Economics and Free Markets

A Reader

Howard Baetjer

• Publisher: Cato Institute
• Year: 2017
• ISBN:
  9781944424510
• Topic: Philosophy
• Subtopic: Political Philosophy

When we stop to consider it, a free economy is a marvel. Millions of people, mostly unknown to one another, each producing some particular good or service, somehow manage to coordinate their actions in a vast, cooperative, productive order with no one in charge. How does it work?

Economics helps us understand. This book introduces the concepts on which all of economics is founded, concepts such as subjective value and gains from trade, scarcity and opportunity cost, thinking at the margin, division of labor, and comparative advantage. It then introduces the foundational theory with which we understand how market prices emerge and change to reflect changing conditions: supply and demand analysis. It also introduces the principles that underlie spontaneous economic order: market prices provide the information we need to coordinate our actions with others' actions, while profit-and-loss feedback guides entrepreneurs as to how best to satisfy others' wants. Private property rights and freedom of exchange give us the incentive to interact in mutually beneficial ways.

Part One:

Foundational Concepts

We begin with the concepts that underlie most everything in economics: (a) the nature of value and of wealth, (b) the meaning of scarcity and opportunity cost, (c) the fact that we generally make economic decisions “at the margin,” and (d) the benefits we all realize from specializing according to comparative advantage and trading with other specialists for the rest of what we need.

1

Subjective Value and Gains from Trade

We begin this introduction to economics by getting clear on some foundational concepts. In this chapter, we consider the nature of value, the gains we realize from trade, and the unlimited possibilities of wealth creation.

Value Is Subjective

Among the most important concepts in economics is that different people value things differently. Some people love seafood; others dislike it. Some enjoy watching football; others prefer old movies. Tastes in music vary widely. And the same person values the same thing differently in different times and situations. The value you put on a nice meal, for example, depends on how recently you last ate.

The term we use in economics for this fact is that “value is subjective.” Value is in the eye of the beholder, so to speak; it is in the person, the subject doing the valuing rather than in the object being valued.

Subjective value stands opposed to the older labor theory of value: the mistaken view (articulated by Adam Smith in The Wealth of Nations and taken up by Karl Marx as one of the foundations of his economic theory) that the value of any good is determined by the amount of labor required to produce it. A bottle of water, say, is held to be worth a dollar because a dollar’s worth of labor was required to obtain and filter the water, to produce the plastic of the bottle and the lid, to put the water in the bottle, and to produce and glue on its label.

But the labor theory of value is untenable. If it were true, then an apple pie that took four hours to produce would be worth the same amount as a mud pie that took the same four hours. It’s not, because people don’t like to eat mud. The tastes and preferences of the people doing the valuing are what determine something’s value.

Voluntary Trade Creates Wealth, Makes Traders Wealthier According to Their Own Values

That value is subjective has a wonderful consequence: people can make one another better off merely through trading, through exchange. When Jimmy prefers Ted’s backpack to his own skateboard, and Ted prefers Jimmy’s skateboard to his own backpack, the boys can exchange backpack for skateboard and make each boy better off according to his own subjective values. In an important sense, each boy is wealthier after the trade. When crabbers in my home state of Maryland trade blue crabs to Washington State apple growers for their apples, both groups are better off—wealthier according to their different values—as each group gives up what it values less for what it values more.

Notice how this insight about the mutual benefits from voluntary exchange contradicts the widespread notion that exchange is zero-sum, that in a market economy, some people benefit at the expense of others. The notion is there in the expression “the rich get richer and the poor get poorer.” That implies that the rich get rich at the expense of the poor. We hear “one man’s loss is another man’s gain,” as if there is only a certain amount to go around, so that if one person becomes better off, someone else must have become worse off. Underlying a lot of the animus against “haves” is the notion—perhaps unconscious and unexamined—that the wealth of “haves” comes at the expense of “have-nots.”

But that is not true, as long as the wealthy earn their wealth in voluntary exchange (rather than through special privileges from government, such as bailouts, subsidies, or protected monopolies). Consider Steve Jobs, LeBron James, and Beyoncé. They are all “haves.” Did they become wealthy at the expense of the rest of us? Not at all. They became wealthy by delighting us with their electronic devices, athletic prowess, and great songs and videos.

Invisible Hand Principle

That participants in voluntary exchange mutually benefit one another is so important that it can hardly be overemphasized. It has this important corollary: in a free and competitive economy, people who want more for themselves are guided, as if by an invisible hand, to benefit others. Why? Because in a free society, others don’t have to interact with us at all. If we want something from others, we must persuade them to give it to us by offering them something they value more in return. In the words of my grad school professor Walter Williams: “In a free market, you get more for yourself by serving your fellow man. You don’t have to care about him! Just serve him.”

We call this the “invisible hand principle” after Adam Smith’s statement in The Wealth of Nations that although a person engaged in commerce may “intend . . . only his own gain, . . . he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention,” namely, to promote the public interest.

Wealth Is Not Fixed; People Create It and Can Do So without Limit

Virtually all wealth is created by human ingenuity and effort. A few good things come to us for free—the blessed rain, the sunshine, and the air we breathe come to mind—all the rest we must create. Houses, farms, backhoes, clothing, soap, oil refineries, flat-screen TVs, and every other good thing that supports and enriches our lives we humans create by transforming raw materials. The physical stuff from which we fashion those things has always been here, but through the application of our ingenuity, we transform that physical stuff into goods and services we value.

