations. Once again, we are left with an unintended consequence:
FDA regulation may lower the health of the very population that the agency is entrusted to
protect.
So what's the problem with our government? Why these unintended consequences of well-
intentioned regulations? Is it because government is filled with bungling idiots who either
are too incompetent to know better or too insensitive to care? We don't think so. In our
opinion, the fundamental problem here is one of INFORMATION.6
How much do consumers value child-resistant safety caps? How much happiness will
consumers get from that new drug? Are they willing to forego other goods to get products
that are safer? Or is the cost of the safety so high that consumers would rather do without the
good if they are forced to pay for the extra safety? These are incredibly difficult questions to
answer, but they are questions of life and death.
Note that the issue isn't whether to have safety or not. The issue is, how much safety? When
government mandates safety standards, it is extremely difficult for consumers to signal their
evaluations of those standards. Only markets are positioned to collect and convey the
information that resource owners need to know if they are to allocate resources so as to
maximize society's happiness. This is a topic we explore further in the next chapter.
TABLE OF CONTENTS
HOME
Notes
1
The Daily Oklahoman, July 27, 1992.
2
W. Kip Viscusi, John Vernon, Joseph E. Harrington, Jr. Economics of Regulation and Antitrust.
Lexington, MA: D.C. Heath and Company, 1992, p. 738.
3
W. Kip Viscusi, John Vernon, Joseph E. Harrington, Jr. Economics of Regulation and Antitrust.
Lexington, MA: D.C. Heath and Company, 1992, p. 732..
4
David Friedman, The Machinery of Freedom, 2nd Edition, La Salle, Illinois, Open Court, 1978.
5
It is worth noting that even with FDA regulations dangerous drugs still make it to market.
6
Another problem relates to the incentives facing government bureaucrats. Government bureaucrats
don't have the incentives that firms do to weigh out the social benefits and costs of devoting more
resources to safer medicine caps, electricians, drugs, etc. If a drug company procrastinates in getting a
drug to market, it loses millions of dollars in potential revenues. Those revenues are a reflection of the
happiness that consumers will miss out on by not having the new drug. If a bureaucrat in the FDA
delays the approval of a new drug, what is the cost to him? A denied promotion? A smaller raise? In
fact, there is an incentive for a bureaucrat not to approve a new drug--he would share a huge portion of
the blame if the drug turned out to be dangerous. How about with respect to potentially dangerous
drugs? While pharmaceutical companies may have an incentive to bring out a drug sooner, that does not
mean they will be rash. If a drug company rushes a potentially dangerous drug to the market, it will
incur substantial costs if the drug harms public health. Not only is there the financial damage from lost
sales and damaged reputation, but there is also the liability expenses from harmed consumers. (Juries are
generally not timid in awarding damages to consumers who have been hurt by a company's products.)
Thus, profit-maximizing firms are in a unique position to weigh out the social benefits and costs of new
drug introductions.
CHAPTER 29
A Game Called Hot 'N Cold
"COMPANY GROWING MO' AND MO'. Apache, OK (AP)--It's

been a year of expansion for Maury Tate, whose plan for a simple
sideline business to help him cover rodeo entry fees has mushroomed
into the nationally known Mo' Betta shirts....'We didn't have a clue,'
Tate said about his small-town company that has bloomed into a
national sensation. 'Everything that has happened has been crazy.'
Crazy enough that business for the 100 employees has increased 40
to 50 percent this year alone."1
When we were kids, we played a game called Hot 'N Cold. The way the game works is like
this: The players agree on an object, say a quarter, that will be hidden someplace in a room.
Somebody is chosen to be "it" and is led outside while the door is closed him. Back inside,
the other players hide the object, maybe on the seat of a chair, in a planter, on top of the
stereo system. The player who was taken outside the room is then brought back in. His job is
to find the hidden object.
The only information he has to go on are the "hot" and "cold" clues of the other players. If
the player who is "it" is searching the room far away from where the object is hidden, the
other players say things like, "Brrrr! You're freezing and you're going to catch cold if you
aren't careful," "Put a parka on, Chump", and "Frostbite! Frostbite!" As "it" gradually moves
closer, the other players tell him he's "getting warmer." When he gets really close to the
object, they say things like "You're starting to sweat, baby" and "Watch out! You're going to
burn yourself!"
Besides being revealing about our incredibly deprived childhoods, this game serves as a
beautiful picture of how a free-market economy operates (we confess that we didn't
necessarily make this connection when we were kids). Think of "it" as the firm. The firm's
job is to combine resources in such a way that it will make society better off. It doesn't have
a clue about the best way to do that. Despite the best efforts of its production engineers and
market consultants, it is led into the "room" not knowing what combination will produce the
best result for society. Profits are like the "hot" and "cold" signals described above. When a
firm does a poor job of combining resources to make a product--either because it is taking
resources that are really valuable in other activities, or because the product it produces isn't
much wanted by consumers--it earns negative profits. That's the economy's way of saying
"Brrrr! You're freezing."
Alternatively, as it hits on a better combination of resources, either by improving its product

or economizing on inputs, it starts to earn a reasonable rate of return on its investment. That
is, the economy says, "You're getting warmer." Every now and then there is a firm that
develops a new good or service, and it earns incredible profits--say McDonald's perfects the
concept of fast food, or Microsoft develops an incredibly powerful operating system called
MSDOS. What does the economy say then? "Hot dog! You're burning out of control, baby!"
In a world of darkness and uncertainty, profits are the consumers' way of telling firms when
they get it right. There are many different ways of producing a product, many different ways
of improving a product so that consumers will like it more (derive more happiness from it).
And what makes this all difficult for firms is that oftentimes consumers don't know
themselves what they will like before they experiment with it. Nor do consumers know how
long they will like it. Pet rocks, bell bottoms, and Teenage Mutant Ninja Turtles were all
"products" that produced huge profits for their inventors that were relatively short-lived.
Frisbees, blue jeans, and the Beatles are products that have continued to produce happiness
for consumers long after their initial introduction. Who could have guessed how much
happiness these products would have produced at the time of their introduction? Or for how
long consumers would continue to find pleasure in them?
But profits also play another important role. When one firm earns exceptional profits from
hitting on the right combination of resources to please consumers, an inevitable reaction
occurs. Other firms try to copy the winning combination. Imitation--copy catting. That is
one of the great trademarks of free-market/capitalism. The rise of McDonald's sets in motion
forces that spawn competitors producing like products, such as Burger King and Wendy's.
Apple Corporation's menu-driven operating system gives rise to Microsoft's Windows and
Windows 95. Dodge Caravan gives rise to Ford Windstar. There was a time when salad bars
were only to be found in health food restaurants. Now they're everywhere.
One can picture the whole economy as an enormous room filled with firms roaming around,
each trying to find where consumers have "hidden" the object that will produce the most
happiness for society. When consumers tell one firm that "they're hot," a flock of other firms
swarm over to where that firm is and try to copy--and improve--what that first firm is doing.
It's like the whole economy is one huge game of Hot 'N Cold.
Both of these functions of profits are well-illustrated in the story of Maury Tate, the main
character in the article excerpt which began this chapter. In 1987, Maury Tate was a full-
time, professional rodeo rider. He had a family friend sew colorful materials into his rodeo
shirts. When his fellow competitors saw Tate's shirts, they offered to buy them. Tate would
literally sell the shirt off his back to another rider who liked what Tate was wearing. One
thing led to another, and soon Tate found himself the owner of a company that was
producing shirts for national chain stores. Tate just happened to hit upon a combination that
pleased consumers. But then something else happened. Soon he found that his weren't the
only shirts that offered colorful western-style looks. Everybody starting to produce them.
Levi started to produce similar looking shirts. And Wrangler's. Even Sears, Wal-Mart, and
Target. Each day, thousands of firms try to mimic what Maury Tate did by accident. They
assemble resources, drawing them away from other parts of the economy, hoping to
combine them in a way that will make them the next big success in the economy's hit
parade.
This perspective of the world as being a world of "darkness and uncertainty" is a

controversial perspective with far-reaching consequences. It differs with most conventional
textbook presentations of how the economy operates. It is customary, for example, for
economics textbooks to represent firms as being fully cognizant of the revenues and costs
they would experience at every possible level of production. Armed with this knowledge,
the major task of firms is merely to choose the level of output that maximizes total profits.
Rarely is there a sense of the lack of information that characterizes most firm decision-
making. There is little to no mention of the role of the entrepreneur.
In fact, most textbooks represent a view of the economy in which firms settle down to what
is called "long-run equilibrium." That's where there is no more impetus for change in an
industry. Each firm produces the same products and quantity as the year before. Further, all
the firms in the industry are completely identical. Each earns zero economic profits. There
are no new firms who enter this industry, and no old firms who depart.
Contrast this world with the picture of the economy that is represented by your local paper's
Business section. What kind of world is this? This is the world of bankruptcies and business
mergers. Of new products. Of firms that were the leader in their fields last year, but are now
trying to compete with new entrants who are threatening to take away their market share this
year. It is the world of Lee Iaccocca, of Bill Gates, of Robert Crandall. It is a world in which
automobile corporations report record earnings one year, and multi-billion dollar losses the
next. Where firms try to "redesign" themselves to fit changing business environments. It is a
jungle out there! Each firm scrambling, trying to figure out what it is that consumers want
this year. Nothing is certain, everything is risky. Where is this world in the standard
economics textbook?
On one extreme, we have a picture of an economy in which everything is known. The most
difficult task facing firms is to choose the level of output which will maximize profits. On
the other extreme, we have a picture in which the economy is characterized by great
uncertainty, in which firms grope and stumble in the dark trying to find out what will please
consumers. It turns out that which worldview one subscribes to has important implications
for public policy.
Suppose one believes that lack of information is a serious problem facing the economy.
Then one is inclined to try to place as many resources as possible under the control of profit-
maximizing firms. One sees the entrepreneur as the driving force of the economy, and a key
agent for improving society's happiness. One supports minimizing regulations which restrict
firms from pursuing profit-increasing combinations of resources. One becomes a proponent
of the FREE-MARKET; one advocates leaving as many resource allocations to the price
system as possible.
On the other hand, suppose one believes that lack of information is not a serious problem. In
this case, the informational role played by profits is relatively unimportant. An economic
planner can decide what and how much to produce, just as well as any firm. In fact, the
economic planner can probably do it better. After all, he or she can produce the good
without "wasteful competition." This is the worldview which underlies much of

GOVERNMENT REGULATION of consumer safety, for example. It is also the worldview
of economic policy makers who believe that government spending can be used to stimulate
economic growth. Here the question of what to produce is not considered a problem. It is
assumed that those in charge of disbursing the funds will know what it is that consumers
want--and how the rest of the economy will respond to the government's intervention. In this
case, one is a proponent of an ACTIVIST GOVERNMENT, a government that tends to use
planners, regulations, taxes, subsidies, and the like to direct resources to various uses.
Two very different worldviews--two very different policy positions. Which worldview is
right? In the end, it's a matter of one's best judgement. That's because the fundamental
element--information--is unseen. Nobody can know just how much unknown information is
out there. Despite our best efforts to remain scientifically neutral and unopinionated, you've
probably been able to figure out what our worldview is. How about yours? Think about
it....Anybody for a game of Hot 'N Cold?
TABLE OF CONTENTS
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Notes
1
The Daily Oklahoman, December 27, 1992.
CHAPTER 30
Moving to Greener Pastures
"My own congressional district suffered the effects of the runaway

plant in 1972 when the Garwood plant in Wayne [Michigan] moved
and left 600 unemployed workers behind....Mr. Speaker, the reason
these firms are moving away is not economic necessity but economic
greed. For instance, the Federal Mogul Co. in Detroit signed a
contract in 1971 with the United Auto Workers and six months later
announced it would be moving to Alabama. A spokesman for the
company was quoted as saying they were moving 'not because we are
not making money in Detroit, but because we can make more money
in Alabama.'"1
We now enter a new section of our exploration of economics. The previous chapters
developed a working model of how an economy functions, how resources are directed to
consumers and divided up among them. We know that a firm's revenues represent the
happiness that society receives from the firm's output. We know that a firm's costs represent
the happiness society could receive if those resources were freed up for their next best use.
By comparing the two, we can tell whether the firm's resource transfers result in a net
increase or net decrease in happiness. We also understand the tremendous problems that
arise when the information that firms receive from the marketplace is distorted by subsidies
and taxes. This theory represents the foundational building blocks of economics.
Our next task is to apply this framework to a number of issues that have likely been nagging
at you this whole book. We begin with international trade. Is it a good thing for the
economy? How do trade policies affect society's happiness? And trade deficits? Are they
harbingers of doom? How can we be so sure that displaced workers will find jobs? In
addition to these questions, we'll also look at how markets work to conserve natural
resources for future generations. In the pages ahead we shall take a giant step toward our
goal of making you an armchair economist...and a hit at cocktail parties.
While it might seem like a funny place to start, we're going to begin our study of
international trade by looking at plant relocations. Let's consider the economic insights
offered by the distinguished Representative from Wayne, Michigan. His big beef with the
Federal Mogul Co. is that it decided to close down its plant in Detroit and open up a new
plant in Alabama, not because it wasn't making money in Detroit, but because it could
make more money in Alabama. We've got to admit, that does sound awfully greedy. We
suspect that the owners are probably not very nice people (even the name of the company--
the Federal Mogul Co.--sounds rather cold and heartless). But we're going to leave the
moralizing to those who have earned the right to judge others by virtue of their own
impeccable behavior--the politicians.
Let's consider why the Federal Mogul Co. might want to move from Detroit to Alabama.
While we can only surmise, it seems reasonable that costs may have played the primary role
in the firm's decision. Many plant closings are driven by the desire to move to locations
where the costs of production are lower. How can this be represented in the context of our
simple Profit Table? The key is to identify the gains and losses to the firm of shutting down
the plant in Detroit and opening up another plant in Alabama.
Let's suppose that the costs of production in Detroit are $32 million. By shutting down the
plant there, the firm saves $32 million. Since this is what the firm stands to gain by
relocating to Alabama, we report this gain on the firm's "Revenues" line of the Profit Table.
(The trick is to always report the dollar value of the gain to the firm on the "Revenues" line.)
What is the cost of opening up the plant in Alabama? It is the cost of production there.
Supposing that costs are expected to be only $20 million in Alabama, we report this on the
associated "Costs" line. Now look at our Profit Table and see if we haven't captured the
essence of the firm's relocation decision.
REVENUES (gain from shutdown): $32 M
COSTS (for a plant in Alabama): $20 M
PROFITS (from moving the factory): +$12 M
Ignoring the costs of moving for the moment, we see that the Federal Mogul Co. could
increase their profits by $12 million if they relocated from Detroit to Alabama.
In order to keep the problem simple, let's assume that the Alabama and Detroit plants
produce the same quantity and quality of goods. This simplification is consistent with our
initial supposition that cost considerations are the driving force behind the move. As a result
of this assumption, the customers of the firm are unaffected by its decision to relocate. We
are now in a position to investigate the gains and losses to society caused by the firm's
relocation decision.
Note that there are two sets of resource transfers represented in the Profit Table above.
When the Federal Mogul Co. shuts down in Detroit, it releases its inputs (land, labor, locally
purchased materials, etc.) so that other firms can employ them. As these other firms move in
to put these resources to work, additional goods and services are produced. Consumers
benefit from these additional goods and services. How much happiness do these consumers
receive from the additional goods and services? Don't be bashful about saying
approximately $32 million of happiness. After all, that was what the Federal Mogul Co. was
paying to employ those inputs. And we know that the happiness that those inputs could
produce elsewhere is reflected in their market price.
A second set of resource transfers takes place when the firm opens up in Alabama. In order
to begin production, the Federal Mogul Co. has to take away inputs that could have been
used to produce other goods and services. The workers who ended up working for the good
folks at Federal Mogul were bid away from alternative employers. Who knows what they
might have been doing otherwise? Flipping burgers at McDonald's, washing cars at the
Skweeky Kleen Kar Wash, working as a barmaid at the Suds 'N Duds Laundromat, Bar, and
Grill. No matter. As a result of these workers signing on with Federal Mogul, there will now
be fewer burgers flipped, fewer "kars kleened," and fewer mugs of beer while customers
wait for the spin cycle to end at the Suds 'N Duds. That means lost consumer happiness.
How much? Approximately $20 million, of course.
Forgetting whatever heartless motives may have lurked in the minds of the evil corporate
chieftains at Federal Mogul Co., the bottom line is that relocating the plant to Alabama
results in an increase in society's happiness. We can say this because we know that the
ultimate reason that costs were higher in Detroit is because resources were more valuable
there. By releasing the more valuable resources in Detroit, and replacing them with less
valuable resources in Alabama, the Federal Mogul Co. has acted in society's best interests.
Thank goodness they weren't content with the money they were making in Detroit, but
wanted to make even more!
Let's come back now to some points that we glossed over earlier. Haven't we ignored
moving costs? Yes we have, but including moving costs leaves our essential analysis
unchanged. To see this, just add the moving costs to the "Costs" line of the Profit Table. Say
moving costs are $7 million, raising total costs to $27 million. Moving costs also represent
resources that the Federal Mogul Co. has taken away from consumers who could have
benefitted from them. As long as moving costs are less than $12 million, the firm will still
decide to relocate, and society will be better off if they do.
Suppose the moving costs are greater than $12 million? Say they're 15 million? Then the
firm doesn't relocate. But again, this is exactly what we want the firm to do. If total costs are
$35 million ($20 million + $15 million), then the firm would tie up resources that could
have produced a total of $35 million of happiness elsewhere, while releasing resources that
will produce only $32 million of happiness. If the firm relocated, it would lower society's
happiness by $3 million. The bottom line is always the same. IF THE FIRM'S PROFITS
ARE INCREASED BY RELOCATING, THEN WE EXPECT THAT SOCIETY'S
HAPPINESS IS ALSO INCREASED. WE CAN TRUST THE FIRM TO DO WHAT IS
RIGHT FOR SOCIETY, AS LONG AS IT DOES WHAT IS BEST FOR ITSELF.
One last twist. Suppose the firm found it profitable to relocate from Detroit to Dallas, Texas,
instead of Alabama. Would that increase society's happiness? "Of course!" you say. Suppose
the firm found it profitable to relocate from Detroit to San Antonio, Texas. Would that
increase society's happiness? "Of course!" you say again. Suppose the firm found it
profitable to relocate from Detroit to El Paso, Texas. Would that increase society's
happiness? "Of course!" you say for the third time.
One last question. Suppose the firm found it profitable to cross that short little bridge that
leads from El Paso, Texas to Juarez, Mexico--a mere 100 yards further south. Would that
increase society's happiness? "Oh no! I've been tricked!" you say. (You probably saw it
coming all along.) Here's the question we want to wrestle with. If it increases society's
happiness to have a plant relocate from Detroit, Michigan to El Paso, Texas, what could be
so fundamentally different if we relocate that plant just 100 yards further south--in Juarez,
Mexico. Shouldn't that also increase society's happiness?
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Notes
1
U.S. House of Representatives, Congressional Record, 94th Congress, 1st Session, 10 June 1974, p.
18559.
CHAPTER 31
That Loud Sucking Sound
"That loud sucking noise you hear is the sound of American jobs
going south to Mexico"--Ross Perot, 1992 U.S. Presidential
candidate, arguing against the North American Free Trade
Agreement (NAFTA).
If society's happiness increases when a plant moves from Detroit, Michigan to El Paso,
Texas because costs are lower in El Paso, then what is different about the plant moving to
Juarez, Mexico to take advantage of lower costs there? In fact, there is a difference. As we
shall see, though, it is a difference that affects the interpretation of the numbers in the table,
but not our conclusion about the impact of this move on society's happiness.
The numbers below represent the case where the firm's costs of production are $32 million
in Detroit, but only $20 million in Juarez. To keep it simple, we once again assume that the
$20 million plant in Juarez will produce the same quantity and quality of goods as the $32
million plant in Detroit, so that the firm's customers are unaffected by the move. We also
assume that unions aren't a problem, so that the $32 million of costs in Detroit represent the
amount of happiness those resources will produce in the rest of the economy when they are
released.
REVENUES: $32 M
COSTS: $20 M
PROFITS: +$12 M
The numbers all look the same! Indeed they do. The difference lies in their interpretation.
When the plant closes down in Detroit, $32 million of resources are released to produce
other goods and services for consumers elsewhere in the economy. This social "gain" from
the plant closing down is the same whether the plant ends up relocating in El Paso or Juarez.
But now look at the costs. When the plant opens up in El Paso, resources are pulled away
from other activities that could have produced happiness for our consumers. (Remember--
fewer burgers flipped, fewer "kars kleened," and fewer beers consumed at the Suds 'N
Duds.) When the plant opens up in Juarez, there is no corresponding withdrawal of
resources from other activities.
Oh sure, there are fewer resources available to produce happiness for MEXICAN
consumers. But we don't care about Mexican consumers. That didn't sound very nice, did it?
Let's put it another way: in deciding what's best for the happiness of AMERICAN society,
we don't consider the effect of our trade actions on the consumers of other societies. We
focus solely on what's good for American consumers. If this lack of concern for our
international neighbors bothers you, take heart. We will demonstrate later that voluntary acts
of trade between nations make both societies better off.
What then, is the nature of the costs to the U.S. society when this plant opens up in Juarez?
While it's true that no American consumers are adversely impacted because there are fewer
resources available to produce other goods and services, there is another cost. Do you see it?
The American firm is going to pay its Mexican workers $20 million to operate the plant in
Juarez. What are the Mexican workers going to do with all that money? One option is to go
shopping. Suppose they take that $20 million and go on a huge shopping spree north of the
border. Let's imagine that they come back with a gigantic shopping cart full of American
goods and services: cowboy boots, Coupe DeVille's, bar-b-que ribs, 10-gallon hats, and
souvenir t-shirts ("My parents went to Texas and all I got was this lousy t-shirt"). How has
this hurt American consumers? THESE GOODS AND SERVICES ARE NO LONGER
AVAILABLE FOR AMERICAN CONSUMERS.
The Mexican shopping spree is no different than if a tornado tore through Texas destroying
$20 million of goods and services. Whether they are taken away by a natural disaster or by
Mexican workers purchasing them with dollars earned from their American employer, the
fact is that those goods can no longer be consumed by American consumers.
If the price of a pair of snakeskin cowboy boots is $100, then having one less pair of those
cowboy boots means that American consumers lose $100 in happiness. If $5000 worth of
snakeskin cowboy boots (50 pairs at $100 a pair) are withdrawn from the American
economy, then consumers in the U.S. will be out approximately $5000 of happiness. And so
it follows that when Mexicans buy $20 million of American stuff, it imposes a loss in
happiness on American consumers of approximately $20 million.
Let's go back to our Profit Table to review why relocating the plant from Detroit to Juarez,
Mexico will improve (American) society's happiness. The resource transfers resulting from
this plant relocation result in both gains and losses for the U.S. economy. When the plant in
Detroit closes down and releases $32 million of resources, those resources are reemployed,
producing approximately $32 million of happiness. When the plant opens up in Juarez and
pays the workers there $20 million, those workers will take their money and buy American
goods and services. When they do so, they remove goods and services worth $20 million
from American stores and supermarkets. Since those goods and services can no longer be
consumed by Americans, consumers in the U.S. will lose out on the approximately $20
million in happiness. When the social gains are weighed against the social losses, the net
impact is a $12 million increase in society's happiness. Whether the firm relocates to El Paso
or Juarez, the bottom line is the same. Only the story is somewhat different.
Are you convinced? Not really? Let's consider some common criticisms of this analysis.
CRITICISM NUMBER ONE: "Your story is hopelessly unrealistic! The Mexican workers
aren't going to be paid in dollars. They're going to get paid in pesos. And even if they were
paid in dollars, they wouldn't spend all their dollars in the U.S. So what does that do to your
theory, buster?"
Suppose they are paid in pesos rather than dollars. In order to get pesos, the plant had to take
its $20 million and trade it with someone (or some firm) who was willing to give up pesos to
get dollars. But why would anyone be willing to trade their pesos for American dollars?
Because they wanted those dollars to buy American goods and services. So whether the
plant gives the $20 million directly to the workers, or gives it to someone else who wants to
buy American goods and services, the result is the same: less stuff for consumers in the U.S.
"Not necessarily," you say. "Suppose the someone who traded pesos for dollars really didn't
want to buy anything in America? Suppose instead that they used those dollars to buy things
from some other foreign country, say oil from Saudi Arabia? After all, dollars are an
international currency." While this still raises the question of what that person from Saudi
Arabia is going to do with all those American dollars, we concede the point. Some of those
dollars may not all come back to the American economy.
Let's take the worse case scenario. Suppose none of those dollars come back to the U.S.
economy. Then what? Then we just made the following trade: In exchange for the goods and
services produced for American consumers by hardworking Mexican laborers, we gave
up...$20 million of green pieces of paper.
Doesn't that make us poorer? DANGER...DANGER...DANGER...ECONOMIC FALLACY

IN THE MAKING! Once again, the fallacy comes from taking our eyes off the ball. The
U.S. economy may have fewer dollar bills circulating around it, but there are now more
goods for consumers to enjoy. Do you see why? Recall that our working assumption is that
the $20 million plant in Juarez will produce the same quantity and quality of goods as the
$32 million plant in Detroit. This means when the plant closed down in Detroit and opened
up in Juarez, the firms' output of goods and services remained the same. However, when the
resources released by the Detroit plant were reemployed by other firms, we gained extra
goods and services that we didn't have before. And what did we have to give up in order to
get these extra goods? Absolutely nothing! Just a bunch of green paper that didn't cost
hardly anything to produce. The bottom line is that there are more goods and services for the
same number of American consumers. That can only mean one thing: The happiness of
(American) society has increased.
A second criticism that one hears frequently in discussions of international trade is the
following. CRITICISM NUMBER TWO: "There's no way American workers getting paid
$10 or $15 an hour can compete with cheap Mexican labor willing to work for $10 or $15 a
DAY! In order to increase their profits, American firms will close down their U.S. plants
and factories and move south of the border. As the quote at the beginning of this chapter
says, 'That loud sucking noise you hear is the sound of American jobs going south to
Mexico.'"
Stated like that, it sure does seem like cheap foreign labor poses a threat to the high standard
of living we enjoy in the U.S.1 But consider the following. If it's a bad deal for the U.S.
economy when foreign workers are willing to do what American workers do for only $10 a
day, then it must be an even worse deal when those foreign workers are willing to work for
$5 a day. And if it's a really bad deal when foreign workers are willing to work for only $5 a
day, then it must be a terrible deal for the U.S. economy when they're willing to work for $1
a day. And if it's a terrible deal when foreign workers are willing to work for only $1 a day,
then that can only mean one thing. If foreign workers were willing to work for absolutely
nothing--if they were willing to produce goods and services for American consumers asking
nothing in return--that can only mean ECONOMIC DISASTER!
What's wrong with this argument? Suppose Mexican workers got together and took out a
full page ad in the New York Times and said: "Hola, Gringos! We love you! We're willing
to produce your cars, your stereos, your tv sets, anything you want, for free. Don't bother
paying us. It's just our little way of saying thanks for being such a great neighbor. And
hey...Have a nice day."
Economists have a word for this. They call it Christmas! When somebody gives you a gift
for Christmas, what's your response? Do you whine and complain about how all these gifts
are ruining your life? Or do you sit down and write a thank you note? When Mexican
workers produce goods and services for American consumers for cheap, that's just like a gift
to the American economy. The cheaper they work, the bigger the gift. It's just as if they
wrapped up those cars, stereos, and tv sets, put them in pretty boxes with bright red bows,
and wrote a note saying, "Feliz Navidad! Love, Juan (or Pedro, or Maria)." We don't know
about you, but it seems to us that there's only one response when somebody is being this
nice. Smile and say, "Muchas Gracias!"
Which brings us to CRITICISM NUMBER THREE: "Your whole theory depends on those
American workers getting reemployed again. If they aren't reemployed, then there's no
additional goods and services to produce happiness for American consumers. That loud
sucking noise you hear is the sound of your theory going down the drain."
We may surprise you by saying this criticism is true. Our whole theory depends on displaced
American workers finding employment. To illustrate, consider the effect on our nation's
happiness if no workers were reemployed after the plant in Detroit closed down and moved
to Juarez. We assumed that the factory in Mexico ships us the same quantity and quality of
goods, so American consumers lose nothing in that transaction. But then we have to ship
Mexican consumers $20 million worth of goods and services as payment. So now we are
down $20 million in happiness. If the laid off Detroit workers don't produce anything (i.e.
remain unemployed), then we have no gain in happiness. Society's revenues from this
transaction are 0, while its costs are $20 million. In order for us to say free trade is a good
thing, we must be confident that workers will be reemployed. That just happens to be the
subject of our very next chapter.
TABLE OF CONTENTS
HOME
Notes
1
However, there must be some reason why wages in the two countries are different in the first place.
The average American worker can simply produce more than the average Mexican worker because, in
part, American workers are more skilled. (In economic terms, American workers are more productive
than Mexican workers.) So it may be worth it to firms to stay in America and pay higher wages. Surely
with completely free trade some firms, after considering the relative skills of American and Mexican
workers, will take advantage of lower wages and move some jobs and factories to Mexico. It is unclear
how many will do so, but this unimportant to our analysis. We can consider the extreme case and
assume that Mexican workers can produce just as much as their American counterparts while receiving
much lower wages.
CHAPTER 32
But Where Will the Jobs Come From?
"JOB LOSSES EVERYWHERE, BUT SO ARE JOBS. NEW YORK

