Tag Archives: economics

Top Ten Bad Assumptions: 9 – People making more cause other people to make less.

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Alternate Assumption: People making more cause other people to also make more.

Income inequality is one of the hottest political issues in America today.  People don’t think it is fair that some people make substantially more money than other people.  Proposed solutions include increasing taxes on the wealthy, raising the minimum wage, and limiting the pay of CEO’s.  The key assumption in this whole debate is that the total amount of wealth is a fixed pie.  People who take a bigger slice of pie force others to take a smaller slice.

It is a basic principle of economics that wealth is not a fixed pie.  It grows and contracts. The key to growing wealth is voluntary transactions.  For example, you buy a cup of coffee.  You are buying the coffee because to you the coffee is worth more than the money that you are paying for it.  The coffee shop owner sells you the coffee because to him or her, the money you pay is worth more than the coffee.  You both feel you are better off by making this transaction.  If not, you wouldn’t make the transaction.  This transaction has made both you and the coffee shop owner better off than if you hadn’t made the transaction.  In essence, you are both a little bit wealthier.

The key here is that the transaction is voluntary.  If the transaction is not voluntary, wealth is not increased.  If someone steals your money, wealth is not created.  When government taxes you, wealth is not created.  It is only when the transaction is voluntary, when both parties to the transaction think they are better off, that we create wealth.

Steve Jobs was exceptionally good at creating wealth.  When he returned to Apple as CEO, Apple was on the verge of bankruptcy.  Now Apple has the highest market value of any company in America according to the latest rankings by Fortune magazine.  Steve Jobs earned billions as a result.  He was not the only one who benefited, however.  Millions more benefited from his success.  pPeople who invested in Apple, work for Apple, work for companies who sell to Apple, work for companies who develop software for Apple, or who simply enjoy using iPhones and iPads are all better off.   Would all of these people have better lives if we stopped Steve Jobs from creating wealth because he made too much money?

In the feudal societies of the middle ages, most transactions were not voluntary.  Nobles forced serfs to work for them and taxed from them just about everything they had.  Kingdoms grew wealthy not from innovating and creating but from plundering weaker kingdoms.  In these feudal societies, the assumption that one person growing wealthier causes others to become poorer was valid.  It is also why society did not progress for over a thousand years.  This assumption is also true in a modern autocratic society where dictators plunder from the rest of the population.

It is not true, however, in societies where most transactions are voluntary, where there is economic freedom.  The Heritage foundation ranks each country by economic freedom. Look at their rankings:  2015 Index of Economic Freedom.  Note that the most economically free countries are also the wealthiest countries.  The least free countries are the poorest countries.

Bernie Sanders, the Vermont senator who is currently running for president, is calling for a top tax rate of 90%?  Why should an investor put money into a risky new company that might become the next Apple if when the company fails, the investor loses everything, but if the company succeeds, the investor only gets to keep 10% of the gain.  The investor doesn’t make this investment and just puts the money in the bank for a safe low interest. As a result, society loses the next Apple.

The belief that people making more cause other people to make less is a very popular, very dangerous, very bad assumption.

Basic Economics Part 7 – Why do so many people prefer socialism?

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This is the final part in a series on basic economics inspired by the works of Thomas Sowell.

The prior segment in this series clearly shows that a capitalistic, free economy greatly outproduces a centralized, less free economy.  Why then do so many prefer socialism?

Many people actually believe that socialism produces better economic results than capitalism.  I believe I have shown that this is totally mistaken and that the evidence overwhelmingly shows that capitalism outproduces socialism.  I would welcome anybody who can refute my previous arguments here to respond.

Even those who agree that more capitalism leads to greater overall wealth still favor government control of economies to a varying degree, from heavy government regulation to socialism to communism.  These are reasons they give:

  • Capitalism can be corrupt.  People point to “crony capitalism” where government supports favored companies, frequently those who give the biggest campaign contributions.
  • Unfettered capitalism and out of control greed lead to major crises such as the great depression and the financial collapse of 2008.
  • Without regulation, capitalists will exploit the environment, their workers, and their customers to increase profits.
  • Capitalism is inherently immoral.  Everybody should work for the greater good instead of for themselves.
  • Profits represent waste.  Goods and services could be provided more cheaply if there weren’t profits.
  • Wealth isn’t everything.  People are happier under socialism.

I believe that some of these statement contain some truth while others I vehemently disagree with.  I will return to discuss each of these topics in future segments.

Except, I would like to discuss the last issue right now.  I think it is the most important argument, because I think it is the only argument where they are right.  Many people are happier under socialism.

According to the Heritage Foundation’s 2014 Index of Economic Freedom, Chile is ranked one of the most free countries in the world, and is the most free in Latin America with a per capita income of $18,419 .  Honduras in contrast is one of the least free with a per capita income of $4,610.  The bottom 20% in Chile has an average income roughly twice the average income in Honduras.  Despite this, in happiness surveys, Honduras rates as a much happier country than Chile.

If you are poor and everyone else around you is poor, you  tend to be happier than someone who is much better off but who is surrounded by even wealthier neighbors.

In remarks before the World Affairs Coucil of Greater Dallas in 2003 Alan Greenspan talked about “the creative destruction” of capitalism where the standard of living rises as new technologies and methods replace old.   This leads to both progress and stress.  He stated, “I do not doubt that the vast majority of us would prefer to work in a less stressful, less competitive environment”.

Basically, under capitalism there are winners and losers.  This is an essential element of capitalism.  Socialism tries to have no losers.  It is much more stressful to have to compete first to survive and then to better yourself.  There is an attraction to having everything handed to you, even if you don’t get as much.

Picture a classroom with no grades.  Nobody passes or fails.  If you show up, you get promoted.  There are no tests.  In this environment there are some who would likely be at the top of the class who would hate this.  The majority would probably prefer this stress-free environment.  Overall happiness would be higher than in a classroom where students compete for grades.  Does anybody think though that the students would learn more in a class without grades?

Economics is a field where we make choices.  Do we prefer an economy that grows and progresses but produces stress?  Do we prefer an economy that keeps most people mired in poverty but produces less stress?

If you found these segments interesting, I recommend that you read “Basic Economics” by Thomas Sowell.   You will find some of what I said embodied in his work while some are my own extensions based upon the Sowell’s concepts.

Sources:

http://www.heritage.org/index/ranking

http://books.google.com/books?id=s-YPDQIlJAYC&pg=PA181&lpg=PA181&dq=chile+vs+honduras+happiness&source=bl&ots=Yyw1i2TRBg&sig=Supf4_aN6mBj_bZ8PZ8lTf_0ma0&hl=en&sa=X&ei=NttvU87VItSmyASy34KwDA&ved=0CCYQ6AEwAA#v=onepage&q=chile%20vs%20honduras%20happiness&f=false

http://www.telegraph.co.uk/news/8198810/Money-really-doesnt-buy-happiness-in-the-long-term-at-least.html

http://www.federalreserve.gov/BoardDocs/Speeches/2003/20031211/default.htm

Basic Economics Part 6 – Capitalism vs. Socialism

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Basic Economics Part 6 – Capitalism vs. Socialism

This is the sixth in a series inspired by Basic Economics by Thomas Sowell.

Previously I had argued that wealth is created whenever there is a voluntary transaction as each side believes they are better off due to the transaction.  In my last segment I poked holes in my own argument by showing that just because a person believes he is better off, it doesn’t mean he is actually better off.

This leaves us with one huge question.  Do we create more wealth in a decentralized capitalistic economy relying on people to make good decisions more often than not, or do we create more wealth in a centralized command economy where experts make the key decisions for everyone?

You could design this as a scientific experiment where you randomly divide people into two groups and have one group follow a capitalistic model and one group follow a command model.  While this is the most scientific method, it would be very difficult if not impossible to simulate all of the complications or real life.

Alternatively, you could take a country and split it down the middle.  This way you start with a common culture and similar natural resources.  The key differentiating factor would be the economic system.

The real world has conducted this experiment for us, twice.  West Germany and South Korea employed the capitalist model.  East Germany and North Korea employed the command model.  West Germany and South Korea produced thriving, growing economies.   East Germany and North Korea became economic basket cases.  The results of these inadvertent lab tests show unquestionably that capitalist economies greatly outperform command economies.

The Heritage Foundation maintains an index of economic freedom.  This chart clearly shows that greater economic freedom strongly relates to greater Gross Domestic Product (GDP)   Image

Changes within a country can make a dramatic difference.  Following the fall of the Berlin Wall, both China and India have moved away from a command economy to a more capitalistic economy.   As a result, nearly one billion people have been lifted out of extreme poverty.

http://www.economist.com/news/leaders/21578665-nearly-1-billion-people-have-been-taken-out-extreme-poverty-20-years-world-should-aim

Capitalism clearly outperforms socialism.  It isn’t even close.  Despite this obvious fact, socialism is still very popular in the world today.  Why is this?  This will be the focus of the next and (I think) final installment in this series.

Basic Economics Part 5 – The Problems with Voluntary Transactions

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This is the fifth part in a series on Basic Economics, inspired by the work of Thomas Sowell.

As a note, my frequent use of he/she I decided is quite clumsy.  From now on I will arbitrarily alternate between he or she.  Unless gender is the subject of discussion, the actual gender I use has no consequence.

In my last segment, I argued that when a person becomes richer through entirely voluntary transactions, she makes others richer as well.  The premise for this is that she does not enter into a voluntary transaction unless she believes the transaction will make her better off.  She does not buy a cup of coffee unless she believes she is better off with the coffee than with the money required to buy the coffee.

The giant hole in this argument is the assumption that if a person believes a transaction will make her better off, it doesn’t mean it will actually make her better off.  There are many reasons that her perception of the value may greatly differ from the actual value of the transaction.

  • She may not have sufficient information.  She may not know that the coffee will taste horrible or that the coffee shop is not sanitary.
  • She may be defrauded.  The coffee shop might advertise that they use an expensive premium coffee but actually are using a cheap substitute.
  • She might have pre-purchased a card good for ten coffees but the coffee shop decides to discontinue the pre-purchase program and refuses to honor her card.
  • She might make a poor decision such as choosing short-term impulse gratification over long term goals.  Anybody who has ever tried to lose weight and eaten a whole bag of potato chips can understand that.
  • She might be mentally incompetent to determine what makes her better off.

With all of these potential problems in voluntary transactions, can we truly say that a capitalist system that relies on the premise that people make decisions that better themselves is a good idea?  Would it better to have a centrally planned economy where enlightened experts make decisions for the betterment of everybody?

That will be the focus of the next segment.

Basic Economics – Part 4 – Creating Wealth

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This is the fourth post in a series inspired by Thomas Sowell

I would postulate that most people look at the wealth of the world as a giant pie of which everybody has a slice, large or small. If one person has a larger slice, , that means he or she is taking pie from others, forcing others to have less pie. When one person gets richer that means somebody else must get poorer. This assumption is the underlying argument in the whole income inequality debate.

This assumption is also totally false. Wealth is not a fixed size pie. For example, lets say a sculptor takes a plain rock worth nothing and carves it into a beautiful statue and sells it for $1000. The sculptor now is wealthier, but has she made anybody else poorer? Obviously, she hasn’t. She has increased the wealth of the world by the value of the statue over the rock. She has created wealth.

Wealth is the total value of all of the goods and services. Money is not wealth. Money is the total claim against wealth. If you own one one trillionth of the money in the world, you can claim one trillionth of the wealth. Let’s say tomorrow the United States government implemented a new policy where for every dollar a person owned, he or she would receive an additional dollar. If you owned $10,000 before, you now own $20,000. This would not double wealth. It would not create any new wealth. This creates no new goods or services. It just doubles the claim against existing wealth so each dollar would now be worth half of what it was before. If something cost $10 before, it would cost $20 after.

I once had an economics professor burn a dollar bill in front of the class. He stated that in doing so he did not destroy any wealth. By removing his claim of $1 worth of wealth, he made everybody else an infinitesimally tiny amount richer.

If a person becomes richer without creating any value in exchange, this means he or she is taking a larger slice of the same sized pie and is in fact making somebody else poorer. On the other hand, if the person becomes richer by creating additional value, he or she is making the pie bigger. Not only is this person not making anybody else poorer, but if this person takes less pie than he or she creates, the person is making other people richer as well. So how can we say if value is created? We can say value is created when someone voluntarily pays for it. If our sculptor creates an ugly statue that nobody will pay for, she has created no economic value. If she creates a masterpiece that she sells for one million dollars, she has created a lot of economic value.

In our previous example, we know the coffee shop has created value, created wealth when someone is voluntarily willing to pay for the coffee. When someone works for an hour and someone voluntarily pays for the work, there is value. If on the other hand someone works for an hour and the government says the boss has to pay the person, then we really have no idea if the person created value. The person could have done just what the boss wanted or the person could have done absolutely nothing. When a transaction stops being voluntary on both sides, we no longer have any way to measure value, to determine if wealth is created.

People only participate in a voluntary transaction if they perceive the value of what they receive is greater than the value of what they pay. If the boss has to pay you $10/hour and the boss perceives that in doing so he can’t generate at least $10 an hour in additional income, then the boss isn’t going to hire you. There is no reason for the boss to hire you. If, however, the boss thinks he can make an additional $20 by hiring you, then the boss hires you. You make $10 and the boss makes $10 and both of you are better off.

Steve Jobs made billions of dollars through his innovations with Apple. In making his billions, did he make the rest of the world richer or poorer? The answer here is obvious.

At the beginning I stated that most people have the false assumption that when somebody makes more money, he makes other people poorer. I am showing here that the reverse is true.

If someone makes more money, he makes other people richer!

Now I know this is not always true. There are holes in this argument. I will address these holes in the next segment.

Basic Economics, Part 3 – Voluntary vs. Non-Voluntary Transactions

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This is the third post in a series explaining the fundamentals of economics inspired by the work of Thomas Sowell.  In the last post I showed how in a voluntary transaction both sides feel they are better off.  This in essence, creates wealth as both parties feel wealthier after the transaction than before.  This wealth creation effect can only be surmised in a voluntary transaction.  If either party is forced to make the transaction, the total wealth may be greater, unchanged, or lessened.

For example, lets say that government perceives we have a coffee shop problem.  New coffee shops are opening and forcing old coffee shops out of business.  Some coffee shops have long lines while others are empty.  To make things fair, a government official decided that each coffee shop has a territory.  If you live in that territory, you can only buy coffee from that coffee shop.  The coffee shop cannot sell to people outside of the territory.  Since there is no price competition, the government decides what it considers to be a fair price for coffee.  To level out demand, the government also says that each person must buy one and only one cup of coffee per day.

Now when someone buys a cup of coffee, each side may not think they are better off.  You might not want coffee but you need to buy it anyhow.  You might love coffee but you don’t like the coffee at this coffee shop.  The coffee shop might not want to sell you coffee because they can’t make money selling you coffee at this price.  Since the transaction is not voluntary, we can’t assume that each party considers themselves better off for the transaction.  Therefore the transaction may or may not create wealth.

Even if the government decision maker is the world’s leading expert on coffee shops, it doesn’t make a difference.  If a transaction is not voluntary, it also may not be wealth-creating.

The next topic in this series will discuss the creation of wealth and how one views this is the most fundamental of assumptions.

 

Basic Economics, Part 2 – Maximizing Total Wealth

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This is a second in a series of posts based on the concepts from the book “Basic Economics” by Thomas Sowell.

In my last post I explained how there are many different ways of allocating resources.  As an example I talked about many different ways of allocating beachfront real estate.  The next question is how we can evaluate whether one allocation method is superior to other allocation methods.  Fundamentally, there are two different ways we can evaluate allocation methods.

  • Practically;  Which method maximizes total wealth?
  • Morally:  Which method is the fairest?

Today I will only start to address the practical question.  I will address the moral question later.

What do I mean by maximizing total wealth?  Isn’t total wealth fixed and the only question is how we allocate it?  After all, we can’t create any more beachfront real estate no matter how we allocate it.

Let’s say you visit a coffee shop and buy a coffee.  As you take your coffee, you thank the clerk and the clerk thanks you.  Why do you both thank each other?  Each of you believe you are better off with this transaction.  At the time you want the coffee more than you want the money.  The coffee shop wants the money more than it wants the coffee.  Both sides of this transaction think they are better off due to this transaction.

Total wealth produced is the sum of all goods and services.  Whenever there is a transaction the extra value that each party perceives from the transaction increases the wealth.  When you buy your coffee, the total wealth increases because each side is better off for the transaction.

The best way to assure that both sides are better off from a transaction is for the transaction to be voluntary.  When you buy your coffee, nobody is forcing you to buy it and nobody is forcing the coffee shop to sell you the coffee.  Whenever there is a voluntary transaction then, at the moment at least, each party feels they are better off, that their wealth is increased.  Of course, this momentary perception can be wrong and in the long run, one or the other party is not better off.  I will address this later in this series.  For the moment, assume that the momentary perception is correct and each party actually is better off.

Of all of the allocation systems discussed in my last post, the only system that is totally voluntary is the free market priced based system.  If buyer and seller can agree on a price, there is a transaction where both parties believe they are better off.  When we have this voluntary transaction, wealth is increased.

In a central planning economy, a government official could either decide who buys or sells the coffee or the government official might set the price.

In the next post I will continue this discussion by contrasting the  central planning approach to the free market approach.

 

Basic Economics – Part 1 – Different Economic Systems

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This  will be the first in a series of posts about basic  economics.  By no coincidence, “Basic Economics” by Thomas Sowell is the inspiration for much of these postings, though I will be doing quite a bit of paraphrasing.

The British economist Lionel Robbins gave the classic definition of economics:

Economics is the study of the use of scarce resources which have alternative uses.

For any desirable resource, there will frequently be more people who want the resource than there is resource available.  For example, let’s consider beachfront property.  Beachfront property is a scarce resource.   There are far more people who would like to own beachfront property than there is property available.  Some people will get this property and others won’t.  There are many different ways this property could be allocated.  For example:

  • In a pure capitalist economy, whoever pays the most, gets it.
  • In a command economy, a government official would decide who gets it.
  • In an anarchistic economy, whoever is strong enough to seize it and hold it gets it.
  • It could be allocated randomly through a lottery.
  • It could be allocated on a first come, first serve basis.
  • It could be allocated based on some type of contest.

Beachfront property also has alternative uses:

  • It can be used as a public beach.
  • It can be used as a private estate.
  • It can be used as an inexpensive hotel.
  • It can be used as a luxury hotel.
  • It can be used as a timeshare.
  • It can be used as a marina for small boats.
  • It an be used as an industrial port.
  • It can be used as a port for large passenger ships.
  • It can not be used at all and kept as a nature reserve.

I’m sure that more time brainstorming could determine other allocation mechanisms and other uses.

The key point here is that no matter how we allocate beachfront property, there will be some people who get it and others who don’t.  That is true whether we have a capitalist economy, a communist economy, or any other economy.  We can’t expect any economic system to make everybody happy.  How then should we determine which is the best economic system?

Stay tuned.