Ironically, the problems caused by trying to run an economy by direct orders or by arbitrarily-imposed prices created by government fiat were foreseen in the nineteenth century by Karl Marx and Friedrich Engels, whose ideas the Soviet Union claimed to be following.
Engels pointed out that price fluctuations have “forcibly brought home to the individual commodity producers what things and what quantity of them society requires or does not require.” Without such a mechanism, he demanded to know “what guarantee we have that necessary quantity and not more of each product will be produced, that we shall not go hungry in regard to corn and meat while we are choked in beet sugar and drowned in potato spirit, that we shall not lack trousers to cover our nakedness while trouser buttons flood us in millions.”{31} Marx and Engels apparently understood economics much better than their latter-day followers. Or perhaps Marx and Engels were more concerned with economic efficiency than with maintaining political control from the top.
There were also Soviet economists who understood the role of price fluctuations in coordinating any economy. Near the end of the Soviet Union, two of these economists, Shmelev and Popov, whom we have already quoted, said: “Everything is interconnected in the world of prices, so that the smallest change in one element is passed along the chain to millions of others.”{32} These Soviet economists were especially aware of the role of prices from having seen what happened when prices were not allowed to perform that role. But economists were not in charge of the Soviet economy. Political leaders were. Under Stalin, a number of economists were shot for saying things he did not want to hear.
SUPPLY AND DEMAND
There is perhaps no more basic or more obvious principle of economics than the fact that people tend to buy more at a lower price and less at a higher price. By the same token, people who produce goods or supply services tend to supply more at a higher price and less at a lower price. Yet the implications of these two simple principles, singly or in combination, cover a remarkable range of economic activities and issues—and contradict an equally remarkable range of misconceptions and fallacies.
Demand versus “Need”
When people try to quantify a country’s “need” for this or that product or service, they are ignoring the fact that there is no fixed or objective “need.” Seldom, if ever, is there a fixed quantity demanded. For example, communal living in an Israeli kibbutz was based on its members’ collectively producing and supplying each other with goods and services, without resort to money or prices. However, supplying electricity and food without charging prices led to a situation where people often did not bother to turn off electric lights during the day and members would bring friends from outside the kibbutz to join them for meals. But, after the kibbutz began to charge prices for electricity and food, there was a sharp drop in the consumption of both.{33} In short, there was no fixed quantity of “need” or demand for food or electricity, despite how indispensable both might be.
Likewise, there is no fixed supply. Statistics on the amount of petroleum, iron ore, or other natural resources seem to indicate that this is just a simple matter of how much physical stuff there is in the ground. In reality, the costs of discovery, extraction and processing of natural resources vary greatly from one place to another. There is some oil that can be extracted and processed from some places for $20 a barrel and other oil elsewhere that cannot repay all its production costs at $40 a barrel, but which can at $60 a barrel. With goods in general, the quantity supplied varies directly with the price, just as the quantity demanded varies inversely with the price.
When the price of oil falls below a certain point, low-yield oil wells are shut down because the cost of extracting and processing the oil from those particular wells would exceed the price that the oil would sell for in the market. If the price later rises—or if the cost of extraction or processing is lowered by some new technology—then such oil wells will be put back into operation again. Certain sands containing oil in Venezuela and in Canada had such low yields that they were not even counted in the world’s oil reserves until oil prices hit new highs in the early twenty-first century. That changed things, as the Wall Street Journal reported:
These deposits were once dismissed as “unconventional” oil that couldn’t be recovered economically. But now, thanks to rising global oil prices and improved technology, most oil-industry experts count oil sands as recoverable reserves. That recalculation has vaulted Venezuela and Canada to first and third in global reserves rankings. . .{34}
The Economist magazine likewise reported:
Canada’s oil sands, or tar sands, as the goo is known, are outsized in every way. They contain 174 billion barrels of oil that can be recovered profitably, and another 141 billion that might be worth exploiting if the oil price rises or the costs of extraction decrease—enough to give Canada bigger oil reserves than Saudi Arabia.{35}
In short, there is no fixed supply of oil—or of most other things. In some ultimate sense, the earth has a finite amount of each resource but, even when that amount may be enough to last for centuries or millennia, at any given time the amount that is economically feasible to extract and process varies directly with the price for which it can be sold. 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 often vastly greater.
