Basic Economics

by Sowell, Thomas

  Costs and Capacity

  Costs vary not only with the volume of output, and to varying degrees from one industry to another, they also vary according to the extent to which existing capacity is being used.

  In many industries and enterprises, capacity must be built to handle the peak volume—which means that there is excess capacity at other times. The cost of accommodating more users of the product or service during the times when there is excess capacity is much less than the cost of handling those who are served at peak times. A cruise ship, for example, must receive enough money from its passengers to cover not only such current costs as paying the crew, buying food and using fuel, it must also be able to pay such overhead costs as the purchase price of the ship and the expenses at the headquarters of the cruise line.

  To handle twice as many passengers on a given cruise at the peak season may require buying another ship, as well as hiring another crew and buying twice as much food and fuel. However, if the number of passengers in the off season is only one-third of what it is at the peak, then a doubling of the number of off-season passengers need not require buying another ship. Existing ships can simply sail with fewer empty cabins. Therefore, it pays the cruise line to try to attract economy-minded passengers by offering much reduced fares during the off season. Groups of retired people, for example, can usually schedule their cruises at any time of the year, not being tied down to the vacation schedules of jobs and usually not having young children whose school schedules would limit their flexibility. It is common for seniors to get large discounts in off-season travel, both on land and at sea. Businesses in general can afford to do this because their costs are lower in the off season—and each particular business is forced to do it because its competitors will take customers away otherwise.

  Excess capacity can also result from over-optimistic building. Because of what the Wall Street Journal called “an ill-timed building frenzy in luxury ships,” luxury cruise lines added more than 4,000 new berths in a little over a year during the early twenty-first century. When they found that there was no such demand as to fill all the additional cabins at their existing prices, the net result was that Crystal Cruises, for example, offered their usual $2,995 cruise through the Panama Canal for $1,695 and Seabourn Cruise Line cut the price of its Caribbean cruise from $4,495 to $1,999.{215} They would hardly have done this unless the pressures of competition left them no choice—and unless their incremental costs, when they had excess capacity, were lower than their reduced prices.

  Unutilized capacity can cause price anomalies in many sectors of the economy. In Cancun, Mexico, the cheapest room available at the modest Best Western hotel there was $180 a night in mid-2001, while the more luxurious Ritz-Carlton nearby was renting rooms for $169 a night. The Best Western happened to be filled up and the Ritz-Carlton happened to have vacancies. Nor was this peculiar to Mexico. A four-star hotel in Manhattan was renting rooms for less than a two-star hotel nearby, and the posh Phoenician in Phoenix was renting rooms for less than the Holiday Inn in the same city.{216}

  Why were normally very expensive hotels renting rooms for less than hotels that were usually much lower in price? Again, the key was the utilization of capacity. Tourists going to popular resorts on limited budgets had made reservations at the low-cost hotels well in advance, in order to be sure of finding something affordable. This meant that fluctuations in the number of tourists would be absorbed by the higher-priced hotels. A general decline in tourism in 2001 thus led to vacancies at the luxury hotels, which then had no choice but to cut prices in order to attract more people to fill their rooms. Thus the luxurious Boca Raton Resort & Spa in Florida gave guests their third night free and tourists were able to get last-minute bargains on luxurious beachfront villas at Hilton Head, South Carolina, where reservations usually had to be made six months in advance.{217}

  Conversely, a rise in tourism would also have more effect on luxury hotels, which could raise their prices even more than usual. After three consecutive years of declining profits, hotels in 2004 began “yanking the discounts,” as the Wall Street Journal put it, when increased travel brought more guests. The luxury hotels’ reactions took the form of both price increases—$545 a night for the smallest and cheapest room at the Four Seasons Hotel in New York—and elimination of various free extras:

  It’s already tougher this year for families to find the offers of free breakfasts and other perks that business hotels have been freely distributing for the past three years in an effort to fill empty beds.{218}

  Because prices can vary so widely for the same room in the same hotel, according to whether or not there is excess capacity, auxiliary businesses have been created to direct travelers where they can get the best deals on a given day—Priceline and Travelocity being examples of such businesses that have sprung up to match bargain-hunters with hotels that have unexpected vacancies.

  Since all these responses to excess capacity are due to incentives created by the prospect of profits and the threat of losses in a market economy, the same principles do not apply where the government provides a good or service and charges for it. There are few incentives for government officials to match prices with costs—and sometimes they charge more to those who create the least cost.

  When a bridge, for example, is built or its capacity is expanded, the costs created are essentially the cost of building the capacity to handle rush-hour traffic. The cars that drive across the bridge between the morning and evening rush hours cost almost nothing because the bridge has idle capacity during those hours. Yet, when tolls are charged, often there are books of tickets or electronic passes available at lower prices per trip than the prices charged to those who drive across the bridge only occasionally during off-peak hours.

