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Chapter 2
UNDERSTANDING YOUR ECONOMIC SOCIETY
Your Economic Society
The U.S. economy is incomprehensibly large and complicated: more than 300 million people, in nearly 120 million households, of
which about two thirds are families and the remainder is single persons. The U.S. labor force is about 155 million people, about
47% of whom are women. Of those workers over 25 years of age, more than 90% have completed a high school education, and
a little more than one-third have a college education. Thirty-one million business enterprises (with over 25 million proprietorships
and partnerships and 6 million corporations) produce and exchange a bewildering conglomeration of goods and services worth
about $15 trillion annually (about 20-25% of the world total). That's an average of over $48,000 per person annually, though the
annual incomes of people fluctuate and differ widely.
You live in a private property society. Whether or not it is in any sense the best system is not our question here. We know only
that it has evolved and dominated in competition against other systems. Though, most economic resources in the United States
are privately owned and managed, some, such as large acreages of land and sophisticated and massive military equipment, are
held as government property. Also, while about 80% of national income is earned in the private sector, government operations
(e.g., fire, police, defense, education, roads, sanitation, judiciaries) yield the other 20%.
Rights and Property Rights
In every society, each person has rights of one kind or another. Since the word "'right" is often used loosely, we'll explain what
we mean by a "'right." A “right” means a person's socially recognized and supported authority to do certain things. One of those
“things” is making the choice of use of goods to which you have the property rights. You have a “right” only if the community at
large will protect you from others who try to interfere. If people saw someone trying to steal your car – violate your right to it –
they would call the police or alert other bystanders. Your property right to the car rests on the willingness and ability of other
people, not your own ability, to protect your control over that resource – your property. You don't have a “right” unless the
community at large will protect you from others who may interfere. Though you may have physical possession of an automobile,
you don’t thereby have a "right" to it. As an example of different interpretations of the word "right", consider Mother Nature. In a
pride of lions, the male by dint of sheer physical prowess takes first choice of feeding on prey. That could be called a "right", but
that's not what is meant here by a “right.” A right is lacking, because other lions don’t enforce rights of other lions. Instead, there
is cowed tolerance by dominant lions.
Private Property Rights.
Private property rights are a person’s exclusive, transferable rights to make decisions about the "physical conditions” and
services of specified goods. A parcel of land is your private property if the society protects your rights. Private property rights
restrain you from interfering with other peoples’ rights. Incidentally, don't be misled by statements that private property rights put
rights of property above the rights of people. That's nonsense, because private property rights are rights of people over uses of
goods that they own.
Physical Attributes, Not Market Value
Private property rights protect your property from physical effects caused by other people. For instance, I can’t legally break the
windows or put graffiti on your building. But you are not protected from market value effects caused by a reduced demand for
your property. For example, if I build an apartment building and increase the supply of apartments enough to reduce the rental
value of your apartment, that's legal. Or, if this textbook reduces the sales of a competitor’s book, that's legal. Your private
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property rights to your building do not prevent me from affecting your rental values by attracting customers from you – so long as
I don't also change the physical condition of your property.
Beware of Presumed Clarity and Definiteness of Private Property Rights
The distinction between physical effects and market value effects seems clear – at first thought. But consider the following
situation. From your land you have a beautiful view for several miles over land owned by someone else, who proposes to erect a
building obstructing your view. Would the physical attributes of your land be affected? Yes and No – depending on what is
meant by the physical attributes of your land. Physical features might not be interpreted to include the “light rays” that are
reflected on to your land. They usually, but not always, are excluded from your private property rights. Your neighbor can block
your view without violating your private property rights. This example illustrates that the meaning of “physical effects” has some
ambiguities. The moral is : when buying private property rights to something, first identify what the rights include and what is
excluded. The less that is included, the lower the market value will be.