(AP)--Layoffs. Layoffs. Layoffs....Just last week, Woolworth said it
would slash 13,000 jobs. Two weeks before, in a single day, four
companies--Martin Marietta, USAir, DuPont and Chemical Waste
Management-- announced job reductions totaling 16,000.
Nonetheless, beneath the appearances of a pink slip blizzard,
something surprising is happening: job growth."
A plant closes down in Detroit. Thousands of jobs are lost. Suddenly, workers who thought
they had secure futures find themselves facing an uncertain job market and wondering how
they'll be able to pay their bills and keep their families fed. And what do we have to say
about all this? We say labor is a resource like any other, and when a plant closes
RESOURCES ARE RELEASED TO PRODUCE HAPPINESS FOR CONSUMERS
ELSEWHERE IN THE ECONOMY! Preposterous! How can we be so sure that these
workers will get reemployed? We base our confidence on three reasons.
OUR FIRST REASON FOR BELIEVING THAT UNEMPLOYED WORKERS WILL BE

REEMPLOYED IS THAT THE HISTORICAL RECORD SAYS THEY WILL. One of the
great disservices of modern textbook presentations of the economy is that they present a
picture of an economy at "equilibrium." Just the very sound of that word brings to mind
comforting images of workers secure in their jobs, of firms happily producing the same
goods year in and year out, of a world in which everything proceeds pretty much the same as
it did yesterday, yestermonth, and yesteryear. O contraire!
This has never been the experience of the real economy. The real economy is characterized
by tremendous turbulence. In 1800, approximately 80 percent of the population was
involved in the production of agricultural products. In 1900, the number was close to 40
percent. In 1993, it was a little less than 3 percent. This incredible transformation of the U.S.
economy over long stretches of time merely reflects the underlying turbulence that
characterizes the economy--and labor markets--all the time. The table below shows the rate
of job losses in the labor market from 1970 to 1993.
The occurrence of job losses isn't a recent phenomenon. It's something that happens all the
time. And not just during the bad times. Even during times of overall growth for the U.S.
economy, there is significant job churning; large numbers of workers are laid off and
reemployed or voluntarily leaving jobs for better opportunities elsewhere. Furthermore, the
process of job creation and job destruction is by no means a nice, even one. The pictograph
below shows how net job creation was distributed across the United States during one
particular year.
While jobs in California, Michigan, and New Jersey were declining in number, a substantial
increase in new jobs was taking place in Idaho, Utah, and Texas.
But how can we know whether the process ends up creating more jobs than it destroys?
Here's a simple test. Watch the candidates during the next presidential election. When the
incumbent President stumps on the campaign trail to offer reasons for why the American
people should vote for him or her, see if he doesn't say something like the following: "My
fellow Americans, only I can offer you the hand of experience as we steer the ship of state
through uncharted waters. Under my wise leadership, the U.S. economy created millions of
new jobs. (INTERRUPTION AS SUPPORTERS ENTHUSIASTICALLY CHEER.) Under
my careful guidance, there are now more jobs in the American economy than at any point in
this great country's history. (INTERRUPTIONS AS SUPPORTERS CHEER EVEN MORE
ENTHUSIASTICALLY.) And if you vote for me this coming November, I promise you that
I will continue my tireless efforts to create even more jobs so that together, we can build a
better, brighter future. Good night. And God bless America. (PANDEMONIUM ERUPTS
AS SUPPORTERS YELL "FOUR MORE YEARS...FOUR MORE YEARS...")"
What is responsible for the creation of all these jobs year after year? The "wise leadership"
and "careful guidance" of our politicians have relatively little to do with it. Historically, job
creation in the U.S. economy has been practically a sure thing. If just about every President
can brag at the end of his four years that there were more jobs than when he took office, then
who happens to occupy the White House has relatively little to do with job creation. Instead,
it has a lot to do with the dynamics of the economy itself. Why are we confident that laid off
workers will get reemployed? Because historically they always have. Maybe not every
worker, maybe not immediately. But it is indisputable that the U.S. economy has continued
to create millions of new jobs--year in, year out--for decade after decade. The promise that
the economy will continue to create new jobs in the future is a far more reliable promise
than most of the promises you'll hear made on the campaign trail.
This brings us to our SECOND REASON for why we are confident that unemployed
workers will be reemployed. It is no mere accident that the U.S. economy is able to
continually find new ways to put to work the millions of workers who lose their jobs each
year. There is a powerful dynamic--a magnet if you will--that serves to unite unemployed
workers with the consumption desires of the members of society. To illustrate how this
works, we're going to reveal some personal things about one of the authors of this book.
(Don't worry--it's not going to be that personal.)
A little over ten years ago, one of the authors of this book (let's call him "Bob") took his first
job teaching economics at a large, public university. Bob's first teaching position paid him
$27,500 a year, an average wage for someone just leaving graduate school at that time. This
was the first real job Bob had ever had. Now don't get the wrong impression. He had
previously worked at a number of different jobs while going to school. He delivered
newspapers, worked the graveyard shift at an all-night gas station, operated the night desk at
an executive hotel, ran his own painting crew during summer vacations, etc. The guy wasn't
lazy. But none of these jobs paid any real money. For Bob, $27,500 seemed like an
impossibly large sum. Bob just couldn't imagine how in the world he was going to spend all
of that money. (Just so you don't stay in suspense, you'll be relieved to know that he did
eventually get it figured out. All the money got spent just fine, thank you.)
Now let's fast-forward through Bob's life, ten years later. He makes a lot more money now.
But here is the amazing thing. You would think that with all the extra money Bob is making,
his desire for additional goods and services would have slacked off a little bit. Not at all. If
anything, his desire for goods and services has increased--not decreased. When Bob was a
single guy coming out of graduate school, he rented a little apartment. He didn't have much
furniture, and his wants were pretty simple. Just give him some good economics books,
leave him alone, and he was happy. Now Bob owns a home. And now that he has a home,
Bob needs furniture inside the house so it doesn't look so empty. When he lived in his little
apartment, his living room furniture consisted of a couple of bean bags. Now that he has a
respectable home, bean bags won't do. Owning a home has created a desire for furniture that
Bob never had when he rented a simple apartment.
Bob also has a lawn around his home. When Bob was living in an apartment building, he
never bothered with how the outside of his place looked. But now he is concerned with
keeping up with the Jones' (actually, the next door neighbor he has to keep up with are the
Browns). Their lawn looks really nice. And so Bob feels pressure to make his lawn look
nice. He buys trees and shrubs to keep it nicely landscaped. He hires a lawn service to keep
it fertilized and growing, and he spends lots of money keeping it watered during the hot
summer months. This is the same Bob who didn't care a whit about how the outside of his
old rental place looked. Having a nice home in a nice neighborhood has created a desire for
a nice lawn. A desire that Bob never had when he rented a simple apartment.
And it goes on and on. Bob is now married with four kids. He worries about having enough
money to pay doctors' bills, glasses and braces for the kids, about having enough money so
that his kids can go to college. He works hard to make sure that there's money in the bank--
or at least sufficiently small balances on his credit cards--so that he can replace the
refrigerator, or the cars, or the roof. And we're still not done. Because Bob also has a lot of
things that he would love to do, but can't afford right now. In ten years of marriage, Bob and
his family have never taken a real vacation. He'd love to go to Disneyland, he'd love to have
a fancy computer system to play games on and hook up to the Internet. And he'd love to not
have to work so hard so he could have more time to spend with his wife and kids.
Well, that is Bob's story. Admittedly, it is not a very exciting one. Then again, Bob is not a
very exciting guy. But that's the point. His story is typical. When he was starting out in his
first job, Bob couldn't figure out how he'd ever spend all the money he was making. Now he
can't ever imagine making so much money that he'd run out of things to spend it on. The
more he makes, the more new desires he discovers for additional goods and services. At
least in this respect, Bob is not unusual. It's just human nature.
Ask yourself: Do you know anybody who complains about having too much money?
Despite the fact that Americans enjoy the highest standard of living ever known in the
history of the world, there is absolutely no evidence to suggest that they have had enough.
They want better computers, safer cars, improved health care, more vacation time, and the
list goes on. And so we are led to this fundamental fact about consumers: CONSUMERS
HAVE INFINITE DESIRES FOR ADDITIONAL GOODS AND SERVICES. They are a
bottomless consumption pit. No matter how many goods and services the economy manages
to dish up, consumers will always want more.
Now we come to the powerful principle which explains why we have confidence that
workers will get reemployed when they lose their jobs. On the one hand, we have
unemployed workers who want to work. On the other hand, we have consumers with infinite
desires for additional goods and services. And in the middle are entrepreneurs who stand to
gain substantial profits by bringing these two sides together. This is the ultimate explanation
for why the economy creates more jobs each year. Why shouldn't we have every expectation
that entrepreneurs will continue to match workers with consumers? What will keep
entrepreneurs from performing this role? You tell us.
Now don't get us wrong. We do not subscribe to a fairy tale world in which all workers
become instantly reemployed once they are laid off. It takes time for entrepreneurs to figure
out how they can use these workers. There may be periods when the unemployment rate
rises because it is not immediately clear to entrepreneurs how best to employ these idle
workers. But entrepreneurs will figure it out. As long as government hasn't created barriers
that make it difficult for firms to reap the rewards of matching workers to consumers--
barriers like minimum wages, mandated benefits for all employees, and burdensome
regulations on small businesses--entrepreneurs will continue to employ workers to satisfy
consumers' demands. That is the powerful dynamic that serves as a giant magnet to bring
together willing workers and hungry consumers. Thus, OUR SECOND REASON FOR
BELIEVING THAT UNEMPLOYED WORKERS WILL GET REEMPLOYED IS THAT
THE INFINITE DESIRES OF CONSUMERS PROVIDE AN INCENTIVE FOR
ENTREPRENEURS TO HIRE UNEMPLOYED WORKERS IN ORDER TO PRODUCE
ADDITIONAL GOODS AND SERVICES.
Still unconvinced? Perhaps you're thinking that all this is fine and good, but it assumes that
workers can produce additional goods and service. Maybe they can't. Maybe they don't have
any skills that would allow them to produce things that consumers want. As a result, no firm
wants to hire them after they're laid off. Isn't that possible? Theoretically, yes. But then we
have to ask ourselves another question. Why was the workers' former employer willing to
pay them so much money if they didn't have any other employment opportunities?
Let's see if we have this straight. The Federal Mogul Company--a firm interested solely in
increasing its own profits--was paying $32 million to workers who had no other employment
opportunities? What's wrong with this picture? Why did the firm feel compelled to offer so
much money to these workers to begin with? If there really were no other jobs for these
workers, they would gladly have been willing to work for less. And the firm could have
hired its workforce for only $30 million, or $20 million, or less. So why was it paying $32
million, and not less?
The reason is simple. The firm paid its workers $32 million because it was forced to.
Anything less, and the workers would have refused to work for the Federal Mogul Co. and
would have taken jobs elsewhere. To argue that these workers have no alternative
employment doesn't make any sense given the large sum of money Federal Mogul Co. was
paying them. Such an argument implies that Federal Mogul Co.--and other firms like it--are
really bleeding heart philanthropists who pay wages far in excess of what they have to. We
have heard a lot of charges made against the labor practices of corporations, but excessive
generosity isn't one of them!
Okay. Let's consider one more possibility. Maybe the firm paid the lowest wages it could
when it hired its workers, but that was many years ago. Now these workers are older. Not
only that, but the labor market has deteriorated where the firm was located. When it laid its
workers off, those workers found it a lot more difficult to find jobs than when they first went
to work for the firm, many years ago. Isn't this possible?
The first thing to note is that this argument still assumes that the $32 million in labor costs is
far in excess of the amount required to keep those workers from taking jobs elsewhere. But
we're willing to concede that maybe this happens sometimes in the real world. After all,
we're reasonable people. Maybe in the real world it does happen that workers are laid off
and the only jobs that they can find are jobs that pay less than what the workers made
before. Does that destroy our argument? Consider once again the Profit Table for a firm that
closes down in Detroit and opens up in Juarez.
REVENUES: $32 M
COSTS: $20 M
PROFITS: +$12 M
From the perspective of society's happiness, the costs represent $20 million in goods and
services that will be withdrawn from the U.S. economy. The revenues represent the $32
million of happiness from the additional goods and services that get produced when these
workers get reemployed. Suppose the former employees of the Federal Mogul Co. are
unable to find jobs that pay the same wages they had before. Instead, suppose these workers
all end up making only two-thirds of what they made at their old jobs. That means they find
jobs that pay them $24 million in wages instead of $32 million. Then instead of society
receiving $32 million of happiness from additional goods and services, it only gets $24
million of happiness. SOCIETY IS STILL BETTER OFF.
In return for gaining additional goods and services that produce $24 million of happiness,
we have to send $20 million of goods and services south of the border. We're still ahead in
the happiness department by $4 million.1 In fact, as long as these workers end up with new
jobs that pay more money than what the firm is paying its Mexican workforce (more than
$20 million), society as a whole ends up being better off. We can be confident that this will
happen. After all, if the next best employment opportunities of these laid off workers paid
less than $20 million, they probably would have negotiated with the company for a wage
which would keep the plant from shutting down.
In conclusion, OUR THIRD REASON FOR HAVING CONFIDENCE THAT THESE

WORKERS WILL BE REEMPLOYED IS THE FACT THAT THEIR WAGES WERE SO
HIGH TO BEGIN WITH. We emphasize that this conclusion does not require workers to
get reemployed at new jobs paying wages equal to their old jobs. In order for plant
relocations to increase society's happiness, American workers need only get reemployed at
wages that are higher than that received by the foreign workers who replaced them. The
lower the wages of their foreign substitutes, the more likely that will happen. And that loud
sucking noise you hear is the sound of American households feverishly consuming the
additional goods and services that foreign plant relocations make possible.
TABLE OF CONTENTS
HOME
Notes
1
If it bothers you that this increase in society's happiness was bought at the expense of these workers'
personal fortunes, we have a solution. Give 'em money.
CHAPTER 33
Who Gains From Trade?
"It is the maxim of every prudent master of a family, never to

attempt to make at home what it will cost him more to make than to
buy. A taylor does not attempt to make his own shoes, but buys them
of the shoemaker. The shoemaker does not attempt to make his own
cloaths, but employs a taylor. The farmer attempts to make neither
the one nor the other, but employs those different artificers....What is
prudence in the conduct of every private family, can scarce be folly
in that of a great kingdom."--Adam Smith, Wealth of Nations1
Suppose that last night, while you were sleeping, government agents came during the dark
of night to blockade your house. In the morning, when you went to take out the garbage, you
were greeted by the following sight: barbed wire sealed off all points of exit from your
property, tanks poked their turrets from between tree limbs, Army sharpshooters patrolled
the perimeter to make sure that nobody attempted to escape. What would your reaction be?
("Hey, honey, there's a lot of people outside our house. Did you forget to pay the phone bill
this month?") Suppose you found out that the reason for all this activity is that the
government was simply enforcing a new law: "Henceforth, each household is forbidden to
engage in trade with any other household." Power and telephone lines were cut. Water lines
into the home were blocked. Effective immediately, each family was responsible for
providing all its own food, clothing, entertainment, and other needs. Take some time to
answer the following question: What would be the effect of this new law on society's
happiness?
Seems like a no brainer, right? Suppose instead, government passed a new law which
mandated the following: "Henceforth, each town is forbidden to engage in trade with any
other town." Now the barbed wire, tanks, and Army sharpshooters are pulled back to the city
limits. This law isn't quite as severe as the previous law, because there are at least some
opportunities for trade within the town. But it's still pretty bad. The good news is the local
paper gets delivered to your home, since the newspaper company is located in town. The bad
news is that the paper is done in crayon, because the company that produces the ink is
located in a different city. The good news is that you're able to watch programming from the
local cable TV company. The bad news is that instead of watching Baywatch, the only
station in town is showing repeats of the production of "Goldilochs and the Three Bears" by
Mrs. Smith's 5th grade class. You get the idea.
A law which discouraged trade outside a town's borders would surely lower society's
happiness. Similarly, a law which discouraged trade outside a state's borders would also
surely lower society's happiness. Does it not follow, then, that protectionist policies which
discourage trade outside a country's borders can only have the same effect?
Or think of it this way. Suppose Adam and Johnny agree to a voluntary exchange of goods.
Since the exchange is voluntary, Adam and Johnny must both believe that the trade has
made them better off. The same thing holds true for trade between Annalisa and Josephine.
And Andrew and Joanne. And Adonirah and Jack. Now let's join Adam, Annalisa, Andrew,
and Adonirah together and call them a country, like "America." And let's join Johnny,
Josephine, Joanne, and Jack together and call them a country, like "Japan." If these
voluntary exchanges make each person better off individually, how can the same set of
voluntary exchanges make the countries of "America" or "Japan" worse off? How can
something be unquestionably good at the individual level, but bad when we sum up the
exchanges?
International trade--that is, trade between countries--is remarkably simple to understand

because, in principle, it is no different than trade within countries. That was the point that
Adam Smith was making when he wrote the words that begin this chapter--over two
hundred years ago. Not surprisingly then, the same, simple framework that we have used to
analyze resource transfers within countries can also be applied to resource transfers between
countries.
Suppose an American car dealership imports Honda Civics from Japan. The dealer pays
$12,000 to Honda of Japan to import the car. It turns around and sells the Civic for $16,000.
Ignoring the other costs of the dealer, we can represent this transaction in our beloved Profit
Table as follows.
Profits from the Honda Civic Trade
REVENUES: $16,000
COSTS: $12,000
PROFITS: +$4,000
Assuming the market price of Honda Civics is right around $16,000, the dealer's revenues
represent a dollar measure of the happiness that some American consumer will receive
because one more Civic was available. In exchange for this car, Americans have traded
$12,000 of green pieces of paper. What will Honda of Japan do with this money? One
possibility is that they will trade their dollars for yen at the foreign exchange desk at the
Bank of Tokyo. But the Bank of Tokyo isn't all that interested in holding on to American
dollars (the local McDonald's only takes yen), so it looks for someone who is willing to
swap yen for dollars. Maybe a Japanese business office in Osaka is interested in buying
American personal computers. It goes to the Bank of Tokyo and exchanges its yen for the
$12,000. The business office can now buy 3 personal computers at $4,000 a piece. After a
short trip abroad, those twelve thousand dollars return to the U.S. to pay for 3 personal
computers that get shipped to Osaka.
From the perspective of the U.S. economy, here is the trade we just made with Japan. In
exchange for one Honda Civic, American consumers gave up three personal computers. Was
it a good deal? Sure. Since the personal computers were each priced at $4,000, losing three
personal computers meant that American consumers missed out on $12,000 of happiness.
That's a bummer. But in return they got a Honda Civic that produced $16,000 of happiness.
The bottom line is that this trade has resulted in a net increase of $4,000 in (U.S.) society's
happiness. (Lest we think we just pulled a fast one on the Japanese, we should remember
that since the Japanese made this trade voluntarily, it must mean that they also were made
better off).
Let's use this example to consider the much loathed and generally feared practice of foreign
"dumping." Dumping is a practice whereby foreign countries sell their goods in American
markets at prices lower than what they charge in their home markets. Why might a foreign
country do this? There are a lot of reasons, but consider the one that seems to most offend
Americans. Suppose the government of Japan subsidizes the export of Hondas. For every
Civic that Honda ships to the U.S., the Japanese government gives Honda of Japan a large
cash payment.
Now this seems really unfair. How in the world can American car manufacturers compete
against the Honda Civic if the Japanese government subsidizes them? Good question.
Though not necessarily the right question. We'd rather ask, how does the practice of foreign
dumping affect the happiness of U.S. society? This depends on the amount of the foreign
subsidy. If a small subsidy is a little offensive, then a large subsidy should be downright
nauseating. So let's assume the absolutely worst case scenario. Let's assume that the
Japanese government subsidizes the entire cost of the Civic. Rather than having to pay
$12,000 for the Civic, the American car dealer picks up the entire car for nothing, thanks to
the Japanese government. We're forced to agree, this is unfair competition at its most unfair.
Let's see how this transaction gets reflected in the dealer's profit statement.
REVENUES: $16,000
COSTS: -- 0 --
PROFITS: +$16,000
Nice looking profits! This car dealer certainly has no complaints about foreign dumping. But
how has this transaction affected society's overall happiness? On the one hand American
consumers get a spanking new Honda Civic. On the other hand, American consumers give
up....what? What did American consumers have to give up in return for the Honda? The
answer is, absolutely nothing (note that the dealer's costs are zero). Since the dealer didn't
have to send $12,000 to Honda of Japan, Honda of Japan never had $12,000 to exchange
with the Bank of Tokyo, which in turn didn't have $12,000 to trade with the business office
in Osaka. As a result, the business office in Osaka never placed an order for three personal
computers, which means that those three personal computers can now be enjoyed by
American consumers.
Here is the trick: the less dollars we have to send abroad to get the goods we want, the less
dollars foreign countries have to make claims on our goods and services. And the less goods
and services foreign countries take from us, the more we have for ourselves. Dumping?
What's to complain about? Rather than taking foreign firms to court for violating anti-
dumping laws, we should be doing something more productive, like writing thank you
notes!
But...but...but...won't this hurt American car manufacturers? Indeed it will. If the Japanese
really did ship us their cars for free, this would dramatically lower the price of cars in
America. Of course, those lower prices are telling us something. With all these nice new
Japanese cars over here, the extra happiness of an additional American car is pretty small.
As a result, we'd like American car manufacturers to stop producing so many cars. Instead,
we'd like them to devote their resources to producing other, more valuable things. And if
they can't think of anything else to do with those resources, then they better release them to
those who can.
How about the fairness argument? It surely isn't fair that American car manufacturers have
to compete against foreign cars that are heavily subsidized by their governments. Indeed it
isn't, and so we have to return to the purpose of the economy. Is the purpose of the economy
to guarantee fairness to all producers? Or is it to maximize the happiness of consumers?
Whose benefit are we running this economy for anyway? For Lee Iacocca's benefit? Or for
you, a consumer?
From the perspective of the producer, it makes no difference if the price of cars is low
because Japanese cars are subsidized by their government, or if car prices are low because
Americans have a change of heart and all decide they'd rather take the bus. Wouldn't that be
unfair too? ("How dare those consumers decide they don't like our cars anymore! You think
they would at least have called and told us they were taking the bus before we shipped all
these new cars to the showroom.") And speaking of fairness, was it fair to the horse and
buggy industry when Henry Ford introduced his non-hay eating, non-manure producing
form of transportation? Talk about unfair competition!
The answer to the question of what is fair is a tough one. We sure are glad we don't have to
answer it. In contrast, the answer to the question, Who gains from trade? is an easy one.
American consumers do. And as long as trade proceeds voluntarily, the greater the trade, the
greater the increase in society's happiness. It's just that simple.
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Notes
1
Adam Smith, An Inquiry Into the Nature and Causes of the Wealth of Nations, Indianapolis: Liberty
Classics, 1976, pages 456f.
CHAPTER 34
How To Spite Our Collective Face by Cutting Off Our Collective
Noses
"FRENCH FARMERS PROTEST U.S. CALLS FOR SUPPORT

