PART I:Ten Key Elements of Economics
1. Incentives Matter
ALL ECONOMIC THEORY IS BASED on the postulate that changes
in incentives influence human behaviour in a predictable manner. Personal benefits and
costs influence our choices. If the benefits derived from an option increase, people will
be more likely to choose it. Conversely, if the personal costs of an option increase,
people will be less likely to choose it.
This basic postulate of economics is a powerful tool because its application is so
widespread. Incentives affect behaviour in virtually all aspects of our lives, ranging
from market activities to household decision-making to political choices.
In the marketplace, this basic postulate indicates that, if the price of a good increases,
consumers will buy less of it; producers, on the other hand, will supply more of it since
the price increase makes it more profitable to produce the good. Both buyers and sellers
respond to incentives. Market prices will bring their actions into harmony. If the
quantity buyers want to purchase exceeds the quantity sellers are willing to provide, the
price will rise. The higher price will discourage consumption and encourage production of
the good or service, bringing amount demanded and amount supplied into balance.
Alternatively, if consumers are unwilling to purchase the current output of a good,
inventories will accumulate and there will be downward pressure on the price. In turn, the
lower price will encourage consumption and retard production until the amount demanded by
consumers is once again in balance with production of the good. Markets work because both
buyers and sellers alter their behaviour in response to changes in incentives.
Of course, this process does not work instantaneously. It will take time for buyers to
respond fully to a change in price. Similarly, it will take time for producers to build an
additional plant in response to a price increase or to reduce production if price
declines. Nonetheless, the implications are clear - market prices will coordinate the
actions of both buyers and sellers and will bring them into harmony.
The response of buyers and sellers to the higher gasoline prices of the 1970s illustrates
the importance of incentives. As gasoline prices rose, consumers eliminated less essential
trips and did more car pooling. Gradually, they shifted to smaller, more fuel-efficient
cars in order to reduce their gasoline consumption still further. At the same time,
petroleum suppliers increased their drilling, used a water flooding technique to recover
more oil from existing wells, and searched more intensely for new oil fields. By the early
1980s, this combination of factors was placing downward pressure on the price of crude
Incentives also influence political choices. The person who shops in the supermarket is
the same person who shops among political alternatives. In most cases, voters are more
likely to support political candidates and policies that provide them with net personal
benefits. Conversely, they will tend to oppose political options when the personal costs
are high relative to the benefits provided.
The basic postulate of economics - that incentives matter - is just as applicable under
socialism as it is under capitalism. For example, in the former Soviet Union, managers and
employees of glass plants were at one time rewarded according to the tons of sheet glass
produced. Not surprisingly, most plants produced sheet glass so thick that one could
hardly see through it. The rules were changed so that the managers were rewarded according
to the square meters of glass produced. The results were predictable. Under the new rules,
Soviet firms produced glass so thin that it was easily broken. Changes in incentives
influence actions under all forms of economic organization.
Some critics have charged that economic analysis only helps explain the actions of
self-centred, greedy materialists. This view is false. People act for a variety of
reasons, some selfish and some humanitarian. The basic postulate of economics applies to
both the altruist and egotist. The choices of both will be influenced by changes in
personal costs and benefits. For example, both the altruist and the egotist will be more
likely to attempt the rescue of a small child in a three-foot swimming pool than in the
rapid currents approaching Niagara Falls. Similarly, both are more likely to give a needy
person their hand-me-downs rather than their best clothes. Incentives influence the
choices of both.
2. There is No Such Thing as a Free Lunch
SCARCITY CONSTRAINS US. THE REALITY of life on our planet
is that productive resources are limited, while human desires for goods and services are
virtually unlimited. Since we cannot have as much of everything as we would like, we are
forced to choose among alternatives.