Alienability of Private Property Rights
Another essential feature of private property rights is “transferability”, often also called “alienability.” That’s the right to sell (or
give) your rights to someone else. That makes you pay attention to potential market value of what you own. The way you use
your car or house will affect your car’s or house’s market value, and you’ll pay attention to that! If you have the right to resell this
textbook, you'll take better care of it than if you have no right to sell it. This salability of rights to the resource is a key,
fundamental, basic, critical – to emphasize excessively – difference between private property rights and all other forms of
property rights over resources. In England, up until about 100 years ago, major land holdings were not “alienable”. They passed
from parent to child. All the “owner-occupant” could do was live on it or enjoy its income if rented to someone else. In China
publicly traded companies issue shares of “ownership” that are not resalable without government approval. In Switzerland, until
a couple of decades ago, shares in many publicly traded corporations could not be sold to other people unless the buyer were
approved by the corporate directors.
At your college, which most likely is not a privately owned institution – though it may be a private non-profit institution – no one
has a private property right to the marketable value of the college’s resources. Because the administrators are thereby more
insulated from changes in market values of the resources, they use those resources less in accord with their highest market
valued uses. None of this means that private property rights are necessarily always better. For example, there's a reason for not
having private property rights in some institutions, such as “not-for-profit” hospitals, colleges, museums, fraternities and sororities
– as we'll see later.
Torts
We note also another kind of "property right.” A taking or using of another person's property in an emergency is called a "tort."
Because this occurs commonly, there is a whole body of law about “torts.” For example, if in a sudden, surprising storm on a
lake, you berth your boat at my dock to save your life (without prior negotiation for my permission), have my "rights" been
violated? Or, if you could have attracted my attention and asked for the right to use my dock, could I extract from you a promise
to all your wealth to save your life? Would I? One purpose of this example is to emphasize that private property rights are not
all-or-nothing. Another is to alert you to the fact that there are also other rights that control what people can do with resources.
We'll consider some later, after we're better prepared.
The Rule Against Perpetuities
An important restriction on the scope of private property rights is contained in the “Rule Against Perpetuities.” That rule restricts
your control of the future uses of what you own now. You might in your will try to restrict the future uses of your enormous wealth.
You might leave a parcel of land to a foundation which is to use the land forever as a refuge for deer. However, a reason for the
ban on your unlimited future control is that it reduces the influence of future market values on the way resource will be used in
the future. The “dead-hand of the past” overrules the “invisible hand” of the future living generations, as evidenced in the future
market values. The rule against perpetuities permits restrictions on use and salability of resources for only about 21 years after
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the death of persons alive at the time of the death of the donor. If that rule were not enforced, resources today would still be used
in ways they were generations ago – a most intriguing and potentially unpleasant result, fit for the theme of a bizarre movie.
A major difference between societies is not whether property rights do or do not exist, but, is instead the extent to which they
apply. In former communist Russia, people owned and could buy and sell furniture and automobiles. An economy with
extensive private property rights over most resources is usually called a "capitalist" economy. The term "capitalism" applies
because with salable resources the anticipated future consequences of present uses of resources are "capitalized" into current
market values of the resources, as we'll be examining later. Explaining what those capitalized market values reflect, and how
they influence our behavior and uses of resources is one of the basic achievements of economic analysis – the objective of this
text.
To do that we have to recognize the problem of the consistency of actions of different people. We have to do that in
an economy in which decisions and adjustments are independent in the sense that each person chooses without
requiring permission from someone else. Yet, the decisions are dependent in that they depend on what other people
are expected to do. The major general social restriction on what a person can do is the private property restriction.
The economy is therefore most reliably conceived of as individuals making risky decisions about innovating,
competing and bearing the consequences of their decisions of uses of their privately owned resources. What can be
considered to be the "system" is the pattern of dependencies among buyers and sellers. In some cases a
dependency on specific other people lasts for a long time, and in some it's momentary with anonymous people.
Similar to any other social action, whether in games, work or family, the rules of the "game" affect what people do. If
the rules are known and reliably enforced, a "system" can be said to prevail. And it is the operation of that system to
which economic principles will be applied in this text.