CUTS. Paris (AP) French farmers burned an American flag and
clashed with riot police in a rainstorm Wednesday near the U.S.
Embassy in a protest against U.S. pressure to cut European crops
subsidies. ....The...administration has threatened $300 million in
punitive tariffs on European farm products unless the Europeans
agree by Dec. 5 to cut subsidies to farmers for growing soybeans and
other oilseeds."1
How should we feel when our government representatives retaliate against European
soybean subsidies (or South Korean shipbuilding subsidies, or Canadian wheat subsidies,
etc.) by imposing punitive tariffs against the offending countries? Should we write our
officials letters of support, thanking them for preventing unfair trade? Before you get out
your stationary, let's do a simple analysis.
As has already been demonstrated in our analysis of dumping, when foreign countries
subsidize their products, they make them cheaper for us to import. Translated, that means we
don't have to give up as many of our goods and services in order to get what we want from
our foreign trading partners. How could anybody argue that lower prices make consumers
worse off? When you go car shopping and see a sticker price of $12,000, do you say to the
salesman, "I'll give you $14,000 and not a penny less?"
But when our government tries to prevent foreign governments from subsidizing their
exports, we are saying, in effect, "No Francois, you must charge us $5 for that bushel of
soybeans, not $3. Oui, $5 and not a penny less!" When foreign governments subsidize their
products, it is like a blue-light special at KMart. ("Attention, KMart shoppers, please direct
your attention to Aisle 17 where you'll find some very special prices on European soybeans.
For the next hour, you can buy two--yes, two--European soybeans for the price of one.")
It's bad enough that the American government doesn't extend an official letter of
appreciation to the kindly French taxpayers when they subsidize their agricultural exports to
us. (We were raised to write Thank You notes whenever someone sent us a gift.) As if rude
manners weren't bad enough, our government adds injury to insult by using bad economics.
Let's use our Profit Table to show the effect of a retaliatory tariff on the happiness of
American consumers.
Suppose a PUNITIVE TARIFF was imposed on French white wines (which was exactly
what happened in this particular case). Now consider an American importer of French
wines. Prior to the tariff, this importer could buy a bottle of Chablis from a French wine
company for $18. In return, that importer could turn around and sell that wine for $25 in the
U.S., generating a nifty $7 profit. Now the U.S. government slaps a $10-a-bottle tariff on all
French white wines. The plan works brilliantly. Less Chablis gets shipped to the U.S. This is
represented in our Profit Table by the fact that the importer can no longer make a profit on
this transaction. Hence the trade does not take place.
Before Tariff After Tariff
REVENUES: $25 $25
COSTS: $18 $18 + $10 = $28
PROFITS: +$7 -$3
What is the impact on America's consumers? Clearly, they have lost out on the happiness
they would have received from the French wine. In this instance, that would be a loss of
approximately $25 in happiness. There is, however, some corresponding gain. American
consumers get to keep $18 of goods and services that would have ended up getting shipped
to France. Alas, the gain does not compensate for the loss. By discouraging this trade, the
punitive tariff has resulted in a $7 decrease in the happiness of American consumers.
What would happen if, instead, the $10 tariff were placed on the French firm shipping the
wine, rather than the American importer? In that case the French would no longer be willing
to sell their wine to us for $12. If they were forced to pay the $10 tariff, they would simply
charge the American importer $10 more. This would increase the cost to the American
importer from $12 to $22. Thus, the American importer would end up paying for the tariff
anyway, only indirectly, by having to pay higher wine prices. And the Profit Table would
end up being the same as when the American importer directly paid the tariff.2
Finally, note that we get the same result again if the government imposes an IMPORT
QUOTA on French Chablis. Suppose the bottle of wine represented in the Profit Table is a
bottle of wine that would have been beyond the allowable limit after the U.S. government
imposed the quota. Suppose further that the penalty associated with violating the quota was
$15. The result, not surprisingly, is the same.
So who exactly gets punished when punitive tariffs are imposed? It's true that the French get
hurt. After all, they--like us--derive benefits from this trade. They valued the $20 in
American goods and services more than the Chablis they were giving up in return. But
clearly, American consumers are also punished. And it is by no means clear that the hurt
suffered by Americans will be any less than that suffered by the French.
Picture the following scene. It's a beautiful Christmas morning. Outside, the freshly fallen
snow glistens in the sun's early rays. Inside, the happy sounds of children playing with their
new toys fills the house. A warm, crackling fire burns on the hearth. And from the living
room CD player, the Mormon Tabernacle Choir sings the holiday's favorite hymns.
Suddenly, there is a knock at the door. A neighbor has arrived with another gift! The
children all gather round in giddy curiosity to see what the special present is.
But before the gift can be opened, the man of the house, in a fit of furious rage, comes
storming down the staircase and yells at the neighbor, "Get that gift out of my house!" The
children are shocked. The neighbor says, "Merci, Monsieur! It eez a geeft! Weeth love, from
me and my familee!" "You miserable bum, you no good son of a French milking maid, who
said you could bring that present in this house? Get out. Get out before I throw you out."
"But Daddy, Daddy," the children say, "the man was only trying to be nice."
"I'll show you nice," says the father. He reaches back and throws a walloping, roundhouse
punch right to the neighbor's jaw. The neighbor reels backwards. And then the father does
the craziest thing. He grabs a frying pan from the kitchen and hits himself over the head.
Again, he punches the neighbor, grabs the frying pan, and hits himself over the head. Over
and over this continues, until the neighbor stumbles out of the house, taking his package
with him. Bruised and hurt, the father slumps to the floor. But before he slips into
unconsciousness, he turns to his disbelieving children and triumphantly announces, "I guess
I showed him."
An unbelievable story you say? Something that would never happen in any normal
household you say? You're probably right. And yet this happens everyday in the world of
international trade. It's bad enough that our government turns down gifts that could make
Americans better off. But just in case one of those pesky foreign countries persists in trying
to give us their goods for cheap, our government hits American consumers over the head
with a figurative frying pan in its efforts to keep those gifts at bay. It's like cutting off one's
nose to spite one's face!
OPTIONAL SECTION FOR ECONOMISTS: T h e f i g u r e b e l o w i d e n t i f i e s t h e w e l f a r e l o s s a s s o c i a t e d w i t h a

ta r if f o n im p o r t s . T h e im p o s itio n o f th e t a r if f c a u s e s th e s u p p ly c u r v e to s h ift u p b y th e a m o u n t o f th e t a r if f. T h is
r e d u c e s t h e q u a n t i t y o f i m p o r t s f r o m Q 0 t o Q 1. T h e s h a d e d a r e a i n d i c a t e s t h e " l o s t h a p p i n e s s , " o r w e l f a r e l o s s ,
c a u s e d b y th e t a r if f.
T h e a le r t r e a d e r w ill n o te th a t t h e a n a ly s is a s s u m e s t h a t th e s u p p ly c u r v e o f im p o r t s is p e r f e c tly e la s tic . T h e g r a p h

b e lo w s h o w s t h a t if th e s u p p ly c u r v e o f im p o r ts is u p w a r d s lo p in g , t h e im p o s it io n o f a ta r iff h a s a m b ig u o u s w e lfa r e
e f fe c t s . A r e a B id e n tifie s th e lo s t g a in s f r o m tr a d e r e s u lt in g f r o m th e r e d u c tio n i n i m p o r t s f r o m Q 0 t o Q 1. A r e a A
r e p r e s e n t s t h e w e lf a r e g a in r e s u ltin g f r o m t h e fa c t th a t A m e r ic a n c o n s u m e rs n o w p a y P 1-t a r i f f i n s t e a d o f P 0 f o r t h e
q u a n t i t y Q 1. I f A r e a B i s l a r g e r t h a n A r e a A , t h e n t h e r e is a n e t w e lfa r e lo s s a s s o c ia te d w it h th e t a r if f. If A r e a B is
s m a lle r th a n A r e a A , t h e n th e ta r iff c a u s e s a n e t w e lfa r e g a in .
N O T E : W h e n th e s u p p ly c u r v e o f im p o r ts is u p w a r d s lo p in g , t h e P r o fit T a b le ig n o r e s a s o u r c e o f w e lfa r e c h a n g e s .
T h is is th e fir s t tim e in th is b o o k th a t o u r P r o f it T a b le h a s n o t c a p t u r e d a n im p o r t a n t w e lf a r e e ff e c t! W h y d id th is
h a p p e n ? In t h e p a s t, p r ic e c h a n g e s d id n o t c o n t r ib u te to c h a n g e s in s o c ia l w e lf a r e . T h e y s im p ly m e a s u r e d w e a lt h
tra n s fe rs b e tw e e n " c o n s u m e rs " a n d " p ro d u c e r s " ( i .e ., c o n s u m e r s c u m o w n e r s o r s h a r e h o ld e r s ) . H o w e v e r , in
in t e r n a t io n a l t r a d e , p r o d u c e r 's s u r p lu s r e p r e s e n t s t h e g a in to th e fo r e ig n tr a d in g p a r t n e r . T h u s , c h a n g e s in
p r o d u c e r 's s u r p lu s c o n t r ib u t e t o A m e r ic a n s o c ia l w e lfa r e . A s a p r a c tic a l m a t te r , a lm o s t a ll e c o n o m is ts a g r e e th a t th is
la t te r e ff e c t is r e la t iv e ly s m a ll, a n d t h a t th e im p o s itio n o f ta r iff s c a u s e s a n e t lo s s fo r A m e r ic a n s o c ia l w e lfa r e .
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Notes
1
The Daily Oklahoman, November 19, 1992.
2
We note that this analysis does assume that the supply curve of imports is perfectly elastic. If the
supply curve is upward sloping, there is a benefit to American society of imposing the tariff, that may or
may not compensate for the lost gains from trade described in the Profit Table. This is described further
in the "Optional Section for Economists" at the end of this chapter.
CHAPTER 35
Are Trade Deficits Bad?
"U.S. TRADE DEFICIT WORST IN 6-1/2 YEARS. Washington

(AP) The U.S. trade deficit jumped to $9.17 billion in May as higher
oil prices and a big drop in sales of commercial airliners contributed
to the worst merchandise trade performance in 6-1/2 years."1
Perhaps no other single topic in all of economics has been so widely misunderstood as the
trade deficit. Strangely enough, the trade deficit is a remarkably simple subject. Suppose you
and your neighbor Jim get to talking one Saturday morning, and the two of you decide that
each has some things the other wants. So you decide to trade. Jim gives you his 15
horsepower, John Deere riding lawnmower that is still in mint condition. In exchange, you
give him a rake. Jim agrees to grill steaks for your family every night for the next six
months. You give him a bag of dogfood. Jim gives you his brand new Porsche. You give
him a bottle cap opener. Using any reasonable accounting standard, you have just
accumulated a tremendous "trade deficit:" the value of the items that you have received is
greater than the value of the items you gave up. When a trade deficit occurs at the individual
level, you thank your lucky stars that you were fortunate enough to live next door to a
chump like Jim. ("It's just like the realtor said, honey, the three most important things in
choosing a home are location, location, and location.") Why is it then, that when a trade
deficit occurs at the national level, it is a source of great consternation and travail?
Let's consider trade between two countries, say America and Japan. Suppose Sony of Japan
sells 10,000 camcorders to Sears, Roebuck and Company in the U.S. for $500 a piece. At
this point in the transaction, this trade can be summarized as follows: The U.S. gets 10,000
camcorders, and Japan gets $5,000,000 (equals 10,000 times $500) in green pieces of paper.
What can Japan do with its $5,000,000? There are THREE POSSIBILITIES.
First, JAPAN CAN SPEND ITS MONEY ON AMERICAN GOODS AND SERVICES.
This was exactly the scenario described in Chapter 33 when we discussed "Who Gains From
Trade?" Let's suppose the Japanese spend their money on American personal computers
costing $2,000 a piece. Then America ends up trading 2,500 personal computers (2500 times
$2,000 equals $5,000,000) in exchange for 10,000 Sony camcorders. If we follow the flow
of goods and money in a diagram, it would like something like this.
There are two things to observe in the diagram above. The first is that money and goods
flow in opposite directions. If money is flowing out of the country, goods and services must
be flowing into the country. Since it is goods and services that provide happiness, not
money, we need to be careful and keep our eye on the ball when considering the impact of
trade on America's happiness. The second thing to note is that there is no trade deficit in this
case: $5,000,000 flows out of the country, and $5,000,000 flows back into the country. The
monetary value of the goods we import is exactly equal to the monetary value of the goods
we export.
Note that even though the monetary value of imports and exports is the same, Americans are
still benefitted from this trade. Because Sears is motivated by profits, we know the reason it
was willing to buy the camcorders in the first place was because it figured its customers
would pay a higher price to Sears than what Sears paid to the Japanese. As a result, we know
that Americans should receive more than $5,000,000 in happiness from these camcorders.
Thus, this trade allows American consumers to give up personal computers that would have
produced only $5,000,000 of happiness, in order to get camcorders that produce more than
$5,000,000 of happiness. Even though there is no deficit or surplus, Americans are clearly
made better off by this trade. So far, so good.
Now let's consider the second possibility: JAPAN CAN SPEND ITS MONEY ON GOODS
AND SERVICES FROM OTHER COUNTRIES. It just so happens that American
greenbacks are widely accepted as payment in international commercial transactions. So if
Japan wants to buy, say, oil from Saudi Arabia, it could do that without having to first
exchange its dollars for riyals (the currency of Saudi Arabia). Of course, that just pushes
back the question of what happens to those $5,000,000. To keep this saga short, let's
suppose that after the Saudi's sell their oil to Japan, they take the $5,000,000 they earned
from that sale to buy personal computers from America. Now if we follow the flow of goods
and services, it will look like this.
You would certainly think that--from the perspective of America's happiness--it shouldn't
make a difference whether the Japanese spend their $5,000,000 in the U.S. directly, or buy
oil from the Saudi's who in turn spend the money in the U.S. After all, the bottom line is that
we are still getting camcorders in return for giving up $5,000,000 of personal computers.
But look now at the respective trade balances between America and her two trading partners.
Because the U.S. received camcorders from Japan and sent nothing back in exchange, we
are recorded as having a $5,000,000 trade deficit with Japan. What significance should we
attach to this trade deficit?
Do we even have to say it? This trade deficit with Japan is of absolutely no consequence for
the happiness of U.S. consumers. For at the same time that we are running a trade deficit
with Japan, we are running a trade surplus with Saudi Arabia of exactly the same amount.
This should make clear that looking at bilateral trade balances can be very misleading.
Again, why should we care whether Japan uses its dollars to buy from us or to buy from
other countries, who in turn will buy from us? So even though we are now running a trade
deficit with Japan, the outcome of this case is precisely the same as in the previous case: the
happiness of America's consumers is still increased by the trade.
Let's now look at the third possibility. JAPAN EITHER HOLDS THE MONEY IT EARNS
IN TRADE WITH THE U.S. OR BUYS GOODS FROM OTHER COUNTRIES, WHO IN
TURN HOLD THE MONEY. This is the last remaining possibility. To see the impact on the
happiness of America's consumers, let's keep careful track of the flow of goods and dollars.
The diagram represents the case where Japan decides to keep the $5,000,000 it earns from
selling camcorders in the U.S.
Just like in the previous case, America is running a trade deficit with Japan. Only this time,
the dollars don't come back. There are no trade surpluses from other trade partners to
balance this trade deficit. And this fact changes everything from the perspective of
(American) society's happiness. Because now in return for getting camcorders, the U.S.
gives up....you guessed it--absolutely nothing (or just about absolutely nothing). We have
traded $5,000,000 of green pieces of paper in return for 10,000 shiny new camcorders. This
is a great trade! As long as we remember that we don't get any happiness from dollars, but
from the goods and services that dollars can buy, we see that the U.S. has gotten something
of great value (camcorders) by giving up something of very little value (little green pieces of
paper). It kind of makes us wonder...has our friend Jim moved to Tokyo?
In summary, when Japan (or any country) sells goods to the U.S., there are three--and only
three--things it can do with the dollars it earns. If it comes right back and buys American
goods and services, then Americans have to give something up for its imports, but it's still a
good trade. If Japan buys goods from other countries, and those countries buy American
goods and services, then it's exactly the same as the first case. And if it holds onto the
dollars it earns, or buys from other countries and they hold on to the dollars, it's nothing less
than a generous gift from one of our trading partners. It's Christmas all over again! Only this
time Santa Claus speaks Japanese. That's it. Three possibilities, no more. The first two are
good for the happiness of U.S. consumers. The third is even better. So why all this hair-
pulling and chest-thumping over the trade deficit?
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Notes
1
The Daily Oklahoman, July 20, 1994.
CHAPTER 36
Trade Wins, and Losses
It seems that most people who are concerned about the trade deficit are bothered by the fact
that the U.S. imports more than it exports. But they forget (or perhaps never knew): An
increase in imports causes an increase in the happiness of U.S. consumers. In contrast, AN
INCREASE IN EXPORTS REPRESENTS A DECREASE IN THE HAPPINESS OF U.S.
CONSUMERS BECAUSE IT MEANS THERE ARE LESS GOODS AND SERVICES
FOR AMERICANS TO CONSUME. Exports are simply the price we pay to enjoy imports.
Once that is understood, a lot of trade policies that pass for wisdom are exposed as plain old
foolishness.
For example, why would the U.S. government ever want to put pressure on its trading
partners to buy more American goods? It should be doing the opposite. If the elected
representatives of the United States really wanted to help ordinary Americans, they should
pressure other countries to subsidize their exports to the U.S.
Or how about this one? The U.S. Treasury Department and Federal Reserve often conspire
with the central banks of other countries to prop up their currencies against the dollar. For
example, the official policy of the U.S. in 1994 was to keep the Mexican peso from
declining in value against the dollar. When the Mexican peso is strong, it makes Mexican
goods more expensive for Americans to import. Similarly, a strong Mexican peso makes
American goods cheaper for Mexicans, and encourages the flight of U.S. goods and services
south of the border and out of the hands of American consumers. So why would the U.S.
government work hard to make sure its citizens get less foreign goods to consume, but have
to give up more of their own goods and services in exchange? Who are these guys working
for, anyway?1
So why do so many people get confused on trade issues? That's a hard question to answer.
However, it's our experience that most people get confused because they tend to think of a
country as a firm. That is, when a firm takes in less money than it spends, it earns losses. So
when a country takes in less money than it spends, it seems only natural to think that the
country is in trouble. The difference is that a country is not a firm. The goal of a firm is to
maximize profits. The goal of a country is to maximize the happiness it gets from
consumption.
When more money consistently enters a firm than leaves that firm, its shareholders are
enriched. In contrast, when more money consistently enters a country than leaves that
country, its citizens are impoverished. Because that means that lots of goods and services are
leaving the country, while only a few goods and services are coming back in. As always, the
trick is to keep one's eyes on the ball: Happiness doesn't come from little green pieces of
paper, it comes from the consumption that those little green pieces of paper will buy. Can it
really be this simple you say? The short answer to this question is "yes." But we confess,
there is a little more to this story.
The main reason the dollar value of American imports is larger than the dollar value of
American exports is not because foreign nations aren't spending their American dollars.2
Rather, they're spending their dollars investing in our country, instead of buying our goods
and services.3 For example, suppose the Japanese sells us camcorders. But rather than use
their dollars to buy American computers, they use their dollars to buy the firms that produce
those personal computers. Hah! Now that changes everything! Right? Not exactly.
Let's think of why the Japanese would want to own American firms. Presumably, Japanese
investors have the same motivation for owning American firms as American investors do.
They want to make money. But what will they do with that extra money? Perhaps they'll buy
some more firms. Then they'll be able to make even more money. At some point, however,
we have to come to grips with the ultimate reason for why Japanese investors want to make
all this money. It's the same reason why American investors want to make more money. The
reason they want to make those extra dollars is so they can buy more (American) goods and
services.
Yup, we're back where we started from: For the most part, Americans pay for imports by
giving up goods and services in return. When a Japanese investor chooses to buy an
American firm instead of American goods, he's really saying that--rather than having some
American goods right now--he'd rather have even more American goods later. Buying a
company, or commercial property, or Treasury Bills, is like buying a stream of future
American goods and services. In fact, once this is understood, the overall trade deficit can be
understood as a loan by foreigners to Americans. They agree to give Americans goods and
services now. In return, Americans agree to send goods and services back to the foreigners,
later.
Well, isn't that bad for Americans? There are a lot of ways we can answer this. How about
this one: Do YOU have any loans? Do you think that loans have made YOUR life worse
off? Suppose we outlawed all loans. Would you be made better or worse off? Most people
would agree that the ability to borrow money has improved their quality of life. If someone
felt that borrowing money would make them worse off, they could always choose not to
borrow. If the ability to borrow money is good for any one individual, how can it be bad
when we put a bunch of individuals all in one country and call them Americans?
Does this mean that the standard of living of Americans is going to fall in the future when it
comes time to pay off all those loans? That depends. Again, think of yourself. Is your
standard of living going to be lower because you borrow money? The answer depends on
what you choose to spend the money on.
Suppose you zip out your Visa card and decide to have the vacation of a lifetime. You jet to
Acapulco. You spend a glorious month in the sun, drinking Margaritas and writing postcards
to all your friends back at home (just to make them jealous). You stay in the Penthouse suite.
You order all your meals through room service. The hotel masseuse comes to your room to
give you a stress-relieving, mind-numbing, absolutely delicious massage in the comfort of
your own room...three times a day. It's quite a vacation all right. Yessiree. You go back
home and everything is just wonderful until one day you get your Visa bill in the mail. And
you spend the rest of your life working three jobs to pay it off! In this case, consuming a lot
of extra goods now means that you will have to sacrifice future happiness as you pay off
those loans in the future.
But not all loans make one poorer in the future. For example, most students borrow money
to help pay for their college education. Sure, they'll have to use some of their future income
to pay back those loans. But they're banking that the education they receive will make them
richer in the future. So much richer, in fact, that even after they subtract their loan payments,
their take home pay will be higher as a result of their educational investments.
So what is America doing with all those loans it is receiving from foreigners? Is it enjoying
a huge consumption binge? Or is all this borrowing allowing it to invest in its future
production capacity? The fact is, nobody knows. And, ultimately, it really doesn't make a
difference. Because the most important thing to keep in mind about the trade deficit is...the
U.S. is getting a bunch of great stuff.4 Whatever the reason, we're made better off. Maybe
it's because foreigners are trading their merchandise for our goods. Maybe it's because
foreigners are trading their merchandise for our services. Or maybe it's because foreigners
are willing to make loans to us at rates lower than what we're willing to lend to ourselves.
This is essentially what happens whenever foreigners pay more for American firms,
commercial properties, and government securities than Americans are willing to pay. A full
understanding of how this makes Americans better off must wait until we have a chance to
talk about financial markets, and interest rates. It just so happens that this is the subject of
our very next chapter.
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Notes
1
Interventions in international currency markets such as this are often described as "leaning against the
wind." A more apt characterization would be "spitting against the wind." When central banks attempt to
resist market forces pushing down the value of a particular currency, they only delay the eventual
outcome. Disastrous consequences often follow, as the pent-up forces causing the depreciation
eventually prevail, resulting in economic havoc. Such was the case in December 1994 when the
Mexican and American authorities stopped trying to artificially prop up the value of the peso. The result
was a tumultuous decline in the value of the peso that shook international financial markets and
destabilized the Mexican government. If price controls are a bad idea in domestic markets, why would
one think they were a good idea in international markets? Like spitting in the wind, such policies are
ultimately helpless in fighting market-driven "headwinds."
2
To be sure, some of the trade deficit, a small portion, is due to this. Because American dollars are
useful in international commerce, many nations hold cash balances of dollars to facilitate their trade with
other countries. When this happens, it is Christmas, plain and simple: the U.S. gets valuable goods and
services in return for little green pieces of paper.
3
It should be noted that, sometimes, what gets reported as the "trade deficit" is actually the
"merchandise trade deficit." For example, suppose that instead of buying personal computers with the
money they earn for selling camcorders to America, the Japanese purchase other, non-"merchandise"
things. Like what? A significant portion of the trade deficit, but not the majority, is accounted for by
"services." For example, when Japanese tourists fly American airlines and stay at U.S. hotels, that gets
figured into services. Well, you ask, why should it make a difference whether those camcorders get paid
for with American personal computers, or romantic nights for Mr. and Mrs. Hayashi at an American
Hilton? Exactly.
4 Many economists point out that much of the borrowing represented by the trade deficit during the
1980s was the result of government deficit spending. If the trade deficit is a result of government
spending and the government spends the money unwisely, then the trade deficit very well could make us
worse off. Of course, the problem here is not the trade deficit, but the government spending which is
driving it.
CHAPTER 37
The Information Contained in Interest Rates
"We must also change our current use of [interest] rates, the device
by which we systematically undervalue the future consequences of
our decisions....To accomplish the transition to a new economics of
sustainability, we must begin to quantify the effects of our decisions
on the future generations who will live with them. In this, we have
much to learn from the Iroquois nation, which requires its tribal
councils to formally consider the impact of their decisions on the
seventh generation into the future, approximately 150 years later."-
Al Gore, U.S. Vice President.1
So far, most of the resource transfers we have discussed are assumed to take place, if not
instantaneously, at least in a very short amount of time. But what about the transferring
resources across time? How should society decide whether to consume one ton of coal
today, or save that coal for next year? Should we adopt the advice of the Vice President of
the United States, who advocates the abolition of the interest rate system for making
decisions about resource allocations over time? Even if we took his advice about
"quantifying the effects of our decision on the future generations," how would we
implement it practically? How should we trade off the well-being of our generation with the
well-being of the "seventh generation into the future?" After all, resources saved for future
generations represent lost happiness for consumers today. Should the impact of a decision
felt 150 years from now be given the same weight as an impact felt 1 year from now?
Furthermore, who would be empowered to make these decisions ("Welcome back,
Economic Dictator!")? These are tough questions. And yet, they must be addressed.
Implicitly or explicitly, a society makes countlessly many decisions every day which
profoundly impact both the current and future happiness of its consumers. Before we
consider how an economy should allocate resources across generations, let's first examine
how individuals allocate resources across time in a free-market economy.
ONE WAY WHICH INDIVIDUALS CAN ALLOCATE CURRENT RESOURCES FOR

FUTURE CONSUMPTION IS THROUGH SAVING. Saving represents giving up
consumption now in order to gain consumption in the future. When you take home your
paycheck and stuff a certain percentage of it in a savings account or a Certificate of Deposit,
you are saying--in effect--that you do not want to consume now, but would rather save your
consumption for sometime in the future. You are storing happiness. You may be saving for
retirement, for a new computer system, or for a child's education. But you are certainly
saving for the sake of future consumption. Only a miser stores money for the sake of money.
Everyone else saves money so that they can enjoy consumption later on (or so that their
loved ones can enjoy consumption later on). So from now on, think of saving as storing
happiness.
Now that we have an idea of what saving represents, let's turn to its counterpart, borrowing.
BORROWING IS A WAY BY WHICH INDIVIDUALS CAN TRANSFER FUTURE
CONSUMPTION TO THE PRESENT. Few families can afford to buy a home or a new car
and pay for it all at once. Instead, they borrow the money from a lender. However, in order
to induce a lender to give up his money, the borrower must promise to pay back an amount
whose sum total is greater than the original amount of the loan. Why would borrowers ever
agree to pay back more money than they borrowed? The answer lies in human nature.
Most people prefer enjoyment now over enjoyment later. Indeed, it's something for which
they're willing to pay a premium. Instead of waiting three more paychecks to buy a big
screen television set, a football fan might want it right now, in time for the Super Bowl. If
the big screen television costs $1,000 to buy right now, but a total of $1,100 if bought on
lay-away, the extra $100 can be thought of as the price the football fan paid for the
immediate enjoyment of the television set.
By now, you're probably dying to know if there is some easy way to relate borrowing and
saving, present consumption and future consumption. Of course, it's the interest rate. We
know we promised to cut through the boring terms like "interest rate," but bear with us a
moment, because interest rates may be more interesting than you think. Perhaps the best way
to explain how interest rates serve to allocate resources over time is to consider each
person's "own" interest rate, something we'll call their "personal interest rate."
To illustrate this, let's consider the situation of one of the authors of this book (let's call him
"Max"). Max is a student paying for graduate school with only meager assistance from his
parents and the federal guaranteed student loan program. Like most students, Max's life is a
constant financial struggle. There never seems to be enough money for even the most basic
necessities of life. Max rides a bicycle to school to save transportation costs. He washes his
paper dishes to keep his household expenses down. He rarely goes out, even when the most
desirable women on campus beg him for a date. ("Sorry, baby, I'd love to, but I'm a little
short this month..No, I mean a little short on cash.") And a fancy dinner at home consists of
a meal of beaner wieners (RECIPE: one (1) hot dog, carefully sliced, and slowly added to
one (1) can of baked beans, gently brought to a boil over an open flame. For a special treat,
try pouring the can into a sauce pan.)
As would surprise few, Max has a very high personal interest rate. Max is living off of very
little money as it is, and he is already borrowing to help finance his education. Therefore, he
values present consumption quite a lot. If pressed, Max would say his "personal interest
rate" is currently around 20 percent. This means that Max would be indifferent between
having $1200 dollars a year from now, or having a $1000 today. We can think of this in two
ways. In order to get Max to save a $1000 today, we would have to guarantee that he receive
something more than $1200 a year from now. Alternatively, Max would be willing to
borrow $1000 today, as long as he could pay back less than $1200 next year.
Now let's consider the other author of this book ("Bob"). Bob is a family man with a wife,
three children, and two dogs to support. As we discussed earlier, Bob is concerned about
having enough money in the future to pay for his children's college educations, future dental
bills, and the possibility of having to put in an expensive, French drain system around his
house. With all this future consumption in mind, Bob values present consumption relatively
little and wants to save his money. If pressed, Bob would admit to having a personal interest
rate of around 5 percent. In other words, Bob would be willing to give up $1000 today as
long as he received anything more than $1050 a year from now.
Now it seems that Max and Bob have an incentive to trade. Max would be willing to borrow
$1000 as long as he could pay back less than $1200 next year. Bob is willing to lend $1000
as long as he can get more than $1050 a year from now. After a (perhaps lengthy) period of
bargaining, we would expect that the interest rate established between the two will be
somewhere between 5 and 20 percent. (BOB: "Hey, Max, I'm willing to lend you $1000 at
191/2 percent interest." MAX: "191/2 percent! That's outrageous! I thought you said your
personal interest rate was only 5 percent?" BOB: "It is." MAX: "Forget it. Some friend you
are." BOB: "Have it your way. Hope you enjoy those beaner wieners tonight!" MAX:
"Where do I sign?")
Now imagine a million Max's, and a million Bob's (talk about a scary thought!). Each has
his own personal interest rate, each wanting to either lend money, borrow money, or
consume just equal to their current incomes. After the interaction of all these players, a
market interest rate will be determined. What is the information contained in this market rate
of interest?
We can think of each individual's personal interest rate just like a personal "willingness to
pay" value. For example, a person with a personal interest rate of 10 percent is willing to
pay approximately $1100 next year in order to have an extra $1000 right now. Since the
market rate of interest is a price like any other price, we can use exactly the same logic that
we used in Part I to determine the information contained in this price. In particular, THE
MARKET RATE OF INTEREST TELLS US HOW MUCH HAPPINESS SOCIETY
WOULD HAVE TO RECEIVE NEXT YEAR--MEASURED IN DOLLARS--TO
COMPENSATE IT FOR GIVING UP A DOLLAR'S WORTH OF HAPPINESS TODAY.
Alternatively, IT TELLS US HOW MUCH HAPPINESS SOCIETY IS WILLING TO
GIVE UP NEXT YEAR--MEASURED IN DOLLARS--IN ORDER TO GAIN AN
ADDITIONAL DOLLAR'S WORTH OF HAPPINESS TODAY.
If the market rate of interest is 10 percent, that means that the happiness of society would be
increased as long it could get more than $1.10 worth of goods and services next year, in
return for giving up $1.00 worth of goods and services today. If giving up $1.00 worth of
consumption today results in an increase of less than $1.10 worth of consumption next year,
society's happiness is lowered.
Now that we know the information that is contained in interest rates, we can see how free-
market economies allocate resources over time. When a firm invests--say by building a new
plant, researching a new line of products, or expanding capacity--it takes away resources
that could have been used for current consumption, and directs those resources towards
producing greater consumption in the future. THE MARKET RATE OF INTEREST

