Basic Economics

by Sowell, Thomas

  Although business enterprises based on profit have become one of the most common economic institutions in modern industrialized nations, an understanding of how businesses operate internally and how they fit into the larger economy and society is not nearly as common. The prevalence of business enterprises in many economies around the world has been so taken for granted that few people ask the question why this particular way of providing the necessities and amenities of life has come to prevail over alternative ways of carrying out economic functions.

  Among the many economically productive endeavors at various times and places throughout history, capitalist businesses are just one. Human beings lived for thousands of years without businesses. Tribes hunted and fished together. During the centuries of feudalism, neither serfs nor nobles were businessmen. Even in more recent centuries, millions of families in America lived on self-sufficient farms, growing their own food, building their own houses, and making their own clothes. Even in more recent times, there have been cooperative groups, such as the Israeli kibbutz, where people have voluntarily supplied one another with goods and services, without money changing hands. In the days of the Soviet Union, a whole modern, industrial economy had government-owned and government-operated enterprises doing the same kinds of things that businesses do in a capitalist economy, without in fact being businesses in either their incentives or constraints.

  Even in countries where profit-seeking businesses have become the norm, there are many private non-profit enterprises such as colleges, foundations, hospitals, symphony orchestras and museums, providing various goods and services, in addition to government-run enterprises such as post offices and public libraries. Although some of these enterprises supply goods and services different from those supplied by profit-seeking businesses, others supply similar or overlapping goods and services.

  Universities publish books and stage sports events that bring in millions of dollars in gate receipts. National Geographic magazine is published by a non-profit organization, as are other magazines published by the Smithsonian Institution and a number of independent, non-profit research institutions (“think tanks”) such as the Brookings Institution, the American Enterprise Institute and the Hoover Institution. Some functions of a Department of Motor Vehicles, such as renewing automobile licenses, are also handled by the American Automobile Association, a non-profit organization, which also arranges airline and cruise ship travel, like commercial travel agencies.

  In short, the activities engaged in by profit-seeking and non-profit organizations overlap. So do the activities of some governmental agencies, whether local, national or international. Moreover, many activities can shift from one of these kinds of organizations to another with the passage of time.

  Municipal transit, for example, was once provided by private profit-seeking businesses in the United States before many city governments took over trolleys, buses, and subways. Activities have also shifted the other way in more recent times, when such governmental functions as garbage collection and prison management have in some places shifted to private, profit-seeking businesses, and such functions of non-profit colleges and universities as running campus bookstores have been turned over to companies like Follet or Barnes & Noble. Traditional non-profit academic institutions have also been supplemented by the creation of profit-seeking universities such as the University of Phoenix, which not only has more students than any of the private non-profit academic institutions but more students than even some whole state university systems.

  The simultaneous presence of a variety of organizations doing similar or overlapping things provides opportunities for insights into how different ways of organizing economic activities affect the differing incentives and constraints facing decision-makers in these organizations, and how that in turn affects the efficiency of their activities and the way these enterprises affect the larger economy and society.

  Misconceptions of business are almost inevitable in a society where most people have neither studied nor run businesses. In a society where most people are employees and consumers, it is easy to think of businesses as “them”—as impersonal organizations, whose internal operations are largely unknown and whose sums of money may sometimes be so huge as to be unfathomable.

  BUSINESSES VERSUS

  NON-MARKET PRODUCERS

  Since non-market ways of producing goods and services preceded markets and businesses by centuries, if not millennia, the obvious question is: Why have businesses displaced these non-market producers to such a large extent in so many countries around the world?

  The fact that businesses have largely displaced many other ways of organizing the production of goods and services suggests that the cost advantages, reflected in prices, are considerable. This is not just a conclusion of free market economists. In The Communist Manifesto, Marx and Engels said of capitalist business, “The cheap prices of its commodities are the heavy artillery with which it batters down all Chinese walls.”{273} That by no means spared business from criticism, then or later.

  Since there are few, if any, people who want to return to feudalism or to the days of self-sufficient family farms, government enterprises are the primary alternative to capitalist businesses today. These government enterprises may be either isolated phenomena or part of a comprehensive set of organizations based on government ownership of the means of production, namely socialism. There have been many theories about the merits or demerits of market versus non-market ways of producing goods and services. But the actual track record of market and non-market producers is the real issue.

  In principle, either market or non-market economic activity can be carried on by competing enterprises or by monopolistic enterprises. In practice, however, competing enterprises have been largely confined to market economies, while governments have usually created one agency with an exclusive mandate to do one specific thing.

  Monopoly is the enemy of efficiency, whether under capitalism or socialism. The difference between the two systems is that monopoly is the norm under socialism. Even in a mixed economy, with some economic activities being carried out by government and others being carried out by private industry, the government’s activities are typically monopolies, while those in the private marketplace are typically activities carried out by rival enterprises.