Please notice that the preceding sentence separated the "system" from the "economic principles." The "economic
principles" are applicable to any economic system. They reflect regularities of "preferences" and regularities of "ability
to produce". We will use the term "demand" to identify the regularities of preferences among types and quantities of
goods. We will use "supply" to identify the regularities of ability to produce goods and services. And, as we start the
exposition, in the next chapter, we’ll look at “demand" for various amounts and types of goods, assuming initially they
already have been produced.
Alert! A common error and misconception: Free speech Is Not “Free resources”:
The Difference Between What Is Economically “Free” and Political “Freedom.”
We now call your attention to a surprising implication of a system of private property rights. Your private property rights to your
land prevent me from encroaching on your land to pitch a tent or dump garbage or hold a meeting without your permission. I
would be violating your private property rights to your land. Similarly, if, without prior permission, I took your loudspeaker to talk
to people, I would be violating your private property rights to the loudspeaker. I do have a right to free speech, but that does not
mean I have a right to take your loudspeaker or your land to exercise my free speech rights. The concept and protection of “free
speech” does not consist of the "right" to take economic resources – without the owner’s permission – to be used for "speech",
regardless of whether other people want to hear what you have to say. Furthermore, a right of free speech is not "economically"
free right. It uses scarce resources. "Free speech" means the right to communicate with your own resources to other willing
listeners without political intervention about what you say. I can't force you to hear or read my "speech", any more than I can
force you to give me your wealth. I can't take other people’s property to communicate, nor can I regard the attention of other
people as "free" to me. I do not have a right to use others’ resources as if they were economically free, even if I use them to try
to communicate with you. That would confuse "economic free" resources with "political freedom" from government restraint. I
must use my own, or rented resources to communicate, and then only to willing persons.
Both these critical features: (1) use of owned resources by the speaker and (2) willing reception are often ignored. For an
example of the first point, if I enter (use) your land to talk to people, I violate your private property rights. Nor do I have any right
to send messages on Internet to computers owned by unwilling readers, who don't want messages put on their machine. Free
speech does not make your resources politically nor economically "free" to me, nor require you to be a listener. "Free speech"
does not mean the right to use other person's private property to communicate with recipients, willing or not. "Politically free"
does not encompass "economically free."
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This kind of confusion of "free speech" with a right to use resources, as if they become "free" when the resources are to be used
for speech, has confounded many judges and lawmakers and college administrators. The US Supreme Court is and has been
faced with this confusion. Someone sends messages on Email to your computer. You are an unwilling recipient. Both required
conditions of free speech are violated. Your computer is used by someone else without your permission, and you are not a
willing recipient. "The right of free speech is neither a right to ‘free’ access to the resources of other people, nor a right to force
one’s message on "unwilling listeners." Confusion results when the conception of "freedom of speech” fails to account for the
difference between “economic free" and "political free" (absence of government restraint on what you can say).
Final note: Even the concept of speech free from governmental restrictions is not absolute. Consider that there are laws against
slander (a form of speech), and the oft-cited quote from Supreme Court Justice Oliver Wendell Holmes, Jr., wherein he stated
that the constitutional protection of free speech “would not protect a man falsely shouting fire in a theater and causing a panic…”
(Schenck v. United States, 249 U.S. 47, 1919)
Meaning of Theory
When someone says "What’s your theory?” about something they don’t understand, the word "theory" in that context often
suggests a conjecture or speculation. However, a theory is NOT a conjecture or speculation. A scientific "theory" refers to a set
of reliable principles, which, when logically used, will guide your analysis, understanding, and interpretation of events.