GOVERNS HOW MUCH FIRMS WILL INVEST FOR THE FUTURE, AND HOW
MUCH SOCIETY GETS TO CONSUME IN THE PRESENT. When a firm is deciding
whether to invest in a project, the owner or manager will compare the projected rate of
return from the investment against the cost of borrowing that money. If the firm expects to
see a 15 percent return on its investment over the next year, and the market rate of interest is
only 10 percent, the profit-seeking firm's choice is clear: it will choose to borrow the needed
funds and proceed with its investment plans. However, if the firm decides that it will likely
make only a 5 percent return on its investment, the firm will choose to scuttle the proposed
project. It cannot make a profit if it borrows the money at a 10 percent interest rate. On the
other hand, if the firm already has the money for the project, it could make a greater profit
by lending it at the market rate of 10 percent.
The 10 percent market rate of interest is society's way of telling firms, "Hey, guys, listen up!
If you want to produce more consumption goods for us next year, that's great. But you better
be pretty sure you can produce at least 10 percent more goods with those resources you're
taking away from us." If a firm believes it can generate a 15 percent return on its investment,
then society's happiness will be increased. Oh sure, the investment will mean taking
resources away from the production of current goods and services. But the extra goods and
services that consumers will gain next year will more than compensate them for their current
losses.
Alternatively, if a firm decides that its investment project will only generate a 5 percent rate
of return, then proceeding with the project would serve to decrease society's happiness. In
effect, society says to the firm--via the market rate of interest--, "Hey thanks for thinking of
us. But we don't want you taking our resources away. We'd rather have the happiness that
those resources could produce for us right now, rather than the happiness you'd be able to
generate for us next year."
Thus, in a free-market, capitalistic economy, firms allocate resources over time exactly how
society wants them to. When interest rates are high, society says it has a strong preference
for current consumption as opposed to future consumption. Accordingly, firms invest less.
When interest rates are low, society says it wouldn't mind giving up some current
consumption right now, as long as there is a modest increase in goods and services next
year. Accordingly, firms invest more. Once again, the "invisible hand" guides our firms to
allocate resources so as to maximize society's happiness. All of this is great for explaining
for resources are allocated within a given generation. But how about across generations?
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Notes
1
Al Gore, Earth in the Balance, Boston: Houghton Mifflin Company, 1992, page 339.
CHAPTER 38
Who Watches Out for Our Children's Children?
The interaction between firms, consumers, and the interest rate goes far in explaining how
individuals allocate consumption over their lifetimes. It wouldn't make any sense for
individuals to use up all of their resources when they were young and then have nothing left
for old age.1 In general, people will save for themselves on their own. They will plan for
their futures. But don't the members of society have a built-in incentive to use up all of
society's resources during their own lifetimes? After all, what's keeping them from engaging
in a happy orgy of consumption now and forgetting the welfare of future generations? An
easy answer would be that people often save for their children. But that still leaves the
question of future generations unresolved. How can we be sure that we are not consuming
too many resources right now, and that not enough will be left for future generations to
enjoy?
We will start by assuming that the human race has about the same concern for its future
generations as hamsters have for theirs (recall that hamsters are famous for eating their
young). That is, let's assume that if people had the chance, they would throw themselves into
greed, debauchery, and binge consumption on a scale that would make Nero blush. They
would live solely for themselves, with nary a thought for the well-being of future
generations.
Let's try to imagine how this hypothetical world--peopled with greedy, thoughtless
consumers--would work. Suppose one day, these consumers got together and decided to
consume all the natural gas they could. "To heck with the kids," they say, "let's eat, drink,
and consume some non-renewable resources, for tomorrow we may die!" (Note how utterly
despicable it is for these consumers to deplete non-renewable resources, since these are
physically finite and cannot be replenished.) Accordingly, in dead of winter, these
consumers leave their doors wide open, take out their energy-conserving windows, remove
insulation, and crank up the thermostat to about 105 degrees. They convert their homes into
luxury saunas. In short, they commit themselves to using up as much natural gas as possible.
What would happen in a world like this? Would the children of these consumers be left with
a planet having little or no natural gas? At first glance, the answer would appear to be yes.
After all, if the current generation wants to consume all of the world's natural gas supply,
who's going to stop them? Before you conclude that all is hopeless and the fate of the
world's grandchildren rests on the dubious goodness of the current generation, think a
moment about our old hero--the firm.
Any rapid increase in consumption would certainly cause an increase in the price of natural
gas. As prices rose, deposits which previously were too costly to exploit (perhaps too deep
in the ground or under arctic ice) would suddenly become profitable. As a result, firms
would take resources away from other activities and commit them to natural gas production.
The supply of natural gas would increase. And these new reserves would serve to
accommodate the current generation's lust for natural gas, leaving adequate supplies for the
future. Thus, we see that profit-maximizing firms will serve as a buffer to protect future
consumers from the rapaciousness of current consumers.
"Okay," you say, "but what if there were absolutely no extra deposits of natural gas? What if
firms couldn't expand the supply of natural gas?" In that case, the prices of other, substitute
energy sources could be expected to rise dramatically. Consequently, the supply of
conventional energy sources--like oil, coal, and nuclear energy--would increase.
Unconventional energy sources--like wind power, solar power, and geothermal energy--
would also become more profitable, and their supply would likewise increase. There would
be a great scramble among firms as each struggled to supply alternative energy in order to
profit by the depletion of natural gas. As they served their own interests, these energy firms
would also be serving future generations of consumers by insuring that energy was as
plentiful as possible.
There is yet another reason to be sure that firms will protect the wellbeing of future
generations. As the current generation binges on natural gas consumption, driving up its
price, firms will have a strong incentive to preserve current supplies of natural gas so that
they can sell them at even higher prices in the future. To see why, imagine that you are
convinced that--at present rates of consumption--the world will run out of natural gas in ten
years. If you really believed this, then you'd want to purchase as much gas as possible now
so that you could store it and sell in the future. Imagine what a price natural gas will fetch
ten years from now when almost none is left! You could make a fortune!
You don't think firms can figure this out? Rather than passively accommodating consumer's
rabid appetites for natural gas, firms would withhold some supplies from today's consumers.
They would voluntarily save some of their supplies so that they will have them to sell in the
future, when the coming scarcity of natural gas will guarantee a corresponding high price.
And so it is. Entrepreneurs and firms will act to counter consumers' rabid consumption of
non-renewable resources today, motivated by their desire to make even more money
tomorrow.2
Usually, when some shortage causes fears of a resource crisis, policy makers are quick to
appeal for conservation on the part of consumers and firms. You will notice that up to this
point, we've said relatively little about conservation. Of course, many consumers and firms
will voluntarily choose to refrain from consuming a good whose price has risen, and this is
certainly desirable.
Nevertheless, it is important to remember (recall our discussion of recycling in Chapter 17)

that it takes resources to save resources. Consumers have to buy insulation to save on the
consumption of natural gas for home heating. Firms have to employ new machines that can
run off of alternative sources of energy. But insulation and machines have alternative uses.
These alternative uses may be even more important than preserving natural gas. Without the
guidance of prices (including the interest rate) it is impossible to know where these
resources have their highest valued use. The beauty of unregulated markets is that firms
have all the right incentives to employ resources to conserve natural gas whenever
conservation is the highest valued use of those resources. Nobody has to tell consumers or
firms to conserve, or make impassioned appeals to their patriotism. When conservation is
the right way to increase society's happiness, consumers and firms will choose this way
voluntarily.
In conclusion, we can rest assured that firms will be on the lookout for any future decrease
in the supply of a resource. While we sit at home enjoying yet another exciting episode of
Baywatch, commodities brokers in Chicago, Tokyo, and London are researching available
stocks of energy, predicting future prices and future resource availability. While we snuggle
comfortably in our warm beds at night, firms are tirelessly searching for new ways to
preserve and expand resources for future generations. The beauty of free-market capitalism
is that even in a cold, cruel world, we can sleep soundly. The wellbeing of our children's
children is being watched over by those profit-seeking, money-grubbing firms. Our view of
the world may sound a bit rosy, and it is. Admittedly, we are incurable optimists. And if
history is any guide, we are right.
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Notes
1
Unless they could band together, form a powerful voting block, and then pressure the government to
coerce the young to make them transfer payments. NOTE: Any resemblance between this theoretical
possibility, Social Security and the American Association of Retired Persons (AARP), is purely
unintentional.
2
Perhaps you've heard of commodities and futures markets? In these markets, firms sell contracts in
which they promise to make delivery of goods and commodities at specific dates in the future. That is,
markets explicitly exist which allow firms to cash in today by agreeing to reserve goods and services for
the future. This isn't some nice theoretical possibility, but the real business world as it currently
operates!
CHAPTER 39
The Great Timber Famine
We are now ready to play "Guess That Time Period," the exciting game where eager
contestants read a series of newspaper excerpts and attempt to guess the year those articles
were originally published. The following are excerpts from three newspaper articles. Read
them carefully. Try to figure out what year these articles first appeared in the paper. Good
luck!
"THE END OF THE LUMBER SUPPLY.--There is a growing

conviction among the statisticians of the lumber industry that a
timber famine is imminent in the near future, and that under the
most favorable conditions of systematic forestry it will be impossible
to grow wood fast enough to permit the maintenance of the current
rate of consumption."
"URGES LAWS TO SAVE TREES. If the present destruction of

trees in the United States continues for ten years more there will not
be a forest tree left standing in the country, and the commerce,
agriculture, and health of the country will be seriously impaired.
This was the statement of James S. Whipple, State Forest, Fish and
Game Commissioner...he advised a movement to have the
Legislature pass stringent laws at once to protect the forests."
"TIMBER FAMINE NEAR SAYS [PRESIDENT]. That this

country is in peril of a timber famine...was asserted by President this
afternoon in an address before the American Forest Congress. In
the course of his remarks the President said: 'If the present rate of
forest destruction is allowed the continue, a timber famine is
obviously inevitable. Fire, wasteful and destructive forms of
lumbering, and legitimate use are together destroying our forest
resources far more rapidly than they are being replaced....Unless the
forests can be made ready to meet the vast demands which...growth
will inevitably bring, commercial disaster is inevitable.'"
Yes, there once was a time when this nation quaked in fear at the prospect of an imminent
timber famine. It was bad. How bad, you ask? Bad enough that pastors asked their
congregations to avoid the use of evergreen trees to celebrate the Christmas holidays.1 Yes,
it was very bad. Gloom and doom filled the newspapers. America was using up its precious
natural resources. The country was running out of trees and "commercial disaster was
inevitable." The most reputable experts of the time agreed. The leading political leaders of
the time agreed. Something had to be done. And indeed, something was done. Quick now--
were you able to figure out what year these articles were published? Here's a hint. It was
because of this great outcry for action that the federal government created the National
Forestry Service.
You see, the prevailing wisdom of the time was that lumber firms were good at things like
cutting down existing stocks of trees. But they couldn't be counted on for doing things like
growing new trees. And that was a problem. Because as the newspaper excerpts make clear,
at the rate trees were being cut down, there would soon be few left. And so, with great
dispatch, the United States created the National Forestry Service to place vast tracts of land
under the control of the federal government. The idea was that under the federal
government's careful stewardship, this land could be guarded against wanton lumbering.
And in this fashion, the country would be assured that there would be sufficient lumber for
their children's children.
Have you figured it out yet? All the excerpts are taken from articles that appeared in the
prestigious New York Times.2 The President was Theodore Roosevelt. And the years were
1900 to 1908. "What's that?" you say. You don't remember reading in your history books
about any great timber famine in the early twentieth century? Funny thing was, after all the
hype and hysteria about a coming timber famine, no great timber famine ever occurred. The
story about the great timber famine that never was is a fascinating story of how profit-driven
firms responded to rising lumber prices by both increasing the production of lumber and its
substitutes, and adopting new technologies to conserve on the amount of lumber.3
This would be just an amusing little footnote in American history except for one fact. Driven
by fears of a great timber famine, the federal government began an aggressive program of
removing land from the private sector--an effort that continues to the present day. For the
idea that the government needs to "protect" resources so they will be available to future
generations is an idea that is very much alive and well. As of 1990, local, state, and federal
governments owned approximately 40 percent of the American land mass. A little over a
third of the entire country is directly owned by the federal government. And while some of
this land has been procured for military purposes, the great majority is set aside in order to
protect resources of one kind or another from being depleted by the private sector.
Perhaps you still find yourself unconvinced that the private sector can be counted on to serve
as stewards of precious natural resources. After all, maybe the reason we have plenty of
lumber available today is precisely because the federal government so wisely saved precious
timberlands from commercial lumbering many decades ago. This is an interesting
hypothesis. And one that is easily tested. What do you think is the correct answer to the
following question is:
QUESTION: What percent of current U.S. lumber needs

are provided by trees grown on private forests?
Ten percent? Twenty-five percent? Fifty percent? (Remember, 40 percent of the entire
country is owned by the public sector.) In 1995, the actual figure was approximately 80
percent.4 Despite the fact that trees must grow ten or more years before they can be
harvested for profit--and that the land on which the trees grow can be used for little else--
over 80 percent of domestic lumber consumption is satisfied by trees grown on private
forests. Companies like Weyerhauser and Georgia-Pacific patiently grow trees for profit on
millions of privately-owned acres, providing a powerful refutation to fears that "the
investment is too large and the returns too slow to make it attractive as a business
proposition."5
In the remainder of this chapter, we want to address two final questions. How does all this
tie into our Profit Tables? And what does all this have to say about how societies should
allocate resources across generations? To answer the first question, let's first consider how a
lumber company would approach the decision to grow trees for profit. As has already been
pointed out, the problem with growing trees is that the firm incurs costs right now, as it buys
land and plants seedlings. However, the benefits from planting trees is received by the firm
only after many years later. To see how we can represent this problem in our Profit Table,
we have to introduce the notion of PRESENT VALUE.
Suppose the market rate of interest is 10 percent. Then if a firm put $1000 in the bank, it
would receive $1100 back ($1000 times 1.10), one year later. Thus, the PRESENT VALUE
of $1100 a year from now is $1000. That is, it would take $1000 in the bank today to yield
$1100 in principal plus interest next year. Suppose a Georgia pecan farmer determined that
he could sell one-year old pecan trees to nurseries for $5 a tree, and that he could grow 220
pecan trees on an acre of land. Suppose further that the costs of renting the land, planting the
seedlings, etc., was $800. So an initial outlay of $800 resulted in a return of $1100 (220
times $5) a year from now. In terms of our Profit Table, this transaction would be
represented by the following.
REVENUES: $1000
COSTS: $800
PROFITS: +$200
Note that we do not enter the $1100 the farmer would earn next year on the Revenues line of
the Profit Table. Instead, we enter the corresponding present value amount of $1000. In
effect, the pecan farmer says, "Hey, I would have to put $1000 in the bank today to produce
$1100 in revenues next year. But I can get the same return next year by putting only $800
into pecan trees. No way am I going to pass up a profitable opportunity like that. What do
you think I am...nuts?"
Of course, the farmer would have come to precisely the same conclusion if he had compared
the rate of return on his pecan tree investment with the market rate of interest. Earning
$1100 next year on an $800 investment today is a 371/2 percent rate of return, which sure
beats the 10 percent market rate of interest. This demonstrates that our Profit Table is easily
generalized to include cases in which the firm's revenues and costs occur over time. Present
values are based on interest rates, and interest rates are used to identify where resources will
have their highest valued use over time. Since firms employ present value considerations to
make decisions, we can be sure that letting profit-maximizing firms allocate resources across
time maximizes the happiness of all generations of society, and not just the current
generation.
We are now ready to address the questions raised at the beginning of chapter 37, "How
should society trade off the well-being of the current generation with the well-being of the
'seventh generation into the future?' Our answer to this question is that WE SHOULD
TREAT OTHER GENERATIONS NO BETTER OR WORSE THAN WE TREAT
OURSELVES.
If we follow this approach, then the impact of a decision 150 years from now should not be
given the same weight as an impact felt 1 year from now. The reason is simple: we ourselves
weight the present more than the future when it comes to maximizing our personal welfares.
Since society is nothing more than the collection of its individual members, why should
"society" have a different rule for allocating resources than the rule its individual members
use in their own lives? In other words, this approach says that we should treat the members
of the seventh generation just how we would treat ourselves if we were to live that long. No
better or no worse. Once this is seen, it follows that our current use of interest rates does not
"systematically undervalue the future consequences of our decisions." In contrast, it
provides precisely the right value in weighing out the consequences of our actions on future
generations.
While we don't claim any higher authority for this social rule of resource allocation, it does
come remarkably close to religion's golden rule of "loving your neighbor as yourself"--even
when one's neighbor is seven generations removed. And isn't that remarkable? The free-
market, capitalistic approach to allocating resources across generations essentially
implements the golden rule of moral behavior as advocated by the world's great religions.
That's definitely food for thought.
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Notes
1
You think we're making this stuff up as we go along? Read for yourself. The following is also a
newspaper excerpt from this same time period: "BANISHES CHRISTMAS TREES.--The Rev. Dr.
Robert S. MacArthur of the Calvary Baptist Church advised his Current Events class yesterday morning
to...use as few evergreen trees as possible in order that each one might do his share to prevent the
deforestation that is believed to threaten the [country]...'How came we to adopt this custom, which is
one of the many taken from the heathen? We are deforesting many portions of our State and country.
We ought to save the trees to prevent floods and give the proper amount of shade. To do my share in the
work I have forbidden the purchase of evergreen trees by this church for the coming holidays."
2
The date of the respective articles are: "THE END OF THE LUMBER SUPPLY"-December 31,
1900; "URGES LAWS TO SAVE TREES"-December 16, 1908; "TIMBER FAMINE NEAR"-January
6, 1905; and "BANISHES CHRISTMAS TREES"-December 7, 1908. This chapter borrows heavily
from the chapter "The Timber Crisis," in Charles Maurice and Charles Smithson, The Doomsday Myth,
Stanford, CA: Hoover Institution Press, 1984.
3
An excellent account of these events can be found in Sherry Olson, The Depletion Myth, Cambridge,
MA: Harvard University Press, 1971.
4
This number was reported to one of the authors in a telephone conversation with a spokesman from
the U.S. Forestry Service, Department of Agriculture. It is consistent with the statement "that private
forestlands have accounted for about 85 percent of the total tree planting and seeding in the United
States" (Ronald Bailey, The True State of the Planet, New York: The Free Press, 1995, page 203).
5
This statement was made by the chief geographer of the U.S. Geological Survey, in the article "THE
END OF THE LUMBER SUPPLY," cited above.
CHAPTER 40
A Little Bit of Heaven on Earth
"GORBACHEV CLAIMS CHRIST PREACHED SOCIALIST

VALUES. Milan, Italy (AP)--Former Soviet President Mikhail
Gorbachev says true socialism promotes the values preached by
Christ. In a newspaper interview published here he said true
socialism works for social justice, freedom, equality and human
values. 'In short,' he added, 'we promote the cause of Christ.'"1
While we believe that economics is good at explaining an awful lot of things, even we have
to admit that there are some topics outside its purview. For example, we don't intend to
address the issue of issue of whether "Christ preached socialist values." That's best left to
theologians (and former heads of state). Instead, in this and the next chapter, we want to ask
the following question: Which system do you think would do a better job of promoting
peace and goodwill on earth among men? Socialism or capitalism?
In discussing socialism, we agree with former Soviet President Gorbachev that it is best to
focus on "true socialism." "True" socialism is to be distinguished from "observed" socialism,
which is the only form of socialism that has actually been implemented in human
experience. "Observed" socialism is the form of economic organization that has been
practiced in the former Soviet Union, China, the former East Germany, Cambodia, Uganda,
Cuba, Iraq, and many other countries with equally distinguished economic records.
Observed socialism is usually associated with tyrannical dictatorship centered around one
absolute ruler. Observed socialism is now widely recognized for being primarily responsible
for the economic impoverishment of much of the world's population. And under observed
socialism, literally hundreds of millions of people have been killed in the twentieth century
by their own governments in places like the former Soviet Union under Stalin, China under
Mao Tse Tung, Cambodia under Pol Pot, etc. Indeed, as proponents of socialism are quick to
point out, true socialism should never be confused with observed socialism. So what would
"true socialism" be like?
Since it's never been tried in real life, this is a difficult question to answer. But let's suppose
we attempted to organize a society around the idea "from each according to his ability, to
each according to his need." To begin with, let's suppose that our society is composed
entirely of saints. Big-hearted people. People who are motivated solely by the desire to help
others. In other words, let's suppose we have an entire society composed of Mother
Theresa's and her ilk.
In this kind of world, how would the well-intentioned Mother Theresa's know what to do?
How would they know whether their fellow citizens needed more carrots, or more green
beans? Whether they wanted bigger homes located outside the cities, or smaller apartments
located within the cities? How would they know whether they should produce more cars, or
more roads; or maybe both, but fewer schools? In other words, how would the do-gooders
know what good to do?
Consider the following problem. Suppose two Mother Theresa's went to Proletariat-Mart,
the state-owned version of Wal-Mart. They both had poor neighbors who needed extra
blankets to keep them warm at night. But there wasn't enough blankets at the store for both
neighbors. What should Mother Theresa Number One do? Which is the nicer thing to do?
Let Mother Theresa Number Two have the blankets for her neighbor, or try to get them for
her own neighbor? You see, even in a world where people are very nice and are trying to
help their fellow man, the problem of allocating goods to their highest valued use doesn't go
away.
Even in an imaginary world populated by tender-hearted do-gooders, it's not at all clear that
a socialistic society would be a place you'd want to live. Oh the people would be very nice.
But it would be a very confusing and chaotic world. In fact, we imagine that a socialistic
society full of Mother Theresa-like beings would be a little bit like two very nice people
trying to enter a building.
FIRST PERSON: "Please, you go first."
SECOND PERSON: "Thank you, that's very nice of you, but, please, you go first."
FIRST PERSON: "No, I insist, you go first."
SECOND PERSON: "No, I just couldn't, you go first."
FIRST PERSON: "No, no, no, your time is much more valuable than mine. Please, you go
ahead."
SECOND PERSON: "No, really, I wasn't in any hurry at all. I just couldn't bear the thought
of cutting in front of you."
POLICE OFFICER: "If you ladies don't get moving, I'm afraid I'll have to arrest the two of
you for loitering."
BOTH PERSONS: "Oh please officer, it wasn't her fault, arrest me."
Now consider the following scene in a free-market/capitalistic economy: A man walks into a
department store. He examines the winter coats on the rack. He decides not to purchase one.
He walks out. To the untrained eye, this might seem like a fairly unremarkable event. Not
the kind of thing which would cause one to call the city newspaper and tell them to stop the
presses. But consider what has just happened. A consumer went into a store interested in
buying a winter coat for himself. After examining a particular coat, he decided that the price
was too high. While he wanted a new winter coat, it wasn't worth it to him to pay that much
money. In other words, he decided to leave the coat for somebody else who wanted the coat
more than he did.
It is exactly the same as if the man had said to himself: "You know, I like this coat. I would
get some pleasure from having this coat. But there is a brother of mine--somewhere out
there in the economy--who wants this coat more than I do. I don't know who he is or where
he lives. I don't know if his old coat is wearing thin, or if he's shivering in the cold even
now. But I do know this. If I take this coat, it won't be available for him. So I choose to
leave this coat so that it will be here for him when he comes into this store. I hope it brings
him much happiness." And as he leaves the store without the coat, he quietly sings, "He
Ain't Heavy, He's My Brother."
Of course the reality is that this consumer probably didn't spend a moment thinking about
the other consumers in the economy. And that's too bad. Indeed, the world would be a nicer
place if people spent more time thinking of others. We heartily agree that a first-best world
would be a place where people really cared about other people.
But free-market economies do an amazing thing. They take people, imperfect as they are,
and get them to behave AS IF they really cared about other people. This is a truly amazing
achievement. For surely the next best thing to having a world full of caring people is having
a world full of people behaving as if they cared. FREE-MARKET ECONOMIES TAKE
GREEDY, SELFISH, SELF-INTERESTED PEOPLE AND GET THEM TO BEHAVE AS
IF THEY WERE RAVING ALTRUISTS.
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Notes
1
The Daily Oklahoman, September 12, 1992.
CHAPTER 41
All for One and One for All?
"PRESIDENT URGES TRUCE FOR TIMBER. Portland, Ore.

