Continuing the series I started two weeks ago, here are points one through three in part two of the Ten Key Elements of Economics series:
1. Private Ownership: People Will Be More Industrious and Use Resources More Wisely When Property is Privately Owned
Men always work harder and more readily when they work on that which belongs to them.It is surely undeniable that, when a man engages in remunerative work, the impelling reason and motive of his work is to obtain property and thereafter to hold it as his very own.
– Pope Leo XIII (1878)
PRIVATE OWNERSHIP OF PROPERTY INVOLVES three things: (a) the right to exclusive use, (b) legal protection against invaders, and (c) the right to transfer. Property is a broad term that includes labour services, ideas, literature, and natural resources, as well as physical assets like buildings, machines, and land. Private ownership allows individuals to decide how they will use their property. But it also makes them accountable for their actions. People who use their property in a manner that invades or infringes upon the property rights of another will be subject to the same legal forces that were set up to protect their own property. For example, private property rights prohibit me from throwing my hammer through the screen of a computer that you own, because if I did, I would be violating your property right to your computer. Your property right to your computer restricts me and everyone else from its use without your permission. Similarly, my ownership of my hammer and other things that I own restricts you and everyone else from using them without my permission.
The important thing about private ownership is the structure of incentives that emanate from it. There are four major reasons why this incentive structure will promote economic progress.
First, private ownership encourages wise stewardship. If private owners fail to maintain their property or if they allow it to be abused or damaged, they will bear the consequences in the form of a decline in the value of their property. For example, if you own an automobile, you have a strong incentive to change the oil, have the car serviced regularly, and see that the interior of the car is well kept. Why is this so? If you are careless in these areas, the car’s value to both you and potential future owners will decline. Alternatively, if the car is well-maintained and kept in good running order, it will be of greater value to both you and others who might want to buy it from you. With private ownership, wise stewardship is rewarded.
In contrast, when property is owned by the government or owned in common by a large group of people, the incentive to take good care of it is weaker. For example when housing is owned by the government, there is no owner or small group of owners who will pay a dear price if the property is abused and poorly maintained. Therefore, it should not surprise us when we observe that, compared to privately-owned housing, government-owned housing is generally run down and poorly maintained in both capitalist countries like the United States and socialist countries like Russia and Poland. This laxity in care, maintenance, and repair simply reflects the incentive structure that accompanies government ownership of property.
Second, private ownership encourages people to develop their property and use it productively. With private ownership, individuals have a strong incentive to improve their skills, work harder, and work smarter. Such actions will increase their income. Similarly, people have a strong incentive to construct and develop capital assets like houses, apartments, and office buildings. When such developments add more to revenues than to costs, the wealth of the private owners will increase.
Farming in the former Soviet Union illustrates the importance of property rights as a stimulus for productive activity. Under the Communist regime, families were permitted to keep and/or sell all goods produced on small private plots ranging up to an acre in size. These private plots made up only one percent of the total land under cultivation; the other 99 percent was cultivated by state enterprises and huge agricultural cooperatives. Nonetheless, as the Soviet press reported, approximately one-fourth of the total Soviet agricultural output was raised on this tiny fraction of privately farmed land.
Third, private owners have a strong incentive to use their resources in ways that are beneficial to others. While private owners can legally “do their own thing” with their property, their ownership provides them with a strong incentive to heed the wishes of others. Private owners can gain by figuring out how to make their property and its services more attractive to others. If they employ and develop their property in ways that others find attractive, the market value of the property will increase. In contrast, changes that are disapproved of by others – particularly customers or potential future buyers – will reduce the value of one’s property.