  Although it is the regular rush-hour users who create the huge costs of building or expanding a bridge’s capacity, they pay less because it is they who are more numerous voters and whose greater stake in toll policies makes them more likely to react politically to toll charges. What may seem like economic folly can be political prudence on the part of politically appointed officials operating the bridges and trying to protect their own jobs. The net economic result is that there is more bridge traffic during rush hours than if different tolls reflected costs at different times of day. Higher rush hour tolls would provide incentives for some drivers to cross the bridge either earlier or later than the rush hours. In turn, that would mean that the amount of capacity required to handle rush hour traffic would be less, reducing costs in both money terms and in terms of the use of scarce resources which have alternative uses.

  “Passing On” Costs and Savings

  It is often said that businesses pass on whatever additional costs are placed on them, whether these costs are placed on them by higher taxes, rising fuel costs, raises for their employees under a new union contract, or a variety of other sources of higher costs. By the same token, whenever costs come down for some reason, whether because of a tax cut or a technological improvement, for example, the question is often raised as to whether these lower costs will be passed on in lower prices to the consumers.

  The idea that sellers can charge whatever price they want is seldom expressed explicitly, but the implication that they can often lurks in the background of such questions as what they will pass on to their customers. But the passing on of either higher costs or savings in costs is not an automatic process and, in both cases, it depends on the kind of competition faced by each business and how many of the competing companies have the same cost increases or decreases.

  If you are running a gold mining company in South Africa and the government there increases the tax on gold by $10 an ounce, you cannot pass that on in higher prices to buyers of gold in the world market because gold producers in other countries do not have to pay that extra $10. To buyers around the world, gold is gold, wherever it is produced. There is no way that these buyers are going to pay $10 an ounce more for your gold than for somebody else’s gold. Under these c
ircumstances, a $10 tax on your gold means that your profits on gold sales in the world market will simply decline by $10 an ounce.

  The same principle applies when there are rising costs of transportation. If you ship your product to market by railroad and the railroads raise their freight charges, you can pass that on to the buyers only to the extent that your competitors also ship their product by rail. But, if your competitors are shipping by truck or by barge, while your location will not allow you to do the same, then raising your prices to cover the additional rail charges will simply allow your competitors, with lower costs, to take away some of your customers by charging lower prices. On the other hand, if all your competitors ship by rail and for similar distances, then all of you can pass on the higher railroad freight charges to all your customers. But if you ship your output an average of 100 miles and your competitors ship their output an average of only 10 miles, then you can only raise your prices to cover the additional cost of rail charges for 10 miles and take a reduction in profit by the cost of the other 90 miles.

  Similar principles apply when it comes to passing on savings to customers. If you alone introduce a new technology that cuts your production costs in half, then you can keep all the additional profits resulting from these cost savings by continuing to charge what your higher-cost competitors are charging. Alternatively—and this is what has often happened—you can cut your prices and take customers away from your competitors, which can lead to even larger total profits, despite lowering your profits per unit sold. Many of the great American fortunes—by Rockefeller, Carnegie, and others—came from finding lower cost ways of producing and delivering the product to the customer, and then charging lower prices than their higher-cost competitors could meet, thus luring away their customers.

  Over a period of time, competitors usually begin to use similar technological or organizational advances to cut costs and reduce prices, but fortunes can be made by pioneering innovators in the meantime. That provides incentives for enterprises in profit-seeking market economies to be on the lookout for new ways of doing things, in contrast to enterprises in either government-run economies like those in the days of the Soviet Union or in economies where laws protect private businesses from domestic or international competition, as in India before they began to open their economy to competition in the world market.

  SPECIALIZATION AND DISTRIBUTION

  A business firm is limited, not only in its over-all size, but also in the range of functions that it can perform efficiently. General Motors makes millions of automobiles, but not a single tire. Instead, it buys its tires from Goodyear, Michelin and other tire manufacturers, who can produce this part of the car more efficiently than General Motors can. Nor do automobile manufacturers own their own automobile dealerships across the country. Typically, automobile producers sell cars to local people who in turn sell to the public. There is no way that General Motors can keep track of all the local conditions across the length and breadth of the United States, which determine how much it will cost to buy or lease land on which to locate an automobile dealership, or which locations are best in a given community, much less evaluate the condition of local customers’ used cars that are being traded in on new ones.

  No one can sit in an automobile company’s headquarters and decide how much trade-in value to allow on a particular Chevrolet in Seattle with some dents and scratches, or a particular used Honda in mint condition in Miami. And if the kind of salesmanship that works in Los Angeles does not work in Boston, those on the scene are likely to know that better than any automobile executive in Michigan can. In short, the automobile manufacturer specializes in manufacturing automobiles, leaving other functions to people who develop different knowledge and different skills needed to specialize in those particular functions.

