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Basic Economics - Thomas Sowell

Basic Economics 4th Ed. - Thomas Sowell#

1. What is Economics#

Economics is the study of the use of scarce resources which have alternative uses. - Lionel Robbins

What does “scarce” mean? It means that what everybody wants adds up to more than there is.

Not only scarcity but also “alternative uses” are at the heart of economics.

Efficiency in production—the rate at which inputs are turned into output—is not just some technicality that economists talk about. It affects the life of whole societies.

It is not money but the volume of goods and services which determines whether a country is poverty stricken or prosperous.

2. The Role of Prices#

Money to some people, for a society as a whole money is just an artificial device to get real things done

  • feudal economy (central planning) - the lord of the manor directs / coordinates the operations and activities- same as soviet union
  • market economy - prices coordinate the economy

Consequences matter more than intentions

the simple mechanism of prices does the same job faster, cheaper, and better

Prices are like messengers conveying news

Prices are not just ways of transferring money. Their primary role is to provide incentives to affect behavior in the use of resources and their resulting products. Prices not only guide consumers, they guide producers as well.

Prices formed a worldwide web of communication long before there was an Internet

Prices and Costs#

Prices in a market economy are not simply numbers plucked out of the air or arbitrarily set by sellers. While you may put whatever price you wish on the goods or services that you provide, those prices will become economic realities only if others are willing to pay them and that depends not on whatever prices you have chosen but on what prices other producers charge for the same goods and services, and what prices the customers are willing to pay. Nothing to do with greed.

Allocation of Resources#

The price which one producer is willing to pay for any given ingredient becomes the price that other producers are forced to pay for that same ingredient

Resources tend to flow to their most valued uses when there is price competition in the marketplace.

From the standpoint of society as a whole, the “cost” of anything is the value that it has in alternative uses.

The more government control, bureaucracy and central planning - the worse off the people are.

Losses are just as important as profits, from the standpoint of the economy. Losses stop losing companies and products from continuing and wasting resources.

Supply, Demand and “Need”#

  • People tend to buy more at a lower price and less at a higher price
  • people who produce goods or supply services tend to supply more at a higher price and less at a lower price
  • The is no fixed “need” amount - defined by nation states. No fixed demand nor supply.

The quantity supplied varies directly with price

If the price of oil falls - some low yielding oil wells are shut down. If price rises or extraction becomes cheaper through new technologu - these oil wells return to operation.

Many false predictions over the past century or more that we were “running out” of various natural resources in a few years were based on confusing the economically available current supply at current prices with the ultimate physical supply in the earth, which is vastly greater.

Price fluctuations are a way of letting a little knowledge go a long way. Price changes guide people’s decisions through trial and error adjustments to what other people can and will pay as consumers, as well as what others can and will supply as producers.

Rationing by Prices#

There are all kinds of prices:

  • The prices of consumer goods
  • The wages or salaries of labour
  • The interest for borrowed money

Prices provide incentives to conserve. (scarcity)

Any deal depends on both parties agreeing to the same terms

Competition is the crucial factor in explaining why prices usually cannot be maintained at arbitrarily set levels.

Competition is the key to the operation of a price-coordinated economy. It not only forces prices toward equality, it likewise causes capital, labor, and other resources to flow toward where their rates of return are highest—that is, where the unsatisfied demand is greatest—until the returns are evened out through competition, much like water seeking its own level.

However, the fact that water seeks its own level does not mean that the ocean has a glassy smooth surface. Waves and tides are among the ways in which water seeks its own level, without being frozen at that level. Similarly, in an economy, the fact that prices and rates of return on investments tend to equalize means only that their fluctuations, relative to one another, are what move resources from places where their earnings are lower to where their earnings are higher—that is, from where the supply is greatest, relative to the demand, to where there is the most unsatisfied demand. It does not mean that prices remain the same over time or that some ideal pattern of allocation of resources remains the same.

The real value - the usual level under usual conditions is no more real or valid than their much higher or much lower levels under different conditions.