Your ownership of your labour services provides you with a strong incentive to invest in education and training that will help you provide services that are highly valued by others. Similarly, owners of capital assets have an incentive to develop them in ways that are attractive to others. By way of example, consider the situation of an apartment complex owner. The owner may not care anything about parking spaces, convenient laundry facilities, trees, or well kept “green” open spaces accompanying the apartment complex. However, if consumers value these things highly (relative to their costs), the owner has a strong incentive to provide them because they will enhance both his earnings (rents) and the market value of his apartments. In contrast, those apartment owners who insist on providing what they like, rather than the things that consumers actually prefer, will find that their earnings and the value of their capital (apartments) will decline.
Fourth, private ownership promotes the wise development and conservation of resources for the future. The present development of a resource may generate current revenue. This revenue is the voice of present consumers. But, higher potential future revenues argue for conservation. The potential gain in the form of an increase in the expected future price of the resource is the voice of future users. Private owners are encouraged to balance these two forces.
Whenever the expected future value of a resource exceeds its current value, private owners gain if they conserve the resource for future users. This is true even if the current owner does not expect to be around when the benefits accrue. For example, suppose a 65 year-old tree farmer is contemplating whether to cut his Douglas fir trees. If growth and increased scarcity are expected to result in future sales revenue that exceeds the current value of the trees, the farmer will gain by conserving the trees for the future. When ownership is transferable, the market value of the farmer’s land will increase in anticipation of the future harvest as the trees grow and the expected day of harvest moves closer. Thus, the farmer will be able to sell the trees (or the land including the trees) and capture their value at any time even though the actual harvest may not take place until well after his death. [The conservation function of private ownership is also illustrated by examining alternative property right systems that are applied to animals. Animals like cattle, horses, llama, turkeys, and ostriches that are privately owned are conserved for the future. In contrast, the absence of private ownership has led to the excessive exploitation of animals like the buffalo, whale, and beaver. Contrasting approaches to the conservation of elephants in Africa also provide instructive evidence on the importance of private ownership. In Kenya, elephants roam unowned on unfenced terrain. The Kenyan government tries to protect elephants from poachers seeking valuable ivory by banning all commercial use of the elephant except tourism. In the decade that this policy has been in effect, the Kenyan elephant population has declined from 65,000 to 19,000. Other Eastern and Central African countries that have followed this approach have experienced a similar decline in the size of their elephant population. In contrast, Zimbabwe allows the open sale of elephant ivory and hides, but provides rights of private ownership to local people on whose land the elephant roams. Since assigning private ownership rights to elephants, Zimbabwe has seen its elephant population grow from 30,000 to 43,000. Elephant populations in the countries adopting a similar approach – Botswana, South Africa, Malawi, and Namibia – are also increasing. See Randy Simmons and Urs Kreuter, “Herd Mentality: Banning Ivory Sales Is No Way to Save the Elephant,” Policy Review (Fall 1989), pp. 46-49, for additional details on this topic.]
For centuries, doomsday commentators have argued that we are about to run out of trees, vital minerals, or various sources of energy. In sixteenth-century England, fear arose that the supply of wood would soon be exhausted as that resource was widely used as a source of energy. Higher wood prices, however, encouraged conservation and led to the development of coal. The “wood crisis” soon dissipated. In the middle of the nineteenth century, dire predictions arose that the world was about to run out of whale oil, at the time the primary fuel for artificial lighting. As whale oil prices rose, pressures for a substitute energy source heightened. This led to the development of kerosene, and the end of the “whale oil crisis.”
Later, as people switched to petroleum, doomsday predictions about the exhaustion of this resource arose almost as soon as the resource was developed. An idea about the extent to which early estimates of petroleum supplies underestimated consistently the potential supply can be gathered from the presidential address of Dr. Campbell Watkins to the International Association for Energy Economics in 1992. Watkins notes that the estimates of Alberta’s total gas reserves in 1957 were 75 trillion cubic feet. By 1985 the estimated reserve remaining, in spite of the intervening consumption, was 149 trillion cubic feet. In 1987 the reserve estimated was further adjusted to 170 trillion cubic feet and the 1992 figure was nearly 200 trillion cubic feet. In other words, far from “running out” of natural gas, Canada is actually discovering more gas as time passes.
