Economic Thoughts, Part II: Myths About Markets

This posting is Part II in a series of postings about economic thoughts.

The excerpts in this posting are taken from Chapter 23 in Thomas Sowell's book Basic Economics: A Citizens Guide to the Economy and discuss myths about markets, including: (i) morality and markets; (ii) prices; (iii) the role of profits; (iv) non-profit organizations; and, (v) "trickle down" theory.

Morality and Markets

The market is as moral or immoral as the people in it. So is the government. The fact that we call one set of people "the market" and another set of people "society" does not mean that the moral or other imperfections of the first set of people automatically justify having the second set of imperfect people over-ruling their decisions...the market...is people making their own individual choices and their mutual accomodations.

Once it was fashionable to contrast the selfishness of the isolated individual in a market economy with cooperative actions among people with a more communal spirit under various forms of socialism. One reason such rhetorical or ideological fashions no longer have the same effectiveness is the actual track record of socialist systems in practice. What also needs to be considered is the track record of market economies in creating widespread cooperation among people through individual incentives...

Is cooperation any less because the incentives behind it are the individual benefits of the participants?

Despite the painful facts of history, the idea persists in many places that political decisions are more moral than decisions made through the marketplace...

Empirical consequences, however, often matter less than deeply ingrained beliefs and attitudes. Whether in urgent or less urgent matters, many believe those with political power are better qualified to make moral decisions than are the private parties directly involved...

The idea that third party observers can impose morally better decisions often includes the idea that they can define what are "luxuries of the rich," when it is precisley the progress of free market economies which has turned luxuries of the rich into common amenities of people in general, including the poor...

Prices

There seem to be almost as many myths about prices as there are prices...

Physically identical things are often sold for different prices, usually because of accompanying conditions that are quite different...

Part of the reason for the variations in price [is] the variation in the cost of real estate in the different communities...

Another reason is the cost of inventory...going to different stores meant having different probabilities of finding what you wanted...Cost differences reflected differences in availability, which is to say, differences in the costs of maintaining inventory, even when the particular commodities were physically the same. It also meant differences in the costs measured in the time that a customer would have to spend going from store to store to find all the items on a grocery shopping list.

Mistakes or miscalculations may sometimes cause the same thing to be sold for different prices under comparable conditions temporarily, but competition usually makes this a passing phenomenon...

One of the popular myths that has become part of the tradition of anti-trust law is "predatory pricing."...

One of the most remarkable things about this theory is that those who advocate it seldom provide concrete examples of when it ever actually happened. Perhaps even more remarkable, they have not had to do so, even in courts of law...

A company that sustains losses by selling below cost to drive out a competitor is following a very risky strategy. The only thing it can be sure of is losing money initially. Whether it will ever recover enough extra profits to make the gamble pay off in the long run is problematical...it is by no means clear that eliminating all existing competitors will mean eliminating competition.

Even when a rival firm has been forced into bankruptcy, its physical equipment and the skills of the people who once made it viable do not vanish into thin air. A new entrepreneur can come along and acquire both - perhaps at low distress sale prices...enabling the new competitor to have lower costs than the old and hence be a more dangerous rival...

Bankruptcy can eliminate particular owners and managers, but it does not eliminate competition in the form of new people...Destroying a particular competitor without destroying competition can be an expensive endeavor...

The Role of Profits

Those who favor government intervention in the economy often depict those who prefer free competition as pro-business apologists. This has been profoundly wrong for at least two centuries. Adam Smith, the eighteenth-century father of free-market economics, was so scathingly critical of businessmen that it would be impossible to find a single favorable reference to them...

Skepticism about the business community has remained part of the tradition of free-market economists throughout the twentieth century as well, with Milton Friedman's views being very similar to those of Adam Smith on this point.

Free market competition has often been opposed by the business community...business leaders and organizations have proven equally willing to seek government intervention to keep out foreign competition, bail out failing corporations and banks, and receive billions of dollars in agricultural subsidies, ostensibly for the sake of saving family farms, but in reality going disproportionately to large agricultural corporations...