Natural resources are not the only things that will be supplied in greater quantities when their prices rise. That is true of many commodities and even workers. When people project that there will be a shortage of engineers or teachers or food in the years ahead, they usually either ignore prices or implicitly assume that there will be a shortage at today’s prices. But shortages are precisely what cause prices to rise. At higher prices, it may be no harder to fill vacancies for engineers or teachers than today and no harder to find food, as rising prices cause more crops to be grown and more livestock to be raised. In short, a larger quantity is usually supplied at higher prices than at lower prices, whether what is being sold is oil or apples, lobsters or labor.
“Real” Value
The producer whose product turns out to have the combination of features that are closest to what the consumers really want may be no wiser than his competitors. Yet he can grow rich while his competitors who guessed wrong go bankrupt. But the larger result is that society as a whole gets more benefits from its limited resources by having them directed toward where those resources produce the kind of output that millions of people want, instead of producing things that they don’t want.
Simple as all this may seem, it contradicts many widely held ideas. For example, not only are high prices often blamed on “greed,” people often speak of something being sold for more than its “real” value, or of workers being paid less than they are “really” worth—or of corporate executives, athletes, and entertainers being paid more than they are “really” worth. The fact that prices fluctuate over time, and occasionally have a sharp rise or a steep drop, misleads some people into concluding that prices are deviating from their “real” values. But their usual level under usual conditions is no more real or valid than their much higher or much lower levels under different conditions.
When a large employer goes bankrupt in a small community, or simply moves away to another region or country, many of the business’ former employees may decide to move away themselves from a place that now has fewer jobs—and when their numerous homes go on sale in the same small area at the same time, the prices of those houses are likely to be driven down by competition. But this does not mean that people are selling their homes for less than their “real” value. The value of living in that particular community has simply declined with the decline of job opportunities, and housing prices reflect this underlying fact.
The most fundamental reason why there is no such thing as an objective or “real” value is that there would be no ratio
nal basis for economic transactions if there were. When you pay a dollar for a newspaper, obviously the only reason you do so is that the newspaper is more valuable to you than the dollar is. At the same time, the only reason people are willing to sell the newspaper is that a dollar 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 person must be getting less—in which case, why would the other party continue making such transactions while being continually cheated? Continuing transactions between buyer and seller make sense only if value is subjective, each getting what is worth more subjectively. Economic transactions are not a zero-sum process, where one person loses whatever the other person gains.
Competition
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 indefinitely at a given 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 quantity supplied is greatest, relative to the quantity demanded, 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 indefinitely.
Prices and Supplies
Prices not only ration existing supplies, they also act as powerful incentives to cause supplies to rise or fall in response to changing demand. When a crop failure in a given region creates a sudden increase in demand for imports of food into that region, food suppliers elsewhere rush to be the first to get there, in order to capitalize on the high prices that will prevail until more supplies arrive and drive food prices back down again through competition. What this means, from the standpoint of the hungry people in that region, is that food is being rushed to them at maximum speed by “greedy” suppliers, probably much faster than if the same food were being transported to them by salaried government employees sent on a humanitarian mission.
Those spurred on by a desire to earn top dollar for the food they sell may well drive throughout the night or take short cuts over rough terrain, while those operating “in the public interest” are more likely to proceed at a less hectic pace and by safer or more comfortable routes. In short, people tend to do more for their own benefit than for the benefit of others. Freely fluctuating prices can make that turn out to be beneficial to others. In the case of food supplies, earlier arrival can be the difference between temporary hunger and death by starvation or by diseases to which people are more susceptible when they are undernourished. Where there are local famines in Third World countries, it is not at all uncommon for food supplied by international agencies to the national government to sit spoiling on the docks while people are dying of hunger inland.{iv} However unattractive greed may be, it is likely to move food much faster, saving more lives.
In other situations, the consumers may not want more, but less. Prices also convey this. When automobiles began to displace horses and buggies in the early twentieth century, the demand for saddles, horseshoes, carriages and other such paraphernalia declined. As the manufacturers of such products faced losses instead of profits, many began to abandon their businesses or were forced to shut down by bankruptcy. In a sense, it is unfair when some people are unable to earn as much as others with similar levels of skills and diligence, because of innovations which were as unforeseen by most of the producers who benefitted as by most of the producers who were made worse off. Yet this unfairness to particular individuals and businesses is what makes the economy as a whole operate more efficiently for the benefit of vastly larger numbers of others. Would creating more fairness among producers, at the cost of reduced efficiency and a resulting lower standard of living, be fair to consumers?