When resources are used to produce good A, say a shopping centre, the action diverts
resources away from the production of other goods that are also desired. The cost of the
shopping centre is the highest valued bundle of other goods that could have been produced
and consumed, but now must be sacrificed, because the required resources were used instead
to produce the shopping centre. The use of resources to produce one thing reduces their
availability to produce other things. Thus, the use of scarce resources always involves a
cost; there is no such thing as a free lunch.
Costs play a vitally important function: they help us balance our desire for more of a
good against our desire for more of other goods that could be produced instead. If we do
not consider these costs, we will end up using scarce resources to produce the wrong
things - goods that we do not value as much as other things that we might have produced.
In a market economy, consumer demand and producer costs perform this balancing function.
In essence, the demand for a product is the voice of consumers instructing firms to
produce a good. In order to produce the good, however, resources must be bid away from
their alternative uses - primarily the production of other goods. Producers incur costs
when they bid resources away from the production of other goods. These costs of production
represent the voice of consumers saying that other goods that could be produced with the
resources are also desired. Producers have a strong incentive to supply those goods that
can be sold for as much or more than their production costs. This is another way of saying
that producers will tend to supply those goods that consumers value most relative to their
Of course, a good can be provided free to an individual or group if others foot the bill.
But this merely shifts the costs; it does not reduce them. Politicians often speak of
"free education," "free medical care," or "free housing."
This terminology is deceptive. None of these things are free. Scarce resources are
required to produce each of them. For example, the buildings, labour, and other resources
used to produce schooling could be used instead to produce more food, recreation,
entertainment, or other goods. The cost of the schooling is the value of those goods that
must now be given up because the resources required for their production were instead used
to produce schooling. Governments may be able to shift costs, but they cannot avoid them.
The "scarce resources have a cost" concept applies to all.
With the passage of time, of course, we may be able to discover better ways of doing
things and improve our knowledge about how to transform scarce resources into desired
goods and services. Clearly, this has been the case. During the last 250 years, we have
been able to relax the grip of scarcity and improve our quality of life. However, this
does not change the fundamental point - we still confront the reality of scarcity. The use
of more labour, machines, and natural resources to produce one good forces us to give up
other goods that might otherwise have been produced.
3. Voluntary Exchange Promotes Economic
MUTUAL GAIN IS THE FOUNDATION OF TRADE. Parties agree to an
exchange because they anticipate that it will improve their well-being. The motivation for
market exchange is summed up in the phrase, "If you do something good for me, I will
do something good for you." Trade is productive; it permits each of the trading
partners to get more of what they want.
There are three major reasons why trade is productive - why it increases the wealth of
people. First, trade channels goods and services to those who value them most. A good or
service does not have value just because it exists. Material things are not wealth until
they are in the hands of someone who values them. The preferences, knowledge, and goals of
people vary widely. Thus, a good that is virtually worthless to one may be a precious gem
to another. For example, a highly technical book on electronics that is of no value to an
art collector may be worth hundreds of dollars to an engineer. Similarly, a painting that
is unappreciated by an engineer may be an object of great value to an art collector.
Therefore, a voluntary exchange that moves the electronics book to the engineer and the
painting to the art collector will increase the value of both goods. Simultaneously, the
exchange will increase the wealth of both trading partners and the nation because it moves
goods from people who value them less to people who value them more.
Second, exchange permits trading partners to gain from specializing in the production of
those things they do best. Specialization allows us to expand total output. A group of
individuals, regions, or nations will be able to produce a larger output when each
specializes in the production of goods and services it can provide at a low cost, and uses
its sales revenue to trade for desired goods it can provide only at a high cost.
Economists refer to this principle as the law of comparative advantage.
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In many ways, gains from trade and specialization are common sense. Examples abound. Trade
permits a skilled carpenter to specialize in the production of frame housing while trading
the earnings from housing sales to purchase food, clothing, automobiles, and thousands of
other goods that the carpenter is not so skilled at producing. Similarly, trade allows
Canadian farmers to specialize in the production of wheat and use the revenue from wheat
sales to buy Brazilian coffee, a commodity that the Canadians could produce only at a high
cost. Simultaneously, it is cheaper for Brazilians to use their resources to grow coffee
and trade the revenues for Canadian wheat. Total output is enlarged and both trading
Third, voluntary exchange permits us to realize gains derived from cooperative effort,
division of labour, and the adoption of large-scale production methods. In the absence of
exchange, productive activity would be limited to the individual household.