Change…impermanence…the price is lower because the context has changed

The most fundamental reason why there is no such thing as an objective or “real” value is that there would be no rational basis for economic transactions if there were. When you pay 50 cents for a newspaper, obviously the only reason you do so is that the newspaper is more valuable to you than the 50 cents is.

Voluntary human action

At the same time, the only reason people are willing to sell the newspaper is that 50 cents is more valuable to them than the newspaper is.

If there were any such thing as a “real” or objective value of a newspaper—or anything else—neither the buyer nor the seller would benefit from making a transaction at a price equal to that objective value, since what would be acquired would be of no greater value than what was given up. In that case, why bother to make the transaction in the first place?

On the other hand, if either the buyer or the seller was getting more than the objective value from the transaction, then the other one must be getting less—in which case, why would the other party continue making such transactions while being continually cheated?

Unfairness to particular individuals is what makes the economy as a whole operate more efficiently for the benefit of vastly larger numbers of others - in the context of old world skills not wanted when new tech appears that can produce more efficiently and effectively

3. Price Controls#

Nothing shows more vividly the role and importance of price fluctuations in a market economy than the absence of such price fluctuations when the market is controlled

A ceiling is set but so is a floor.

  • Shortage - Prices rise because the amount demanded exceeds the amount supplied at existing prices.
  • Surplus - Prices fall because the amount supplied exceeds the amount demanded at existing prices.

Rent controls on price kept prices low. The demand therefore increased but supply decreased. No one was willing to supply or create more housing at the same low price.

Just as price fluctuations allocate scarce resources which have alternative uses, price controls which limit those fluctuations reduce the incentives for individuals to limit their own use of scarce resources desired by others.

Landlords provide less maintenance and repair under rent control, since the housing shortage makes it unnecessary for them to maintain the appearance of their premises in order to attract tenants.

Many buildings have been abandoned after their owners found it impossible to collect enough rent to cover the costs of services that they are required by law to provide, such as heat and hot water.

Politicians know that there are always more tenants than landlords and more people who do not understand economics than people who do.

Often it is politically effective to represent rent control as a way to keep greedy rich landlords from “gouging” the poor with “unconscionable” rents. In reality, rates of return on investments in housing are seldom higher than on alternative investments and landlords are often people of very modest means.

Rising prices not only allocate existing housing, they provide incentives for rebuilding and for renters to use less space in the meantime, as well as incentives for those with space in their homes to take in roomers while rents are high.

Price movements allow for goods to move to different regions: In a free market, supply and demand would cause prices to rise where goods are in short supply and fall where they are abundant, providing incentives to move things from regions where there is a surplus to regions where there is a shortage.

No doubt many or most of the motorists whose daily lives and work were disrupted by having to spend hours driving around looking for a filling station with gas, or waiting in line behind other cars when they found one, would gladly have paid a few cents more per gallon of gasoline, in order to avoid such problems and stresses.

Hoarding - Due to a gas shortage - anyone with half a tank of gas would fill up when they saw an open gas station. Therefore exacerbating the relatively small problem.

Price controls almost invariably produce black markets, where prices are not only higher than the legally permitted prices, but also higher than they would be in a free market, since the legal risks must also be compensated.

Price buts are greeted favourably from consumers however when producers stop selling due to no profit to be made - only a loss - consumers have no products and services to purchase. Mugabe thinking…

An apple is not easy to define because apples differ in size, freshness, and appearance, quite aside from the different varieties of apples. Under price control, however, the amount of apples demanded at an artificially low price exceeds the amount supplied, so there is no need to spend so much time and money sorting out apples, as they will all be sold anyway.

Under Britain’s government-controlled medical system, a twelve-year-old girl was given a breast implant while 10,000 people waited 15 months or more for surgery. Prices cause individuals to consider priorities.

A surplus, like a shortage, is a price phenomenon. A surplus does not mean that there is some excess relative to the people. There was not “too much” food relative to the population during the Great Depression. The people simply did not have enough money to buy everything that was produced at the artificially high prices set by the government.