Economic Analysis Is Positive, Not Normative
Economic science is "positive", not "normative". In this respect, it’s like physics and chemistry and biology – strictly an "If this,
then that" form of analysis. It helps only to understand consequences. It contains NO basis for deciding what is good or bad,
commendable or condemnable. (Read the foregoing sentence again and make sure you understand it!) For example, principles
of chemistry explain what happens if you add some iron filings into some sulfuric acid, or if you toss a match into a pile of paper,
but it does not tell whether you should add the filings or toss the match. Physics does not imply carbon is better than lithium, or
that heavier elements are better than lighter ones, nor does economics tell us governments should be smaller rather than larger,
or that taxes should be lower or higher. However, economics can assist you to predict and interpret the consequences of some
law or event just as chemistry teaches you how to predict the consequence of combining different chemicals. Once you are
aware of the implications, you can then decide whether the prior action is desirable for yourself. Whether some event or
consequence is good or bad is NOT indicated by economic theory.
Testable Implications --Not Expressions of Opinions
You are learning economic principles in order to understand and interpret what actually does happen. If it did not, there would be
little point in learning it. You want to be able to deduce that "If A occurs, then B will happen.” If B does not happen when A
occurs, your theory or method of analysis isn't worth much. The “if-then” statements with which we shall be concerned are called
"refutable" principles, because they can be falsified (“refuted”) by events.
Increased or Reduced Probability and Refutable Implications
We intend to not use the words "may" or "might" in the analyses and implications presented in this text. Why? To say something
"may" or "might" or "could" happen is empty, useless, irrefutable -- and worthless! “Could, may, or might” statements permit
anything – not what will or will not happen. The world's entire population may suddenly change their behavior and act like
angels. You may, might, or could, become the world's greatest violinist. A useful statement indicates what will or will not happen
or indicates (a) a probability of the event, or (b) what raises, or lowers, the probability. For example, economic analysis implies
that price controls increase the probability of shortages and discrimination by gender, ethnicity and religion. The collected
evidence supports that implication. Since nothing in the world is certain, except probably death and taxes, you should always
think – even if not explicitly speaking or communicating – in terms of increased or lowered probabilities. For brevity we'll often
say the implied consequence "will" occur. But please remember, life and virtually everything is probabilistic.
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Reported vs. Verified Even
A research “result” is announced in the news. Later, someone re-examines the data to see how, and how reliably, it was
collected, and what significant features, if any, were omitted. But, by then, if the initial results were misinterpreted, the first wrong
impression is hard to remove. Whether in medicine, physics, nutrition or economics – everywhere – you should be especially
careful in placing heavy reliance on the first reports. For example, a spectacular (and still widely believed) but grossly
misunderstood "finding" of discrimination was that reported by a Federal Reserve Bank of Boston study of banks’ home loans.
Discrimination means making decisions of whether or not to grant loans on the basis of features unrelated to applicant’s credit
worthiness for the amount to be loaned. Independent re-examination of the data used in the study revealed important arithmetic
and sampling errors, and failure to take account of some key elements in the loan-making process. When the defective data and
sampling errors were taken into account, the presence of discrimination was not supported by the data. Other examples of
incorrect interpretations and sampling and statistical procedures in economics are plentiful, and embarrassing. As in other fields
also, whether in medicine, nutrition, biology – everywhere – you have to be especially hesitant to rely on initial reports of first
studies. In all scientific studies, the initial analysis that reports some “fact” is accepted only tentatively until verified by subsequent
independently conducted studies.
Economics vs. Economists
Remember: the difference between what economics, and what economists, say. Rely on the former! An economist (one
capable of applying economic analysis logically) may express personal preferences, recommendations and advice, such as,
"Invest more”, “reduce the size of government”, “reduce tariffs”, or “buy this stock." But normative, prescriptive statements like
these are just as authoritative as if uttered by your boyfriend or girlfriend or your spouse. What the economist can do with
economic analysis is to deduce some of the consequences of a proposed act, presumably more accurately than a noneconomist. But to assess and appraise whether the consequences of the action are good or bad is, to the economist, forbidden
fruit. Yet, like Adam, many economists eat of it.
Which Economic Theory?