Self-sufficiency and small-scale production would be the rule. Exchange permits us to have
a much wider market for our output, and thus enables us to separate production processes
into a series of specific operations in order to plan for large production runs - actions
which often lead to enormous increases in output per worker.
Adam Smith, the "father of economics," stressed the importance of gains from the
division of labour more than 200 years ago. Observing the operation of a pin manufacturer,
Smith noted that the production of the pins was broken into "about eighteen distinct
operations," each performed by specific workers. When the workers each specialized in
a productive function, they were able to produce 4,800 pins per worker each day. Without
specialization and division of labour, Smith doubted an individual worker would have been
able to produce even 20 pins per day.
Specialization permits individuals to take advantage of the diversity in their abilities
and skills. It also enables employers to assign tasks to the workers who are more able to
accomplish them. Even more importantly, the division of labour lets us adopt complex,
large-scale production techniques unthinkable for an individual household. Without
exchange, however, these gains would be lost.
4. Transaction Costs are an Obstacle to
Exchange; Reducing This Obstacle Will Help Promote Economic Progress
VOLUNTARY EXCHANGE IS PRODUCTIVE because it promotes social
cooperation and helps us get more of what we want. However, exchange is also costly. The
time, effort, and other resources necessary to search out, negotiate, and conclude an
exchange are called transaction costs. Transaction costs are an obstacle to the creation
of wealth. They limit both our productive capacity and the realization of gains from
mutually advantageous trades.
Transaction costs are sometimes high because of physical obstacles, such as oceans,
rivers, marshes, and mountains. In these cases, investment in roads and improvements in
transportation and communications can reduce them. In other instances, transaction costs
may be high because of man-made obstacles, such as taxes, licensing requirements,
government regulations, price controls, tariffs, or quotas. But regardless of whether the
roadblocks are physical or man-made, high transaction costs reduce the potential gains
from trade. Conversely, reductions in transaction costs increase the gains from trade and
thereby promote economic progress.
People who provide trading partners with information and services that help them arrange
trades and make better choices are providing something valuable. Such specialists or
middlemen include real estate agents, stockbrokers, automobile dealers, publishers of
classified ads, and a wide variety of merchants.
Often, people believe that middlemen are unnecessary - that they merely increase the price
of goods without providing benefits to either the buyer or the seller. Once we recognize
that transaction costs are an obstacle to trade, it is easy to see the fallacy of this
view. Consider the grocer who, in essence, provides middleman services that make it
cheaper and more convenient for producers and consumers of food products to deal with each
other. Think of the time and effort that would be involved in preparing even a single meal
if shoppers had to deal directly with farmers when purchasing vegetables; citrus growers
when buying fruit; dairy operators if they wanted butter, milk, or cheese; and a rancher
or a fisherman if they wanted to serve beef or fish. Grocers make these contacts for
consumers, transport and sell all of the items in a convenient shopping location, and
maintain reliable inventories. The services of grocers and other middlemen reduce
transaction costs and make it easier for potential buyers and sellers to realize gains
from trade. These services increase the volume of trade and thereby promote economic
5. Increases in Real Income are Dependent Upon
Increases in Real Output
A HIGHER INCOME AND STANDARD OF LIVING are dependent upon
higher productivity and output. There is a direct relationship between a nation's per
capita (per person) income and its per capita output. In essence, output and income are
opposite sides of the same coin. Output is the value of the goods and services produced,
as measured by the prices paid by purchasers. Income is the revenue paid to the people
(including the entrepreneur's residual revenue), who supply the resources that generate
the output. This too, must equal the sale price of the goods.