...Business leaders are not wedded to a free market philosophy or any other philosophy. They promote their own self-interest any way they can, like other special interest groups...

...efficient uses of scarce resources by the economy as a whole depends on a system that features both profits and losses. Businesses are interested only in the profit half. If they can avoid losses by getting government subsidies, tariffs and other restrictions against imports, or domestic laws that stifle competition in various agricultural products, they will do so. Losses, however, are essential to the process that shifts resources to those who are providing what consumers want at the lowest prices - and away from those who are not...

Even people who understand the need for competition, and for both profits and losses, nevertheless often insist that it should be "fair" competition. But this is a slippery word that can mean almost anything...Like discussions of fairness in other contexts besides economics, this kind of reasoning ignores the costs imposed on third parties - in this case, the consumers who pay needlessly high prices to keep less efficient businesses operating, using scarce resources which have more valuable alternative uses.

Some people consider it a valid criticism of corporations that they are "just in business to make profits." By this kind of reasoning, workers are just working to earn their pay. In the process, however, they produce all the things that give their contemporaries the highest standard of living the world has known. What matters is not the motivation but the results...the real question is: What are the preconditions for earning a profit?

One precondition is that profit-seeking corporations cannot squander scarce resources the way Soviet enterprises did. Corporations operating in a market economy have to pay for all their inputs - whether labor, raw materials, or electricity - and they have to pay as much as others are willing to bid for them. Then they have to sell their own end product at a price as low as their competitors are charging. If they fail to do both, they fail to make a profit. And if they keep on failing to amke a profit, either the management will be replaced or the whole business will be replaced by some competitor who is more efficient...

...It is in the absence of a profit-and-loss economy that there are few incentives to maintain the long-run productivity of an industrial enterprise or a collective farm, as in the Soviet Union...

Non-Profit Organizations

...what are called "non-profit organizations" can be better understood when they are seen as non-profit and non-loss institutions...

Non-profit organizations have additional sources of income, including fees from those who use their services...However, these fees do not cover the full costs of their operation - which is to say, the recipients are receiving goods and services that cost more than these recipients are paying...Such subsidized beneficiaries cannot impose the same kind of economic discipline as the customers of a profit-and-loss business who are paying the full cost of everything they get...

What changes incentives and constraints is the fact that the money received by a profit-and-loss business comes directly from those who use its goods and services, while the money received by a non-profit organization comes primarily from subsidized beneficiaries, from donors and - indirectly - from the taxpayers who pay the additional taxes made necessary by the tax exemptions of non-profit organizations. That gives the managers of non-profit organizations far more room to do what they want, rather than what either the public wants or what their deceased donors wanted when these organizations were set up.

"Trickle Down" Theory

People who are politically committed to policies of redistributing income and who tend to emphasize the conflicts between business and labor, rather than their mutual interdependence, often accuse those opposed to them of believing that benefits must be given to the wealthy in general or to business in particular, in order that these benefits will eventually "trickle down" to the masses of ordinary people. But no recognized economist of any school of thought has ever had any such theory or made any such proposal. It is a straw man...

In reality, economic processes work in the directly opposite way from that depicted by those who imagine that profits first benefit business owners and that benefits only belatedly trickle down to workers.

When an investment is made...the first money is spent hiring people to do the work...Money goes out first to pay expenses and then comes back as profits later - if at all. The high rate of failure of new businesses makes painfully clear that there is nothing inevitable about the money coming back.

Even with successful and well-established businesses, years may elapse between the initial investment and the return of earnings...The real effect of a reduction in the capital gains tax is that it opens the prospect of greater future net profits and thereby provides incentives to make current investments...

In short, the sequence of payments is directly the opposite of what is assumed by those who talk about a "trickle-down" theory...

Part III to follow...

For the previous posting on Economic Thoughts, refer to:

Part I: What is Economics?