Doomsday forecasters fail to recognize that private ownership provides people with a strong incentive to conserve a valuable resource and search for substitutes when there is an increase in the relative scarcity of the resource. With private ownership, if the scarcity of a resource increases, the price of the resource will rise. The increase in price provides producers, innovators, engineers, and entrepreneurs with an incentive to (a) conserve on the direct use of the resource, (b) search more diligently for substitutes, and (c) develop new methods of discovering and recovering larger amounts of the resource. To date, these forces have pushed doomsday further and further into the future. For resources that are privately owned, there is every reason to believe that they will continue to do so. [The empirical evidence indicates that, adjusted for inflation, the prices of most natural resources have actually been falling for decades, and in most cases, for centuries. The classic study of Harold Barnett and Chandler Morris, Scarcity and Growth: The Economics of Natural Resource Availability, (Baltimore: The Johns Hopkins University Press, 1963) illustrates this point. Updates and extensions of this work indicate that resource prices are continuing to decline. In 1980 economist Julian Simon bet doomsday environmentalist Paul Ehrlich that the inflation-adjusted price of any five natural resources of Ehrlich’s choosing would decline during the 1980s. In fact, the prices of all five of the resources chosen by Ehrlich declined and Simon won the highly publicized bet. A recent study found that of 38 major natural resources, only two (manganese and zinc) increased in price (after adjustment for inflation) during the 1980s. See Stephen Moore, “So Much for `Scarce Resources’,” Public Interest (Winter 1992).]
People who have not thought the topic through often associate private ownership with selfishness. This is paradoxical since the truth is nearly the opposite. Private ownership both (a) provides protection against selfish people who would take what does not belong to them and (b) forces resource users to fully bear the cost of their actions. When property rights are well-defined, secure, and tradeable, suppliers of goods and services will have to provide resource owners with at least as good a deal as they can get elsewhere. Employers cannot seize and use scarce resources without compensating their owners. The resource owners will have to be paid enough to attract them away from alternative users.
In essence, securely defined private property rights eliminate the use of violence as a competitive weapon. A producer that you do not buy from is not permitted to burn down your house. Neither is a competitive resource supplier, whose prices you undercut, permitted to slash your automobile tires or threaten you with bodily injury.
Private ownership keeps power dispersed and expands the area of activity that is based on voluntary consent. Power conferred by private ownership is strictly limited. Private business owners cannot force you to buy from them or work for them. They cannot levy a tax on your income or your property. They can acquire some of your income only by giving you something that you believe to be more valuable in return. The power of even the wealthiest property owner (or largest business) is limited by competition from others willing to provide similar products or services.
In contrast, as the experience of Eastern Europe and the former Soviet Union illustrates, when government ownership is substituted for private property, enormous political and economic power is bestowed upon a small handful of political figures. One of the major virtues of private property is its ability to check the excessive concentration of economic power in the hands of the few. Widespread ownership of property is the enemy of tyranny and the abusive use of power.
Thus, it is clear what the former socialist countries need to do. As Nobel laureate Milton Friedman recently stated, the best program for Eastern Europe can be summarized “in three words: privatize, privatize, privatize.” [Milton Friedman, “Economic Freedom, Human Freedom, Political Freedom,” lecture delivered November 1, 1991 at California State University, Hayward. A booklet containing the lecture is available from the Smith Centre for Private Enterprise Studies of California State University, Hayward.] Private property is the cornerstone both of economic progress and of personal liberty.
2. Freedom of Exchange: Policies that Reduce the Volume of Exchange Retard Economic Progress
VOLUNTARY EXCHANGE IS A FORM OF SOCIAL COOPERATION. It permits both parties to get more of what they want. In a market setting, neither the buyer nor the seller is forced into an exchange. Personal gain provides the motivation for exchange agreements.
As we previously noted, exchange promotes social gain – a larger output and income than would otherwise be achievable. When governments impose blockades that limit cooperation through exchange, they stifle economic progress.