The answer is, "The most useful one!" That's the answer, because the principles of economics, which form what is called
"Economic theory", are intended to be reliable, useful guides to understanding economic events. Don't make the intellectual
mistake of asking whether the theory (the set of principles) is "true"! No theory is true. Ask instead, "Is it useful and reliable
enough for my purposes?” That is, “will it lead to correct implications and guidance at sufficiently low cost without intolerable
error?" That's the question to ask in every discipline, whether chemistry, physics, biology, or economics!
Every theory is wrong and incomplete with respect to some things – just as for maps. Maps of the same area differ in accord with
the purpose of the user. No map, and likewise no theory, is a literally correct representation of every detail. Your useful road
map doesn't show all the bumps, traffic signs, overpasses, degrees of traffic congestion to be expected, etc. There is a variety of
maps, each appropriate for a different purpose – some for travel by car, airplane or boat, and some for surveying land, rivers,
and building roads. Nevertheless, though they differ, all of the maps must be consistent with each other in certain fundamental
respects. No valid map of the United States would show the Mississippi river emptying into San Francisco Bay, though useful
maps will differ in the degree of details. The economic theory presented in this text is "incomplete" in the same sense that a map
is incomplete.
One Basic Theory
There is not one economic theory for capitalism and another for socialism and another for some other form of economy. In every
society, the basic principles of human behavior are the same. The situation parallels biology. The same biological principles
hold no matter where animals and people live.
Economics and Biology
The principles and concepts used in economics apply to all forms of life – not just to you and us. Economics is a part of “biology” –
the study of life. “Economics” concentrates on the activities that are dominantly in the “market” for the production and distribution of
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desired goods and services. Other actions, such as the social activities within the family and in social groups, or in governments,
are studied in sociology and political science – although economics increasingly is being used to explain these actions as well.
The Unit of Analysis Is An Individual, Not a Group.
Economics assumes that choices are made by individuals, not by a group like a family or General Motors or a government. We
don’t inquire about why some “firm” or “union” or “government” does something. Always, it is some person who is doing
something. That’s why we’ll always look at the choices individuals make, whether when isolated or in organizations. This does
not mean people make choices with only their own narrow interests in mind. Effects on other people are not excluded from a
person's consideration when making a choice of action. But, as just emphasized, it's still the individual’s chosen action that is the
locus of our attention.
Efficiency: The Word and the Concept.: "a constrained maximum".
The words “efficient” and “efficiency” as used in economics have a precise meaning, whereas in ordinary discussions they are
vague. In Economics, “efficiency” is a condition in which an increase in the production or achievement of the amount of one
desired entity would necessitate a reduction in the amount of some other desired entities. But, if it were possible to increase
production of some good without a reduction in any of the others, that would be called an inefficient, or wasteful, situation.
Automobiles
B
C
A
Production
Possibilities
Boundary
Wheat
Figure 1
Efficiency and the Production Possibility Boundary:
Each point on the Production Possibilities Boundary represents a combination of annual amounts of automobiles produced,
measured on the vertical axis, and annual amounts of wheat, measured on the horizontal axis. Points inside the curve represent
wasteful production, inefficient (wasteful) situations, because more of either autos, or wheat, or both could be produced. All
points on the curve represent efficient combinations of autos and wheat – meaning you can’t then have more of one without less
of the other.
The concept of efficiency is easily explained by Figure 1, which shows just two goods, automobiles and wheat, with automobiles
measured on the vertical scale and wheat on the horizontal scale. Using just two goods makes it simple, but nevertheless, it’s
sufficient and precise. Think of automobiles and wheat as the only possible alternative goods. The boundary line measures
vertically the maximum amount of autos that can be produced, for the alternative possible specified amounts of wheat, on the
horizontal scale are being produced. The negative, downward, slope of the boundary curve represents the fact that more wheat
means fewer automobiles -- from left to right down along the curve. In reverse, moving upward to the left, the curve means that
more autos are being produced, but with less wheat.
