Economic Thoughts, Part III: Why Policy Goals are Trumped by Incentives They Create & the Role of Knowledge in Economics

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

The excerpts in this posting are taken from Chapter 24, entitled Parting Thoughts, in Thomas Sowell's book Basic Economics: A Citizens Guide to the Economy and discuss: (i) why policy goals are trumped by incentives they create; and, (ii) the role of knowledge in economics.

Why Policy Goals are Trumped by Incentives They Create

Many economic fallacies depend upon not thinking beyond the initial consequences of particular policies...

One of the recurring themes in our consideration of various policies and institutions...has been the distinction between the goals of these policies and institutions versus the incentives they create...

What must be asked about any goal is: What specific things are going to be done in the name of that goals? What does the particular legislation or policy reward and what does it punish? What constraints does it impose? Looking to the future, what are the likely consequences of such incentives and constraints? Looking back at the past, what have been the consequences of similar incentives and constraints in other times and places?...

The Role of Knowledge in Economics

In addition to the role of incentives and constraints, one of our other central themes has been the role of knowledge. In free market economies, we have seen giant multi-billion dollar corporations fall from their pinnacles...because their knowledge of changing circumstances, and the implication of those changes, lagged behind that of upstart rivals...The public benefitted from that, by getting what it wanted at lower prices...

In centrally planned economies, we have seen the planners overwhelmed by the task of trying to set literally millions of prices and keep changing those prices in response to innumerable and often unforeseeable changes in circumstances. It was not remarkable that they failed so often. What was remarkable was that anyone had expected them to succeed, given the vast amount of knowledge that would have had to be marshalled and mastered in one place by one set of people...

Given the decisive advantages of knowledge and insight in a market economy...we can see why market economies have outperformed other economies that depend on ideas originating within a narrow elite of birth or ideology. While market economies are often thought of as money economies, they are still more so knowledge economies, for money can always be found to back new insights, technologies and organizational methods that work...Capital is always available under capitalism, but knowledge and insight are rare and precious under any system.

Knowledge can be bought and sold in a free market, like anything else...

Knowledge should not be narrowly conceived as the kind of information in which intellectuals and academics specialize...

In reality, there is much that the intelligentsia do not know that is vital knowledge in the functioning of an economy. It may be easy to disdain the kinds of highly specific knowledge and implications which are often economically decisive by asking, for example: How much knowledge does it take to fry a hamburger? Yet McDonald's did not become a multi-billion-dollar corporation...for no reason - not with so many rivals trying desperately and unsuccessfully to do the same...

...In all these cases, it was the knowledge that was built up over the years - the human capital - which ultimately attracted the financial capital to make ideas become reality. The other side of this is that, in countries where the mobilization of financial resources is made difficult by deficiencies in property rights laws, those at the bottom have fewer ways of getting the capital needed to back their entrepreneurial endeavors. More important, the whole society loses the benefits it could gain...

Success is only part of the story of a free market economy. Failure is at least as important a part, though few want to talk about it and none want to experience it...Economics is not about "win-win" options, but about often painful choices in the allocation of scarce resources which have alternative uses. Success and failure are not isolated good fortunes and misfortunes, but inseparable parts of the same process.

All economies...are essentially ways of cooperating in the production and distribution of goods and services, whether this is done efficiently or inefficiently, voluntarily or involuntarily. Naturally, individuals and groups want their own particular contributions to the process to be better rewarded, but their complaints or struggles over this are a sideshow to the main event of complementary efforts which produce the output on which all depend. Yet invidious comparisons and internecine struggles are the stuff of social melodrama, which in turn is the lifeblood of the media and politics, as well as for portions of the intelligentsia.

By portraying cooperative activities as if they were zero-sum contests...those with the power to impose their misconceptions on others through words or laws can create a negative-sum contest, in which all are worse off...

Those with a zero-sum vision who have seen property rights as mere special privileges for the affluent and the rich have helped erode or destroy such rights, or have made them practically inaccessible to the poor in Third World countries, thereby depriving the poor of one of the mechanisms by which people from backgrounds like theirs have risen to prosperity in other times and places.

However useful economics may be for understanding many issues, it is not as emotionally satisfying as more personal and melodramatic depictions of these issues often found in the media and in politics. Dry empirical questions are seldom as exciting as political crusades or moral pronouncements. But they are questions that must be asked, if we are truly interested in the well-being of others, rather than in excitement or a sense of moral superiority for ourselves. Perhaps the most important distinction is between what sounds good and what works. The former may be sufficient for purposes of politics or moral preening, but not for the economic advancement of people in general or the poor in particular...

Part IV to follow...

For previous postings on Economic Thoughts, refer to:

Part I: What is Economics?
Part II: Myths About Markets