So long as the market price of the agricultural product covered by price controls stays above the level at which the government is legally obligated to buy it, the product is sold in the market at a price determined by supply and demand. But, when there is either a sufficient increase in the amount supplied or a sufficient reduction in the amount demanded, the resulting lower price can fall to a level at which the government buys what the market is unwilling to buy.

Persistent surpluses are as much a result of keeping prices artificially high as persistent shortages are of keeping prices artificially low

4. Overview#

Cause and Effect#

“Because systemic causation involves reciprocal interactions, rather than one-way causation, that in turn reduces the role of individual intentions. As Friedrich Engels put it, “what each individual wills is obstructed by everyone else, and what emerges is something that no one willed.”

Economics is about results not intentions.

Not only can prices not be set and sustained by an act of will, neither can businesses that compete with other businesses make other important decisions on the whim of the owner and expect to survive. When Henry Ford headed the largest automobile manufacturing company in the world, he thought that he could offer his car in just one color (black) and just one style from year to year. But that is the very reason General Motors overtook the Ford Motor Company to become number one in the automobile industry, by offering cars in a variety of colors and changing the style from year to year.

Just as rent control reduces the supply of housing, so price controls and interest rate controls can reduce the number of stores, pawn shops, local finance companies, and check-cashing agencies willing to operate in neighborhoods with higher costs, when those costs cannot be recovered by legally permissible prices and interest rates.

it is both intellectually and emotionally easier to blame high prices on those who collect them, rather than on those who cause them. Even though the cost and risk of doing business in bad neighbourhoods is higher.

It is also more politically popular to blame outsiders, especially if those outsiders are of a different ethnic background.

During the Stalin era in the Soviet Union, for example, there was at one time a severe shortage of mining equipment, but the manager of a factory producing such machines kept them in storage after they were built, rather than sending them out to the mines, where they were sorely needed. The reason was that the official orders called for these machines to be painted with red, oil-resistant paint and the manufacturer had on hand only green, oil-resistant paint and red varnish that was not oil-resistant. Nor could he readily get the prescribed paint, since there was no free market.

Under any economic or political system, people can make their choices only among the alternatives actually available—and different economic systems present different alternatives.

A waitress brings food to your table, not because of your hunger, but because her salary and tips depend on it. In the absence of such incentives, service in restaurants in the Soviet Union was notoriously bad.

Being prohibitive is precisely how prices limit how much each person uses. If everything were made affordable by government decree, there would still not be any more to go around than when things were prohibitively expensive.


Nothing is easier than to have good intentions but, without an understanding of how an economy works, good intentions can lead to disastrous consequences for a whole nation

inefficiencies in turning inputs into outputs translated into a lower standard of living

But life does not ask us what we want. It presents us with options. Economics is one of the ways of trying to make the most of those options.

Without the role of prices, imagine what a monumental bureaucracy it would take to see to it that the city of London alone is supplied with the tons of food, of every variety, which it consumes every day

Even if the government were to decree that beach-front homes were a “basic right” of all members of society, that would still not change the underlying scarcity in the slightest.

Prices not only guide consumers, they guide producers as well

Markets coordinated by price movements - capitalism, as it is called - is the natural way of things

Although a free market economic system is sometimes called a profit system, it is in reality a profit-and-loss system—and the losses are equally important for the efficiency of the economy, because losses tell producers what to stop doing—what to stop producing, where to stop putting resources, what to stop investing in.

“Losses force the producers to stop producing what consumers don’t want” - they don’t even have to know why.

The staggering number of economic transactions, on ever-changing terms as supply and demand vary almost continuously, is beyond the knowledge and capacity of any individual or any manageable-sized group of planners to direct in any economy, much less in the world market

The significance of free market prices in the allocation of resources can be seen more clearly by looking at situations where prices are not allowed to perform this function

While telling people what to do might seem to be a more rational or orderly way of coordinating an economy, it has turned out to be far less effective in practice.