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Point A on the boundary curve represents the maximum amount of autos (measured vertically) that is possible for the associated
amount of wheat (measured horizontal from left to right.). That number of autos is efficient --- given an acceptance of the
associated amount of wheat. Point B represents an alternate efficient situation. It represents the maximum of autos for the
associated smaller amount of wheat. Every point on the boundary represents an efficient situation. That is, every point on the
boundary represents the maximum of one of the “goods” for a specified amount of the other. If somehow, for any specified
amount of wheat, fewer autos were produced than were then possible, (represented, for example, by point C), that would be
inefficient -- not a maximum given the constraint of the initial specified amount of wheat. Calling it inefficient is just a way of
saying that more of something (autos) could be produced without producing less of any other goods (here, wheat). Thus, a point
on the boundary line represents the concept of “efficient” – the maximum of autos for the specified amount of wheat. Or reversing
the point of view, the boundary represents the maximum amount of wheat that can be produced for each specified amount of
autos. By definition. all combinations outside the boundary are impossible. “Inefficient” means the combination is some point
inside the boundary line. [Note: The bowed shape of the production possibilities boundary will be discussed later; for now, it is
just being used to help you understand the concept of efficiency.]
This concept of “efficient” is different from the concept of a “maximum” – an unconstrained, unconditional maximum. More
housing could be produced if we didn’t care about anything else. That would be maximum of housing, with nothing else. We’d
all starve to death in nice homes. Similarly, a maximum of clean air would mean no production of anything that “dirtied” the air.
We’d all starve to death while breathing perfectly clean air. The maximum amount of bananas would keep us alive for a while –
but not for long, with no other food, clothing, leisure, etc. The maximum security against death by automobile accidents would
require no use of automobiles. Clearly, we want more than just ONE good. But there’s a trade-off among the goods desired.
The amount that can be produced of one good depends on the amounts of other goods being produced. For each and every
specified amount of all the other goods, the maximum that can be produced of the remaining good is called a constrained
maximum (since it depends on the constraint of producing the specified amounts of all the other goods).
Is Efficiency Desirable?
Though the concept is purely mathematical, the names “efficient and inefficient” suggests that it’s “bad” or “undesirable” to be
inefficient, because some more goods or desirable things could otherwise be obtained without any reduction of the presently
available amount of other goods. But if some of the things or goods are “good” in one person’s opinion and bad in another’s,
disputes will result. If someone else thinks one of the goods is a “bad”, you’ll be told you’re considering the wrong set of
alternatives and therefore the efficiency for your set of possible goods is irrelevant with respect to a different broader or narrower
set of (desirable) goods. Therefore, when using the words efficient or inefficient, beware of potential disputes about whether the
set of alternative “goods” or goals are all regarded as desirable.
Incomplete Span of “Components” for Efficiency!
A new refrigerator is called “energy efficient.” What does that mean? A different refrigerator may use less energy but at the cost
of having to use a more expensive motor and with more expensive insulation. Does that mean energy efficient means the least
possible amount of energy is used – regardless of cost of other materials? Certainly, that is not what is meant! Why reduce
energy usage, if costs of others have to be increased by more than the reduced cost of energy. Then, what does “energy
efficient” mean? We don’t know. A minimized single component goal would be like designing an automobile so as to reduce the
amount of steel to a minimum without regard to the costs of substitute materials. Reducing the amount of one component, while
having to increase the costs of other components even more than is avoided on the reduced component is not “cost efficient.”
The concept cost efficiency is more general and inclusive than the narrow concept of, say, “energy”, or “steel”, efficiency. This
explanation of the meaning of “efficiency” has been purely one of defining the concept of efficiency. Every point on the
production boundary curve is efficient. All points inside the boundary are “inefficient”. But which of all the points on the boundary
– all the efficient points – is most desirable is not answered. Furthermore, the location (higher or lower) of the boundary curve
depends on the reliability of laws and contracts, government policies, taxes, security of property, work ethic, entrepreneurship,
education, access to markets, mobility of resources – a lot more than just the number of people and quantity of physical
resources. Those are major features that economic theory helps us understand. We now start the explanation of Economic
analysis and how to use it to more reliably understand the economy in which you live.