Consider the following example: suppose that a construction company hires workers and
purchases other resources, such as lumber, nails, and bricks, to produce output - in this
case, a home. When the home is sold to a buyer, the sale price is a measure of output.
Simultaneously, the sum of the payments to the workers, suppliers of the other resources,
and the residual income received by the construction company (which may be either positive
or negative) is a measure of income. Both the output and income add up to the sale price
of the good, which represents the value of what was produced.
Once the linkage between output and income is recognized, the real source of economic
progress is clarified. We improve our standard of living (income) by figuring out how to
produce more output (things that people value). Economic progress is dependent, for
example, on our ability to build a better house, computer, or video camera with the same
or a lesser amount of labour and other resources. Without increases in real output - that
is, output adjusted for inflation - there can be no increases in income and no improvement
in our living standards.
Historical comparisons illustrate this point. On average, workers in North America,
Europe, and Japan produce about five times more output per capita than their ancestors did
50 years ago. Similarly, their inflation-adjusted per capita income - what economists call
real income - is approximately five times higher.
Output per worker also accounts for differences in earnings per worker across countries.
For example, the average worker in the United States is better educated, works with more
productive machines, and benefits from more efficient economic organization than the
average person in India or China. Thus, the average U.S. worker produces approximately 20
times as much value of output as an average worker in India or China. American workers
earn more because they produce more. If they did not produce more, they would not be able
to earn more.
Politicians often erroneously talk as if the creation of jobs is the source of economic
progress. While campaigning, a recent political leader argued that his economic program
had three pillars: "Jobs, jobs, and jobs." But focusing on jobs is a potential
source of confusion. More employment will not promote economic progress, unless the
employment expands output. We do not need more jobs, per se. Rather we need more
productive workers, more productivity-enhancing machinery, and more efficient economic
organization so we can produce more output per capita.
Some observers argue that technology adversely affects workers. In fact, just the opposite
is true. Once you recognize that expansion in output is the source of higher wages, the
positive impact of improvements in technology is apparent: better technology makes it
possible for workers to produce more and thus to earn more. For example, farmers can
generally produce more when working with a tractor rather than a team of horses.
Accountants can handle more business accounts using micro-computers rather than a pencil
and calculator. A secretary can prepare more letters when working with a word-processor
than with a typewriter.
Sometimes specific jobs will be eliminated. Clearly modern technology has largely
eliminated the jobs of elevator operators, blacksmiths, household workers, ditch diggers,
and buggy manufacturers. These changes, however, merely release human resources so they
can be used to expand output in other areas. Other tasks can now be accomplished with the
newly released resources and, as a result, we are able to achieve a higher standard of
living than would otherwise be the case.
Recognition of the link between output and income also makes it easier to see why minimum
wage legislation and labour unions fail to increase the overall wages of workers. A higher
minimum wage will price some low-skill workers out of the market. Therefore, their
employment will decline, reducing total output. While some individual workers may be
helped, overall per capita income will be lower because per capita output will be lower.
Similarly, labour unions may be able to reduce the competition from nonunion workers and
thereby push up the wages of union members. But without commensurate increases in worker
productivity, unions are unable to enhance the wages of all workers. If they could, the
average wages in a highly unionized country like the United Kingdom would be higher than
in the United States. But this is not what we observe. Wages in the U.K. are at least 40
percent lower than in the U.S., even though nearly half of the workforce is unionized in
the United Kingdom compared to less than 20 percent in the United States.
Without high productivity per worker, there can be no high wages per worker. Similarly,
without growth in the production of goods and services valued by consumers, there can be
no growth in the real income of a nation. Production provides the source of income.
6. The Four Sources of Income Growth are
(a) Improvements in Worker Skills,
(b) Capital Formation,
(c) Technological Advancement, and
(d) Better Economic Organization
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THE 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
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
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.
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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
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.
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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
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
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.
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Last Modified: Wednesday, October 20, 1999.