(Reuter) President Clinton called Friday for a truce between
environmentalists and loggers to find a solution to the bitter battle
over saving timber jobs and protecting a threatened owl and its
ancient forest home....Tens of thousands of people descended on
Portland to press their case. On the fringes of the conference, in a
convention center, there were rallies, concerts, vigils, and news
conferences."
"Rallies, concerts, vigils, and news conferences." "Tens of thousands of people." Oh my

goodness! And why? Because of competing demands for scarce resources. On the one hand,
there are the environmentalists who want to preserve the old-growth forest home of the
northern spotted owl. On the other hand, there are the men and families who earn their
livelihoods from cutting the timber and operating the mills that feed America's lumber
industry. And in the middle is the federal government, owning the land in behalf of "all of
us"...and stymied in trying to find a palatable solution for the parties.
For you see, when we say that the government owns society's resources, what we really
mean is that nobody owns the resources. But each person thinks he does. And so the system
of allocation becomes an intensely political one. Each side musters its supporters. Each side
flexes its political muscles. They converge in rallies and demonstrations. They hold news
conferences. Since the decision will partly be decided in the court of public opinion, each
side attacks the motives of the others. Timber firms are called "greedy corporations
wantonly exploiting the environment." Environmentalists are called "tree huggers who
would rather save an owl than feed a family." And as the government attempts to make
political compromises, each side feels angry and ripped off.
It is often said that there are no laboratories in economics. And yet, every day across the
country, we get a nation-wide experiment in what an economy would look like in which
private property doesn't exist, and everything belongs to everybody. These experiments are
held Monday through Friday, every week of the year right in your home town. You can find
them taking place at your local day care center.
At the local day care center, there is no private property and none of the children are allowed
to rent toys for their private use. Put a bunch of three-year olds in a room full of toys and
what happens? Anybody who has kids knows only too well. SALLY: "Give me that."
MARY: "I was playing with it first." SALLY: "You got to play with it yesterday." MARY:
"No I didn't!" SALLY: "If you don't give it to me, I'm going to tell the teacher." MARY: "If
you tell the teacher, I'm going to bite you." SALLY (grabbing toy): "Lemme have it!"
MARY (holding on to toy): "No, it's mine!" (Both kids yank and jerk on toy. Toy breaks.)
SALLY and MARY (together): "Waaaaah!"
Of course, as consumers get older, they learn to behave in somewhat more sophisticated
ways. Rather than kicking and screaming and biting each other, the consumers hold rallies,
concerts, vigils, and news conferences. They generally act in a more restrained manner. Yet
the dynamics are the same. Each side believes that the resources belong to them. Each side
believes that the other side is illegitimately taking their resources away. And the government
has to play the role of day care provider in deciding who gets what.
Contrast this system of resource allocation with how things work in the private sector. Every
day, millions of resources are allocated with hardly a notice. When the steel companies
decide for whom to produce their steel, there aren't demonstrations and news conferences.
The Teamsters don't send bus loads of workers to Bethlehem, Pennsylvania to argue that the
steel needs to be used for Mack Trucks so that there will be jobs for their members.
Consumer rights advocates don't hold news conferences to alert the public that if the
trucking industry gets the steel, there will be fewer automobiles available for working class
families. Doctors don't demonstrate outside the steel plants on behalf of their patients who
need the steel so that there will be more iron lung machines.
Why not? Because the system of private property rights that underlies free-
market/capitalistic economies says that resources go to those who pay for them. Nobody has
to give something up unless the person who wants to take it from them makes sufficient
compensation. In the process, both buyer and seller are pleased by the working of the
market. Each side feels as if they are made better off by the trade. And in the end, society is
a more decent, civilized place.
It is our impression that most people seem to think that free-market economies--since they
are allegedly based on greed--are morally inferior to socialistic economies. While they admit
that free-market economies make their societies wealthier, they also consider the wealth that
is produced to be a "dirty" kind of wealth. Socialism is thought to represent the higher road.
We beg to differ.
It is very important in this respect to see the distinction between the nature of consumers--be
they greedy, tender-hearted or whatever--and the nature of the economic system they are
placed in. The free-market doesn't require individuals to be greedy. Even in a world full of
Mother Theresa's, we would need to have prices to direct the Mothers so that they would
know where resources have their highest valued use. On the other hand, the free-market also
doesn't require individuals to be saints. It takes people as they are. Saints or sinners, the
beauty of the free-market system is that it provides the information they need to make the
right choices.
However, free-market capitalism also has two incredibly beneficial attributes that are often
overlooked. First, the free-market is able to get people to act AS IF they cared about others
even when they don't. And second, it minimizes the social conflicts that invariably arise
when scarce resources need to be allocated among competing wants. In a twentieth-century
world that has seen great turmoil and strife, the social benefits of free-market economies
represent remarkable achievements indeed.
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CHAPTER 42
What's the Catch?
This chapter closes our discussion of the simple framework and how prices direct resources
to their highest valued use. No doubt at some point, probably at many points, you've asked,
"Can it really be this simple?" After all, if it really were like we said it was, why do
economists disagree on so many issues? Surely, there must be a catch somewhere. And there
is. But before we get to it, let's review the assumptions we've made so far in our analysis.
First, we've assumed that there are a large number of consumers in the market for any
particular good. And second, we've assumed that the prices that buyers and sellers transact at
are "market prices." By this we mean that sellers are free to increase or decrease their prices
in accordance with supply and demand; and that there are plenty of goods and services
available to buyers at the prices sellers set. We haven't required that consumers have perfect
information. We haven't required that there be an infinite number of sellers in the market.
We haven't required that all firms sell identical (homogeneous) products. In short, we
haven't required a lot of things that economics textbooks associate with "perfect
competition," that ethereal world that exists in the minds of economists but nowhere else. As
generations of economics students have no doubt wondered, if the advantages of a free-
market/capitalistic economy require the conditions of perfect competition, and if perfect
competition doesn't exist, then what's so great about free-market/capitalism?
Now comes the catch. The last assumption we need for our conclusions to hold is that there
are no "market imperfections" (usually called "market failures"). What's a "market
imperfection?" The cute answer is that it is anything that invalidates our previous analysis.
Economists usually attempt to define market imperfections by example. In particular, there
are three types of market imperfections which have dominated the debate about the proper
role of government. These three are (i) monopoly, (ii) externalities, and (iii) public goods.
When one finds two economists who disagree about a particular public policy, the great
majority of the time their disagreement can be traced to how significant each one thinks
these market imperfections are. If one believes that neither monopoly, externalities, or
public goods are significantly present in a particular instance, then one is led to the
conclusions of our previous analysis. Namely, government interventions will distort the
allocation of resources and lower society's happiness. On the other hand, if one believes that
one or more of these imperfections exists in a significant way, and if one believes that
government intervention is likely to successfully address the market imperfection, then
government intervention can serve to increase society's happiness.
As we discussed above, most government interventions can be grouped into one of five
categories: (i) price controls, (ii) subsidies, (iii) taxes, (iv) quotas, and (v) mandates. The art
of government intervention consists of applying the right "dose" of the right intervention.
Just because government intervention can improve society's happiness, doesn't mean that it
will. Indeed, as we shall show, public sector allocation decisions are also plagued by
"imperfections." So there is no guarantee that a particular intervention will ever improve the
imperfect allocation of resources made by the private sector. Government intervention

always carries with it the risk of making things worse. Once we leave the world of no
market imperfections, we return to the world of the economic planner--a world of darkness
and uncertainty--where we are never quite sure of what we can do to improve society's
happiness. These are the issues of our next, and final, section.
OPTIONAL SECTION FOR ECONOMISTS: What we call "market imperfections" is synonymous with the
term "market failures" that is commonly used in economics tex tb ooks. We eschew the term "market failure"
b ecause we b eliev e it conv eys a mislead ing impression ab out priv ate sector allocations. When economists say that
the market "fails, " what they are saying is that the market has not achiev ed the perfect allocation of resources. T hat
strikes us as b eing a little harsh. When a stud ent scores less than a perfect g rad e on an ex am, nob od y claims that
the stud ent "failed . " L ikewise, when economists say that the market "fails, " they d o not mean to imply that the
market has performed d ismally b ad . R ather, they are saying that the market has not achiev ed an A + performance.
P erhaps the market d eserv es an A - g rad e, or a B + , or a C -. T hat is, perhaps the market is d oing a g ood , b ut not
perfect, j ob in allocating resources to their hig hest v alued use. L ikewise, we shall see that the pub lic sector also
suffers from prob lems that cause it to miss the perfect allocation of resources. A t the risk of confusing read ers with
an unfamiliar v ocab ulary, we prefer the use of "imperfections" ov er "failures" so that we can emphasiz e that the
choice facing citiz ens is one of two, imperfect--thoug h potentially b eneficial--allocation systems, as opposed to two
"failed " systems.
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CHAPTER 43
Market Imperfections I: Monopolies
The most complicated--and misunderstood--of market imperfections is monopoly. For our
purposes, we will state that a "monopoly problem" exists whenever a firm can significantly
increase the price it can charge by restricting the quantity of goods it sells. Economists call
this ability MARKET POWER. To illustrate the monopoly problem, we are going to analyze
one of the most egregious and ubiquitous examples of monopoly to be found anywhere in
the economy: the neighborhood lemonade stand.
In particular, we will consider the case of one John D. Rockefeller, Jr., "J.D." as he is known
to his friends. From 7:30 a.m. to 3:00 p.m. on Mondays through Fridays, J.D. lives a life
similar to most 10 year-olds. He goes to school, does his classwork, looks forward to recess,
and is in most respects a strikingly unremarkable kid. However, every day after the school
bus lets J.D. off at the stop near his home, he does something unusual. He races home in
front of his two school chums, Sammy and Susie, and opens up his lemonade stand. For you
see, J.D. is the neighborhood entrepreneur. He earns his lunch money by selling lemonade to
his two friends as they walk home from school. Oh yeah. There's one more thing you should
know about J.D.: his is the only lemonade stand in this section of town. J.D. is a monopolist.
Because J.D. sells the same lemonade to the same two kids everyday, he has learned a lot
about the preferences of his two school chums. Sammy derives intense pleasure from
lemonade and is willing to pay 80¢ for a first glass of lemonade, though he never has any
interest in purchasing a second glass. Susie likes lemonade too, but not as much as Sammy.
She is willing to pay 50¢ for a glass of lemonade; and, like Sammy, never wants more than
one. We summarize the willingness to pay of J.D.'s two customers in the table below.
Willingness to Pay Values for J.D.'s Customers
Sammy Susie
80¢ 50¢
Given the preferences of his customers, we see that the quantity J.D. sells affects the price
he can charge. If J.D. wants to sell 2 cups of lemonade, the highest price he can charge is
50¢ a cup. Any amount above this price and Susie will refuse to buy any.1 However, if he
limits his "production" to only 1 cup of lemonade, he can raise his price to 80¢ a cup. In
other words, J.D. can significantly increase the price he charges by restricting the quantity of
lemonade he sells. He has "market power."
Based upon his experience as CEO, Chairman of the Board, and majority stockholder of
Rockefeller's Lemonade Stand, J.D. has calculated the following revenue table with respect
to his lemonade sales. Pay particular attention to the change in Total Revenue as Quantity
increases from 1 to 2.
Price Quantity Total Revenue
80¢/cup 1 $0.80
50¢/cup 2 $1.00
Like all great entrepreneurs, J.D. is a profit maximizer. He has calculated that it costs about
25¢ to "produce" a cup of lemonade (this includes the cost of the lemonade mix, plus the
value of the paper cup, etc.). So what quantity of lemonade will maximize J.D.'s profits? To
answer that question, J.D. has expanded the table above to identify the profit he makes for
differing levels of lemonade "production."
Price Quantity Total Total Total Total Net

Quantity Quantity Revenue Cost Profit Happiness
(1) (2) (3) (4) (5) fr(6)
80¢ 1 $0.80 $0.25 $0.55 $0.55
50¢ 2 $1.00 $0.50 $0.50 $0.80
Column (5) reports the Total Profit that J.D. earns for each level of output. As the table
clearly shows, J.D. maximizes Total Profit when he produces and sells 1 cup of lemonade.
By restricting output to 1 cup, he can charge a price of 80¢ a cup. This yields him a Total
Revenue of $0.80, versus a Total Cost of production of only $0.25. The bottom line is a
Total Profit of $0.55, which is higher than at any other level of sales.
Now things start to get interesting. We are about to see what monopolies do wrong. What
Quantity of lemonade production maximizes society's happiness? From the information we
have concerning Sammy's and Susie's preferences, we know that when only 1 cup of
lemonade gets produced, it goes to Sammy, who receives 80¢ of happiness. In contrast,
society loses 25¢ in happiness from withdrawing resources from other activities in order to
produce that cup. Thus, the Total Net Happiness received by society from the first cup of
lemonade is 80¢ - 25¢ = 55¢.
When J.D. produces 2 cups of lemonade, the second cup goes to Susie. She receives 50¢ of
happiness from her cup. However, society loses another 25¢ of happiness in producing this
cup. Thus, the increase in Total Net Happiness from the second cup is 50¢ - 25¢ = 25¢. If
we add this to the happiness from the first cup, we see that the production of 2 cups of
lemonade results in 55¢ + 25¢ = 80¢ of Total Net Happiness. Column (6) reports Total Net
Happiness for each level of output. Clearly, society's happiness is maximized when J.D.
produces 2 cups of lemonade.
Anybody remember how many cups of lemonade maximize J.D.'s profits? As demonstrated
above, the profit-maximizing level of lemonade production is 1 cup. Did you catch that?
One cup! The happiness-maximizing quantity is 2, while the profit-maximizing quantity is
1! Herein lies the great sin of monopolies. Left to their own devices, MONOPOLIES
PRODUCE TOO LITTLE OUTPUT. In the case of John D. Rockefeller, Jr., society would
like him to produce and sell 2 cups of lemonade. Instead, young Mr. Rockefeller chooses to
sell only 1 cup of lemonade, since that is what maximizes his profits.
Why does J.D. produce too little? As a result of the market power that J.D. possesses, a
decrease in lemonade production increases the price he can charge. For example, if J.D.
were to produce 2 cups of lemonade, he could only charge 50¢ a cup. By decreasing
production from 2 cups to 1, J.D. is able to raise the price he can charge to 80¢ a cup. As a
result, when J.D. sells one less cup of lemonade, he doesn't lose 50¢ in Revenue. The
decrease in sales only costs him 20¢ in Revenue (check out Column (3) in the table above).2
However, producing one less cup of lemonade saves J.D. 25¢ in Cost. As a result,
decreasing production from 2 cups to 1 cup increases his Total Profit by 5¢, even though it
lowers society's happiness (check out Columns (5) and (6)).3
All of this can be illustrated in the context of our familiar Profit Table. The Profit Table
below represents J.D.'s decision to produce a second cup of lemonade. As discussed above,
the extra Revenue associated with increasing production to 2 cups is 20¢. However, the Cost
of producing a second cup of lemonade is 25¢. Increasing production from 1 cup to 2 would
thus lower J.D.'s Profit by 5¢.
PRICE: 50¢
REVENUE: 20¢
COST: 25¢
PROFIT - 5¢
Change in society's happiness is 50¢ - 25¢ = + 25¢
Now this is a fine pickle indeed! Here we have a resource transfer that would make society
better off by approximately 25¢. Unfortunately, J.D. loses 5¢ in profit if he makes this
resource transfer. This keeps him from producing any more than 1 cup of lemonade. And
that is a shame. Because society is a little less happy than it could be if only J.D. would
think of the happiness of others, as opposed to selfishly maximizing his own profits.
What makes J.D.'s situation unique? J.D.'s firm is different from the firms we previously
analyzed because we assumed that J.D. has market power, while the other firms did not.
When a firm doesn't have market power, an increase in production will have little effect on
the Price the firm can charge. If the Price is 50¢, and the firm sells another unit, then the
extra Revenue it receives will also equal 50¢. And we get a Profit Table just like the ones
earlier in the book. However, when a firm has market power, selling more output means the
firm has to charge a lower price. In this case, if the Price is 50¢ and the firm sells another
unit, then the extra Revenue it receives will be significantly less than 50¢.
In conclusion, it's important to remember that even when a firm is a monopoly, prices still
send the right information. The price still approximates the additional happiness that society
would receive from consuming one more unit of the output good. The problem isn't with the
prices. The problem lies with the Revenue incentives facing the firm. Even so, it should
never be forgotten that monopolies are good. They transfer resources from lower-valued to
higher-valued activities. They increase society's happiness. They just don't increase society's
happiness as much as we would like them to.
OPTIONAL SECTION FOR ECONOMISTS: T h e m o n o p o ly p r o b le m a r is e s w h e n e v e r th e

d e m a n d c u r v e is d o w n w a r d s lo p in g . W h e n th is h a p p e n s , M a r g in a l R e v e n u e is le s s th a n P r ic e . In th e
fig u r e b e lo w , Q * id e n tifie s th e q u a n tity th a t m a x im iz e s s o c ia l w e lfa r e . N o te th a t s o c ia l w e lfa r e is
m a x im iz e d a t th e q u a n tity w h e r e P r ic e = M a r g in a l C o s t. In c o n tr a s t, Q M id e n tifie s th e p r o f i t -m a x im iz in g
le v e l o f o u tp u t fo r th e m o n o p o lis t. It is th e q u a n tity a t w h ic h M a r g in a l R e v e n u e = M a r g in a l C o s t. T h e
s h a d e d a r e a r e p r e s e n ts th e w e lfa r e lo s s th a t r e s u lts b e c a u s e th e m o n o p o lis t p r o d u c e s le s s th a n th e
s o c ia lly o p tim a l q u a n tity , Q * .
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Notes
1
We assume that J.D. is forced to charge both Sammy and Susie the same price. While this may be a
bad assumption in this particular case, it is generally valid when considering most monopolies. One
reason is most customers would be unwilling to pay a high price when others were able to buy the good
at a lower price. The other reason is the monopolist usually doesn't know which customers would be
willing to pay a higher price. As a result, the monopolist charges all customers the same price.
2
Economists use the term "Marginal Revenue" to denote the change in Total Revenue caused by an
increase in output of one unit. The "monopoly problem" arises whenever Marginal Revenue is
substantially less than Price at the firm's profit-maximizing level of output.
3
In the case of a competitive market, or a market in which firms have little or no market power,
restricting production would result in lower revenues. For example, when Ura Hogg takes her
watermelons to a watermelon broker, she has to "take" the market price. The broker won't give her more
per watermelon if she offers fewer watermelons to him (e.g. she may sell him 1000 watermelons at $5
apiece for total revenues of $5,000. If she sells him 500 she will have to take the same price, and her
revenues will be halved ($5x500=$2,500)).
CHAPTER 44
A Government Price Fix
And now for the moment you've been waiting for. Are you ready? Having determined that
unregulated, private markets will not maximize society's happiness when a monopoly
problem exists, we now ask the question: Is there anything the government can do to make
things better? Any way that it could intervene in this market to make society better off?
Finally, a mere 44 chapters into our book, we are able to say...YES!
The last chapter demonstrated that the problem with monopolies is that they produce too
little. Therefore, if the government wants to make society better off, it has to get the
monopolist to produce more output. One obvious possibility is to subsidize the monopolist,
so that it will find it profitable to expand production. However, taxpayer-funded subsidies to
monopolists tend not to be very popular with voters. A more politically sensitive solution,
and the one that is by far more commonly employed, is to impose a ceiling on the price that
the monopolist is allowed to charge its customers.
In our example, we could imagine that lawyers from the Antitrust Division of the Justice
Department (perhaps in conjunction with agents from the Federal Trade Commission and
the U.S. Department of Agriculture) might arrange to meet young Mr. Rockefeller one day
after school. After patiently appealing to his youthful idealism and patriotic fervor--and after
explaining how they would confiscate his lemonade stand and throw him in jail if he chose
to disobey them, these government agents would help our fledgling entrepreneur to see the
error of his ways. To correct the monopoly problem, the monopoly regulators impose a price
ceiling of 50¢ a cup. As we shall see, this price ceiling changes J.D.'s profit-maximizing
strategy. The table below represents the relevant price, cost, and profit information for
Rockefeller's Lemonade Stand after the government imposes a price ceiling on lemonade of
50¢ a cup.
Price Quantity Total Total Total Total Net

Quantity Quantity Revenue Cost Profit Happiness
(1) (2) (3) (4) (5) fr(6)
50¢ 1 $0.50 $0.25 $0.25 $0.55
50¢ 2 $1.00 $0.50 $0.50 $0.80
Column (1) shows the immediate effect of the price ceiling. Before the price ceiling, J.D.
could charge 80¢ for lemonade if he restricted output to 1 cup. After the price ceiling, J.D.
can't charge any more than 50¢ per cup. This produces a number of other changes in the
table. In fact, inspection of Column (5) shows that the new profit-maximizing level of output
for J.D. is now two cups of lemonade, in contrast to the one cup which maximized profits
before the price ceiling.
Let's get this straight. Are we saying that A PRICE CEILING CAN CAUSE A
MONOPOLIST TO PRODUCE MORE OUTPUT? Yes, we are. Does this strike you as a
strange result? It should. Price controls almost always result in less, not more, output being
produced. The exception to this rule occurs with monopoly.
How can a price control get a monopolist to produce more output? Look at the effect of the
price ceiling on the firm's Revenues in the table below. A comparison of Columns (3) and
(6) shows that--before the price control--an increase in Quantity from 1 to 2 cups caused
Total Revenue to increase by only 20¢. In contrast, after the price ceiling, the increase in
Total Revenue associated with the second cup of lemonade was 50¢! Thus, the price ceiling
has the effect of increasing the additional Revenue associated with producing more output.
This provides an incentive for the firm to expand production.
BEFORE PRICE CEILING AFTER PRICE CEILING
Price Quantity Total Price Quantity Total

Quantity Quantity Revenue Quantity Quantity Revenue
(1) (2) (3) (1) (2) (3)
80¢ 1 $0.80 50¢ 1 $0.50
50¢ 2 $1.00 50¢ 2 $1.00
This greater incentive to produce is illustrated in the Profit Table below. As before, we
represent the relevant Revenue and Cost information for J.D. as he decides whether to
produce a second cup of lemonade. Before the price ceiling, J.D. found that increasing
production from 1 to 2 cups of lemonade resulted in a 5¢ loss in Profit. After the price
ceiling, the same increase in production produced a 25¢ gain in Profit. All because the price
ceiling increased the Revenue associated with the second cup from 20¢ to 50¢.1
Before Price Ceiling After Price Ceiling
PRICE: 50¢ 50¢
REVENUE: 20¢ 50¢
COST: 25¢ 25¢
PROFIT: - 5¢ + 25¢
Change in society's happiness is 50¢ - 25¢ = + 25¢
In conclusion, when a monopoly problem exists--that is, when a firm has a significant
degree of market power--government intervention can increase society's happiness. Under
the right circumstances, a price ceiling will cause a monopolist to produce more output.
Since the problem with monopoly is that the firm produces too little output, this improves
the allocation of society's resources. However, this raises a question. Can we be assured that
the government intervention will increase society's happiness? Is it possible that government
intervention could make us worse off than if we just left the monopoly problem alone? We
explore this subject in the next chapter.
OPTIONAL SECTION FOR ECONOMISTS: T h e fig u r e be l o w s h o w s h o w ap r ic e c e ilin g c an c au s e a

m o n o p o lis t to p r o d u c e m o r e o u t p u t . T h e im p o s itio n o f t h e p r ic e c e ilin g , P C, c h an g e s t h e f i r m ' s M ar g i n al R e v e n u e
c u r v e t o P C-a-b-c . T h i s n e w M ar g i n al R e v e n u e c u r v e i n te rs e c ts th e m o n o p o l i s t ' s M ar g i n al C o s t c u r v e at q u an t i t y
QC. N o t e t h at t h i s i s l ar g e r t h an t h e l e v e l o f o u t p u t t h at th e m o n o p o lis t w o u l d h av e c h o s e n i n t h e abs e n c e o f th e
p r i c e c e i l i n g ( QM ) .
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Notes
1 Don't be confused into thinking that the price control has made J.D.'s lemonade business more
profitable. Before the price control, J.D. produced and sold 1 cup of lemonade and made a profit of
$0.55. After the price control, J.D. produced and sold 2 cups of lemonade and made a profit of only
$0.50. Thus, the overall effect of the price ceiling is to decrease the profitability of J.D.'s business.
CHAPTER 45
Regulating a Monopolist
"CABLE INDUSTRY EXPECTS PROBLEMS. Less than two years

after Congress passed the Cable Act of 1992 in an effort to regulate
rates, cable companies are again under fire. The Cable Commission
met Tuesday in Washington and voted to cut cable prices across the
board by seven percent....Decker Anstrom, president of the National
Cable Television Association, said the rate decrease won't help the
cable industry...'This will seriously disable cable companies' ability to
invest money in future technology,' he said."1
Let's assume that cable TV is a local monopoly (there is only one supplier in a given town).
If you asked most people what's wrong with cable TV being a monopoly, they would
probably respond that monopolies charge "too much money." It is true, by selling less output
than society wants them to, a monopolist is able to obtain a higher price for its goods. But it
would be a mistake to focus on this part of the problem.2 The real problem with cable TV
being a monopoly is that it results in too few cable TV services being supplied to consumers.
In evaluating the effect of cable TV regulation on the happiness of society, the trick is to
keep one's eye on the ball. Once again, that means concentrating on how the rate regulation
is likely to affect the allocation of resources in the economy. Can this government
intervention increase society's happiness? Following the arguments of the last chapter, we
know the answer is yes. But to be effective, the intervention must cause the cable TV
company to provide more cable services.
For example, suppose--prior to government intervention--a cable TV company had thought

