Laudato Si
Continuing the series I started last week, here are points six through ten in part one of the Ten Key Elements of Economics series:
6. The Four Sources of Income Growth are
(a) Improvements in Worker Skills,
(b) Capital Formation,
(c) Technological Advancement, and
(d) Better Economic OrganizationTHE GOODS AND SERVICES THAT PROVIDE for our standard of living do not just happen. Their production requires work, investment, cooperation, machinery, brain power, and organization. There are four major sources of production and income growth.
First, improvements in the skills of workers will promote economic growth. Skilful workers are more productive. How do individuals improve their skills? Primarily they do so by investing in themselves – by developing their natural abilities. There are literally thousands of ways people can improve their skills, but most of them involve studying and practising. Thus, education, training, and experience are the primary ways people improve their skills.
Second, capital formation can also enhance the productivity of workers. Workers can produce more if they work with more and better machines. For example, a logger can produce more when working with a chain saw than with a hand-operated, cross-cut blade. Similarly, a transport worker can haul more with a truck than with a mule and wagon. Other things constant, investment in tools and machines can help us produce more in the future. But investment is not a free lunch. The resources used to produce tools, machines, and factories could also be used to produce food, clothing, automobiles, and other current consumption goods. Economics is about trade-offs. It does, however, indicate that people who save and invest more will be able to produce more in the future.
Third, an improvement in technology – our knowledge about how to transform resources into goods and services – will also permit us to achieve a larger future output. The use of brain power to discover economical new products and/or less costly methods of production is a powerful source of economic progress. During the last 250 years, improvements in technology have literally transformed our lives. During that time period, the steam engine and later the internal combustion engine, electricity, and nuclear power replaced human and animal power as the major source of energy. Automobiles, buses, trains, and airplanes replaced the horse and buggy (and walking) as the major methods of transportation. Technological improvements continue to change our lifestyles. Consider the impact of compact disk players, micro-computers, word-processors, microwave ovens, video cameras and cassette players, and automobile air conditioners – the development and improvement of these products during the last couple of decades have vastly changed the way that we work, play, and entertain ourselves.
Finally, improvements in economic organization can also promote economic growth. Of the four sources of growth, this one is probably the most often overlooked. The legal system of a country influences the degree of economic cooperation. Historically, legal innovations have been an important source of economic progress. During the 18th century, a system of patents provided investors with a private property right to their ideas. About the same time, the recognition of the corporation as a legal entity reduced the cost of forming large firms that were often required for the mass production of manufactured goods. Both of these improvements in economic organization accelerated the growth of output in Europe and North America.
Effective economic organization will facilitate social cooperation and channel resources toward the production of goods that people value. Conversely, economic organization that protects wasteful practices and fails to reward the creation of wealth will retard economic progress. In Part II we will investigate more fully the broad characteristics of effective economic organization.
7. Income is Compensation Derived from the Provision of Services to Others. People Earn Income by Helping Others
PEOPLE DIFFER WITH REGARD to their productive abilities, preferences, opportunities, development of specialized skills, willingness to take risks, and luck. These differences influence incomes because they influence the value of the goods and services individuals will be able or willing to provide to others.
While considering differences among people, we must not lose sight of precisely what income is. Income is simply compensation received in exchange for productive services supplied to others. People who earn large incomes provide others with lots of things that they value. If they did not, other people would not be willing to pay them so generously. There is a moral here. If you want to earn a large income, you had better figure out how to help others a great deal. The converse is also true. If you are unable and unwilling to help others very much, your income will be quite small.
This direct link between helping others and receiving income provides each of us with a strong incentive to acquire skills and develop talents that are highly valued by others. College students study for long hours, endure stress, and incur the financial cost of schooling in order to become, for example, doctors, chemists, and engineers. Other people acquire training and experience that will help them develop electrician, maintenance, or computer programming skills. Still others invest and start a business. Why do people do these things? Many factors undoubtedly influence such decisions. In some cases, individuals may be motivated by a strong personal desire to improve the world in which we live. However, and this is the key point, even people who are motivated primarily by the pursuit of income will have a strong incentive to develop skills and undertake investments that are valuable to others. Provision of services that others value is the source of high earnings. Therefore, when markets determine incomes, even individuals motivated primarily by the pursuit of personal income will have a strong incentive to pay close attention to what it is that others value.
Some people have a tendency to think that high-income individuals must be exploiting others. Recognition that income is compensation received for helping others makes it easy to see the fallacy in this view. People who earn a large income almost always improve the well-being of large numbers of people. The entertainers and athletes who earn huge incomes do so because millions of people are willing to pay to see them perform. Business entrepreneurs who succeed in a big way do so by making their products affordable to millions of consumers. The late Sam Walton (founder of Walmart Stores) became the richest man in the United States because he figured out how to manage large inventories more effectively and bring discount prices on brand-name merchandise to small town America. Later, Bill Gates, the founder and president of Microsoft, rose to the top of the Forbes magazine “Wealthiest Four Hundred” list by developing a product that dramatically improved the efficiency and compatibility of desk-top computers. Millions of consumers who never heard of either Walton or Gates nonetheless benefitted from their entrepreneurial talents and low-priced products. Walton and Gates made a lot of money because they helped a lot of people.