  Thus, when a hurricane, flood, or other natural disaster strikes some part of the United States, emergency aid usually comes both from the Federal Emergency Management Agency (FEMA) and from numerous private insurance companies, whose customers’ homes and property have been damaged or destroyed. FEMA has been notoriously slower and less efficient than the private insurance companies. One insurance company cannot afford to be slower in getting money into the hands of its policy-holders than a rival insurance company is in getting money to the people who hold its policies. Not only would existing customers in the disaster area be likely to switch insurance companies if one dragged its feet in getting money to them, while their neighbors received substantial advances from a different insurance company to tide them over, word of any such difference would spread like wildfire across the country, causing millions of people elsewhere to switch billions of dollars’ worth of insurance business from the less efficient company to the more efficient one.

  A government agency, however, faces no such pressure. No matter how much FEMA may be criticized or ridiculed for its failures to get aid to disaster victims in a timely fashion, there is no rival government agency that these people can turn to for the same service. Moreover, the people who run these agencies are paid according to fixed salary schedules, not by how quickly or how well they serve people hit by disaster. In rare cases where a government monopoly is forced to compete with private enterprises doing the same thing, the results are often like that of the government postal service in India:

  When Mumbai Region Postmaster General A.P. Srivastava joined the postal system 27 years ago, mailmen routinely hired extra laborers to help carry bulging gunnysacks of letters they took
all day to deliver.

  Today, private-sector couriers such as FedEx Corp. and United Parcel Service Inc. have grabbed more than half the delivery business nationwide. That means this city’s thousands of postmen finish their rounds before lunch. Mr. Srivastava, who can’t fire excess staffers, spends much of his time cooking up new schemes to keep his workers busy. He’s ruled out selling onions at Mumbai post offices: too perishable. Instead, he’s considering marketing hair oil and shampoo.{274}

  India Post, which carried 16 billion pieces of mail in 1999, carried less than 8 billion pieces by 2005, after FedEx and UPS moved in.{275} The fact that competition means losers as well as winners may be obvious but that does not mean that its implications are widely understood and accepted. A New York Times reporter in 2010 found it a “paradox” that a highly efficient German manufacturer of museum display cases is “making life difficult” for manufacturers of similar products in other countries. Other German manufacturers of other products have likewise been very successful but “some of their success comes at the expense of countries like Greece, Spain and Portugal.” His all too familiar conclusion: “The problem that policy makers are wrestling with is how to correct the economic imbalances that German competitiveness creates.”{276}

  In the United States, for decades a succession of low-price retailers have been demonized for driving higher-cost competitors out of business. The Robinson-Patman Act of 1936 was sometimes called “the anti-Sears, Roebuck Act” and Congressman Patman also denounced those who ran the A & P grocery chain. In the twenty-first century, Wal-Mart has inherited the role of villain because it too makes it harder for higher-cost competitors to survive. Where, as in India, the higher-cost competitor is a government agency, the rigidities of its rules—such as not being able to fire unneeded workers—make adjustments even harder than they would be for a private enterprise trying to survive in the face of new competition.

  From the standpoint of society as a whole, it is not superior quality or efficiency which are a problem, but inertia and inefficiency. Inertia is common to people under both capitalism and socialism, but the market exacts a price for inertia. In the early twentieth century, both Sears and Montgomery Ward were reluctant to begin operating out of stores, after decades of great success selling exclusively from their mail order catalogs. It was only when the 1920s brought competition from chain stores that cut into their profits and caused red ink to start appearing on the bottom line that they had no choice but to become chain stores themselves. In 1920, Montgomery Ward lost nearly $10 million and Sears was $44 million in debt{277}—all this in dollars many times more valuable than today. Under socialism, Sears and Montgomery Ward could have remained mail order retailers indefinitely, and there would have been little incentive for the government to pay to set up rival chain stores to complicate everyone’s life.

  Socialist and capitalist economies differ not only in the quantity of output they produce but also in the quality. Everything from cars and cameras to restaurant service and airline service were of notoriously low quality in the Soviet Union. Nor was this a happenstance. The incentives are radically different when the producer has to satisfy the consumer, in order to survive financially, than when the test of survivability is carrying out production quotas set by the government’s central planners. The consumer in a market economy is going to look not only at quantity but quality. But a central planning commission is too overwhelmed with the millions of products they oversee to be able to monitor much more than gross output.