There are various ways that countries stifle exchange. First, many countries impose regulations that limit entry into various businesses and occupations. If you want to start a business or provide a service, you have to fill out forms, get permission from different bureaus, show that you are qualified, indicate that you have sufficient financing, and meet various other regulatory tests. Some officials may refuse your application unless you are willing to pay a bribe or make a contribution to their political coffers. Hernando De Soto, in his revealing book The Other Path, found that in Lima, Peru it took 289 days for five people working full-time to meet the regulations required to legally open a small business producing garments. Furthermore, along the way, ten bribes were solicited and on two occasions it was necessary to pay the bribes in order to get the permission to operate “legally.” In many cases, if you are financed with foreign capital there is an additional maze of regulations. Needless to say, policies of this type stifle business competition, encourage political corruption, and drive decent people into the underground (or what De Soto calls the “informal”) economy.
Second, countries also stifle exchange when they substitute discretionary political authority for the rule of law. Several countries make a habit of adopting high-sounding laws that grant political administrators substantial interpretive power and discretionary authority. For example, in the mid-1980s customs officials in Guatemala were permitted to waive tariffs if they thought that doing so was in the “national interest.” Legislation of this type is an open invitation for government officials to solicit bribes. It creates regulatory uncertainty and makes business activity more costly and less attractive, particularly for honest people. The structure of law needs to be precise, unambiguous, and nondiscriminatory. If it is not, it will be a major roadblock retarding gains from trade.
Third, many countries impose price controls that stifle exchange. When the price of a product is legally fixed above the market level, buyers will purchase fewer units and the quantity exchanged will fall. On the other hand, if the price is fixed lower than the market level, suppliers will be unwilling to produce as many units. This, too, will reduce the volume of exchange. In terms of units produced and sold, it makes little difference whether price controls push prices up or force them down; both will reduce the volume of trade and the gains from production and exchange.
Exchange is productive; it helps us get more from the available resources. Policies that force traders to pass through various political roadblocks are generally counterproductive, even when they are intended to protect a domestic industry. In fact, they are equivalent to shooting oneself in the foot. If a country is going to realize its full potential, restrictions limiting trade and increasing the cost of doing business need to be kept to a minimum. The ability to provide a service that others are willing to purchase voluntarily is powerful evidence that the activity is productive. The market is the best regulator.
3. Competitive Markets: Competition Promotes the Efficient Use of Resources and Provides a Continuous Stimulus for Innovative Improvements
Competition is conducive to the continuous improvements of industrial efficiency. It leadsproducers to eliminate wastes and cut costs so that they may undersell others. It weeds out those whose costs remain high and thus operates to concentrate production in the hands of those whose costs are low. [Clair Wilcox, Competition and Monopoly in American Industry, Monograph no. 21, Temporary National Economic Committee, Investigation of Concentration of Economic Power, 76th Congress, 3rd Session (Washington, DC: U.S. Government Printing Office, 1940).]
– Clair Wilcox
COMPETITION OCCURS WHEN THERE IS FREEDOM of entry into a market and there are alternative sellers in the market. The competition may be among small-scale or large-scale firms. Rival firms may compete in local, regional, national, or even global markets. Competition is the lifeblood of a market economy.
Competition places pressure on producers to operate efficiently and cater to the preferences of consumers. Competition weeds out the inefficient. Firms that fail to provide consumers with quality goods at competitive prices will experience losses and eventually be driven out of business. Successful competitors have to outperform rival firms. They may do so through a variety of methods – quality of product, style, service, convenience of location, advertising, and price – but they must consistently offer consumers as much or more value than they can get elsewhere.