8. Profits Direct Businesses Toward Activities that Increase Wealth
THE PEOPLE OF A NATION will be better off if their resources are used to produce goods and services that are highly valued in comparison with their costs. At any given time, there is virtually an infinite number of potential investment projects. Some will increase the value of resources and promote economic progress. Others will reduce the value of resources and lead to economic decline. If economic progress is going to proceed, the value-increasing projects must be encouraged and the value-reducing projects avoided.
This is precisely what profits and losses do in a market setting. Business firms purchase resources and use them to produce a product or service that is sold to consumers. Costs are incurred as the business pays workers and other resource owners for their services. If the sales of the business firm exceed the costs of employing all of the resources required to produce the firm’s output, then the firm will make a profit. In essence, profit is a reward that business owners will earn if they produce a good that consumers value more (as measured by their willingness to pay) than the resources required for that good’s production (as measured by the cost of bidding the resources away from their alternative employment possibilities).
In contrast, losses are a penalty imposed on businesses that reduce the value of resources. The value of the resources used up by such unsuccessful firms exceeds the price consumers are willing to pay for their product. Losses and bankruptcies are the market’s way of bringing such wasteful activities to a halt.
For example, suppose that it costs a shirt manufacturer $20,000 per month to lease a building, rent the required machines, and purchase the labour, cloth, buttons, and other materials necessary to produce and market 1,000 shirts per month. If the manufacturer sells the 1,000 shirts for $22 each, his actions create wealth. Consumers value the shirts more than they value the resources required for their production. The manufacturer’s $2 profit per shirt is a reward received for increasing the value of the resources.
On the other hand, if the shirts could not be sold for more than $17 each, then the manufacturer would show a loss of $3 per shirt. This loss results because the manufacturer’s actions reduced the value of the resources – the shirts were worth less to consumers than were the resources required for their production.
We live in a world of changing tastes and technology, imperfect knowledge, and uncertainty. Business decision-makers cannot be sure of either future market prices or costs of production. Their decisions must be based on expectations. Nonetheless, the reward-penalty structure of a market economy is clear. Firms that produce efficiently and anticipate correctly the products and services for which future demand will be most urgent (relative to production cost) will make economic profits. Those that are inefficient and allocate resources incorrectly into areas of weak future demand will be penalized with losses.
Essentially, profits and losses direct business investment toward projects that promote economic progress and away from those that squander scarce resources. This is a vitally important function. Nations that fail to perform this function well will almost surely experience economic stagnation.
9. The “Invisible Hand” Principle – Market Prices Bring Personal Self-interest and the General Welfare into Harmony
Every individual is continually exerting himself to find out the most advantageous employment for whatever capital he can command. It is his own advantage, indeed, and not that of the society which he has in view. But the study of his own advantage naturally, or rather necessarily, leads him to prefer that employment which is most advantageous to society. He intends only his own gain, and he is in this, and in many other cases, led by an invisible hand to promote an end which was not part of his intention. [Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, (1776; Cannan’s ed., Chicago: University of Chicago Press, 1976), p. 477.]
– Adam Smith
AS ADAM SMITH NOTED, the remarkable thing about an economy based on private property and freedom of contract is that market prices will bring the actions of self-interested individuals into harmony with the general prosperity of a community or nation. The entrepreneur “intends only his own gain” but he is directed by the “invisible hand” of market prices to “promote an end [economic prosperity] which was not part of his intention.”
The invisible hand principle is difficult for many people to grasp because there is a natural tendency to associate order with centralized planning. If resources are going to be allocated sensibly, surely some central authority must be in charge. The invisible hand principle stresses that this need not be the case. When private property and freedom of exchange are present, market prices will register the choices of literally millions of consumers, producers, and resource suppliers and bring them into harmony. Prices will reflect information about consumer preferences, costs, and matters related to timing, location, and circumstances that are well beyond the comprehension of any individual or central-planning authority. This single summary statistic – the market price – provides producers with everything they need to know in order to bring their actions into harmony with the actions and preferences of others. The market price directs and motivates both producers and resource suppliers to provide those things that others value highly, relative to their costs.
Click here to view photograph
No central authority is needed to tell business decision-makers what to produce or how to produce it. Prices will do the job. For example, no one has to force the farmer to raise wheat, or tell the construction firm to build houses, or convince the furniture manufacturer to produce chairs. When the prices of these and other products indicate that consumers value them as much or more than their production costs, producers seeking personal gain will supply them.
Neither will it be necessary or even helpful for a central authority to monitor the production methods of business firms. Farmers, construction companies, furniture manufacturers, and thousand of other producers will seek out the best resource combination and most cost-effective production methods because lower costs mean higher profits. It is in the interest of each producer to keep costs down and quality up. In fact, competition virtually forces them to do so. High-cost producers will have difficulty surviving in the marketplace. Consumers, seeking the best value for their money, will see to that.