about attracting new subscribers by lowering the cost of its basic package from $25 to $20 a
month. Providing cable TV to additional subscribers would require the firm to transfer
resources away from consumers elsewhere in the economy. What kind of resources? Office
personnel would be needed to keep track of subscribers' accounts. Service representatives
would have to be available to handle customers' problems. These represent withdrawals of
labor from other activities. If adding extra customers resulted in an increase in labor costs of
approximately $15 per customer, then that means that the extra labor required to service an
additional subscriber would produce approximately $15 of happiness at some other activity.
Weighed against this cost is the extra revenue the firm would receive. Suppose the firm
calculated that the extra revenue from selling more cable subscriptions would not
compensate it for the cost of servicing those subscriptions. While the new subscribers would
be paying $20 for their cable service, the cable TV company, in order to attract these new
subscribers, would have to lower prices for everybody. Thus, the extra revenues that the firm
would gain by reaching out to these new customers would be less than $20 per customer.
How much less? Let's say that the extra revenues from an additional customer worked out to
about $5 per new subscriber. Clearly, given these numbers, the cable TV company would
not have a financial incentive to make this resource transfer. This is illustrated for a
representative customer on the Before side in the Profit Table below. The revenue, cost, and
profit lines do not represent totals, but rather the revenue, cost, and profit that occurs from
the production of the extra cable only.
Before Price Ceiling After Price Ceiling
PRICE: $20 $20
REVENUE: $5 $20
COST: $15 $15
PROFIT: - $10 + $5
Change in society's happiness is $20 - $15 = + $5
Everything is different when the government intervenes in the market. Suppose the Cable
Commission imposes a price ceiling on the company, forcing it to lower its rates from $25 to
$20. As discussed in the last chapter, the effect of this policy is to increase the firm's profits
if it increases production, from -$10 to $5. Now the cable company finds that it is better off
dropping its rates and providing more cable services. And that's great. Because the reality is,
as this representative account shows, servicing another customer takes resources worth $15
elsewhere in the economy and directs them to a cable TV customer who gets $20 of
happiness. And while the company's customers rejoice and its shareholders weep, the
bottom line is that society is a little bit happier because of the market intervention of the
good folks at the Cable Commission.
The previous discussion has demonstrated that ordering cable companies to cut their prices
can make society better off. But will it? Now that's an entirely different question. For
example, the government must be careful that it's intervention doesn't decrease the amount
of output the monopolist produces. How can that be, you ask? If the cable TV company is
forced to charge a lower price, and that lower price induces more consumers to subscribe to
cable TV service, won't that necessarily cause the quantity of cable TV services to increase?
Consider the statement by Decker Anstrom, "This will seriously disable cable companies'
ability to invest money in future technology."
Suppose you were the owner of a cable TV company. What would be your incentive for
adopting new technology (e.g., better transmission equipment) or making improvements in
your service (e.g., more attractive bundling of channels)? Higher profits. But suppose you
also knew that the Cable Commission was always looking over your accountant's shoulder,
making sure that you didn't make "too much" profit. How would that affect your incentive to
make investments in future technology and improvements?
It's a "heads you lose, tails you draw" proposition. If the new technology is a bust, or the
improvements aren't a big hit with customers, you've entailed extra expenses with no
rewards. You lose. But suppose your consumers love the new changes and cable demand
increases dramatically. Do you get to reap the rewards? Not necessarily. The Cable
Commission stands poised on the industry sidelines, ready to jump onto the playing field
and take away your profits. If they appropriate your profits, you're back where you started
from. You draw. Who could blame you for asking, why risk it? Why not stay with the safe,
old technology and get your normal, Cable Commission-approved profits? No sweat, no
pain.
When this happens, rate regulation can have the effect of lowering society's happiness by
causing the monopolist to produce less output in the future. Sure, the cable TV company
may have more customers paying lower rates. But the quality of that service will be
adversely impacted by the negative incentives to invest which are a byproduct of rate
regulation. Measured in quality-adjusted units, output may actually fall. Too few resources
will end up being transferred to the cable TV industry. Government intervention will have
served to exacerbate the monopoly problem.
And this is only one possibility. The same lack of incentives that apply to investing in new
technology also apply to lowering costs. Why should the cable company reduce its costs
when regulators will take away any increase in profits by forcing the firm to lower rates still
further? If rate regulation causes the company not to work so hard in reducing costs, that
also decreases society's happiness. Resources aren't being released as they would be in the
absence of regulation. That means lower happiness for consumers elsewhere in the
economy.
Being a regulator is a bit like walking a tightrope...blindfolded. The regulator knows his job
is to get the monopolist to produce more output. But how much more? Here's the rub...HE
HAS NO IDEA. In real life, there are no tables like J.D.'s hypothetical revenue table from
the previous chapter. So the regulator takes a stab in the dark. He sets a new, lower price.
More output gets produced (at least in the short run). But the second he intervenes,
everything changes. The incentives of the monopolist to introduce new technology, improve
service, and reduce costs all change dramatically. Now the regulator can't look at the firm's
actual revenues and costs. He has to imagine what they would be in the absence of his
intervention. He has to imagine a world without regulation, and calculate the happiness-
maximizing level of output in THAT world. And then he has to figure out a way to
manipulate the firm so it produces that level of output in this, the regulated world.
To know whether he has done his job successfully, the regulator has to see how the world
would have existed in the absence of his intervention. Since that world is forever unseen--
leaving the regulator blindfolded, if you will--he can only inch along on the tightrope,
hoping he is increasing--and not decreasing--society's happiness.
Actually, we exaggerate when we say that the unregulated world is forever unseen. Every
now and then, a window into that world opens up. It happens whenever the government
decides to deregulate a previously regulated industry. For example, in the 1980's the airline,
trucking, and telephone (long-distance) industries were all deregulated. The original
argument for regulating these industries was that each of these represented a monopoly.
Hence government intervention was called upon to increase society's happiness. If
government regulation of these industries had been successful, then that regulation should
have persuaded these industries to produce more. Thus, deregulation should have resulted in
these industries producing less output than when they were regulated. What was the actual
result? In each case, industry output increased dramatically under deregulation. Our
evaluation of regulation in these cases can be clear and unequivocal: government
intervention exacerbated the monopoly problem and made things worse, lowering society's
happiness.
We don't give these examples to say that regulation of monopolies will always produce
lower social happiness. Nor to say that regulators are bungling bureaucrats who should
know better. We give these examples to point out the daunting task facing a regulator. Just
because a monopoly problem exists does not mean that government intervention will make
things better. It could make things worse.
So what should society do? The best economics can do is to point out the right questions to
ask. First, just HOW SERIOUS IS THIS MONOPOLY PROBLEM? Is the monopolist
producing a lot less than the amount of output that would maximize society's happiness? A
monopolist will only produce a lot less than the social ideal if it can substantially jack up its
price by restricting the amount it sells (recall J.D. Rockefeller's revenue table from the
previous chapter). While it might be true that the local cable company is the only cable game
in town, even the cable TV company has competitors. There's ABC, NBC, CBS, and Fox,
all of which do not require cable. There's Blockbuster Video and the local video rental stores
in town. Heck, even grocery stores rent videos nowadays. ("Yes, Ma'am. We do have the
new release of Die Hard VII. You'll find it right next to the frozen artichokes in the Produce
section.") In addition, there are all sorts of satellite dish and on-line computer technologies
that stand ready to steal consumers away from cable TV companies should those companies
raise their prices too high. The ability of a monopolist to charge higher prices is restricted by
the willingness of consumers to pay those higher prices. To the extent reasonably close
alternatives exist, the monopolist will not be able to substantially increase its price, and there
will not be a serious monopoly problem.
The second question which needs to be asked is, CAN THE GOVERNMENT
REGULATOR BE REASONABLY CONFIDENT THAT HE CAN INDUCE THE
MONOPOLIST TO PRODUCE MORE OUTPUT? AND CAN HE DO SO WITHOUT
SUBSTANTIALLY REDUCING THE INCENTIVES OF THE MONOPOLIST TO
REDUCE COSTS? A necessary condition for regulation to increase society's happiness is
that one be able to answer these questions affirmatively.
To be sure, these are incredibly difficult questions to answer. Reasonable people will
disagree. One never knows--indeed, cannot know--whether their own answers to these
questions are correct. That doesn't mean that society should never regulate. It simply means
that society should be mindful that the presence of a market imperfection does not guarantee
that government intervention will make things better. Once we leave the unregulated world
of market prices and profit-maximizing firms, we enter a world of darkness--with no
guarantee that the steps we take will move us closer to maximizing society's happiness.
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Notes
1 The Oklahoma Daily, February 23, 1994.
2 Lowering prices makes cable consumers better off and cable TV shareholders worse off. Note that not
all cable consumers are poor, nor are all cable shareholders wealthy. For example, many stocks are
owned by mutual funds. Mutual funds obtain much of their financial capital from employee pension
funds. As a result, a line worker in an automobile factory may be a shareholder of a cable TV company
if his pension contributions are being invested in mutual funds. Thus, lowering cable TV prices
inevitably makes some relatively wealthy people better off, and some relatively poor people worse off.
This is a very crude way to transfer wealth. If the motivation of the government really is to help poor
people, it shouldn't lower cable TV rates. It should just give poor people money and let them spend it on
what they want.
CHAPTER 46
Market Imperfection II: Externalities
Smokestacks belching soot; overfishing causing depletion of fish stocks in the oceans;
species made extinct by the encroachment of man; and to top it all off, a possible warming
of the globe that threatens to disrupt everyone's way of life. All of these are examples of
externalities. AN EXTERNALITY IS A COST OR BENEFIT EXPERIENCED BY A
THIRD PARTY TO A RESOURCE TRANSFER.
For example, Harry the Hog Farmer owns a piece of land out in the country where he raises
hogs for a living. As Harry is quick to confess, he's not in the hog business because it's a
great way to meet interesting people. Harry's in it for the money. And, in general, hogs have
been good to Harry. He's managed to make a decent living for himself and his family.
It just so happens, that Harry lives right next door to the Golden Years' Retirement Home.
Each day the residents of the Golden Years' Retirement Home are subjected to the
disturbing--and downright unappetizing--sound of a herd of pigs all squealing over whose
turn it is to sit in the mud pit. On top of that, Harry is constantly running around the farm
yelling "Soooiee" like there's no tomorrow. Some lucky residents can just turn off their
hearing aids and enjoy the show. But the rest of Golden Years' inhabitants are forced to put
up with this porcine noise pollution. How bad is it? If the truth were known, these residents
would be willing to collectively pay $10,000 a year to silence Harry and his hogs.
Suppose Harry can earn revenues of $40,000 from raising hogs, with costs of $36,000. From
Harry's perspective, this is great. The hog business is profitable. And so he keeps on raising
those porkers. However, from society's perspective, all is not well. When one adds in the
$10,000 of "damages" from the noise pollution suffered by the residents of the Golden
Years' Retirement Home, it is seen that this resource transfer lowers society's happiness. In
fact, the real (gross) Benefit to society from producing the hogs isn't $40,000, it's only
$30,000. That is, the $40,000 in benefits received by the pork consumers must be
diminished by the $10,000 loss of happiness resulting from the noise pollution. Once this
externality of the noise pollution is counted, we see that the Cost is greater than the Benefits.
Rather than increasing society's happiness by $4,000 as Harry's profits seem to indicate, this
resource transfer actually lowers society's happiness by $6,000.
BENEFITS: $40,000 - $10,000 = $30,000
REVENUE: $40,000
COST: $36,000
PROFIT: + $4,000
Change in society's happiness is $30,000 - $36,000 = - $6,000
What happened? Society wants to say, "Let those resources go! Those hogs aren't valuable
enough to justify taking those resources away from other consumers." But Harry's not
getting the message. WHEN EXTERNALITIES ARE PRESENT, PROFITS FAIL TO
ACCURATELY REPORT THE GAINS AND LOSSES TO SOCIETY FROM A
RESOURCE TRANSFER. At its root, the externality problem is a problem of
INCOMPLETE INFORMATION.
The reality is that Harry is making a resource transfer which impacts three distinct groups of
consumers: (i) the consumers of pork products; (ii) other consumers who lose happiness
because resources (land, Harry's time, etc.) are taken away from alternative activities; and
(iii) the residents of the Golden Years' Retirement Home. The price system has done a good
job of reporting the respective happinesses of Groups (i) and (ii). However, the senior
citizens of Group (iii) are ignored in this resource transfer. They are a "third party" that is
suffering a cost from this resource transfer. Because Harry the Hog Farmer never has to
"feel the pain" of the senior citizens, he makes a socially incorrect choice. His positive
profits encourage him to make a resource transfer which will lower society's happiness. And
that's a shame.
Can the government intervene to make society better off? Yes it can. In fact, there are a
number of avenues open to the government. Ideally, the government would like to get Harry
the Hog Farmer to feel the pain he imposes on his neighbors. As things currently stand,
nobody owns the "airspace." As a result, Harry can "pollute" it with impunity. In contrast, if
the government conferred ownership (or "property") rights of the airspace around the
Golden Years' Retirement Home to its residents, Harry would have to compensate them for
filling it with unpleasant noise pollution. He could purchase the right to pollute that airspace.
Does that strike you as being too weird?
If so, consider this. Suppose Harry wanted to use some of the retirement home's land to
dump corn husks left by his hogs after their feedings? The price Harry would have to pay for
that land would force him to think long and hard whether that property was more valuable to
him or the residents. If it was really important for Harry to "pollute" that land with his refuse
corn husks, he would have an incentive to buy it (and the residents an incentive to sell it). As
a result, that resource would go to its highest valued use. The fact that somebody owns the
land keeps Harry from doing to the land what he is doing to the air.
THUS ONE WAY GOVERNMENT CAN INTERVENE WHEN THERE ARE

EXTERNALITIES IS TO ESTABLISH AND ENFORCE PROPERTY RIGHTS. This is
generally the most preferred course of action when addressing an externality problem
(though sometimes it is not enough to solve the externality problem). Establishing property
rights to "airspace" would force Harry to internalize the costs he imposes on his neighbors.
It fixes the "hole" in the price system that allows the interests of third parties to go
unrepresented. We also admit that--in this case at least--establishing property rights to
airspace is not very practical. But it is useful to think about; it reminds us why prices are
failing to report the correct information about the gains and losses from this resource
transfer. And in many cases, it is a practical solution to addressing externality problems.1
If the government can't establish property rights, then what? A COMMON GOVERNMENT
INTERVENTION FOR ADDRESSING EXTERNALITIES IS TO IMPOSE FINANCIAL
PENALTIES AND REWARDS. We must remember that the problem with externalities is
that they cause a misallocation of society's resources. In the case of Harry the Hog Farmer,
too many hogs are being raised. Thus the government could improve the allocation of
resources by discouraging farmers from raising hogs. Suppose hog farms were well
recognized for being a public nuisance. Then the government could require hog farmers to
buy a permit to operate a hog farm. Let the price of the permit be $7,000. Look at how this
government intervention changes the Profit Table associated with this resource transfer.
Before Permit After Permit
BENEFITS: $40,000 - $10,000 = $30,000 $40,000 - $10,000 = $30,000
REVENUE: $40,000 $40,000 - $7,000 = $33,000
COST: $36,000 $36,000
PROFIT: + $4,000 - $3,000
Change in society's happiness is $30,000 - $36,000 = - $6,000
The tax associated with operating the hog farm is causes Harry the Hog Farmer to feel some
of the pain he is imposing on the residents of the Golden Years' Retirement Home. In this
case, it is enough to drive Harry out of business. And that's good. Because society does not
want this resource transfer to take place. From the perspective of society's happiness, there
are only two numbers in the table that matter: $30,000 and $36,000. Harry the Hog Farmer
has taken resources worth $36,000 elsewhere in the economy and directed them to an
activity that produces only $30,000 of net happiness. Society's happiness is lowered. By
discouraging this resource transfer, the government has made society $6,000 better off.
This example of Harry the Hog farmer illustrates the problem of NEGATIVE
EXTERNALITIES. Negative externalities occur whenever third parties to a resource
transfer suffer costs from that resource transfer. When negative externalities are present, too
many resources are directed to an industry. Government intervention can increase society's
happiness by discouraging that industry from withdrawing resources from other activities.
Less common is the problem of POSITIVE EXTERNALITIES. Positive externalities occur

whenever third parties to a resource transfer experience benefits from that resource transfer.
When positive externalities are present, too few resources are directed to an industry--that is,
the industry does not produce enough of the good. Suppose that instead of being a public
nuisance, Harry and his hogs sang four-part harmonies. Then the residents of the Golden
Years' Retirement Home would be blessed by the heavenly melodies emanating from
Harry's farm. In order to make sure that Harry produced the right number of hogs, we would
want him to internalize the pleasure that the residents received from his hogs. Government
could intervene to increase society's happiness by helping Harry to "feel their joy."
Subsidies and mandates are two ways that government can accomplish this.
Before proceeding to a real life application of the externality problem, it's worthwhile to
consider some of the problems that we mentioned in the beginning of this chapter. When
overfishing causes depletion of fish stocks in the oceans and species are made extinct by the
encroachment of man, there is an externality problem. In this case, the source of the problem
is the lack of property rights. Because nobody owns the fish in the oceans, there is no
incentive to save fish so that consumers can enjoy them next year. Fishermen don't "feel the
pain" they impose on consumers by depriving them of fish next year. Likewise, since most
animal species are not owned by humans, there is no incentive to preserve them. Again, the
firms that destroy the natural habitats of these animals aren't being forced to "feel the pain"
that future generations may have to experience because valuable animal species will not be
around to provide happiness for them. In many cases, modern technology can provide
innovative ways to establish property rights.2 In other cases, such as ocean mineral rights,
the problem isn't lack of technology, but lack of law. In both sets of cases, governments can
make dramatic improvements in the allocation of resources by assigning and enforcing
property rights.
Sometimes, as in the example of the noise pollution from Harry and his hogs, establishing
property rights is not a practical solution. When smokestacks send forth plumes of soot into
the atmosphere, costs are imposed on third party consumers who suffer from having to
breathe polluted air. Even if households owned the "air-rights" to the air they breathed, it
would be impractical to identify and prosecute those parties responsible for polluting their
air. In such cases, financial penalties like punitive taxes can help firms to feel the pain they
impose on others. However, how large should the government make these penalties? How
can the government know the amount of third party costs being suffered by consumers?
These are difficult questions which are highlighted in our next chapter on environmental
mandates.
OPTIONAL SECTION FOR ECONOMISTS: T h e fig u re b e lo w illu s t r a te s th e c a s e o f a n e g a tiv e e x te r n a lit y .

In th e a b s e n c e o f g o v e r n m e n t in te r v e n tio n , fir m s in t h e in d u s try w ill p r o d u c e a q u a n t ity Q * . Ig n o r in g th e im p a c t o f
t h e n e g a t i v e e x t e r n a l i t y o n t h i r d -p a r t y c o n s u m e r s c a u s e s th e m a rk e t to o v e r v a lu e th e b e n e f it o f th e g o o d . If th e
m a r k e t c o u ld in t e r n a liz e t h e s e e f fe c t s , it w o u ld p r o d u c e Q ** (th e s o c ia l o p t im u m ). T h e s h a d e d a r e a id e n t ifie s th e
w e lfa r e lo s s a s s o c ia t e d w it h n e g a t iv e e x te r n a lit y .
T h e c a s e o f a p o s it iv e e x te r n a lit y is h a n d le d a n a lo g o u s ly ( s e e f ig u r e b e lo w ) . W it h a p o s it iv e e x te r n a lit y , th e m a r k e t
u n d e r v a lu e s th e b e n e fit o f t h e g o o d . I n th e a b s e n c e o f g o v e r n m e n t in t e r v e n t io n , Q * g e ts p r o d u c e d . H o w e v e r , Q * * is
th e s o c ia l o p tim u m . T h e s h a d e d a r e a r e p r e s e n t s th e c o r r e s p o n d in g w e lfa r e lo s s .
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Notes
1 The insight that the establishment of property rights provides a solution to the externality problem is
attributable to Ronald Coase, 1991 recipient of the Nobel Prize in Economic Science. It is widely known
in the economics literature as the "Coase Theorem." Coase first explained his ideas in a very readable,
nontechnical--and now famous--article entitled "The Problem of Social Cost," Journal of Law and
Economics 3 (October 1960): 1-44.
2 Terry Anderson and Donald Leal discuss a number of innovative attempts to use new technologies to
establish and enforce property rights, such as the following: "Some environmental groups have proposed
that wolves by re-introduced into Yellowstone National Park, but ranchers oppose the plan because they
fear that the wolves will leave the park and prey on livestock. Could the wolves be fenced? Technology
is currently available for "fencing" dogs by burying a cable that emits a radio signal on the perimeter of
a piece of land; the signal, received in the dog's collar, shocks the animal, which then retreats from the
perimeter. Could the same technology be applied to wolves? When red wolves were reintroduced into
South Carolina wildlands, they were equipped with radio collars that allow the animals to be tracked. If
a wolf wanders too far afield, a radio-activated collar injects the animal with a tranquilizing drug so that
it can be returned to its designated habitat. Whales can also be "branded" by genetic prints and tracked
by satellites, providing another way to define property rights [Anderson and Leal, Free Market
Environmentalism, San Francisco: Westview Press, 1991, page 34]."
CHAPTER 47
Environmental Regulation
"EPA OFFICIAL DEFENDS STRICT MANDATES. While some

city officials in Oklahoma feel federal mandates handed down by the
Environmental Protection Agency are too stringent, the EPA says
the benefits of keeping the earth clean far outweigh the costs. Roger
Meacham, a spokesman with the agency's regional office in Dallas,
responded to claims that expensive environmental standards are
placing a heavy burden on municipal taxpayers,...'While there may
be some expense involved initially...the benefits outweigh the
costs.'...Weatherford Mayor Gary Rader said he feels a federal
mandate requiring significant upgrades for solid waste disposal is
unreasonable....The mayor estimates the cost of bringing his city into
compliance with this order at $9 million. The city of Weatherford's
total annual budget is just over $3 million."1
In the case cited by the newspaper excerpt above, the EPA was requiring the city of
Weatherford, Oklahoma to install liners in their existing landfills. In other words, the EPA
was mandating that Weatherford make a specific resource transfer. Why couldn't the
residents of Weatherford be trusted to make the right decision about this resource transfer?
Installing liners in their municipal-owned landfills would make the citizens of Weatherford
better off. There would be a decreased probability that landfills would ooze harmful
substances into the local community. This would mean greater health, and happiness, for the
residents of Weatherford.
Against this benefit is the cost of installing the liners. As we know, these costs represent the
lost happiness that consumers elsewhere in the economy would experience if resources--
such as the labor and materials employed in installing the liners--were withdrawn from other
activities. If the residents of Weatherford decided that the increased happiness they would
receive from having a safer environment was greater than the costs of installing the liners,
one would expect that their political leaders--like Mayor Gary Rader--wouldn't need federal
mandates to make them do the right thing.
The problem here is that there is a third group of consumers whose interests are not being
considered. If harmful substances leach into Weatherford's soil and groundwater, that
doesn't just hurt the citizens of Weatherford. Not too far away are the cities of Clinton,
Thomas, and Hydro. Their citizens could also be harmed by Weatherford's leaky landfills.
When Weatherford considers the costs and benefits of installing liners in their municipal
landfills, it doesn't consider how the citizens of neighboring towns feel about this. That's
natural, since the city of Weatherford has no way of collecting revenues from the citizens of
other cities. But it is unfortunate. Because it means that Weatherford will not "feel the joy"
that other citizens will receive from new landfill liners. This POSITIVE EXTERNALITY
could cause Weatherford to make a socially incorrect resource decision.
Suppose the costs of the new liners is $9 million, and that the citizens of Weatherford would
be willing to pay about $5 million to have these new liners put in. Further, suppose the
residents of the neighboring towns of Clinton, Thomas, and Hydro would be made $7
million happier if Weatherford installed the new liners. We can use our Profit Table to show
how the City of Weatherford's budget office might approach this problem (see "Before EPA
Mandate").
Before EPA Mandate After EPA Mandate
BENEFITS: $5M + $7M = $12M $5M + $7M = $12M
REVENUE: $5M $5M + $7M = $12M
COST: $9M $9M
PROFIT: - $4M + $3M
Change in society's happiness is $12M - $9M = + $3M
It's pretty clear that without any mandates from the federal government, Weatherford has no
incentive to install new liners in the city's landfills. The residents of the city receive too little
benefit ($5 million) to warrant the expense they would have to bear ($9 million). Any local
elected official who tried to implement this resource transfer would certainly incur the
voters' ire. And that's a shame. The reality of the situation is that this resource transfer would
make society better off.
From the perspective of society's happiness, there are only two numbers in the table that
matter: $9 million and $12 million. Installing landfill liners is a resource transfer that takes
away $9 million of happiness from consumers who are denied the goods and services that
these resources could have produced doing something else. But in exchange, the citizens of
Weatherford, Clinton, Thomas, and Hydro collectively receive $12 million in happiness.
Therefore, the net gain to society's happiness of installing the landfill liner is $3 million.
Now the EPA steps in. They tell Weatherford that they better fix their landfill problem--or
else. Or else what? Or else the EPA will hit the city of Weatherford with a very substantial
penalty, a $7 million fine. This changes everything. Now the mayor and the city manager
huddle over the city's budget and come to an entirely different conclusion. By installing the
new liners, the city can make its citizens $5 million better off, and avoid having to pay the
$7 million fine. Once this PENALTY AVOIDANCE BENEFIT is factored in, the citizens of
Weatherford, and their elected officials, decide it is in their best interests to do what the EPA
says. In effect, this penalty avoidance benefit helps the citizens of Weatherford to "feel the
joy" that their neighbors receive from having Weatherford's landfills lined.
In this fashion, the federal government encourages a resource transfer that increases society's
happiness by $3 million.2 This is a clear demonstration that an environmental mandate in the
presence of externalities can make society better off. But will it? Once again, that is an
entirely different question.
To show how government intervention could make things worse, let's suppose that
everything about the problem is exactly the same--with one exception: This time, we assume
that the citizens of the neighboring towns get only $1 million of pleasure from Weatherford
putting liners in their landfills. The only effect this has on the numbers in the Profit Table is
that now the gross Benefit from installing the liners is only $6 million, instead of the $12
million in the previous example. Importantly, this change in the valuation of the benefit by
residents of Clinton, Thomas, and Hydro alters nothing from the perspective of
Weatherford's city budget.
Before EPA Mandate After EPA Mandate
BENEFITS: $5M + $1M = $6M $5M + $1M = $6M
REVENUE: $5M $5M + $7M = $12M
COST: $9M $9M
PROFIT: - $4M + $3M
Change in society's happiness is $6M - $9M = - $3M
It's still the case that before the intervention by the federal government, Weatherford had no
incentive to install the new liners. And it's still the case that after the intervention, it is in
Weatherford's best interests to do what the EPA says. But now the only two numbers in the
table that matter from the perspective of society's happiness are $9 million and $6 million.
The EPA's environmental mandate has forced through a resource transfer that is going to
deprive consumers of $9 million of happiness while producing a gross Benefit of only $6
million. Rather than increasing society's happiness, this same environmental mandate has
now caused society's happiness to decrease of $3 million.
Why the different result? Why did government intervention increase society's happiness in
the first example, but decrease it in the second? It has to do with the size of the penalty
compared to the size of the externality. In the second example, the penalty was too large
relative to the external benefit received by the residents of Weatherford's neighboring towns
($7 million versus $1 million). You see, the purpose of the penalty is to help Weatherford
"feel some of the joy" that citizens in other towns will get from the resource transfer. In
other words, the penalty is supposed to mimic the information that the price system should
be reporting, but isn't.
By threatening Weatherford with a hefty fine, the EPA manufactured an extra $7 million
incentive for Weatherford to install the landfill liners. Unfortunately, this extra incentive
sent the wrong information to Weatherford. It overstated the benefit that the landfill liners
would produce for the other towns. It caused Weatherford to "feel too much joy" from this
resource transfer. As a result of this bad information, the EPA induced Weatherford to
misallocate society's resources. If only the EPA had set the penalty at $1 million instead of
$7 million, Weatherford would not have made this mistake.
This illustrates an important lesson for government intervention: IN ORDER FOR