  That this low quality is a result of incentives, rather than being due to traits peculiar to Russians, is shown by the quality deterioration that has taken place in the United States or in Western Europe when free market prices have been replaced by rent control or by other forms of price controls and government allocation. Both excellent service and terrible service can occur in the same country, when there are different incentives, as a salesman in India found:

  Every time I ate in a roadside cafe or dhaba, my rice plate would arrive in three minutes flat. If I wanted an extra roti, it would arrive in thirty seconds. In a saree shop, the shopkeeper showed me a hundred sarees even if I did not buy a single one. After I left, he would go through the laborious and thankless job of folding back each saree, one at a time, and placing it back on the shelf. In contrast, when I went to buy a railway ticket, pay my telephone bill, or withdraw money from my nationalized bank, I was mistreated or regarded as a nuisance, and made to wait in a long queue. The bazaar offered outstanding service because the shopkeeper knew that his existence depended on his customer. If he was courteous and offered quality products at a competitive price, his customer rewarded him. If not, his customers deserted him for the shop next door. There was no competition in the railways, telephones, or banks, and their employees could never place the customer in the center.{278}

  London’s The Economist magazine likewise pointed out that in India one can “watch the tellers in a state-owned bank chat amongst themselves while the line of customers stretches on to the street.”{279} Comparisons of government-run institutions with privately-run institutions often overlook the fact that ownership and control are not the only differences between them. Government-run institutions are almost always monopolies, while privately-run institutions usually have competitors. Competing government institutions performing the same function are referred to negatively as “needless duplication.” Whether the frustrated customers waiting in line at a government-run bank would consider an alternative bank to be needless duplication is another question. Privatization helped provide an answer to that question in India, as the Wall Street Journal reported:

  The banking sector is still dominated by the giant State Bank of India but the country’s growing middle class is taking most of its business to the high-tech private banks, such as HDFC Bank Ltd. and ICICI Bank Ltd. leaving the state banks with the least-profitable businesses and worst borrowers.{280}

  While some privately owned businesses in various countries can and do give poor service, or cut corners on quality in a free market, they do so at the risk of their own survival. When the processed food industry first began in nineteenth century America, it was common for producers to adulterate food items with less expensive fillers. Horseradish, for example, was often sold in colored bottles, to conceal the adulteration. But when Henry J. Heinz began selling unadulterated horseradish in clear bottles,{281} this gave him a decisive advantage over his competitors, who fell by the wayside while the Heinz company went on to become one of the enduring giants of American industry, still in business in the twenty-first century and highly successful. When the H.J. Heinz company was sold in 2013, the price was $23 billion.{282}

  Similarly with the British food processing company Crosse & Blackwell, which sold quality foods not only in Britain but in the United States as well. It too remained one of the giants of the industry throughout the twentieth century and into the twenty first. Perfection is not found in either market or non-market economies, nor in any other human endeavors, but market economies exact a price from enterprises that disappoint their customers and reward those that fulfill their obligations to the consuming public. The great financial success stories in American industry have often involved companies almost fanatical about maintaining the reputation of their products, even when these products have been quite mundane and inexpensive.

  McDonald’s built its reputation on a standardized hamburger and maintained quality by having its own inspectors make unannounced visits to its meat suppliers, even in the middle of the night, to see what was being put into the meat it was buying.{283} Colonel Sanders was notorious for showing up unexpectedly at Kentucky Fried Chicken restaurants. If he didn’t like the way the chickens were being cooked, he would dump them all into a garbage can, put on an apron, and proceed to cook some chickens himself, to demonstrate how he wanted it done. His protégé Dave Thomas later followed similar practices when he created his own chain of Wendy’s hamburger restaurants. Although Colonel Sander
s and Dave Thomas could not be everywhere in a nationwide chain, no local franchise owner could take a chance on seeing his profits being thrown into a garbage can by the head honcho of the chain.

  In the credit card era, protecting card users’ identity from theft or misuse has become part of the quality of a credit card service. Accordingly, companies like Visa and MasterCard “have levied fines, sent warning letters and held seminars to pressure restaurants into being more careful about protecting the information” about card-users, according to the Wall Street Journal, which added: “All companies that accept plastic must follow a complex set of security rules put in place by Visa, MasterCard, American Express Co. and Morgan Stanley’s Discover unit.”{284}

  Behind all of this is the basic fact that a business is selling not only a physical product, but also the reputation which surrounds that product. Motorists traveling in an unfamiliar part of the country are more likely to turn into a hamburger restaurant that has a McDonald’s or Wendy’s sign on it than one which does not. That reputation translates into dollars and cents—or, in this case, billions of dollars. People with that kind of money at stake are unlikely to be very tolerant of anyone who would compromise their reputation. Ray Kroc, the founder of the McDonald’s chain, would explode in anger if he found a McDonald’s parking lot littered. His franchisees were expected to keep not only their own premises free of litter, but also to see that there was no McDonald’s litter on the streets within a radius of two blocks of their restaurants.{285}

  When speaking of quality in this context, what matters is the kind of quality that is relevant to the particular clientele being served. Hamburgers and fried chicken may not be regarded by others as either gourmet food or health food, nor can a nationwide chain mass-producing such meals reach quality levels achievable by more distinctive, fancier, and pricier restaurants. What the chain can do is assure quality within the limits expected by their particular customers. Those quality standards, however, often exceed those imposed or used by the government. As USA Today reported: