Barbecue Economics: Be Your Neighborhood Expert on Demand, Supply, and the Free Market

Barbecue Economics

Be Your Neighborhood Expert on Demand, Supply and the Free Market

Dick Gillette

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Smashwords Edition

Copyright 2012 Dick Gillette

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Table Of Contents

Foreword

Introduction

Chapter I – Basic Principles

Things We Want Are Scarce

Humans Are Rational

Decisions Are Made At The Margin

People Respond To Economic Incentives

Everything Has An Opportunity Cost

Chapter II – Microeconomics

Markets

How Markets Work

Demand

Elasticity Of Demand

Supply

Price Determination

Rent Control Laws

Elasticity Of Supply

Supply Of Labor

Minimum Wage Laws

Drug Price Controls

Maximizing Firm Profits

Chapter III – Macroeconomics

Gross Domestic Product

The Business Cycle

Classical Economics

Consumption, Saving, And Keynes

Supply-Side Economics And The Laffer Curve

Rational Expectations

Economic Equilibrium

Chapter IV – Fiscal Policy

Taxes

Spending

Borrowing

Chapter V – Monetary Policy

Money

The Federal Reserve

Chapter VI – Regulation

Lyme Disease And Government

Air Pollution

Commercial Licensing

Auto Mileage Standards

Commercial Banking

The Titanic

Chapter VII – Jobs and Income

Creating Jobs

Concentration Of Income

Chapter VIII – Foreign Trade

The Basics

China

Chapter IX – Cronyism: Enemy Of The Free Market

Government

Corporations

Millionaires

Labor

Chapter X – Reflections

Appendix

Glossary of Terms

About the Author

Foreword

This is a book about economics, but it is not an economics book. To really learn economics, consult any number of books written by highly qualified economists. My experience is business, and my formal training in economics is now decades old. I undertook this project to counter the growing quantity of misinformation and un-economic reasoning that passes for wisdom in today’s conversation.

Nor is it a political book. The words Democrat and Republican appear in just two paragraphs of the entire book. No living politician’s name appears anywhere, except as a source.

It is simply a book about economics, how prices and wages are determined in the market, how businesses seek to maximize profits, and how these forces influence the well-being of our economy. I hope to present just enough of the topic so that readers will have a basic command of the vocabulary and can understand how economic decisions are made, and their likely outcomes. Think of it as barbecue economics, the kind that will impress your neighbors at the block party.

The need for economic literacy has never been more acute. Politicians untrained in economics rely on talking points contrived by untrained political staffs. The press generally has little understanding of economic principles, usually just repeating the talking points of their preferred politicians. In truth, given its centrality to society, the lack of economic understanding by public figures is shocking. Economics is a challenging field of study, but there are a few basic principles that informed people should know and use when forming policy opinions, and they are not difficult to understand. The first goal of this book is to help you master them.

Economic study is based on a fundamental truth: as human beings, our wants exceed our resources. Who doesn’t crave that new car, that new video system, the ticket to the Broadway show? For that matter, who wouldn’t like to have more free time to spend with their family or learn to play the piano? There is just not enough money and free time to go around. Economists refer to this unfortunate truth as a condition of scarcity. Economics is the study of how people deal with scarcity.

When things are scarce, trade-offs must be made. If your budget is tight, and you want the new car, you will have to give something else up; you can’t afford everything. Maybe you will give up your vacation this year, or maybe you will cut your entertainment budget. Whatever you decide, it will sting a little.

Bartenders in 19th century American saloons offered free lunches to patrons who would come in and buy a glass of beer. The profit from that one glass of beer, of course, was not enough to cover the cost of the lunch, but the bartenders were sure that, once the lunch was in front of them, their patrons would drink more beer. And just to clinch it, they made the lunch out of saltines, sardines, and other salty snacks. The profit from all those beers more than made up for the cost of the lunch so, in the end, there really was no free lunch for the patrons. It was all marketing fluff. There are no free lunches in economics either.

Lawmakers lose sight of this. Difficult decisions don’t get you reelected; it’s bringing home the bacon that counts. So, they reallocate our resources at the margin, a little here, a little there. Each program sounds worthwhile; who could be against saving the (fill in the blank)s? There seems to be no over-arching set of rules that guides their actions.

Our lawmakers know something is wrong. They see a federal budgeting process falling apart, and deficits and government debt mounting ominously. Their constituents complain about spending money beyond our means. A basic understanding of the principles of accounting leads them to resolve to pay for all of the new programs they put in place. They seem to believe that, so long as they can find revenues to cover the expenses, the problem is solved. In doing so they lose sight of the real problem, which is that government spending has an economic cost that paying for does not eliminate.

Economists and accountants view the world from different perspectives. To accountants, cost is generally defined as the payment of money. Thus, if a new government program requires an expenditure of $1 billion, an accountant would call that expenditure its cost. To an economist, the cost of the program is what is given up to collect the $1 billion. How might the billion dollars have been otherwise employed, and what effect would that have had? Most lawmakers think like accountants.

In addition to being an economics primer, have a second goal for the book. It is often pointed out that the American free market system is responsible for building the most prosperous society the world has ever known. This is true by almost any measure. Yet, well-intentioned voices in society argue that the free market is nothing more than a manifestation of raw, human greed and unfair to the vast majority of our citizens. From the time of the Robber Barons of the 19th century through today these voices have multiplied and are responsible for legislation that diminishes the freedom of and, therefore, the efficiency of markets.

The argument against free markets is misplaced. The free market is a place where all of us, if we understood the options, would prefer to go to conduct our business. The market is free because each of us can choose to go, or not go, whenever we want, and we know that when we get there we can generally expect to find a broad selection of sellers competing for our business. In addition to providing a wide range of choices of things to buy, the market assures us that, by placing sellers in competition with one another, none of them will have undue influence over the prices and terms available. And the unlimited opportunity for sellers to earn more of your dollars by innovating and creating better products can only exist in a free market.

Consumers have the real power in a free market. Consumers have the money, and without their money, sellers cannot survive. And consumers own one of the most important resources that all manufacturers need to make a profit - their own willingness to work. Freedom of choice - the ability of consumers and sellers to decide what is best for each of them without coercion of any kind - insures that a free market is the most efficient way to allocate resources known to man.

If this description of a free market is counter to your experience, it is likely not because the free market has failed, but rather because the influence of powerful interests has made the market less free. The essence of a free market is competition, and every participant is naturally motivated to try and push the odds a little more in their favor. Businesses petition legislators to protect them against the ravages of competition. Labor unions petition legislators to advantage their members relative to employers and other workers. Environmental groups petition lawmakers to curtail commerce to return to a more pristine state.

Luigi Zingales, professor of economics at the University of Chicago, has written that, while everyone benefits from a free and competitive market, no one has a strong incentive to keep the system competitive and the playing field level. True capitalism, Zingales says, lacks a strong lobby. The second objective of this book is to provide a voice for the free market.

The book has several sections, but two sections - Microeconomics and Macroeconomics - are the guts of economic theory. These are likely to give the uninitiated some pause. Do not lose hope; the rest of the book is quite user-friendly.

I am grateful to the many superb economists at the University of Chicago who sparked my lifelong interest in the field as a student at the University’s Booth School of Business. One measure of the academic energy that permeated the school was that we rarely read textbooks; instead, we read scholarly papers that our professors, and others, had recently published, representing advances in the science that textbooks were just too slow to capture. It was, and continues to be, a truly creative and exciting environment.

I would also like to tip my hat to the editorial page of The Wall Street Journal, which has consistently supported free market principles with sharp analysis and commentary for the forty or more years that I have read it. Theirs is an invaluable contribution to the conversation. Kudos also to publications like National Review and The Weekly Standard and to organizations like the American Enterprise Institute, the Heritage Foundation, and the Competitive Enterprise Institute for their high quality work on behalf of the principles of economic freedom.

Finally, I am grateful to my wife for encouraging me, a first-time author, to write this book, to my daughters for containing their disbelief when told about it (jk), and to all of them for helping me design and edit it. This was definitely a family affair. Thanks, girls.

INTRODUCTION

"A citizen cannot at the same time be free and not free." - Frederic Bastiat

An economic system is a set of laws, rules, and traditions that governs the exchange of money for goods and services by members of society. Only two pure forms of economic system exist. The first is one in which decisions about what goods to supply to the market, what goods to buy, and what prices to charge and pay, are made by millions of people and businesses in freely negotiated transactions every day - a free market system. The other is one in which those decisions are made by a government elite, with only a broad understanding of the needs of the marketplace - a managed economy.

A free market system allows all parties - consumers, merchants, producers - to participate on equal footing with all the others. No single party has undue influence over the others, and all transactions are entered into willingly, based on the self-interest of each party. Since business activities in a free market require the investment of privately owned capital, the term capitalism has come to be closely associated with a free market, and the term free market capitalism is often used. We consider this to be synonymous with free market.

In a sense, the term free market is a straw man; no fully free markets exist today. The Heritage Foundation publishes an Index of Economic Freedom each year, based on extensive research of nearly 180 countries ranked according to their degree of economic freedom. Hong Kong and Singapore are at the top, followed by Australia, New Zealand, and Switzerland. The U.S. ranks tenth. The most visible example of a directed market in the 20th century was the former Soviet Union. Currently, North Korea occupies the bottom of the freedom list.

Most economic systems fall somewhere between the extremes - mixed economies. In a mixed economy, like the United States, relatively free markets exist in certain sectors, while the rest of the economy operates with greater degrees of government involvement. The role of government is, ostensibly, to balance the influence of market participants to keep the market free.

There isn’t much argument among economists today over which system is best. The collapse of the Soviet Union and the extreme poverty and lack of economic growth in places like North Korea and Cuba pretty much put that question to rest. In the Soviet economy, agencies prepared massive five-year plans, directing where every knife, fork, and spoon would be produced, in what volumes, and with what materials, and what their selling prices would be. This bureaucratic system proved incapable of supplying consumers with the quality and variety of products they desired at prices they could afford. This failure, and the government’s excessive allocation of its scarce capital to weapons production, combined to impoverish the nation and doom it to failure. No credible defense of the Soviet system can be made today, and even its closest relative, The People’s Republic of China, has moved beyond a closely managed economy to a more free market orientation.

By the same token, there can be little argument that U.S. economic history validates the principle of a free market. The U.S. has created more wealth, and distributed its benefit more widely than any nation in history.

A logical question, then, is what is the optimal mix of free market and government involvement in a modern economy? To be sure, the recognition and protection of private property and the respect for contracts is critically important to the functioning of a free market, and these functions can only be performed by a competent legal system overseen by the government. Most of us agree on the need for some kind of social safety net for the unfortunate among us. And most of us support government action in areas where the free market does not function well, such as pollution. The extent to which government should be involved beyond areas like these is an open question.

Nineteenth century French political economist, Frederic Bastiat, addressed this question in his pamphlet, The Law, published in 1850. In it, he argued for a strong legal system, saying

Law is justice. And it is under the law of justice — under the reign of right; under the influence of liberty, safety, stability, and responsibility — that every person will attain his real worth and the true dignity of his being. It is only under this law of justice that mankind will achieve — slowly, no doubt, but certainly — God's design for the orderly and peaceful progress of humanity.

But Bastiat feared the consequences of an ambitious and uncontrolled law. He accepted the reality of man’s basic nature to seek the easiest, least painful way to satisfy his needs. And he recognized that this innate drive of man to seek shortcuts caused the fighting at the door of the Legislative Palace by men seeking favors, which he witnessed firsthand as a member of the Assembly. Here I encounter, he wrote, the most popular fallacy of our times. It is not considered sufficient that the law should be just; it must be philanthropic… These two uses of the law are in direct contradiction to each other. We must choose between them. A citizen cannot at the same time be free and not free.

Bastiat’s concern is as relevant today as it was one hundred sixty years ago. A mixed economic system with a bias toward freedom clearly seems to be the best way for society to reach its economic potential, but a government that commandeers too much of the wealth will undermine that effort. The principles of economics will help us understand why this is true. Bastiat’s way of drawing the line is as clear as any; that is, once the government is used for more than the protection of private property rights, it has gone too far.

We are well over that line today. Indeed, Bastiat’s line in the sand may well be an anachronism. The U.S. economy is so complex, with so many vested and conflicting interests, that the idea of returning to a fully free market, the kind of environment that created such massive wealth, can be no more than a dream. We must, instead, seek a balance. It would be useful, however, to understand the direction in which we are headed; too far in one direction, we know, is certain failure. When people are not sure of the direction of policy, they view the future with uncertainty, and uncertainty generally puts a damper on economic growth.

In the pages that follow we will introduce the basic principles of economics. We will show how these principles operate in the context of a free market and in that of our mixed economy. We will illustrate how the forces of people seeking the easy path to success create imbalances that distort the market. We hope at the end to have given you a clearer view of the economic impact of the choices we make, and a sufficient vocabulary to join the debate.

For those who like to view a map before setting sail, we elaborate here on the Table of Contents, which you may have skimmed. We even grade each section for difficulty - SC for Sunny and Calm, LWE for Light Winds Expected, and BDH for Batten Down the Hatches - not so you know which ones to skip, but rather how long it will be before the weather