What keeps McDonald’s, General Motors, or any other business firm from raising prices, selling shoddy products, and providing lousy service? Competition. If McDonald’s fails to provide an attractively priced sandwich with a smile, people will turn to Burger King, Wendy’s, and other rivals. Similarly, as recent experience has shown, even a firm as large as General Motors will lose customers to Ford, Honda, Toyota, Chrysler, Volkswagen, Mazda, and other automobile manufacturers if it fails to keep up with its rivals.
Competition also provides firms with a strong incentive to develop improved products and discover lower-cost methods of production. No one knows precisely what products consumers will want next or which production techniques will minimize per-unit costs. Competition helps us discover the answer. Is that new visionary idea the greatest thing since the development of the fast-food chain? Or is it simply another dream that will soon turn to vapour? Entrepreneurs are free to introduce an innovative new product or a promising production technology; they need only the support of investors willing to put up the necessary funds. The approval of central planners, a legislative majority, or business rivals is not required in a market economy. Nonetheless, competition holds entrepreneurs and the investors who support them accountable; their ideas must face a “reality check” imposed by consumers. If consumers value the innovative idea enough to cover the cost of the good or service that is produced, the new business will prosper and succeed. Conversely, if consumers are unwilling to do so, the business will fail. Consumers are the ultimate judge and jury of business innovation and performance.
Producers who wish to survive in a competitive environment cannot be complacent. Today’s successful product may not pass tomorrow’s competitive test. In order to succeed in a competitive market, businesses must be good at anticipating, identifying, and quickly adopting improved ideas.
Competition also discovers the type of business structure and size of firm that can best keep the per-unit cost of a product or service low. Unlike other economic systems, a market economy does not mandate or limit the types of firms that are permitted to compete. Any form of business organization is permissible. An owner-operated firm, partnership, corporation, employee-owned firm, consumer cooperative, commune, or any other form of business is free to enter the market. In order to be successful, it has to pass only one test: cost-effectiveness. If a form of business organization, such as a corporation or employee-owned firm, is able to achieve low per-unit cost in a market, it will tend to survive. Correspondingly, a business structure that results in high per-unit cost will be driven from a competitive market.
The same is true for size of firm. For some products, a business must be quite large to take full advantage of the potential production economies of scale. When per-unit costs decline as output increases, small businesses tend to have higher production costs (and therefore higher prices) than their larger counterparts. When this is the case, consumers interested in maximum value for their money will tend to buy from the lower-priced larger firm. Most small firms will eventually be driven from the market. Larger firms, generally organized as corporations, tend to survive in such markets. The auto and airplane manufacturing industries illustrate these forces.
In other instances, small firms, often organized as individual proprietorships or partnerships, will be more cost-effective. When personalized service and individualized products are valued highly by consumers, it may be difficult for large firms to compete. Under these circumstances, mostly small firms will survive. For example, this is generally true for law and medical practices, printing shops, and hair-styling salons. A market economy permits cost considerations and the interaction between producers and consumers to determine the type and size of firm in each market.
When large-scale enterprises have lower costs, it will be particularly important that nations do not either limit competition from foreign suppliers or prevent domestic firms from selling abroad. This point is vitally important for small countries. For example, since the domestic market of a country like South Korea is small, a Korean automobile manufacturer would have extremely high costs per unit if it could not sell automobiles abroad. Similarly, domestic consumers in small countries would have to pay an exceedingly high price for automobiles if they were prohibited from buying from large-scale, lower-cost foreign producers.
In summary, competition harnesses personal self-interest and puts it to work elevating our standard-of-living. As Adam Smith noted in the Wealth of Nations, individuals are motivated by self-interest:
It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own self-interest. We address ourselves not to their humanity but to their self-love, and never talk to them of our own necessities, but of their advantages. [Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, p. 18.]
In a competitive environment, even self-interested individuals and profit-seeking business firms have a strong incentive to serve the interests of others and provide consumers with at least as much value as they can get elsewhere. This is the path to greater income and larger profits. Paradoxical as it may seem, personal self-interest – a characteristic many view as less than admirable – is a powerful source of economic progress when it is directed by competition.