The sight of aisle after aisle of shelves neatly stacked with every conceivable type of foodstuff and household item, each in a dozen varieties, both amazed and depressed him. For Yeltsin, like many other first-time Russian visitors to America, this was infinitely more impressive than tourist attractions like the Statue of Liberty and the Lincoln Memorial

The market is coordinated by prices - automatically. Human intervention is only required at the most basic level raising and lower you bid and ask prices.

Scarcity means that we do not have the option to choose whether or not to have an economy in which people compete

Society as a whole always has to pay the full costs

Simply waiting until what you want becomes available has been a common form of non-price rationing. The queues and waiting lists for government things.

A price-coordinated economy facilitates incremental substitution, but political decision-making tends toward categorical priorities—that is, declaring one thing absolutely more important than another and creating laws and policies accordingly.

The creation of red tape is understandable in view of the incentives facing those who create government forms, rules, and requirements for innumerable activities that need official approval. Nothing is easier than thinking of additional requirements that might be useful in some way or other, and nothing is harder than remembering to ask the crucial incremental question: At what cost?

People who are spending their own money are confronted with those costs at every turn, whether they remember or not, but people who are spending the taxpayers’ money—or who are simply imposing uncounted costs on businesses, homeowners, and others—have no real incentives to even find out how much the additional costs are, much less to hold off on adding requirements when the incremental costs threaten to become larger than the incremental benefits to those on whom these costs are imposed by the government

Making anything artificially cheap usually means that it will be wasted, whatever that thing might be and wherever it might be located.

Sometimes the rationale for removing particular things from the process of weighing costs against benefits is expressed in some such question as: “How can you put a price on art?”—or education, health, music, etc. The fundamental fallacy underlying this question is the belief that prices are simply “put” on things. So long as art, education, health, music, and thousands of other things all require time, effort, and raw material, the costs of these inputs are inherent. These costs do not go away because a law prevents them from being conveyed through prices in the marketplace.

In a market economy, it is not necessary that the innumerable decision-makers understand the costs entailed by their decisions. It is only necessary that they be confronted with those costs in the prices charged. In a “planned” economy, however, those who plan the production and distribution have to be able to understand and quantify the costs their decisions entail—a far more formidable task, if actually done, but a task that can be evaded with rhetoric or with estimates whose validity the public is usually unable to judge at the time, and which will usually be forgotten by the time the real costs become clear, often years later.

5. The Rise and Fall of Businesses#

The companies which first introduce a product that consumers like may make large profits, but those very profits attract more investments into existing companies and encourage new companies to form, both of which add to output, driving down prices and profit margins through competition, as prices decline in response to supply and demand.

In short, although corporations may be thought of as big, impersonal and inscrutable institutions, they are ultimately run by human beings who all differ from one another and who all have shortcomings and make mistakes, as happens with economic enterprises in every kind of economic system and in countries around the world.

losses force businesses to change with changing conditions or find themselves losing out to competitors who spot the new trends sooner or who understand their implications better and respond faster.

One of the biggest advantages of an economy coordinated by prices and operating under the incentives created by profit and loss is that it can tap scarce knowledge and insights, even when most of the people—or even their intellectual and political elites—do not have such knowledge.

In a market economy, Penney did not have to convince anybody of anything. All he had to do was deliver the merchandise to the consumers at lower prices.

Neither individuals nor companies are successful forever.

What is important is not the success or failure of particular individuals or companies, but the success of particular knowledge and insights in prevailing despite the blindness or resistance of particular business owners and managers.

No economic system can depend on the continuing wisdom of its current leaders - two bicycle mechanics created the aeroplane. No academic degree or lack of money can stop ideas that work.

Let the prices guide the economy - easier and more efficient and effective that central planners.

The vast amounts of knowledge never have to be organised centrally - they are coordinated with prices decentrally.

A business executive is directed and controlled by the market - customers sending signals and him recieving them. Information from those with more knowledge (the people) to those with less knowledge (the executives). Government only gives orders and hence information moves from those with less knowledge to those with more.