  Middlemen

  The perennial desire to “eliminate the middleman” is perennially thwarted by economic reality. The range of human knowledge and expertise is limited for any given person or for any manageably-sized collection of administrators. Only a certain number of links in the great chain of production and distribution can be mastered and operated efficiently by the same set of people. Beyond some point, there are other people with different skills and experience who can perform the next step in the sequence more cheaply or more effectively—and, therefore, at that point it pays a firm to sell its output to some other businesses that can carry on the next part of the operation more efficiently. That is because, as we have noted in earlier chapters, goods tend to flow to their most valued uses in a free market, and goods are more valuable to those who can handle them more efficiently at a given stage. Furniture manufacturers usually do not own or operate furniture stores, and most authors do not do their own publishing, much less own their own bookstores.

  Prices play a crucial role in all of this, as in other aspects of a market economy. Any economy must not only allocate scarce resources which have alternative uses, it must determine how long the resulting products remain in whose hands before being passed along to others who can handle the next stage more efficiently. Profit-seeking businesses are guided by their own bottom line, but this bottom line is itself determined by what others can do and at what cost.

  When a product becomes more valuable in the hands of somebody else, that somebody else will bid more for the product than it is worth to its current owner. The owner then sells, not for the sake of the economy, but for the owner’s own sake. However, the end result is a more efficient economy, where goods move to those who value them most. Despite superficially appealing phrases about “eliminating the middleman,” middlemen continue to exist because they can do their phase of the operation more efficiently than others can. It should hardly be surprising that people who specialize in one phase can do that particular phase more efficiently than others.

  Third World countries have tended to have more middlemen than more industrialized nations have, a fact much lamented by observers who have not considered the economics of the situation. Farm produce tends to pass through more hands between the African farmer who grows peanuts, for example, to the company that processes it into peanut butter than would be the case in the United States. A similar pattern was found with consumer goods moving in the opposite direction. Boxes of matches may pass through more hands between the manufacturer of matches and the African consumer who ultimately buys them. A British economist in mid-twentieth century West Africa described and explained such situations there:

  West African agricultural exports are produced by tens of thousands of Africans operating on a very small scale and often widely dispersed. They almost entirely lack suitable storage facilities, and they have no, or only very small, cash reserves. . . The large number and the long line of intermediaries in the purchase of export produce essentially derive from the economies to be obtained from bulking very large numbers of small parcels. . . In produce marketing the first link in the chain may be the purchase, hundreds of miles from Kano, of a few pounds of groundnuts, which after several stages of bulking arrive there as part of a wagon or lorry load of several tons.{219}

  Instead of ten farmers in a given area all taking time off from their farming to carry their individually small amounts of produce to a distant town for sale, one middleman can collect the produce of the many farmers and drive it all to a produce buyer at one time, allowing these farmers to apply their scarce resources—time and labor—to the alternative uses of those resources for growing more produce. Society as a whole thus saves on the amount of resources required to move produce from the farm to the next buyer, as well as saving on the number of individual negotiations required at the final points of sale. This saving of time is especially important during the harvest season, when some of the crop may become over-ripe before it is picked or spoil afterwards if it is not picked promptly and then gotten into a storage or processing facility quickly.

  In a wealthier country, each farm would have more produce, and motorized transport on modern highways would reduce the tim
e required to get it to the next point of sale, so that the time lost per ton of crop would be less and fewer middlemen would be required to move it. Moreover, modern farmers in prosperous countries would be more likely to have their own storage facilities, harvesting machinery, and other aids. What is and is not efficient—either from the standpoint of the individual farmer or of society as a whole—depends on the circumstances. Since these circumstances can differ radically between rich and poor countries, very different methods may be efficient in each country and no given method need be right for both.

  For similar reasons, there are often more intermediaries between the industrial manufacturer and the ultimate consumer in poor countries. However, the profits earned by each of these intermediaries is not just so much waste, as often assumed by third-party observers, especially observers from a different society. Here the limiting factor is the poverty of the consumer, which restricts how much can be bought at one time. Again, West Africa in the mid-twentieth century provided especially clear examples:

  Imported merchandise arrives in very large consignments and needs to be distributed over large areas to the final consumer who, in West Africa, has to buy in extremely small quantities because of his poverty. . . The organization of retail selling in Ibadan (and elsewhere) exemplifies the services rendered by petty traders both to suppliers and to consumers. Here there is no convenient central market, and it is usual to see petty traders sitting with their wares at the entrances to the stores of the European merchant firms. The petty traders sell largely the same commodities as the stores, but in much smaller quantities.{220}