GOVERNMENT INTERVENTION TO IMPROVE RESOURCE ALLOCATIONS IN
MARKETS WITH EXTERNALITIES, GOVERNMENT MUST SET THE
PENALTIES/REWARDS EQUAL TO THE VALUE OF THE EXTERNAL
BENEFITS/COSTS RECEIVED BY THIRD PARTIES. If the penalties/rewards are too
large, government intervention can make society worse off.
But how can government know the size of the externalities? It can't. Once again, the
problem here is lack of information. When there is a market imperfection due to externality,
firms will misallocate resources because prices contain incomplete information. The
interests of the third party are not being reported by the price system. But they're also not
being reported by anybody else. Who can look into the hearts and souls of the citizens of
Clinton, Thomas, and Hydro to know how much happiness they would get from having
liners put into Weatherford's landfills?
The whole wonder of the price system is that it is able to produce information that is
virtually unknown and unknowable by any other means. When the price system fails, we are
back to the world of the central planner trying to figure out who wants what. We are forced
to depend on panels of "experts"--like the EPA--as they make their best subjective guess
about the unseen sizes of the externalities.
Does this imply that government should never intervene when there are externalities present
in a given market? Of course not. If a city's landfill is leaking toxic chemicals and people are
falling over dead all around town, then reasonable people will agree that spending $9 million
to line that landfill is a justifiable expense. It gets a lot trickier, however, when the
externalities are smaller and not so visible. How large a number should one assign to
externalities in cases like Weatherford's, where people are not falling over dead all around
town? Reasonable people can--and will--disagree. But it doesn't help when EPA
administrators like Roger Meacham unequivocally state, "the benefits outweigh the costs."
The regulators entrusted with making these resource decisions ought to realize that the
benefits of their actions cannot be known for certain--and that they have the power to do
harm, as well as good.
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Notes
1 The Oklahoma Daily, September 16, 1992.
2 Perhaps this strikes you as unfair. Why should the citizens of Weatherford be asked to subsidize
Clinton-ites, Thomas-ites, and Hydro-ites? Why should people in Weatherford have to pony up money
to pay for something they don't value very much? Note that the EPA could have mandated that the
citizens of these neighboring towns be required to contribute some of the expenses for the new liners.
The fact that they didn't means that there is an implicit wealth transfer from the citizens of Weatherford
to the citizens of these neighboring towns. As always, wealth transfers don't figure into our evaluation of
society's happiness. Weatherford's loss is Clinton's, Thomas', and Hydro's gain. What matters from the
perspective of society's happiness is merely that resources have been transferred from lower-valued uses
to higher-valued uses. Society's total happiness has increased.
CHAPTER 48
Market Imperfection III: Public Goods
The last market imperfection that we will look at is "public goods." The name is misleading.
When economists speak of public goods, they are not talking about goods that are produced
by the public sector (though oftentimes these goods are). Rather, the adjective "public" is
used to distinguish those goods that are not "private" goods. A private good is a good like a
hamburger. When you take a bite out of a hamburger, that's one less bite that is available for
somebody else to consume. Contrast this with a football game. When you watch a football
game on TV, there's just as much of that football game available for somebody else to watch
(consume).
In fact, from the perspective of maximizing society's happiness, WE CAN THINK OF

PUBLIC GOODS AS GOODS THAT ARE CHARACTERIZED BY POSITIVE
EXTERNALITIES. Suppose you are both an avid football fan, and a very wealthy
individual. You love football so much that you arrange with the owners of the Dallas
Cowboys and the San Francisco 49ers for their two football teams to come to your home and
play a scrimmage in your backyard. Chances are, once your neighbors hear about it, they
also will want to watch the game. In other words, though you arrange to watch the game in
your backyard for your private benefit; your neighbors expect to receive an external (third-
party) benefit. And that's okay with you. After all, if they want to come and watch, it will
not diminish your pleasure. As long as the amount you are willing to pay is greater than the
cost of putting on the game, society's happiness is increased. Your neighbors' happiness is
just icing on the cake.
But suppose your willingness to pay isn't large enough to pay the costs of putting on the
game. As a result, no game is held in your backyard. What happens to society's happiness
then? This case is almost identical to the example of the landfill liners of the previous
chapter. If the external benefits received by your neighbors--like Mr. and Mrs. Clinton, Mr.
and Mrs. Thomas, and Mr. and Mrs. Hydro--are sufficiently large, then society's happiness
would be increased if you arrange the game. The problem here is that you don't "feel their
joy" in deciding to schedule the game. In doing what is in your interest, and by not
considering the spillover benefits to your neighbors, your action no longer maximizes
happiness.
THE PROBLEM WITH PUBLIC GOODS, LIKE THE PROBLEM WITH POSITIVE
EXTERNALITIES, IS THAT THE PRIVATE SECTOR WILL PRODUCE TOO LITTLE
OF THE GOOD. Too few resources will be withdrawn from other activities and directed to
the production of this good. And that's a shame. Society will miss out on an opportunity to
increase its happiness.
It's important to note that private markets are not completely helpless in dealing with goods
that have positive spillover benefits. Profit-seeking entrepreneurs will try to figure out some
way of "capturing" the externalities from public goods. For example, one thing you could do
to capture the spillover benefits received by your neighbors from the Cowboys-49ers
scrimmage is build a high wall around your property and then charge admission for those
who wanted to see the game. Then you could begin to "feel their joy." The revenues you
collect would provide information about the amount of pleasure your neighbors received. If
the sum of these revenues and your own willingness to pay was larger than the costs of
putting on the game, you would find it in your interest to arrange the football match. You
would have a private incentive to act in the public interest. In essence, building a wall and
charging admission has turned the third party--your neighbors--into direct participants in the
economic transaction. It has allowed you to internalize the external benefits associated with
hosting the game. The "public" good has been "privatized."
Many times, however, private markets aren't able to capture the external benefits from
public goods. For example, take jokes ("Take my wife...please"). A paying consumer (let's
call her Mary) goes to a comedy club and pays admission to hear a professional comedian
tell jokes. Mary's willingness to pay is a measure of the happiness that she expects to receive
from the show. But consider what happens after she returns home from the club.
The jokes Mary heard are still able to be enjoyed by others even after she has "consumed"
them. Suppose she tells her friends--Laurie Clinton, Lisa Thomas, and Jennifer Hydro--some
of the funny stories she heard. And they get a big guffaw from hearing the comedian's jokes.
While Mary may consider these people her friends, from an economist's perspective, they're
just third parties to a resource transfer. They are getting a benefit from the comedian's jokes
without having to pay for it. As a result, the revenue the comedian receives from producing
jokes does not reflect the pleasure Mary's friends receive. Like all goods with positive
externalities, this is likely to result in too little of the good being produced. Society is a little
less happier--and a little less funnier--because the price system has failed to report the full
pleasure that consumers receive from this comedian.
Note how difficult it would be for the comedian to internalize these external benefits. He
would have to assign a private detective to each paying consumer to follow them around
after the show. Every time Mary told one of the comedian's jokes to a friend, the detective
would have to collect money from the person who heard the joke.
DETECTIVE: "Excuse me, ma'am, I'm from the Comedy Club and that joke's going to cost
you five dollars."
MARY'S FRIEND: "Five dollars, you've got to be joking."
DETECTIVE: "No, ma'am, that's not my job. My job is to collect money for the people who
are joking."
Clearly, it is not practical for the comedian to do this. At least by performing in a club and
charging admission at the door, the comedian is able to capture some of the benefits from
producing this good.
For other types of public goods, even this isn't practical. Consider a road in a downtown area
of a major city. After one consumer uses the road, there is still plenty of road available for
another consumer to use. A private entrepreneur might try to charge each of the users of the
road a fee, but imagine what a mess that would be. Every time one turned the corner from
one street to another, there would be a tollbooth to collect money from drivers. Just think of
the traffic jams this would cause during rush hour as cars queued up to pay tolls at every
corner!
In summary, because public goods produce positive spillover benefits, there arises a
problem in how to get people to pay for the benefits they enjoy. An alternative to the
methods discussed above is voluntary contributions. However, this raises the famous "FREE
RIDER PROBLEM" which is the topic of the next chapter.
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CHAPTER 49
Public Goods and Free Riders
Suppose you own a store in a major shopping district. After two break-ins, you meet with
the owners of several other nearby businesses who have had similar problems. You propose
that you all band together to hire a watchman to patrol the neighborhood after dark. For the
five businesses attending, including yourself, the table below reports how much each is
"willing to pay" for this police protection:
YOU BUSINESS BUSINESS B BUSINESS C BUSINESS

A D
$7000 $5000 $6000 $4000 $8000
It turns out that a watchman can be hired for $15,000. If the costs are equally divided across
the five businesses, each would pay $3,000 apiece. Since everyone's "willingness to pay" is
more than this amount, hiring a night watchman would make each person better off. That is,
this resource transfer would increase society's happiness.
But would you expect each businessperson to agree to this plan? The problem is twofold.
First, each person only knows his or her own willingness to pay. Despite the fact that we
have reported the other businesses' willingness to pay values in the table above, in reality,
this information is hidden--unseen and unknowable. Second, each business knows that they
will enjoy an external benefit if the other businesses hire the night watchman. This external
benefit arises because once burglars know that the neighborhood is being patrolled at night,
they will divert their attention to other parts of town. A business that didn't pay for the night
watchman could still derive benefits from the other stores' having hired a night watchman.
As a result, the owner of Business B might say to his colleagues, "Hey, I really haven't had
any problems. If you guys want to go ahead and get a night watchman, that's fine. Just don't
expect me to pay." The truth is that the owner of Business B values a night watchman's
services at $6,000. But by lying to his friends, he can wind up paying nothing and still get
the benefit of a having a night watchman in his neighborhood. The owner of Business B is
what economists call a "FREE RIDER." You may call him a leech.
The problem with free riding is that if the other businesses follow the same strategy, the
watchman will not be hired. And that is a shame. It is in the interests of society's happiness
to hire a watchman.
Everyone has had experience with free riders. If you have ever worked on a team project in
school, you've probably seen the problem up front and dirty. Suppose a team consists of one
conscientious student and three slackers. These three may be slackers, but they are certainly
no dummies. They know that the conscientious student will work hard no matter what. As a
result, the slackers can sit back and goof off, and still receive an acceptable grade for the
project. They experience a positive externality from the work of the conscientious student.
As a result, they don't work as hard as they would if they were being graded on their own
efforts, and the project suffers.
Another example of free riding occurs every Sunday morning in houses of worship all
across America. People sit in the pews at church, listen to the sermon, enjoy the fellowship
of the congregation, and take advantage of the many services the church has to offer. Yet
when the collection plate gets passed around, does everybody pitch in a contribution to help
pay the costs of the services? Those who don't are free riding on the contributions of the
others.
From these examples, one can see how difficult it is to get the private sector to produce the
quantity of a public good which maximizes society's happiness. Whether because of the
impracticality of collecting revenues or the free rider problem, for-profit enterprises will find
it difficult to collect revenues commensurate with the happiness society receives from public
goods. As a result, the private sector will tend to produce too little of the public good. When
this happens, there is a role for the public sector.
To be sure, most of us would feel uncomfortable about having the government take over the
production of church services. On the other hand, most would agree that government should
play a role in the provision of public goods like city streets, the criminal justice system, and
national defense. But how does the public sector decide how much of these goods to
produce? And will the public sector allocation necessarily be better than the private sector
allocation? To answer these questions, we will need to examine just how the public sector
makes allocation decisions. That is the topic of the final chapters of this book.
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CHAPTER 50
Voting on Public Goods: All in Favor, Say "Aye"
One way the public sector can allocate resources in the presence of market imperfections is
by a dictator. However, famous resource allocators like Joseph Stalin, Adolph Hitler, Pol
Pot, and Idi Amin have generally given this alternative a bad name. As a result, most people
seem to prefer the alternative of MAJORITY VOTING. In the next few chapters, we want to
investigate whether majority voting is likely to improve upon the resource allocations
produced by the private sector in the presence of market imperfections. To do that, we first
need to understand how majority voting works.
City streets are widely acknowledged as being public goods.1 Let's consider an example
from the make-believe city of Dinky, North Dakota. The little township of Dinky consists of
five homes at the end of a cul-de-sac. The cul-de-sac is not paved. In fact, in its current form
it's a miserable excuse for a road, consisting solely of dirt and gravel. Every time the snow
melts or there is a significant rain, the area turns into a sea of mud and pot holes. As a result,
each of the five households has given a lot of thought to the possibility of hiring a contractor
to pave the cul-de-sac. After checking around, they locate a contractor who is willing to
pave their cul-de-sac for $25,000.
The table below represents how much happiness each of these families would receive if the
cul-de-sac was paved.
Andersons Bakers Custers Demeters Ewings
$10,000 $8,000 $6,000 $3,000 $3,000
As the table shows, each household has a different "willingness to pay" value. This is
because some of the families live at the end of the cul-de-sac and have to drive over more
potholes than others. In addition, some of the households own cheap compact cars which
have a tough time making it through the mud and the sludge; while others own Range
Rovers and Jeeps that can go through almost anything.
And now for the really important question: Should Dinky get paved? From the perspective
of maximizing society's happiness, the answer is a resounding yes. The total dollar value of
happiness from paving the cul-de-sac is $10,000+$8,000+$6,000+$3,000+$3,000 = $30,000.
In contrast, since the cost of paving the road is $25,000, we can infer that society will lose
$25,000 of happiness from having the resources used to pave the road--the laborers of the
road crew, the tar and asphalt, etc.--withdrawn from other activities. The net effect will be
an increase in society's happiness of $5,000.
But will the households of Dinky work together to arrange this resource transfer? Let's first
consider how resources would be allocated under a PRIVATE SECTOR arrangement. This
would be problematic, to say the least. While we know the willingness to pay values of the
five households, this is private information. Each household only knows how much
happiness it would receive. Because of this, and because the residents of Dinky are no
stranger to the phenomenon of FREE RIDING, there is no telling what is going to happen.
Maybe all five will agree to contribute enough money so that they road is paved. That would
be great.
On the other hand, maybe some of the families will try to free ride. That is, some of the
families might not really be willing to pay their "willingness to pay" values. For example,
suppose the Ewings decide to free ride off of the other families. They tell their neighbors
that, personally, they enjoy the mud and the potholes. On top of that, it keeps those pesky
door-to-door salesmen away. They lie about the fact that they really want a paved road. And
it just might work. After all, the Andersons, Bakers, Custers, and Demeters together
sufficiently value paving the road. These four families might voluntarily contribute enough
money to pull it off. Then again, they might not. Another family might also try to free ride.
If that happened, then the whole project would fall apart, and the road would not be paved.
No one household gets sufficient happiness out of the paved road to pay for it themselves. It
requires coordination with other households. This points out the problem with private sector
allocations of public goods. If people free ride, or if it's too costly to collect revenues from
those who benefit, there will be a tendency to devote too few resources to the production of
the public good. In this case, the road might not be built or a lesser road, such as a gravel
road, will be chosen over the optimal solution of a paved road.
Now consider what happens when the resources are allocated under a majority voting
arrangement. Suppose the town of Dinky puts a proposition to pave the road on the ballot in
the next general election. In the table below, we reproduce the "willingness to pay" values
from above on the "Benefits" row, but now we include two additional rows. Since the
township of Dinky will arrange with a contractor to have the road paved, it will need to raise
tax revenues. Let's assume that Dinky raises $5,000 in taxes from each family if the
proposition to pave the cul-de-sac passes. We represent this personal tax cost to each family
on the "Costs" row. The "Vote" row reports how each family will vote. If the household's
personal "Benefits" are greater than their "Costs," they vote YES on the proposition.
Otherwise they vote NO. Here are the results. (Note: we let each household have one vote.)
BENEFITS: $10,000 $8,000 $6,000 $3,000 $3,000
COSTS: $5,000 $5,000 $5,000 $5,000 $5,000
VOTE: YES YES YES NO NO
The people have spoken! The proposition to pave the cul-de-sac is passed by a 3 to 2 vote.
The road shall be paved, and society's happiness shall be increased. It may seem a little
unfair that the Demeters and the Ewings had to pay $5,000 in taxes when they only valued
the road at $3,000. But once again, we are not concerned with fairness. We are concerned
with maximizing society's happiness. In the private sector, the road might not have been
paved because the community had no way of forcing everybody who received a benefit from
the road to pay for it. When the government intervenes--precisely because it's the
government--it can force people to pay taxes so that enough money will be collected to pay
for the road paving. It is the ability of the government to coerce individuals to pay for things
that they otherwise wouldn't pay for that enables the government to increase society's
happiness in this case.
Will majority voting always result in public goods being provided if they increase society's
happiness? The answer is no. This is easily seen by manipulating a few numbers to obtain
the table below. If it happened that the Bakers valued the road paving at $10,000 (instead of
$8,000) and the Custers valued it at $4,000 (instead of $6,000) we would obtain the opposite
vote outcome.
BENEFITS: $10,000 $10,000 $4,000 $3,000 $3,000
COSTS: $5,000 $5,000 $5,000 $5,000 $5,000
VOTE: YES YES NO NO NO
In this case, the vote on the road paving proposition would be 3 to 2, against. The road
would not be paved under majority voting. And that's a shame. After all, paving the cul-de-
sac still would generate a net increase in society's happiness of $5,000. The residents of
Dinky would still receive $30,000 of happiness ($10,000+$10,000+$4,000+$3,000+$3,000)
from paving the road; while withdrawing resources which would have produced $25,000 of
happiness elsewhere in the economy.
THEREFORE, MAJORITY VOTING DOESN'T GUARANTEE THAT PUBLIC GOODS

WILL BE PROVIDED EVEN IF THEY INCREASE SOCIETY'S HAPPINESS. How about
the other way? Can majority voting approve resource transfers that lower society's
happiness? What do you think?
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Notes
1 While the following discussion is targeted towards the provision of public goods, the same general
analysis is applicable to instances of market imperfections relating to monopoly and externalities.
CHAPTER 51
Free Riders Versus Forced Riders
In this chapter, we want to continue with the same Dinky example we used last chapter. Five
families. All living at the end of an unpaved cul-de-sac. It still costs $25,000 to hire a
contractor to pave the road. Only this time, we want to use some different "happiness
values" for the five families. After all, nobody ever sees other people's valuations of public
goods. So the following happiness values are in principle just as reasonable as any other.
$7,000 $6,000 $5,500 $1,000 $500
Given these values, do we want the cul-de-sac paved? In this example, the residents of
Dinky get only $20,000 of happiness ( = $7,000+$6,000+$5,500+$1,000+$500) from having
the road to their homes paved. Since paving this road would remove resources worth
$25,000 elsewhere in the economy, we don't want Dinky paved.
Here's the good news: Under a PRIVATE SECTOR arrangement, this road would never be
paved. Figure it out. Even if every one of the residents paid the entire dollar value of the
happiness that the paved road would provide for them, they still wouldn't have enough
money to pay the contractor. To get enough money to pay the contractor, these families
would have to contribute more money than the project was worth to them. Since this would
never happen under a voluntary contribution system, the road would not be paved. This
illustrates a general principle about the private sector provision of public goods (and goods
characterized by positive externalities): UNDER PRIVATE SECTOR ALLOCATIONS,
INDIVIDUALS WILL NEVER ARRANGE TO HAVE PUBLIC GOODS PRODUCED
WHICH LOWER SOCIETY'S HAPPINESS.
But now consider what happens under MAJORITY VOTING. Once again, we reproduce the
individual households' willingness to pay values in the "Benefits" row. The "Costs" row
represents each household's tax burden. The "Vote" row shows how each household would
vote if the road-paving proposition appeared on the Dinky general election ballot.
BENEFITS: $7,000 $6,000 $5,500 $1,000 $500
COSTS: $5,000 $5,000 $5,000 $5,000 $5,000
In this case the proposition passes by a vote of 3 to 2. The road is paved. And that is a
shame. In approving this proposition, the majority of voters have initiated a resource transfer
that will take resources that would have produced $25,000 of happiness elsewhere in the
economy, and directed them to an activity that generates only $20,000 of happiness.
MAJORITY VOTING HAS JUST LOWERED SOCIETY'S HAPPINESS BY $5,000. How
could this happen? How could the majority do this to society? What went wrong?
The solution to this puzzle has to do with NEGATIVE EXTERNALITIES. Only this time,
it's not a private sector externality, but a public sector "externality." Recall what a negative
externality is. It is a cost experienced by a third party to a resource transfer. When a factory
belches black clouds of breath-stifling smoke into the atmosphere, it imposes costs on
consumers who live near the factory. But consider this: When a voter votes for a proposition
that makes other citizens worse off, he also imposes costs on those citizens. Economically
speaking, this voter has just done to other citizens what the factory has done to its neighbors.
We can see this more clearly in the table below. The third row in the table reports the gains
or losses ("Profits") that each voter experiences if the road-paving proposition passes. Note
that the three voters who vote in favor of the proposition receive relatively small gains as a
result of the resource transfer ($2,000+$1,000+$500 = $3,500). In contrast, the two voters
who vote against the proposition sustain relatively large losses ($4,000+$4,500 = $8,500).
Thus, majority voting has allowed the first three households to vote $3,500 of positive
"profits" for themselves at the expense of $8,500 in negative "profits" for the other
households, generating a net decrease in society's happiness of $5,000. Because the
Andersons, Bakers, and Custers do not internalize the costs they impose on the Demeters
and Ewings, they make a socially incorrect resource transfer.
BENEFITS: $7,000 $6,000 $5,500 $1,000 $500
COSTS: $5,000 $5,000 $5,000 $5,000 $5,000
PROFITS: + $2,000 + $1,000 + $500 - $4,000 - $4,500
Perhaps we're being a little too harsh on our voters. Maybe voters are more broadminded
than we give them credit for. Here's a way to check close this story comes to reality. Think
back to the last Presidential election. Did you vote for the Republican or the Democratic
candidate for President? When you voted, did you stop and consider how your friends and
loved ones felt about your choice? How your co-workers and neighbors felt about it?
Probably you knew somebody whose political views were exactly the opposite of yours. Did
that make a difference in your presidential vote? And that's just the feelings of people you
know. How about the feelings of people you don't know? Did you stop and think of what
you were doing to them? Every four years millions of Americans are made miserable for at
least "four more years." Yet most Americans will not let that affect their decision. They will
simply vote for the candidate that they want. In so doing, they are the political equivalent of
belching smokestacks.
In fact, there is an interesting parallel between the imperfections of private sector and public
sector provision of public goods. Private sector provision of public goods is imperfect
because there are external benefits which are difficult for profit-seeking individuals to
capture. Public sector provision of public goods is imperfect because there are external costs
which are difficult for profit-seeking individuals to avoid. Both kinds of imperfections can
lead to resource allocations which do not maximize society's happiness.
Think of public goods provision as a bus ride. When the private sector operates the bus, an
entrepreneur is in control of the steering wheel. He decides where to take the bus. Of course,
the passengers don't have to go along for the ride. They are free to get on or off. The
problem for the private sector lies in the collection of the fares. The nature of public goods is
such that some--perhaps many--passengers can ride the bus without having to pay the fare.
This results in "free riders." If there are too many free riders, the entrepreneur may not
collect enough money to compensate him for operating the bus. So the bus line may go out
of business--even though it's increasing society's happiness.
In contrast, when the public sector operates the bus, the majority is in charge. They control
the steering wheel and take the bus wherever they want it to go. The problem for the public
sector lies in the passengers who have to ride the bus. They are not free to get on or off.
Once a majority decides on a destination, everybody is forced to ride the bus and pay the
fare. The nature of government is such that some--perhaps many--passengers will be forced
to pay for the ride even if they don't want to go where the bus is going. This results in
"forced riders." If the forced riders are made sufficiently worse off by where the majority
want to go, society's happiness will be decreased. But because government makes everyone
pay, the bus line stays in business. It keeps on going even though it lowers the happiness of
its passengers.
Of course, this does not imply that public provision of public goods will lower society's
happiness. Indeed, the previous chapter provided an illustration of how government
intervention in the public goods market could increase society's happiness. It's just that--as
in the case of externalities and public sector regulation of monopoly--there is no guarantee
that government intervention will improve on the private sector allocation of resources. It
could make things worse.
In summary, there is nothing magical about democratic majorities. When it comes to

resource transfers, the problem is always one of information. Majority voting does not
produce the detailed information that is missing in private markets. It tells us how many
people gain or lose from a particular resource transfer. It doesn't tell us how much people
gain or lose from resource transfers. It is the latter information that we need to know in order
to make resource transfers which maximize society's happiness. And because this
information is lacking in political markets, resources can easily be misallocated in the public
sector--just as they are misallocated in the private sector--when market imperfections are
present.
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CHAPTER 52
Exploiting Fellow Citizens for Fun and Profit
Why would Congress spend $100 million a year to store helium gas in underground caverns
in the Texas panhandle? What's that? You haven't heard about that program?
"Washington so loves helium that it has a billion dollars worth of

gas stored underground in the Texas panhandle for fear it will run
out of the inert gas. While the gas sits, the Bureau of Mines of the
Department of Interior suffers a loss of $100 million a year....It all
started with blimps in World War I. Military strategists decided that
airships were the weapon of the future, and in 1929, Congress
appropriated money to put the government into the helium
producing business in case we had to fight that war all over again.
Plants were built and for 30 years, the U.S. government was the
major (almost exclusive) producer of helium in the United States.
Washington provided all the helium needed by agencies like NASA--
who used it to purge fuel tanks in the missile program...'How much
helium do we have underground?' I asked a director of the program
in Washington. At least he was frank. 'We have a whole lot--in fact,
35 billion cubic feet.' 'How long will that last at our present rate of
use?' I asked innocently. He didn't hesitate. 'Well over a hundred
years.'"1
Or how about $35 million for a monorail in Altoona, Pennsylvania.
"The three-mile-long Suspended Light Rail System Technology Pilot

Project is not only a classic government title, it's a $35 million
monorail that is being built by the federal government as part of the
$153 billion Intermodal Surface Transportation Efficiency Act of
1991...The monorail had been projected for a small town in
Pennsylvania--specifically, Altoona--population 57,000. The
chairman of the Subcommittee on Surface Transportation is
Congressman Bud Schuster of Pennsylvania. His district? Where
else but Altoona....This was only one of 460 "demonstration
projects" attached to the mammoth bill. Congressman Schuster
managed to put in 13 projects worth $287 million for his own
district."2
Or how about $25 billion dollars in subsidy payments given to American farmers through
programs like the following:
"One of the most abrasive programs in the farm-welfare

armamentium is the "0-92" scheme, a true farmer dole. It is a
bizarre federal idea that allows a farmer not to work, not to plant at
all, and live as well as he ever did...The Congressional Budget Office
explains...'Current law allows participants in U.S. Department of
Agriculture price- and income-support programs to receive 92
percent of their deficiency [subsidy] payments even though...they do
not plant any of the program crop (the 0-92 program available for
wheat and feed grain producers).'...What's behind all this? The
federal official involved in auditing the farm program...adds...'The
politicians in the farm areas are desperately trying to keep their
constituents in business and agriculture happy, and they seem to be
successful at it.'"3
Millions of dollars for the underground storage of helium gas (to prepare our forces for the
imminent Russian blimp invasion?); a monorail for Altoona, Pennsylvania (to alleviate the
traffic congestion around this metropolis?); and cash subsidies for farmers not to grow crops
(no comment). And this is only the tip of the iceberg. The list goes on and on. How is it that
elected officials--popularly chosen by democratic majorities--can engage in such massive
squandering of taxpayers' money? Why can't they just say no to wasteful spending? In this
section, we want to show the inescapable logic that underlies these wasteful uses of public
funds.
Let's consider a particular resource transfer, say the storage of helium gas in underground
caverns in the Texas panhandle. Let's assume there are a hundred voters in the economy and
that it costs a $100 to purchase and store the helium gas--$50 to buy the helium and $50 to
rent the land under which the helium is stored. Thus, each voter would have to pay $1 in
taxes to fund the program.
To keep it simple, we assume that everyone in the economy agrees that there are absolutely
no social benefits to storing helium gas. However, some voters do receive a financial benefit
from this government program. These are the landowners--we'll assume there are five of
them--from whom the government will rent the land to store the helium. If the government
didn't rent this land, these five landowners could each receive $6 by putting their land to
some other purpose (say drilling oil). But if the government goes ahead with the helium gas
storage program, it will pay these five landowners $10 each to use their land. Accordingly,
each of these five landowners would receive a $4 financial gain from the program. Now
suppose we held an election to determine whether we wanted the government to store
helium gas. The table below reports how this election would go.
Landowners Other Voters