This process has no apparent limit because the ability to create new wealth is bounded only by the human imagination, and humans are endlessly imaginative.

The Ultimate Resource

Some people worry that human wealth and well-being are limited by the finiteness of physical resources, such as oil, metals, and arable land. The worry is needless because, as economist Julian Simon has taught us, the ultimate resource is the human imagination coupled with the human spirit. Human imagination ceaselessly finds new and better ways to satisfy human wants and needs. It literally creates resources; it finds ways to do more with less; it finds substitutes for resources as they get more expensive.

In what sense do people literally create resources? They do so by discovering how physical stuff once considered useless can in fact be used. Consider the sticky black stuff that used to gunk up streams in Pennsylvania and Oklahoma: petroleum. That was not a resource until creatively thinking human beings discovered that it could be refined into kerosene, gasoline, and the like. That discovery turned petroleum into a resource.

Consider the vast lakes of shale, miles below the earth’s surface, until recently considered useless. Those lakes were turned into a valuable resource when people discovered that with horizontal drilling and hydraulic fracturing (“fracking”), we can profitably extract great quantities of oil and natural gas from them.

The ultimate resource—the human imagination coupled with the human spirit—is constantly finding us ways to do more with less. I remember when it took a strong man to crush a beer can in his hand, because beer cans were made of thick metal. But people discovered how to make cans with metal so much thinner and lighter—and therefore less expensive—that now anyone can crush a beer can. I remember concerns that LP record albums, the leading technology for recording music, would become terribly expensive as the cost of the vinyl used to make them was rising. Those albums also took up a lot of space in my cabinet. Then came compact discs, which held many more songs in less space than a vinyl record. And now I can store hundreds of songs on an SD card little larger than a fingertip.

I used to lug heavy books with me to read on vacation. Now I can take all the books I want on my Kindle, the size of one thin paperback. People endlessly discover ways to do more with less.

And we develop substitutes, often better and cheaper than what we used before. Consider transoceanic telephone calls. They used to be carried by copper cable, tons of copper torn out of the mountains of Idaho and Peru and laid across the ocean at great expense. The calls themselves were expensive and of poor quality, with delays and signal loss. But the human imagination found substitutes for copper cable—optical fiber and satellites—that carry hundreds of times more phone calls inexpensively, at the speed of light, and with virtually no signal loss. And the optical fibers, like SD cards, are made of cheap and abundant sand.

And as former Saudi Arabian oil minister Sheikh Zaki Yamani said three decades ago, “The Stone Age did not end for lack of stone, and the Oil Age will end long before the world runs out of oil.” Human imagination coupled with the human spirit will find a replacement for oil. I wonder what it will be.

Money Is Not Wealth

Let us finish this chapter with the important distinction between money and wealth. Of course, in a money economy, having more money makes one wealthier, other things remaining equal. Nevertheless, strictly speaking, money is not wealth. We can’t eat it, wear it, build shelters with it, or listen to MP3s with it. Money’s great value to us is as a medium of exchange. It frees us from the limitations of barter. We don’t value money in itself, but for what it can buy. As economist Antony Davies says, “Money is just the conveyor belt.” Ultimately, we trade goods and services not for money, but for other goods and services.

In this book, when we think about wealth, let’s think about the goods and services we value—what Adam Smith called the “necessaries and conveniences of life”—and not about money.

2

Scarcity and Opportunity Cost

Scarcity

Another of the foundational concepts of economics is scarcity. In Thomas Sowell’s words:¹ “What does ‘scarce’ mean? It means that people want more than there is.” In the words of my textbook, scarcity means “there is less of a good freely available from nature than people would like.” Sowell again: “There has never been enough to satisfy everyone completely. That is what scarcity means.”

Scarcity is not rareness: Cars are not rare; they are everywhere. But they are scarce nonetheless because not everyone who wants one has one, and not everyone who wants two has two.

Virtually all goods are scarce. In fact, the only good I can think of that is not scarce is air. We breathe in all we want, freely available from nature. We might think that water is not scarce, but even outside drought-stricken areas, clean, drinkable water surely is.

To appreciate scarcity and its significance, focus on the scarcity of productive resources: the land, human talent, and capital goods—buildings, machinery, and equipment—we require for producing what people want. We have unlimited desires for goods and services, but the land, labor, and capital available to produce them are all limited at any particular time. They are scarce. Accordingly, so are the goods and services we can produce with them.

This insight is at the heart of economics. Because there are not enough resources with which to produce everything we want at any time, we must decide how to allocate those resources and thereby decide to produce some goods instead of others. We constantly face such tradeoffs, because if we use resources to produce one thing, we can’t use them to produce another instead. How we make those choices (and, implicitly, who makes them) is what economics is about. As Sowell says, “Economics is the study of the use of scarce resources which have alternative uses.”

That is a helpful definition, one to keep in mind throughout this book.

Rationing

The next principle follows from the fact of scarcity: scarcity necessitates rationing. Rationing is the allocation of scarce resources among their myriad possible uses. We can’t avoid rationing, but we can choose how to do it.

Think of all the ways in which we humans can ration goods. Sadly, we often do it by force—the biggest and strongest just take what they want. We sometimes do it by equal division, in which everyone gets the same share. We can do it by some kind of lottery in which chance determines who gets what. Some things we r...

Table of contents

• Cover Page
• Title Page
• Copyright Page
• Contents
• Introduction
• Part One: Foundational Concepts
• Part Two: Demand and Supply
• Part Three: Free Markets
• Conclusion
• Notes