The invisible hand of the market process works so automatically that most people give little thought to it. Most simply take it for granted that goods people value will be produced in approximately the quantities that consumers want to buy them. The long waiting lines and “sold out until next week” signs that characterize centrally-planned economies are almost totally unknown to the residents of market economies. Similarly, the availability of a vast array of goods that challenges even the imagination of modern consumers is largely taken for granted. The invisible hand process brings order, harmony, and diversity. The process works so quietly, however, that it is both little understood and seldom appreciated. Nonetheless, it is vital to our economic well-being.
10. Ignoring Secondary Effects and Long-term Consequences is the Most Common Source of Error in Economics
HENRY HAZLITT, PERHAPS THIS CENTURY’S greatest popular writer on economics, authored the book Economics in One Lesson. Hazlitt’s one lesson was, that when analyzing an economic proposal, one
must trace not merely the immediate results but the results in the long run, not merely the primary consequences but the secondary consequences, and not merely the effects on some special group but the effects on everyone. [Henry Hazlitt, Economics in One Lesson, (New Rochelle: Arlington House, 1979), p. 103.]
Hazlitt believed that failure to apply this lesson was, by far, the most common source of economic error.
It is difficult to argue with this point. Time and again, politicians stress the short-term benefits derived from a policy, while completely ignoring longer-term consequences. Similarly, there seems to be an endless pleading for proposals to help specific industries, regions, or groups without considering their impact on the broader community, including taxpayers and consumers.
Of course, much of this is deliberate. When seeking political favours, interest groups and their hired representatives have an incentive to put the best spin on their case. Predictably, they will exaggerate the benefits, while ignoring important components of costs. When the benefits are immediate and easily visible, while the costs are less visible and mostly in the future, it will be easier for interest groups to sell befuddled economic reasoning.
It is easy to point to instances where the secondary effects are largely ignored. Consider the case of rent controls imposed on apartments. Proponents argue that controls will reduce rents and make housing more affordable for the poor. Yes, but there will be secondary effects. The lower rental prices will depress the rate of return on housing investments. Current owners of rental units may be forced to accept the lower return, but this will not be true for potential future owners. Many of them will channel their funds elsewhere; apartment house investments will fall; and the future availability of rental units will decline. Shortages will develop and the quality of rental housing will fall with the passage of time. These secondary effects, however, will not be immediately observable. Thus, rent controls command substantial popularity in communities from Montreal and Toronto to New York and Berkeley, California even though a declining supply of rental housing, poor maintenance, and shortages are the inevitable result. In the words of Swedish economist Assar Lindbeck: “In many cases rent control appears to be the most efficient technique presently known to destroy a city – except for bombing.” [Assar Lindbeck, The Political Economy of the New Left, 1970 (New York: Harper and Row, 1972), p. 39.]
The proponents of tariffs and quotas to “protect jobs” almost always ignore the secondary effects of their policies. Consider the impact of trade restrictions that reduce the supply of foreign-produced automobiles in the North American market. As a result, employment in the domestic automobile industry expands. But what about the secondary effects on others? The restrictions will mean higher prices for automobile consumers. As a result of the higher prices, many auto consumers will be forced to curtail their purchases of food, clothing, recreation, and literally thousands of other items. These reductions in spending will mean less output and reduced employment in these areas. Furthermore, there is also a secondary effect on foreigners. Since foreigners sell fewer automobiles to Americans, they acquire fewer dollars with which to import American-made goods. When foreigners sell less to us, they will have less purchasing power with which to buy from us. Therefore, U.S. exports will fall as a result of the restrictions on automobile imports. Once the secondary effects are considered, the impact on employment is clear. The restrictions do not create jobs; they reshuffle them. Employment is higher in the auto industry, but lower in other industries, particularly export industries. Unfortunately, the jobs of the people actual working in the automobile industry are highly visible, while the secondary effects – the “lost jobs” in other industries – are less visible. Thus, it is not surprising that many people fall for the “protecting jobs” argument even though it is clearly fallacious.
Let’s consider one final misconception that reflects a failure to consider the secondary effects. Politicians often argue that government spending on favoured projects expands employment. Of course, there may be good reasons for government expenditures on roads, increased police protection, administration of justice, and so forth. The creation of jobs, however, is not one of them. Suppose the government spends $2 billion employing workers to build a high speed train linking Windsor and Montreal. How many jobs will the project create? Once the secondary effects are considered, the answer is none. The government must either use taxes or debt to finance the project. Taxes of $2 billion will reduce both consumer spending and private savings and thereby destroy as many jobs as the government spending will create. Alternatively, if the project is financed by debt, the borrowing will lead to higher interest rates and a decline in $2 billion of private investment and consumption expenditures. As in the case of trade restrictions, the result is job re-shuffling, not job creation. Does this mean the project should not be undertaken? Not necessarily. But it does mean that its justification must come from benefits provided by the high-speed train rather than the illusory benefits of an expansion in employment.