The gains and losses are not isolated or independent events. The crucial role of prices is in tying together a vast network of economic activities among people too widely scattered to all know each other. However much we may think of ourselves as independent individuals, we are all dependent on other people for our very lives, as well as being dependent on innumerable strangers who produce the amenities of life. Few of us could grow the food we need to live, much less build a place to live in, or produce such things as computers or automobiles. Other people have to be induced to create all these things for us, and economic incentives are crucial for that purpose. As Will Rogers once said, “We couldn’t live a day without depending on everybody.”{36} Prices make that dependence viable by linking their interests with ours.
“UNMET NEEDS”
One of the most common—and certainly one of the most profound—misconceptions of economics involves “unmet needs.” Politicians, journalists, and academicians are almost continuously pointing out unmet needs in our society that should be supplied by some government program or other. Most of these are things that most of us wish our society had more of.
What is wrong with that? Let us go back to square one. If economics is the study of the use of scarce resources which have alternative uses, then it follows that there will always be unmet needs. Some particular desires can be singled out and met 100 percent, but that only means that other desires will be even more unfulfilled than they are now. Anyone who has driven in most big cities will undoubtedly feel that there is an unmet need for more parking spaces. But, while it is both economically and technologically possible to build cities in such a way as to have a parking space available for anyone who wants one, anywhere in the city, at any hour of the day or night, does it follow that we should do it?
The cost of building vast new underground parking garages, or of tearing down existing buildings to create parking garages above ground, or of designing new cities with fewer buildings and more parking lots, would all be astronomically costly. What other things are we prepared to give up, in order to have this automotive Utopia? Fewer hospitals? Less police protection? Fewer fire departments? Are we prepared to put up with even more unmet needs in these areas? Maybe some would give up public libraries in order to have more places to park. But, whatever choices are made and however it is done, there will still be more unmet needs elsewhere, as a result of meeting an unmet need for more parking spaces.
We may differ among ourselves as to what is worth sacrificing in order to have more of something else. The point here is more fundamental: Merely demonstrating an unmet need is not sufficient to say that it should be met—not when resources are scarce and have alternative uses.
In the case of parking spaces, what might appear to be cheaper, when measured only by government expenditures, would be to restrict or forbid the use of private automobiles in cities, adjusting the number of cars to the number of existing parking spaces, instead of vice versa. Moreover, passing and enforcing such a law would cost a tiny fraction of the cost of greatly expanding the number of parking spaces. But this saving in government expenditures would have to be weighed against the vast private expenditures currently devoted to the purchase, maintenance, and parking of automobiles
in cities. Obviously these expenditures would not have been undertaken in the first place if those who pay these prices did not find the benefits to be worth it to them.
To go back to square one again, costs are foregone opportunities, not government expenditures. Forcing thousands of people to forego opportunities for which they have willingly paid vast amounts of money is a cost that may far outweigh the money saved by not having to build more parking spaces or do the other things necessary to accommodate cars in cities. None of this says that we should have either more parking spaces or fewer parking spaces in cities. What it says is that the way this issue—and many others—is presented makes no sense in a world of scarce resources which have alternative uses. That is a world of trade-offs, not solutions—and whatever trade-off is decided upon will still leave unmet needs.
So long as we respond gullibly to political rhetoric about unmet needs, we will arbitrarily choose to shift resources to whatever the featured unmet need of the day happens to be and away from other things. Then, when another politician—or perhaps even the same politician at a later time—discovers that robbing Peter to pay Paul has left Peter worse off, and now wants to help Peter meet his unmet needs, we will start shifting resources in another direction. In short, we will be like a dog chasing his tail in a circle and getting no closer, no matter how fast he runs.
This is not to say that we have the ideal trade-offs already and should leave them alone. Rather, it says that whatever trade-offs we make or change should be seen from the outset as trade-offs—not meeting unmet needs.
The very word “needs” arbitrarily puts some desires on a higher plane than others, as categorically more important. But, however urgent it may be to have some food and some water, for example, in order to sustain life itself, nevertheless—beyond some point—both become not only unnecessary but even counterproductive and dangerous. Widespread obesity among Americans shows that food has already reached that point and anyone who has suffered the ravages of flood (even if it is only a flooded basement) knows that water can reach that point as well. In short, even the most urgently required things remain necessary only within a given range. We cannot live half an hour without oxygen, but even oxygen beyond some concentration level can promote the growth of cancer and has been known to make newborn babies blind for life. There is a reason why hospitals do not use oxygen tanks willy-nilly.
Basic Economics Page 4