(5) (95)
BENEFITS: $4 $0
COSTS: $1 $1
PROFITS: + $3 - $1
VOTE: YES NO
The electorate--in its infinite wisdom--chooses not to support the helium gas storage
program. The vote is 5 in favor and 95 against. And that's great. Because the helium gas
storage program would decrease society's happiness by $80. Why $80? First there is the
withdrawal of helium gas which costs $50. The price of the helium gas tells us that this gas
would produce $50 of happiness elsewhere in the economy if it wasn't stored under the
Texas panhandle. On top of that, the helium gas storage program would have withdrawn $6
of land from each landowner. Therefore, we know that this land could have produced a total
of $30 of happiness ($6 times 5 landowners) if it were used for something else--like cattle
production. Thus, the $100 cost of the program consists of an $80 decrease in society's
happiness plus a $20 wealth transfer ($4 times 5 landowners).
But, unfortunately, we have left out an important part of the story. Suppose that voting took
some effort. That is, a person had to leave work and drive to the polling booth or find a
babysitter to watch the kids while she went off to vote. Let's suppose that this effort made
each voter worse off by $2. Now let's reconsider our election results. First the
"Landowners": If this bill gets passed, each landowner will be made better off by $3 (see the
"Profits" row). Even with a $2 cost to voting, it still pays for the landowners to go to the
polls and vote in favor of the storage program.
But now consider the "Other Voters": if the bill passes, each of these voters is made worse
off by a $1. This dollar loss is small compared to the $2 cost of voting. As a result, these
voters stay home, or at work, and don't turn out to vote. That is, the loss that they suffer
from this program is too small to justify protesting against it. The final election result? 5 in
favor and 0 against. The helium gas storage program passes in a landslide! Welcome to the
LAW OF CONCENTRATED BENEFITS AND DISPERSED COSTS.
That's crazy, you say. It doesn't work like that. It doesn't? Okay, here's a little test for you.
Now that you know that the government is stockpiling a hundred year's worth of helium gas
under the Texas panhandle--and assuming that you don't live in the Texas area--what are
you going to do about it? Are you going to contact your congressman (what's his name?) and
demand that he put an end to this program?
Part of the problem is that the funding for this program is buried somewhere deep in the
federal budget (and since the federal budget contains over 200,000 line item accounts and is
well over a thousand pages long, it could be very deep). This means that there is no House
or Senate legislation entitled "The Precious Gasses Conservation and Storage Act" which
your congressman could argue and vote against. Rather, he'd have to lobby his colleagues on
the respective budget appropriations committees to have this item removed from the federal
budget. But why should he?
Your congressman has only so much time in the day. If he spends his time lobbying against
funding for this program, that's less time he has to work on other issues. And relative to
most of the issues your congressman faces, this program is hardly worth noticing. Because
the reality is, as federal programs go, $100 million is only a drip in the public bucket. It
amounts to less than 1/15,000th of the total federal budget! It's so small that it might not
even appear as a separate item in the federal budget. So even if your congressman wanted to
do something about wasteful federal spending, it wouldn't make any sense for him to focus
his efforts on this measly, little $100 million federal program.
But why would your congressman want to work hard to eliminate specific programs that
waste taxpayers' money? Are you going to vote against him if he doesn't? Let's try and
figure this out. As a rough approximation, let's say there are about a 100 million, taxpaying
households in America. Assuming you are an average American household, how much is
this program costing you? About a dollar a year. One dollar. A hundred pennies. That's it.
We repeat the question: Now that you know that the government is stockpiling a hundred
year's worth of helium gas under the Texas panhandle--and assuming that you don't live in
the Texas area--are you going to badger your congressman to do something about this? And
if you're not, who will? We should hardly expect congressmen to wage battle against
wasteful government programs if the elimination of these programs is of such small concern
to ordinary voters.
In contrast, there is a group of voters for whom these programs are very important. Now
suppose you are a resident in this Texas panhandle district and a recipient of government
funds from the helium program. You hear that Congress is thinking about axing this
program. What are you going to do? Maybe you're making $100,000 a year from this
program. Do you have an incentive to protest this cut? Yes indeed. At the very least, you'll
phone your congressman's office and tell him you want him to fight this budget cut. Since
losing this program means you're out a $100,000, you'll probably do a lot more. You might
threaten your congressman that unless he stops this budget cut, you'll stop donating the
thousands of dollars you contribute each year to his campaign. Maybe you'll hire a lobbyist--
if you haven't already--to plead your case before the relevant congressional subcommittees.
Your congressman gets the message: this program means a lot to his constituents. And now
he'll fight like a dog to make sure this program is preserved.
How will this congressman mobilize support for this program? He won't do it by telling his
colleagues on the budget committee that they should preserve this program because it's a
huge boondoggle for you and your friends. No way. He'll give a rousing speech on the floor
of the House that will sound something like this:
Mr. Speaker, my colleagues in this distinguished institution, my fellow
Americans. I am here today to talk to you about a vital, vital program.

The helium gas storage program has been in existence for over half a
century. During this time, this program has served important American
interests. As most of you know, these gasses played a fundamental
role in our space program that helped put the first man on the moon,
and kept the missiles in place that have protected this country so ably
over the past decades against foreign aggressors.
And now there's talk about cutting this program. This program costs
Americans virtually nothing. In fact, it costs the average American
family less than A PENNY A DAY. And what does America get in
return for this minuscule investment? I'll tell you what America gets. It
gets a guaranteed supply of precious gasses that can never be disrupted
by the vagaries of the market. Gasses that are vital to the functioning
of this economy.
But it gets more--a lot more. It provides support to honest,

hardworking Americans who have dedicated their lives to helping this
country stay strong. They were there for the working people of this
country back when many Americans really wondered whether we
could put a man on the moon--or whether we could defend ourselves
against the communist threat. If we cut this program now, we will
throw these hardworking, god-fearing American families out in the
cold. Thousands of jobs will be lost. Communities will be devastated.
Families will be broken apart. These very same families who have
sacrificed so much--so that we could have the peace and prosperity
that we know today.
I was not elected to this great institution to sit idly by while

misinformed and mean-spirited budget-cutters throw decent folks out
in the street. This isn't a vote about saving a few million dollars. It's a
vote about what we stand for in this great country. It's a vote about
whether we care more about people--or about dollars. I trust that you--
my distinguished colleagues--will also not sit idly be and allow this
great injustice to be done. And so I appeal to you, don't cut this vital
program. Think of the families. Think of the children. And may God
bless America.
Haven't you heard this--or something like this--before? And when the committee that's in
charge of considering the budget cuts sits down to deliberate--after they've heard speeches
like the one above--they'll likely hear some more speeches. But this time not from
politicians. Farmers, housewives and their children, small businessmen, all will be flown
into Washington to testify before the committee about the great good this program has done
for them. And there will be tearful pleas to the congressmen to preserve this program.
Who will be there to speak against this program? Where will the advocates come from to
argue in behalf of the millions of Americans who have to pay for this? The fact is, there
won't be many. It just isn't an important enough issue for any one voter or household to try
to fight. It's not worth the effort. Just like it wasn't worth the effort for our "Other Voters" to
show up and vote against this program in our hypothetical example above. When the
members of this committee get together to decide the fate of this program after a hard day of
hearing testimony, what do you think the vote will be? How about 5 in favor and 0 against?
Does all of this still sound too-farfetched? Consider the following. The political scientist
James Payne, author of the book The Culture of Spending, spent several years in
Washington, D.C. in the late 1980's. During that time he attended a large number of House
and Senate appropriation committee meetings. He kept a running count of the number of
supporters of federal spending programs; and compared this to the number of opponents of
federal spending programs. What do you think the ratio of supporters to opponents was?
Five to one? Ten to one? A hundred to one? Try 145 to 1! Of 1,060 witnesses who appeared
before appropriation committees during this time period, 1,014 were supporters of or
program or spending; 39 were neutral or mixed; and only 7 were opponents of programs or
spending.4 How can we explain this? CONCENTRATED BENEFITS AND DISPERSED
COSTS.
When the benefits of a federal spending program are concentrated on a relatively small
percentage of the population, there is a great incentive to mobilize support for that program.
When the costs are spread across the entire taxpaying population--as they are when
programs are funded out of general tax revenues--there is little or no incentive to mobilize
opposition against that program. In effect, the beneficiaries all vote in favor of the program
while the taxpayers stay home and don't fight it. The result? A virtual landslide of electoral
support in favor of individual spending programs! So everybody complains about high taxes
and wasteful federal spending, but when it comes time to vote for their congressman, they
reelect the ones who bring home the pork.
This very simple truth goes far to explain why we see Congress approving billions of dollars
to special interest groups. When the congressional delegation from Texas fights hard for the
preservation of the helium gas program, the congressmen from Pennsylvania and the
Midwest farm states are easily won over. They agree to vote for the helium gas program. In
exchange, the congressmen from Texas agree to vote for a monorail for Altoona,
Pennsylvania; and agricultural subsidies for wheat farmers. These programs produce
concentrated benefits for their respective constituents. And these constituents will reward
their congressmen for preserving these programs by reelecting them to office. In return,
since the costs of these programs are so spread out, no congressman from Texas is going to
lose an election because he didn't fight a monorail project for Altoona, or an agricultural
subsidy for wheat farmers.
It's a crazy system, but it all makes perfect sense. For the most part, it has nothing to do with
corrupt politicians. It is not the character of the people who are sent to Congress. Rather, it is
the incentive structure that exists when they get there. An incentive system imposed on
politicians by their own voters. And if Congressman Smith tries to fight the system
singlehandedly by voting against special interest legislation, what will happen to him?
Chances are his colleagues in Congress won't be very willing to approve programs that
provide special benefits for Mr. Smith's constituents. Perhaps after a few years, the voters in
Mr. Smith's district will get disgusted with him for not bringing enough federal money back
to their district. Perhaps they'll throw him out of office and replace him with somebody else
who can do a better job.
If all this were a simple tale of wealth transfers between groups, it might strike one as unfair,
but it wouldn't be a source of alarm. However, when wealth transfers to special interest
groups result in resource misallocations, society as a whole becomes poorer. Think back to
our example of voting for the helium gas storage program. A relatively small group of
landowners was able to generate a resource transfer that made them $20 better off ($4 times
5 landowners), but lowered society's overall happiness by $80. Now multiply this example
by thousands--tens of thousands--of special interest groups, each interested in increasing
their share of the economic pie, but not concerned with the costs they impose on others, and
one sees just how alarming this problem can be. BECAUSE OF THE LAW OF
CONCENTRATED BENEFITS AND DISPERSED COSTS, DEMOCRATIC
MAJORITIES HAVE AN INHERENT TENDENCY TO MISALLOCATE RESOURCES
AND LOWER SOCIETY'S HAPPINESS.
As long as individual self-restraint, or constitutional restrictions, is able to discourage

widespread feeding at the public trough, public sector interventions powered by democratic
majorities are not likely to cause significant damages to society's happiness. However, once
these constraints are relaxed, societies face the prospect of voting themselves poorer. A
sobering insight. But not a new one. Not at all. The eighteenth-century Scottish historian
Alexander Tytler wrote:
"A democracy cannot exist as a permanent form of government. It

can only exist until a majority of voters discover that they can vote
themselves largess out of the public treasury."
Think about it.
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Notes
1Martin L. Gross, The Government Racket: Washington Waster from A to Z, New York: Bantam
Books, 1992, pages 98f.
4 James Payne, The Culture of Spending, San Francisco, California: ICS Press, 1991, page 13.
CHAPTER 53
Why Economists Disagree
Just as we promised, once one leaves the world of many buyers, market-clearing prices, and
no imperfections, things become awfully complicated. Furthermore, it must be conceded
that one can always find a market imperfection if one looks hard enough. Take
MONOPOLY for example. Virtually every business has some degree of market power. That
is, almost every business could charge higher prices if it was willing to settle for fewer sales.
The gas station on the corner. The neighborhood hair salon. The movie theater at the mall.
Does this mean that the government should take over every business in the economy and
regulate its price and output? If you answered yes to this question, then there's no point in
reading further. Rather, may we recommend a fine, three volume work on economics called
Das Kapital by Karl Marx. We think you'll like it.
Since the problem with monopoly is that the monopolist doesn't produce enough, a
necessary condition for government intervention to improve society's happiness is that it
force the monopolist to produce more. Most people don't believe that government regulation
of prices would result in more output from gas stations, hair salons, and movie theaters. (Just
imagine if the local beauty parlor were run like the Post Office.) On top of that, a vast
amount of resources would have to be spent setting and controlling prices for so many
companies. These are resources that could produce happiness doing something else. In other
words, massive price regulation would be a prescription for pain with little gain.
Accordingly, most people would agree that it probably is best not to price-regulate these
firms.
So let's move on to a case where reasonable people can disagree. Let's consider the case of a
privately owned subway (as in underground transportation) company in a large city. Here is
a textbook example of a monopolist--a single seller. It seems reasonable to assume that a
subway company--like J. D. Rockefeller's lemonade stand in Chapter 43--would have a
significant degree of market power in setting its price. It could charge a very low price and
get many riders. Or it could charge a much higher price and get fewer riders. As a result, it is
likely that the fare that would maximize the subway company's profits would result in "too
few" passengers. What should society do?
Regulation is certainly an option. A Subway Commission could be elected, or appointed by

other elected officials, to regulate the subway's fares. Would lower rates result in more
passengers? It's not so clear, is it? On the one hand, lower fares would mean that more
consumers will want to ride the subway. On the other hand, the subway company would
make less money. One way it could try to get its profits back up is to decrease the quality of
its service. It could do this by spending less money on keeping its cars clean and attractive.
Or it could spend less money on keeping its cars in good repair, increasing the risk of
passengers being subject to inconvenient disruptions in service. Furthermore, the subway
company might decide that the lower fares were not sufficient to maintain the frequency of
its trips during off-peak hours. So it might cut back service during these times. Another
possibility is that the company might decide that certain routes were unprofitable at the
lower fares and cancel service to these areas.
On top of this, since the Subway Commission is politically appointed, it would be subject to
the forces of CONCENTRATED BENEFITS AND DISPERSED COSTS discussed in the
last chapter. That is, special interests might attempt to capture benefits for themselves at the
expense of other citizens. How might this happen? For one thing, downtown merchants
might find that frequent service to their store locations increased their profits. So they would
lobby the Subway Commission to make sure that the subway made frequent stops in their
part of town. Or residents from a particular section of the city would fight to make sure that
service to their neighborhood was continued, even though the subway company wanted to
cancel that service because it was unprofitable. What are we left with in the end? Do we
think that the allocation of resources under public sector regulation will result in greater
happiness than what would have resulted if the subway company had remained unregulated?
Tough question.
An economist sympathetic to the working of unregulated private markets and distrustful of

public sector intervention might reasonably come to the opinion that it was best to leave the
subway company unregulated. While he would acknowledge the potential gains to society's
happiness from lowering fares and encouraging greater ridership, he would also place great
faith in the ability of the subway company's managers to find ways to subvert the lower fares
by reducing service. On the positive side, he would have faith that the bus, above-ground
train, and cab companies would all opportunistically attempt to steal away the subway's
customers if it tried to raise fares too much. This economist would also be fearful that the
influence of special interests on the Subway Commission would result in the subway
company making resource transfers which actually lowered society's happiness, such as
continuing service on routes that were unprofitable--something the subway company would
never do in the absence of regulation.
How about an economist who was sympathetic to the benefits of government intervention?
This economist would see the same things the first economist did. But he would likely
believe that the gains in happiness from lower fares and increased ridership far outweighed
any negative effects from service cutbacks and resource misallocations. Who's right? Let's
just be honest here. Nobody can know for sure. Despite the fancy analyses that economists
get paid to do in order to answer questions like this (and the more the money, the fancier the
analysis), the fact is the ultimate answer depends on things that nobody can know. How
many extra riders would ride the subway if the company charged lower fares? (How could
we know until we actually lowered fares?) How will the company respond to the lower,
regulated fares? (How could we know until we actually tried to lower the company's fares?)
What will be the influence of special interests on the Subway Commission? (How could we
know until a Subway Commission was actually established?)
Let's shift gears now and consider the case of a negative externality. Suppose a developer
wanted to build a shopping mall close to a residential section of town. With the shopping
mall would come increased traffic in the residential neighborhood. Residents in that
neighborhood would be adversely impacted by the increased traffic. As a result, the
shopping mall would impose a NEGATIVE EXTERNALITY. What should society do?
Once again, regulation is an option. In an ideal world, public sector regulators would
determine the dollar value of the negative externality. They would then tax the mall an
amount equal to the cost it imposed on residents. The developer would then consider this
along with his other costs to determine whether it was profitable to build the mall. In
contrast, what usually happens in the real world is that a Zoning Board, composed of or
appointed by elected officials, approves or denies permission for the developer to build the
mall. That is, the Zoning Board attempts to weigh out the (unseen) costs caused by the
increased traffic against the gains society would receive from the mall.
An economist sympathetic to the working of unregulated private markets and distrustful of

public sector intervention might reasonably come to the opinion that it was best to let the
developer proceed unhampered in his pursuit of increased profits. This economist would
recognize that the developer--by not internalizing the costs he was imposing on nearby
residents--might make the wrong resource allocation decision. That is, the developer might
go ahead and build the mall even though the net effect was to lower society's happiness. On
the other hand, this economist would recognize that the Zoning Board might also make a
wrong resource allocation decision. The Board might overestimate the costs of the (unseen)
externalities and subsequently deny permission to the developer. On top of that, this
economist would be fearful that special interests might influence the Zoning Board's
decision. For example, residents in the neighborhood might have a great incentive to lobby
the Board members to keep the mall from being built. Local merchants might band together
to influence the Board so that this unwanted competition was prevented from "invading their
territory."
And how about an economist sympathetic to government intervention? He would see all
these things too. However, in contrast to the free market economist, he would be inclined to
emphasize the benefits of controlling unwanted external costs from development. He would
have greater faith in the Zoning Board's ability to accurately guess the relevant costs and
benefits and to remain unswayed by the lobbying efforts from special interests. Who would
be right? Again, an honest answer is that we just don't know. It's a judgement call.
There you have it. Now you know a major reason why "if you laid all of the economists
from end to end they would never reach a conclusion." It's not that economists have different
frameworks. Indeed, the main theme of this book is that there are not multiple frameworks
for understanding economics. There is only one. The difference isn't in the framework. Its
lies primarily in two subjective evaluations. So let's lay out these evaluations clearly.
FIRST, ECONOMISTS DISAGREE BECAUSE THEY DIFFER IN THEIR OPINION OF

THE SEVERITY OF THE MARKET IMPERFECTION. How much below the socially
optimal level is the monopolist producing? How much beyond the socially optimal level is
the firm with the negative externality producing? Is the private sector producing too little of
the public good? Because these questions cannot be answered objectively, reasonable people
can--and will--arrive at different answers to these questions. If one believes that the market
imperfections are not very severe, then one is led to a laissez faire position of leave well
enough alone. On the other hand, if one believes that the private market is off by a lot, then
one will want to seriously consider whether government intervention could make things
better.
SECOND, ECONOMISTS DISAGREE BECAUSE THEY DIFFER IN THEIR OPINION

OF GOVERNMENT'S ABILITY TO MAKE THINGS BETTER. Will price regulation of
the monopolist backfire so that the end result is less output than what the unregulated
monopolist would have produced? Will governmental restrictions on firms producing
negative externalities be so burdensome that consumers receive too few goods and services?
Will public sector provision of public goods result in so many "forced riders" that the public
sector allocation is worse than the private sector allocation? Finally, will special interests
use their political influence to exploit government oversight of the private sector for their
own gain at the expense of society's overall happiness?
The great value of the economic way of thinking is that it leads one to ask the right
questions. The answers to these questions, however, are open to debate. They oftentimes
depend on factors that are unknown and unknowable. In the final analysis, each individual
must come to their determination of the proper role of government.
TABLE OF CONTENTS
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CHAPTER 54
Closing Thoughts
It is the argument of this book that there is a simple framework by which one can evaluate
public policy. Every policy involves transferring resources from one activity and to another.
As a consequence, every policy has winners and losers. The framework presented here
provides a means by which one can organize and--under the right circumstances--measure,
the resulting gains and losses. Good policy, as we define it, is policy for which the gains of
the winners are larger than the losses of the losers.
A major insight gained from our analysis is that when there are no significant market
imperfections, profit-seeking firms will tend to direct resources towards their highest valued
use. In this case, government interventions (price controls, subsidies, taxes, quotas, and
mandates) can only decrease society's happiness. In contrast, when market imperfections are
present, government interventions can--but may not--increase society's happiness. Thus, A
MAJOR IMPLICATION OF OUR FRAMEWORK IS THAT CITIZENS--and that includes
you, dear reader--SHOULD EXPECT PROPONENTS OF GOVERNMENT ACTIVISM
TO IDENTIFY A SIGNIFICANT MARKET IMPERFECTION BEFORE INTERVENING
IN MARKETS. For example, in the public debate over health care policy, or education, or
regulation of industry, the first step should consist of identifying the market imperfection
which causes private markets to misallocate society's resources.
Unfortunately, even when a market imperfection is identified, there will be many instances
where our simple framework will be unable to determine the desirability of a given public
policy. As we have seen, this determination will oftentimes depend on factors that are
unknown and unknowable (e.g., the size of the negative externality associated with
pollution, the effect of special interests on regulatory boards, the willingness to pay of
consumers for a public good, etc.). Thus two individuals, both using the same framework for
analyzing public policy, might justifiably come to opposite conclusions. But if that is the
case, how useful can our framework be?
Remarkably, just THE MERE RECOGNITION THAT RESOURCES HAVE

ALTERNATIVE USES WOULD REPRESENT SIGNIFICANT PROGRESS IN MANY
PUBLIC DEBATES OVER POLICY. City, state, and federal governments commonly pass
legislation that guarantees basic rights or services to selected groups without debating, or
even acknowledging, that these laws have the potential of lowering society's happiness.
Indeed, resistance to the idea that public policies should consider costs as well as benefits
runs deep.
When environmental advocates argue that we should preserve an endangered species "no
matter what;" when health advocates argue that everyone is entitled to the "best medical care
available;" when legal aid champions argue that every citizen--no matter what their race,
sex, age, religion, sexual orientation, etc.--is entitled to "fair treatment" on the job; it should
always be remembered that these policies withdraw resources from other activities. These
may be good policies. These may be desirable policies. But they are certainly costly policies.
Wishing they weren't costly doesn't make it so. Indeed, one of the great services of prices in
a market economy is that they force us to confront the fact that resources have alternative
uses, even when we prefer to close our eyes to this fact.
But what are we to do when, having acknowledged the costs of policies, our framework still
leaves us unsure about the desirability of government intervention? Is there any guide, any
rule of thumb, that can guide us as we confront difficult policy issues? We wish to close this
book by suggesting that the twentieth century contains a vitally important lesson in this
regard.
In the 1940s and 1950s an intense debate raged among economists about the merits of
socialism. Previously, most economists had focused on the incentives of economic agents to
produce under socialism. That is, if firms weren't allowed to keep their profits, and
individuals weren't allowed to keep their earnings, then how could society motivate its
members to make their resources available for the public good? In the midst of this debate
came a number of free-market economists who said that this controversy was centered
around the wrong question. The most important question with respect to maximizing
society's happiness is not, how can we get people to use their resources for the public good?
Rather, the most important question with respect to maximizing society's happiness is, how
can we know what the public good is?
This debate came to be known as the Socialist Calculation Debate. It proved to be the
intellectual deathknell for socialism. It was eventually recognized that socialism could
provide no alternative to the informational role of prices in a free-market/capitalistic system
of resource allocation. In the end, socialism had no intellectually credible answer for how
the state could identify the public good. The fundamental problem of economics--lack of
information--had to be acknowledged.
Half a century later, the superiority of a market-based system of resource allocation over
socialism is no longer confined to mere intellectual argument. It has been demonstrated in
the great laboratory of the world's economies. Indeed, nowadays it is commonly asserted
that socialism is dead. THE GREAT ECONOMIC LESSON OF THE TWENTIETH
CENTURY IS THAT PUBLIC SECTOR CONTROL OF THE ECONOMY--PRECISELY
BECAUSE IT HAS NO WAY OF DETERMINING THE HIGHEST VALUED USE OF
RESOURCES--IMPOVERISHES ITS PEOPLE.
What should citizens do when our framework leaves the desirability of government
intervention uncertain? While each individual must decide for himself, we recommend a
presumption in favor of unregulated private markets, and against government intervention in
the economy. The theory of how private markets tend to increase society's happiness
provides an explanation for the great success of the wealthiest economies in the world. It
teaches us that it is no accident that the most prosperous economies in the world are those
economies that have generally favored private over public control of the allocation of
resources.
At the very least, citizens who favor greater reliance on public sector direction of the
economy should be keenly aware of what they leave behind. The system of prices directing
resources in unregulated private markets yields a number of invaluable benefits for society.
It is a system that generates information vital for knowing how best to employ society's
resources. It is a system that channels the self-interest of man and directs it in favor of the
public good. It is a system that minimizes social conflict over the use of resources. And it is
a system that has produced the wealthiest societies in the history of mankind. These are
extraordinary accomplishments. The great economic lesson of the twentieth century should
teach us not to dismiss them lightly.
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TABLE OF CONTENTS Page 1 of 3

PRICES AND INFORMATION

W. Robert Reed and Max Schanzenbach

© 1996 W. Robert Reed and Max Schanzenbach

CHAPTER 1: Why You Should Read This Book

PART II: A Simple Framework for Analyzing Public Policy

CHAPTER 13: The Big Picture

CHAPTER 22: Can We Afford to Let the Maritime Industry Sink?

PART III: Extensions of the Simple Framework

CHAPTER 30: Moving to Greener Pastures

PART IV: Market Imperfections and the Public Sector

CHAPTER 43: Market Imperfection I: Monopolies

I'M READY FOR SOME PRACTICE

CONTINUE ON TO THE NEXT CHAPTER

TAKE ME BACK TO THE TABLE OF CONTENTS

HOLD ON! I'VE GOT A QUESTION!

Response Number Three states, "The purpose of an economy is to increase production." By

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CONTINUE ON TO THE NEXT CHAPTER

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Now don't misunderstand us. We do not personally advocate equalizing incomes or

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Willingness to Pay Values for the Five Consumers

Consumer A Consumer B Consumer C Consumer D Consumer E

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Willingness to Pay Values for the Five Consumers

Consumer A Consumer B Consumer C Consumer D Consumer E

Willingness to Pay Values for the Ten Consumers-Before

Willingness to Pay Values for the Ten Consumers-After

$3.50 0 0 $5.60 $7.90 0 $8.90 0 0 0

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CONTINUE ON TO THE NEXT CHAPTER

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CONTINUE ON TO THE NEXT CHAPTER

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CONTINUE ON TO THE NEXT CHAPTER

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than a clean floor!

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PROFITS = REVENUES - COSTS